Financial Instruments, Financial Markets, and Financial Institutions Chapter Three Chapter 3 The Financial System Financial Instruments, Financial Markets, and Financial Institutions

Introduction We look at three components of the financial system in this chapter: Financial instruments (or securities) Stocks, bonds, loans and insurance (these are contracts). What is their role in our economy? Financial Markets New York Stock Exchange, Nasdaq, etc. Where investors trade financial instruments. Financial institutions Why they exist and what they do.

Introduction Direct Finance: Borrowers sell securities directly to lenders (savers) in the financial markets. Direct finance provides financing for governments and corporations. Indirect Finance: An intermediary (financial institution) stands between lender and borrower. We get a loan from a bank or finance company to buy a car.

World Without Financial Intermediaries(FI) Lender – Saver (Households…) Equity and Debt Securities Borrower - spender (Businesses…) Cash In this world (all direct finance) – 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) Borrowers must be screened and monitored and this is a hassle. Prefer to leave the screening and monitoring to others. There is also a lack of liquidity – why?

World With Financial Intermediaries (FI) Financial Intermediary Lender – Saver (Households….) FI - Broker Borrower – spender Businesses….) FI - Asset Transformer Cash Debt and Equity Deposits and Insurance policies Here we have both direct and indirect finance.

Something of value that you own Something you owe. Basic Balance Sheet Assets Liabilities and Net Worth Something of value that you own Something you owe. Net Worth = Assets - Liabilities

Financial Intermediary - Commercial Bank Assets (Uses of Funds) Liabilities and Net Worth (Sources of Funds) - Cash (vault cash) Deposits at Fed (Reserves) Mortgages Commercial Loans US Gov’t bonds Demand Deposits Time Deposits Debt (Borrow) 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 and their assets are long-term.

Financial Intermediary - Investment Bank Assets (Uses of Funds) Liabilities and Net Worth (Sources of Funds) Stocks MBS US Gov’t bonds Corporate bonds Bunch of other stuff - Issue Debt (Borrow) - Equity Capital

Financial Intermediary - Insurance Company Assets Liabilities and Net Worth Insurance Policies (Promise, contingent liability) Equity Capital - Cash - Mortgages - Corporate Bonds - US Gov’t bonds - Equity (Stocks) Asset Transformation – Insurance companies issue liabilities with one set of characteristics and use the proceeds to purchase assets with a different set of characteristics

Examples of Direct Finance: Initial Public Offering of a stock Ford Motor sells bonds to the public GE issues commercial paper to public to fund its payroll Key point – the lender has a direct claim on the borrower

Financial Instrument Financial Instrument: Legal obligation of one party to transfer something of value (usually money) to another party at some specified date, under specified conditions. Trade value for a promise. obligate one party (person, company, or government) to transfer something to another party. specify payment will be made at some future date. specify conditions under which a payment will be made. The enforceability of the obligation is important.

We can organize financial instruments by how they are used: Instruments used as stores of value: Bank loans Borrower obtains funds from a lender to be repaid in the future. Bonds A form of a loan issued by a corporation or government. Can be bought and sold in financial markets.

Instruments used as stores of value: Home mortgages Home buyers usually need to borrow using the home as collateral for the loan. A specific asset the borrower pledges to protect the lender’s interests. Stocks The holder owns a small piece of the firm and entitled to part of its profits. Firms sell stocks to raise money. Primarily used as a stores of wealth.

Instruments used as stores of value: Asset-backed securities Buyers share in the payments arising from specific assets, such as home mortgages, car loans, student loans. A Mortgage Backed Security(MBS) is an asset-back security that bundles a large number of mortgages together into a pool in which shares are sold.

Instruments used to transfer risk: Insurance contracts. Primary purpose is to assure that payments will be made under particular circumstances. Futures contracts. An agreement between two parties to exchange a fixed quantity of a commodity or an asset at a fixed price on a set future date. A price is always specified.

Instruments used to transfer risk: Options Derivative instruments whose prices are based on the value of an underlying asset. Give the holder the right, not obligation, to buy or sell a fixed quantity of the asset at a pre-determined price on either a specific date or at any time during a specified period. Swaps Agreements to exchange two specific cash flows at certain times in the future.

Characteristics of Financial Instruments Can be simple contracts or very complex. Complexity is costly. Individuals do not want to bear these costs – let someone else do it. Bank loans can be very complex Standardization of financial instruments overcomes potential costs of complexity. US Gov’t bond is an example of a simple contact. Most mortgages feature a standard application with standardized terms. Financial instruments are designed to handle the problem of asymmetric information. Borrowers have some information they don’t disclose to lenders.

