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

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

3. 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.

4. Financial and Economic Development

5. 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。

6. 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

7. 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.

8. 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.

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

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

11. 3.3 Financial Markets
Financial Markets are the places where financial instruments are bought and sold.

12. 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

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

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

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

16. Market Size and Investor Protection

17. 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

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

20. Valuing Stocks

21. Financial Markets
assume that the firm pays dividends forever, then

22. 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.

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

24. 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)

25. Financial Markets

26. 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)

27. 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.

28. Investing in Stocks For the Long Run

29. Investing in Stocks For the Long Run

30. 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.

31. (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.

32. 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

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

34. §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.

35. Financial Institutions

36. Financial Institutions

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

38. Chapter 3
End of Chapter