1. Lecture 4: Financial instruments and regulation
Mishkin chapter 2 – part C
Page 28-32, 42-47

2. Role in the financial system
Indirect finance
Financial Intermediaries
(e.g. bank)
Lender
Borrower
Money
Money
Financial instrument A
(e.g. saving account)
Financial instrument B
(e.g. student loans)
Regulation
Financial instruments (e.g. bond, stock)
Financial markets
Money
Direct finance

3. Financial instruments
A financial instrument (also called security) is a claim on the issuer’s future income or assets.
Financial assets vs. real assets
Classification:
Money market instruments and capital market instruments
Bonds (debt instruments) and stocks (equity)

4. Financial Instrument A: Financial Instrument B:
Bank
Borrower
Lender
Money
Financial Instrument A:
e.g. Mortgage loan
Financial Instrument B:
e.g. Deposit
Financial instrument A is ‘issued’ by the borrower and is essentially a claim on borrower’s future income or asset. Financial instrument B is ‘issued’ by the Bank and is essentially a claim on Bank’s future income or asset. After financial instrument A is issued and sold to the Bank, it becomes a financial asset of the Bank. After financial instrument B is issued and sold to the lender, it becomes a financial asset of the lender, the liability of the Bank.
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5. Financial asset vs. real asset
Real assets: houses, equipments, human resources, etc.
Financial assets: claims against real assets.
Generally, borrowers obtain funds from lenders by selling newly issued claims ("IOU's") against their (borrower’s) real assets.
IOUs are essentially financial assets.
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6. Money market instruments
Money market instrument is shorter-term security generally with one year or less remaining to maturity.
Treasury bill, commercial paper, CDs, etc.
Many are held by institutions like banks, insurance companies and mutual funds, less often by individuals.

8. Capital market instruments
More than one year to maturity.
Stock, residential mortgages, long-term bonds, consumer loans, etc.

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10. Bonds
A bond is a debt security/instrument that promises to make payments periodically for a specified period of time.
Bond price is closely (negatively) related to interest rate.
Default risk: the possibility that the issuer (borrower) fail to pay back.

11. Stocks
A share of stock is a claim on the net income and assets of the corporation.
Holders of common stocks:
earn from price appreciation and dividends.
have ownership interest in the company proportional to shares owned:
‘residual claimant’
have voting rights, or ‘vote with feet’.
Stock prices are volatile.

12. Regulation in the financial system
More regulation than in other industries.
Why need regulation?
information (efficiency concern)
bankruptcy (stability concern)
control of monetary policy (optimality concern)

13. How would regulations help?
Increase the information available to investors:
SEC forces listed corporations to disclose information
reduce insider trading
Ensure the soundness of financial intermediaries, fight against bankruptcy, prevent financial panics:
Restrictions on entry (chartering), reporting requirements, restrictions on assets and activities, deposit insurance, limits on competition, etc.

14. Recap Financial instrument
Money market instrument vs. capital market instrument
Bonds vs. stocks
Why is regulation in financial system so important? How would regulation help?