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

The Financial System: The Big Questions What is a financial instrument and what is their role in the economy? What are financial markets and how do they work? What are financial institutions and why are they so important?

The Financial System: Roadmap Financial Instruments Financial Markets Financial Institutions

Preliminaries: Definitions Assets & Liabilities Asset: Something of value that you own Liability: Something you owe. Question: to a bank, what is its assets? Liability?

Financial Instruments: Definition A written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions. Example: student loan Why do we need financial instruments?

Financial Instruments: Uses Means of Payment Purchase goods and services Store of Value Transfer purchasing power into the future Transfer of Risk Transfer risk to from one person to another

Financial Instruments: Characteristics Standardization Overcome the costs of complexity Makes them easier to understand Communicate Information Summarize essential information about issuer Eliminate expense of collecting information

Financial Instruments: Classes Underlying Used to transfer resources Examples: stocks and bonds Derivative Value derived from underlying instruments Examples: Futures and options

Financial Instruments: How to price financial instruments? Size of the payment: Larger  more valuable Timing of payment: Sooner  more valuable 3. Likelihood payment is made More likely  more valuable Conditions under with payment is made When you need it most  more valuable

ICE: Assume you have $1,000 and would like to invest in the stock market. In a good economy (20% likelihood), you can make about 20% of return. In a normal economy (50% likelihood), your return could be 5%. But in a crisis, you are going to lose 5%. You can borrow another $1000 from your friend at 3% of interest rate. What is your return under each economic condition, with and without the loan?

Financial Instruments: Examples Primarily Used as Stores of Value Bank Loans Bonds Home Mortgages Stocks Asset-backed securities

Financial Instruments: Examples Primarily used to Transfer Risk Insurance Contracts Futures Contracts Options

Financial Markets: Definition Places where financial instruments are bought and sold.

Financial Markets: Roles Liquidity: Ensure owners can buy and sell financial instruments cheaply. Information: Pool and communication information about issuers of financial instruments. Risk sharing: Provide individuals a place to buy and sell risk.

Importance of Financial Markets This is important. For example, if you save $1,000, but there are no financial markets, then you can earn no return on this – might as well put the money under your mattress. However, if a carpenter could use that money to buy a new saw (increasing her productivity), then she’d be willing to pay you some interest for the use of the funds.

Importance of Financial Markets Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. Financial markets also improve the well-being of consumers, allowing them to time their purchases better.

Structure of Financial Markets Debt Markets Short-Term (maturity < 1 year) Long-Term (maturity > 10 year) Intermediate term (maturity in-between) Represented $41 trillion at the end of 2007. Derivative market: Financial claims based on underlying instruments are bought and sold for payment at a future date Equity Markets Pay dividends, in theory forever Represents an ownership claim in the firm Total value of all U.S. equity was $18 trillion at the end of 2005.

Structure of Financial Markets Primary Market New security issues sold to initial buyers Typically involves an investment bank who underwrites the offering Secondary Market Securities previously issued are bought and sold Examples include the NYSE and Nasdaq Involves both brokers and dealers (do you know the difference?)

Structure of Financial Markets Even though firms don’t get any money, per se, from the secondary market, it serves two important functions: Provide liquidity, making it easy to buy and sell the securities of the companies Establish a price for the securities

Structure of Financial Markets We can further classify secondary markets as follows: Exchanges Trades conducted in central locations (e.g., New York Stock Exchange) Over-the-Counter Markets Dealers at different locations buy and sell Best example is the market for Treasury securities NYSE home page http://www.nyse.com

Classifications of Financial Markets We can also further classify markets by the maturity of the securities: Money Market: Short-Term (maturity < 1 year) Capital Market : Long-Term (maturity > 1 year) plus equities

Financial Markets: Characteristics Well functioning markets have Low transaction costs Communicate accurate information Protect Investors

Flow of Funds through Financial Institutions

Financial Institutions: Their Role Reduce transactions cost by specializing in the issuance of standardized securities Reduce information costs of screening and monitoring borrowers. Issue short term liabilities and purchase long-term loans.

Asymmetric Information: Adverse Selection and Moral Hazard Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits. Adverse Selection 1. Before transaction occurs 2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Moral Hazard 1. After transaction occurs 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

Types of Financial Intermediaries

Size of Financial Intermediaries

Videos to watch (optional) Wall Street trader's NYSE Trading Floor Tour http://www.youtube.com/watch?v=TPUDPhpCecA http://www.youtube.com/watch?v=EX33ZpRPoUU&feature=related NASDAQ on AWS - Customer Success Story http://www.youtube.com/watch?v=vHSuwbklX4g Introduction to The NASDAQ http://www.youtube.com/watch?v=BXCUe6M8BAs CBOT Trading Soybean market pit trading http://www.youtube.com/watch?v=XZEBz01t5vg MGEX - The final minute of trading in the pits, forever. http://www.youtube.com/watch?v=S43zvtdJcxI&feature=related Ira, Fixed Income Capital Markets, BNP Paribas CIB, New York http://www.youtube.com/watch?v=qk8DxoLYj0w http://www.youtube.com/watch?v=g-QZMW2zbhw&feature=relmfu

HWs: Page P66, questions 4, 5, 10, 12, 13 and 14.