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

CONTENS 3.1 Introduction: Indirect and Direct Finance 3.2 Financial Instruments 3.3 Financial Markets 3.4 Financial Institutions

3.1 Introduction: Indirect and Direct Finance Indirect Finance An Institution stands between lender and borrower. Direct Finance Borrowers and lenders deal directly with each other.

Financial and Economic Development

Financial Instruments 1. Definition A financial instrument is the written legal obligation of one party to transfer something of value – usually money – to another party at some future date, under certain conditions, such as stocks, loans, or insurance。

3.2 Financial Instruments 2. Functions: Serve as a: Means of payment (Like Money) Store of Value (Like Money) allow for the trading of risk

Financial Instruments 3. Characteristics Standardization Communicate Information 4. Classes of Financial Instruments Primary – underlying Instruments Derivative Instruments Value derived from the behavior of Underlying instruments.

Financial Instruments 5.Value of Financial Instruments (1). Size the promised payment. (2). When the payment will be received. (3). The likelihood the payment will be made (risk). (4). The conditions under which the payment will be made.

Financial Instruments 6. Examples of Financial Instruments Primarily Stores of Value Bank Loans Bonds Home Mortgages Stocks Asset-backed securities

Financial Instruments Examples : Primarily to transfer risk Insurance Futures Contracts Options

3.3 Financial Markets Financial Markets are the places where financial instruments are bought and sold.

2. Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency

Financial Markets Role of Financial Markets. Offer liquidity to borrowers and savers. Pool and communicate Information. Allow risk sharing

Financial Markets 3. Structure of Financial Markets Primary vs. Secondary Markets Centralized Exchanges vs. Over-the- counter Markets. Debt and Equity vs. Derivative Markets

Financial Markets 4. Characteristics of a well-run financial market Low transaction costs. Information communicated must be accurate. Investors must be protected.

Market Size and Investor Protection

Financial Markets (1) Stock Index 5. Stock Market (1) Stock Index Measuring the Level of the Stock Market The Dow Jones Industrial Average The Standard & Poor's 500 Index Nasdaq Composite index Wilshire 5000 www.bloomberg.com

Financial Markets Fundamental Value and the Dividend-Discount Model (2) Valuing Stocks Fundamental Value and the Dividend-Discount Model

Valuing Stocks

Financial Markets assume that the firm pays dividends forever, then

Financial Markets (3) Why Stocks Are Risky Stocks are risky because the shareholders are residual claimants. Since they are paid last, they never know for sure how much their return will be.

Financial Markets Risk and the Value of Stocks Return to Holding Stock for One Year = .

Financial Markets Since the ultimate future sale price is unknown the stock is risky the investor will require compensation in the form of a risk premium Required Stock Return (i) = Risk-free Return (rf) + Risk Premium (rp)

Financial Markets

Financial Markets Implications of the Dividend-Discount Model with Risk: Stock Prices are High When Current dividends are high (Dtoday is high) Dividends are expected to grow quickly (g is high) The risk-free rate is low (rf is low) The risk premium on equity is low (rp is low)

Financial Markets (4)The Theory of Efficient Markets The basis for the theory of efficient markets is the notion that the prices of all financial instruments, including stocks, reflect all available information When markets are efficient, the prices at which stocks currently trade reflect all available information, so that future price movements are unpredictable.

Investing in Stocks For the Long Run

Investing in Stocks For the Long Run

Financial Markets Professor Jeremy Siegel of the University of Pennsylvania’s Wharton School wrote a book titled Stocks for the Long Run investing in stocks is risky only if you hold them for a short time. But if you buy them and hold them for long enough, they really are not very risky.

(6)The Stock Market’s Role in the Economy Financial Markets (6)The Stock Market’s Role in the Economy The stock market plays a crucial role in every modern capitalist economy. The prices determined there tell us the market value of companies, which determines the allocation of resources.

Financial Markets Firms with a high stock market value are the ones investors prize, so they have an easier time garnering the resources they need to grow. In contrast, firms whose stock value is low have difficulty financing their operations

Financial Markets bubbles persistent and expanding gaps between actual stock prices and those warranted by the fundamentals. These bubbles inevitably burst, creating crashes.

§3.4 Financial Institutions 1.Role of Financial Institutions 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.

Financial Institutions

Financial Institutions

Financial Institutions 2. The structure of the financial industry Depository Institutions Insurance Companies Pension Funds Security Firms Finance Companies Government Sponsored Enterprises

Chapter 3 End of Chapter