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

2. The Financial System: The Big Questions
What is a financial instrument and what is their role in the economy?
What are financial markets and how do they work?
What are financial institutions and why are they so important?

3. The Financial System: Roadmap
Financial Instruments
Financial Markets
Financial Institutions

4. Preliminaries: Definitions
Assets & Liabilities
Asset: Something of value that you own
Liability: Something you owe.
Question: to a bank, what is its assets? Liability?

5. Financial Instruments: Definition
A written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions. Example: student loan Why do we need financial instruments?

6. Financial Instruments: Uses
Means of Payment Purchase goods and services
Store of Value Transfer purchasing power into the future
Transfer of Risk Transfer risk to from one person to another

7. Financial Instruments: Characteristics
Standardization Overcome the costs of complexity
Makes them easier to understand
Communicate Information Summarize essential information about issuer Eliminate expense of collecting information

8. Financial Instruments: Classes
Underlying Used to transfer resources Examples: stocks and bonds
Derivative Value derived from underlying instruments Examples: Futures and options

9. Financial Instruments: How to price financial instruments?
Size of the payment: Larger  more valuable
Timing of payment: Sooner  more valuable
3. Likelihood payment is made More likely  more valuable
Conditions under with payment is made When you need it most  more valuable

10. ICE:
Assume you have $1,000 and would like to invest in the stock market. In a good economy (20% likelihood), you can make about 20% of return. In a normal economy (50% likelihood), your return could be 5%. But in a crisis, you are going to lose 5%. You can borrow another $1000 from your friend at 3% of interest rate. What is your return under each economic condition, with and without the loan?

11. Financial Instruments: Examples
Primarily Used as Stores of Value
Bank Loans
Bonds
Home Mortgages
Stocks
Asset-backed securities

12. Financial Instruments: Examples
Primarily used to Transfer Risk
Insurance Contracts
Futures Contracts
Options

13. Financial Markets: Definition
Places where financial instruments are bought and sold.

14. Financial Markets: Roles
Liquidity: Ensure owners can buy and sell financial instruments cheaply.
Information: Pool and communication information about issuers of financial instruments.
Risk sharing: Provide individuals a place to buy and sell risk.

15. Importance of Financial Markets
This is important. For example, if you save $1,000, but there are no financial markets, then you can earn no return on this – might as well put the money under your mattress.
However, if a carpenter could use that money to buy a new saw (increasing her productivity), then she’d be willing to pay you some interest for the use of the funds.

16. Importance of Financial Markets
Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them.
Financial markets also improve the well-being of consumers, allowing them to time their purchases better.

17. Structure of Financial Markets
Debt Markets
Short-Term (maturity < 1 year)
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Represented $41 trillion at the end of 2007.
Derivative market: Financial claims based on underlying instruments are bought and sold for payment at a future date
Equity Markets
Pay dividends, in theory forever
Represents an ownership claim in the firm
Total value of all U.S. equity was $18 trillion at the end of 2005.

18. Structure of Financial Markets
Primary Market
New security issues sold to initial buyers
Typically involves an investment bank who underwrites the offering
Secondary Market
Securities previously issued are bought and sold
Examples include the NYSE and Nasdaq
Involves both brokers and dealers (do you know the difference?)

19. Structure of Financial Markets
Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:
Provide liquidity, making it easy to buy and sell the securities of the companies
Establish a price for the securities

20. Structure of Financial Markets
We can further classify secondary markets as follows:
Exchanges
Trades conducted in central locations (e.g., New York Stock Exchange)
Over-the-Counter Markets
Dealers at different locations buy and sell
Best example is the market for Treasury securities
NYSE home page

21. 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) plus equities

22. Financial Markets: Characteristics
Well functioning markets have
Low transaction costs
Communicate accurate information
Protect Investors

23. Flow of Funds through Financial Institutions

24. Financial Institutions: Their Role
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.

25. Asymmetric Information: Adverse Selection and Moral Hazard
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits.
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

26. Types of Financial Intermediaries

27. Size of Financial Intermediaries

28. Videos to watch (optional)
Wall Street trader's NYSE Trading Floor Tour
NASDAQ on AWS - Customer Success Story
Introduction to The NASDAQ
CBOT Trading Soybean market pit trading
MGEX - The final minute of trading in the pits, forever.
Ira, Fixed Income Capital Markets, BNP Paribas CIB, New York

29. HWs: Page P66, questions 4, 5, 10, 12, 13 and 14.