Presentation on theme: "Types of Financial Instruments"— Presentation transcript:
0 An Overview of the Financial System LectureAn Overview of the Financial SystemChapter 2
1 Types of Financial Instruments Securities: pieces of paper that give the owner a claim on the issuer’s assets or future payment.- Simple contracts- Negotiable (can be resold, traded)- Used in both direct and indirect financeLoans:Contracts that are more complicated than securities.Usually non-negotiable. Have collateral requirements and covenants.Used almost exclusively indirect finance.
2 Types of Finance Direct Finance Indirect Finance Borrowers borrow directly from lenders in financial markets by selling financial instruments (securities)which are claims on the borrower’s future income or assetsIndirect FinanceBorrowers borrow indirectly from lenders via financial intermediaries that issue financial instruments which are claims on the borrower’s future income or assets
3 World Without Financial Intermediaries Equity and Debt SecuritiesLender – Saver(Households…)Borrower - spender(Businesses…)CashIn this world - the flow of funds from savers to borrowers is likely to be low:As a lender, how do you know you will get your money back (problem of adverse selection)As a lender, how do you know the borrower will use funds as stated? (problem of moral hazard)Monitoring is a hassle. Prefer to leave the monitoring to others.Lack of liquidity.
4 World With Financial Intermediaries (FI) Lender – Saver(Households….)FI BrokerBorrower – spenderBusinesses….)FI Asset TransformerCashDebt and EquityDeposits and Insurance policiesHere we have both direct and indirect finance.
5 Mishkin’s Representation: Function of Financial Markets
6 Indirect Finance Involves Asset Transformation AssetsLiabilities and Net WorthSomething of value that you ownSomething you owe.Net Worth = Assets - Liabilities
7 Financial Institution - Commercial Bank AssetsLiabilities and Net WorthCash (vault cash)Deposits at Fed (Reserves)MortgagesCommercial LoansUS Gov’t bondsDemand DepositsTime DepositsDebt (Borrowing)Equity Capital(Bank Capital)Asset Transformation – Banks issue liabilities with one set of characteristics and use the proceeds to purchase assets with a different set of characteristics.Also, referred to as maturity Transformation – Bank liabilities are short-term, assets are long-term.
8 Financial Institution - Insurance Company AssetsLiabilities and Net WorthInsurance Policies (contingent liability)Equity CapitalCash- MortgagesCorporate BondsUS Gov’t bondsEquity (Google StockAsset Transformation – Insurance companies issue liabilities and use the proceeds to purchase assets
9 Examples of Direct Finance: Initial Public Offering of a stockFord sells bonds to the publicGE issues commercial paper to public to fund its payrollBowie Bonds
10 Structure of Financial Markets Debt MarketsShort-Term (maturity < 1 year)Long-Term (maturity > 10 year)Intermediate term (maturity in-between)Represented $52.4 trillion at the end of 2009.Equity MarketsPay dividends, in theory foreverRepresents an ownership claim in the firmTotal value of all U.S. equity was $20.5 trillion at the end of 2009.
11 Structure of Financial Markets Primary MarketNew security issues sold to initial buyersTypically involves an investment bank that underwrites the offeringSecondary MarketPreviously issued securities are bought and soldExamples include the NYSE and NasdaqInvolves both brokers and dealers (do you know the difference?)
12 Structure of Financial Markets Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:Provides liquidity, making it easy to buy and sell the securities of the companiesEstablish a price for the securities
13 Structure of Financial Markets We can further classify secondary markets as follows:ExchangesTrades conducted in central locations - Auction (e.g., New York Stock Exchange, CBT)Over-the-Counter MarketsDealers at different locations buy and sellBest example is the market for Treasury Securities
14 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)
15 Principal Money Market Instruments: Short-term debt instruments with maturity < 1 year 15
16 Principal Capital Market Instruments Maturity > 1 year
17 Internationalization of Financial Markets Foreign Bonds: bonds sold in a foreign country and denominated in that country’s currencyEurobond: bond denominated in a currency other than that of the country in which it is soldEurocurrencies: foreign currencies deposited in banks outside the home countryEurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks17
18 Financial Intermediaries - Indirect Finance This is actually the primary means of moving funds from lenders to borrowers.More important source of finance than securities markets (such as stocks)Why? Transaction costs, information costs (asymmetric information), risk sharing and liquidity.
