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

People who need funds borrowers/issuer/seller People who have funds to give lenders/savers/buyers

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

Direct finance Borrowers sell securities directly to lenders e.g. corporate and Treasury bonds

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

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

my mortgage I am the borrower (liability) the bank is the buyer/holder (asset) the bank has a claim on my house

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

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

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

examples (p. 43/44 or 46/47) bank loans stocks bonds home mortgages asset-backed securities option and futures contracts insurance policies

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…

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”

Debt vs. Equity Markets debt security cash flows are fixed bonds, loans equity security cash flow variable, residual common stock

Exchanges vs. OTC Markets buying & selling of securities in physical location NYSE OTC (over-the-counter) dealers in many locations buy & sell securities

Money vs. Capital Markets money market short-term debt securities (up to 1 yr.) highly liquid, low risk capital market longer-term debt equity

III. Financial Institutions aka. financial intermediaries Why have them? Transactions costs search costs to find borrower & lender contract costs economies of scale

Risk sharing intermediaries are experts at bearing risk Asset transformation short-term to long-term illiquid to liquid

Types of intermediaries Depository institutions “banks” accept deposits, make loans

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

Nondepository institutions insurance companies pension funds finance companies Mortgage, auto, office equipment Securities firms gov’t-sponsored enterprises (GSEs)

Subprime mortgage meltdown Hit several types of financial institutions: finance companies Countrywide securities firms Citigroup, Merrill Lynch GSEs Fannie Mae, Freddie Mac