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