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

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Presentation on theme: "Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial."— Presentation transcript:

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

2 People who need funds  borrowers/issuer/seller People who have funds to give  lenders/savers/buyers 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 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 Direct finance  Borrowers sell securities directly to lenders  e.g. corporate and Treasury bonds

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6 I. Financial Instruments aka. securities, financial assets definition (p. 36 (1 st ) or 41 (2 nd )) = 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 aka. securities, financial assets definition (p. 36 (1 st ) or 41 (2 nd )) = 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 exampleexample 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 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 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 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 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 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 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… 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” 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 debt security  cash flows are fixed  bonds, loans equity security  cash flow variable, residual  common stock

16 Exchanges vs. OTC Markets exchange  buying & selling of securities in physical location  NYSE OTC (over-the-counter)  dealers in many locations buy & sell securities exchange  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 money market  short-term debt securities (up to 1 yr.)  highly liquid, low risk capital market  longer-term debt  equity

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20 III. Financial Institutions aka. financial intermediaries Why have them? Transactions costs  search costs to find borrower & lender  contract costs  economies of scale 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 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 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 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) 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 Hit several types of financial institutions:  finance companies Countrywide  securities firms Citigroup, Merrill Lynch  GSEs Fannie Mae, Freddie Mac


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