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Chapter 3: Financial Instruments, Markets and Institutions

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1 Chapter 3: Financial Instruments, Markets and Institutions
Financial Markets Financial Institutions

2 People who need funds borrowers/issuer/seller People who have funds to give lenders/savers/buyers

3 Indirect vs. Direct Finance
Indirect finance Borrowers and lenders meet through a financial intermediary (e.g. bank) Loan is a liability for borrower, and asset for a bank

4 Direct finance Borrowers sell securities directly to lenders e.g. corporate and Treasury bonds


6 I. Financial Instruments
aka. securities, financial assets definition (p. 36 (1st) or 41 (2nd)) = written legal obligation of one party to transfer something of value, usually money, to antoher party at some future date, under certain conditions a security is an asset for the buyer/lender, but a liability for the issuer/borrower/seller

7 example shares of stock in Time Warner, Inc. shares of ownership in TW
a claim on the earnings/assets of TW a liability for Time Warner an asset for me

8 my mortgage I am the borrower (liability) the bank is the buyer/holder (asset) the bank has a claim on my house

9 uses of financial instruments
means of payment but much less liquid than money store of value better than money over time, but also greater risk transfer of risk buyer transfers risk to seller e.g. insurance policies, futures contract

10 Valuing financial instruments
sizing, timing & certainty of promised cash flows Size: how much is promised? the larger the cash flows, the greater the value Timing: when is it promised? the sooner the cash flows are received, the greater the value

11 Certainty: how likely its it that payments will be made?
the likelier the payments the greater the value Under what conditions? e.g. insurance, derivatives payments when we need them the most are more valuable

12 examples (p. 43/44 or 46/47) bank loans stocks bonds home mortgages
asset-backed securities option and futures contracts insurance policies

13 II. Financial Markets where financial instruments are bought and sold
these markets provide liquidity for buying/selling information through prices risk-sharing among buyers/sellers classified in various ways…

14 Primary vs. Secondary Markets
primary market newly issued securities -- investment banking secondary market brokers match buyers and sellers dealers act as buyers and sellers -- “market-makers”

15 Debt vs. Equity Markets debt security cash flows are fixed
bonds, loans equity security cash flow variable, residual common stock

16 Exchanges vs. OTC Markets
buying & selling of securities in physical location NYSE OTC (over-the-counter) dealers in many locations buy & sell securities

17 Money vs. Capital Markets
money market short-term debt securities (up to 1 yr.) highly liquid, low risk capital market longer-term debt equity



20 III. Financial Institutions
aka. financial intermediaries Why have them? Transactions costs search costs to find borrower & lender contract costs economies of scale

21 Risk sharing intermediaries are experts at bearing risk Asset transformation short-term to long-term illiquid to liquid

22 Types of intermediaries
Depository institutions “banks” accept deposits, make loans

23 Commercial banks largest in total assets least restricted Savings & Loans originally restricted to savings deposits and mortgages less restricted today Credit Unions consumer loans nonprofit, organized around a group

24 Nondepository institutions insurance companies pension funds
finance companies Mortgage, auto, office equipment Securities firms gov’t-sponsored enterprises (GSEs)

25 Subprime mortgage meltdown
Hit several types of financial institutions: finance companies Countrywide securities firms Citigroup, Merrill Lynch GSEs Fannie Mae, Freddie Mac

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