Derivatives - Skip Details for Now

Primer on Valuing Financial Instruments Four fundamental characteristics influence the value of a financial instrument: (Skip for now) Size of the payment (size): Larger the payment - more valuable. Timing of payment (maturity): Sooner the payment - more valuable. Likelihood payment is made (risk): More likely the payment will be made - more valuable. Conditions under which payment is made (liquidity): Made when we need them - more valuable.

Financial Markets Financial markets are places where financial instruments are bought and sold. Provide market liquidity: Ensure owners can buy and sell financial instruments cheaply. Keeps transactions costs low. Provide information: Pool and communication information about issuers of financial instruments. Provide risk sharing: Provide a place to buy and sell risk.

The Structure of Financial Markets Primary or secondary markets - distinguish between markets where new financial instruments are sold and markets where previously issued instruments are resold or traded. Centralized or not - Categorize by the way financial instruments are traded. Type of instrument

Primary versus Secondary Markets A primary market is one in which a borrower obtains funds from a lender by selling newly issued securities. Occurs out of the public’s view. An investment bank determines the price, purchases the securities, and resells to clients. This process is called underwriting and is usually very profitable.

Primary versus Secondary Markets Secondary markets are where people can buy and sell existing (previously issued) securities. Buy a share of Netflix stock not from the company, but from another investor in a secondary market. These are the prices we hear about in the news.

Centralized Exchanges, OTCs, and ECNs Historically there were: Centralized exchanges - buyers and sellers meet in a central, physical location. Over-the-counter markets (OTS’s) - decentralized markets where dealers stand ready to buy and sell securities electronically. More recently, there are electronic communication networks (ECN’s): Electronic system bringing buyers and sellers together without the use of a broker or dealer.

Debt and Equity versus Derivative Markets Debt markets are markets for loans, mortgages, and bonds. Equity markets are the markets for stocks. Derivative markets are the markets where investors trade instruments like futures, options, and swaps.

Markets and Maturity Debt instruments categorized by the loan’s maturity Repaid in less than a year called a money market instrument traded in money markets. Maturity of more than a year called a capital market instrument traded in capital market. Equity does not mature. It is a capital market instrument.

Principal Money Market Instruments: Short-term debt instruments with maturity < 1 year http://research.stlouisfed.org/fred2/graph/?id=COMPOUT 27

Principal Capital Market Instruments Maturity > 1 year

Characteristics of a Well-Run Financial Market Keep transaction costs low. Information communicated must be accurate and widely available. Borrower promises to pay lenders must be credible. Lenders must be able to enforce their right of repayment quickly and at low cost.

Characteristics of a Well-Run Financial Market Because of these criteria, the government is an essential part of financial markets - they enforce the rules of the game. countries with better investor protections have bigger and deeper financial markets.

Financial Institutions Firms that provide access to the financial markets to both savers who wish to purchase financial instruments directly and borrowers who want to issue them. Called financial intermediaries. Examples: banks, insurance companies, securities firms, and pension funds.

The Role of Financial Institutions reduce transaction costs by specializing in the issuance of standardized securities. reduce the information costs of screening and monitoring borrowers. Provide liquidity - savers have ready access to their funds – checking account deposit.

The Structure of the Financial Industry Two broad categories of financial intermediaries: Depository institutions, Take deposits and make loans Commercial banks, S&Ls and credit unions. Non-depository institutions. Insurance companies, securities firms, mutual fund companies, finance companies, and pension funds.

The Structure of the Financial Industry Depository institutions take deposits and make loans. Insurance companies accept premiums, which they invest, in return for promising compensation to policy holders under certain events (contingent liability). Pension funds invest individual and company contributions in stocks, bonds, and real estate in order to provide payments to retired workers.

The Structure of the Financial Industry Securities firms include brokers, investment banks, underwriters, mutual fund companies private equity firms, and venture capital firms. Brokers and investment banks issue stocks and bonds for corporate customers, trade them, and advise customers. Mutual-fund companies pool the resources of individuals and companies and invest them in portfolios - passive investing. Hedge funds do the same for small groups of wealthy investors.

The Structure of the Financial Industry Cont. Private equity and venture capital firms also serve wealthy investors by acquiring controlling stakes in a few firms and manage them actively. Finance companies raise funds directly in the financial markets in order to make loans to individuals and firms. Finance companies tend to specialize in particular types of loans, such as consumer, automobile, or business equipment.

Money Market Mutual Funds Finance Companies Commercial Banks Insurance Companies Loans deposits Bonds Stocks Insurance Policies Pension Funds Mutual Funds Retirement Plans Bonds Stocks Stocks Shares Money Market Mutual Funds Finance Companies Auto Loans Consumer Loans Commercial paper ABCP Bank Loans Commercial paper T-Bills Shares/ “deposits”