19 Transaction Cost - Direct Finance is Expensive Legal Costs: Loans and securities are legal contracts which must be written carefully to be enforced. Loans are more complicated – covenants and collateral.Regulatory costs: Securities. SEC filing requirements. Must file registration statement, prospectus, periodic financial statements.Sales Costs: Cost of matching buyers and sellers- Primary Markets: Investment bankers market topotential buyers and guarantee a minimum initial pricefor a fee.
20 Financial Intermediaries Reduce Transactions Costs Financial intermediaries make profits by reducing transactions costsReduce transaction costs by developing expertise (screening and monitoring) and taking advantage of economies of scale
21 Financial Intermediaries - Economies of Scale Most transaction costs associated with a financial transaction are fixed costsIndependent of size of transactions and number of transactions.- Legal cost for a $100,000 loan similar to$1,000,000 loan.- Repeated transactions => spread the cost over alarge number of loans (e.g. spread $10,000legal cost over 2,000 loans = $5.00 per loan)
22 Financial Intermediaries - liquidity Banks provide liquidity services - services that make it easier for customers to conduct transactionsBanks provide depositors with checking accounts that enable them to pay their bills easilyDepositors can earn interest on checking and savings accounts and convert them into goods and services whenever necessary
23 Financial Intermediaries – reduce risk reduce the exposure of investors to risk, through risk sharingFIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another partyThis process is referred to as asset transformation, risky assets are turned into safer assets for investors
24 Financial Intermediaries – reduce risk Allow individuals and businesses to diversify their asset holdings.Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.
25 Financial Intermediaries: Indirect Finance Information cost - asymmetric information.One party lacks crucial information about another party, impacting decision-making.adverse selection and moral hazard.
26 Function of Financial Intermediaries: Indirect Finance Adverse SelectionBefore transaction occursPotential borrowers most likely to produce adverse outcome are ones most likely to seek a loanSimilar problems occur with insurance where unhealthy people want their known medical problems covered
27 Asymmetric Information: Adverse Selection and Moral Hazard After transaction occursHazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan backAgain, with insurance, people may engage in risky activities only after being insured
29 Types of Financial Intermediaries Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts.Commercial banks (around 7,000)Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loansCollectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios
30 Types of Financial Intermediaries Thrifts: S&Ls & Mutual Savings Banks (1,300) and Credit Unions (9,500)Raise funds primarily by issuing savings, time, and checkable deposits which are most often used to make mortgage and consumer loans, with commercial loans also becoming more prevalent at S&Ls and Mutual Savings BanksMutual savings banks and credit unions issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a company’s workers
31 Contractual Savings Institutions (CSIs) CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysisFire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predictPension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities
32 Types of Financial Intermediaries Investment Intermediaries Finance Companies sell commercial paper (a short-term debt instrument), and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operationsMutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds
33 Types of Financial Intermediaries Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instrumentsInvestment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets.
36 Regulation of Financial Markets Main Reasons for RegulationIncrease Information to InvestorsEnsure the Soundness of Financial Intermediaries
37 Regulation of the Financial Markets Ensure the soundness of financial intermediaries:Restrictions on entry (chartering process).Disclosure of information (SEC)Restrictions on Assets and Activities (control holding of risky assets).Deposit Insurance (avoid bank runs).In the past, regulation placed limits on competitionRestrictions on bank branchesRestrictions on Interest Rates
38 Classifying Financial Instruments 1. Type of claim -Equity (Common Stock): Gives owner a share ofthe firm’s assets and profits. Also have votingrights.Debt (loans, bonds, commercial paper): Entitlesowner to specific payments on specific dates.If firm fails, get paid before equity holders.Equity holders have a residual claim.2. Maturity: Length of the claim. Money Market orCapital Market. Equity does not mature.
39 Classifying Financial Instruments 3. Risk: degree of uncertainty as to payment.Equity generally has the highest risk. Next is variousgrades of debt, then unsecured debt such as consumerloans. Safest: treasury bills and insured bank deposits4. Liquidity: How quickly converted into mediumof exchange (money). Demand deposits, followed bysavings deposits, treasury securities.
40 Classifying Financial Instruments Expected Returns.As shown on the next slide, returns are typically higher for riskier, less liquid and longer-maturity assets.Highest risk: Equities, followed by various grades of debt.Lowest risk: Treasury bills, demand deposits.
41 Risk and Return by Asset Class - Ibbotson Associates 200920099.811.8200911.916.6
42 The Ibbotson Chart Returns are at 5 % increments. Most risk - Equity ( small cap). Low, spread-out “skylines”.Least Risk - Treasury bills. Narrow skyline.