Financial Instruments, Financial

Markets, and Financial

Institutions

 Well-functioning financial markets are an essential

part of any modern healthy economy
funds are offered by the lenders/savers who have
excess funds and purchased by the
borrowers/spenders who need those funds
direct finance- when borrowers and lenders
meet directly
Indirect finance- when borrowers and lenders
meet through financial intermediary

 Through these markets the funds flow that allow

for the development of new products/ideas, the
expansion of the production of existing products,
and consumer spending on "big ticket" items
like houses, cars, and college tuition
Without these markets, firms may be unable to
expand production or invent new products and
consumers will be unable to afford certain
products.

Financial Instruments
transfer of available funds
buying and selling offinancial instruments or
securities
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.

Financial Instruments
1) binding, enforceable contract under the rule of
law, protecting potential buyers.
2) transfer of value between two parties, where a
party can be a bank, insurance company, a
government, a firm, or an individual.
The future dates may be very specific (like a monthly
mortgage payment) or may be quite uncertain and
depend on certain events (like an insurance policy)

Financial instruments
can function as a means of payment or a store of value
means of payment
fall well short of money in terms of liquidity, divisibility,
and acceptance
better stores of value since they allow for greater
increases in wealth over time, but with higher levels of
risk

Financial instruments
3) function of these instruments is risk
transfer
buyers are shifting risk to the seller
paying the seller to assume certain risks
Ex. insurance

Financial instruments
standardized in that they have the same
obligations and contract for buyers
Ex. Stocks, loans
Uniformity reduce cost

Financial instruments
provide certain relevant information about
the issuer, the characteristics and the risks
of the security
even the playing field among different
parties and reduce unfair advantages

Financial instruments
size, timing and certainty of cash flows are all important
The larger amount promised, the greater the value
The sooner the payments are promised, the greater
the value
The more certain the payments, the greater the value
The more needed the payment, the greater the value
Ex. insurance

Instrument type
Asset class

Securities

Other cash

Exchangetraded
derivatives

OTC derivatives

Bondfutures
Optionson
bondfutures

Interest rate
swaps
Interest rate
caps and floors
Interest rate
options
Exotic
derivatives
Forward rate
agreements

Debt (long
term)
>1 year

Bonds

Debt (short
term)
1 year

Bills, e.g.T-bills Deposits

Commercial
Certificates of
paper
deposit

Short
terminterest
rate futures

Stock

Stockoptions
Equityfutures

Equity

Loans

N/A

http://en.wikipedia.org/wiki/Financial_instrument

Stockoptions
Exotic
derivatives
Foreign
exchangeoptio

Financial Markets
many markets, each dealing with a
particular type of financial instrument
providing a mechanism for quickly and
cheap buying and selling of securities
financial markets offerliquidity

Financial Markets
interaction of buyers and sellers to
determine the price
priceconveys important informationabout
the prospects of the issuer
mechanism for buying and selling the
instruments thattransfer risksbetween
buyers and sellers.

Primary vs. Secondary Markets

primary marketare brand new, or new
issues
sold to the buyer by the issuer
Secondary- resold by the previous buyers

 primary market,investment banksassist a

business in selling a new issue to the public
Investment banksunderwritenew securities,
meaning that they buy the new issue from the
business and sell it to the public
banks charge fees for this service

 the secondary market

Securitiesbrokersfacilitate trade by
match buyers with sellers
commission on each match (or trade).

 Securities dealers act as the buyer and seller

quoting a price at which they will buy a
security (thebid price) and the price at which
they will sell the security (theask price).
difference is known as thebid-ask spread
how dealers make their money

 dealers are often referred to as "marketmakers

"make a market" in that security
own an inventory of the securities

 the better the secondary market, the better the

primary market.
liquidity
If, for example, Microsoft stock is easy to buy
and sell in the secondary market (highly liquid)
then it will be popular in the primary market.

Exchanges vs. OTC Markets

buying and selling occurs in a central,
physical location, then securities are traded
on anexchange.
Ex. PSE

 dispersed buyers and sellers, linked by

computer. This is known as anover-thecounter(OTC) market
Today OTC markets link buyers and sellers
electronically through dealers
Ex. PDEX, NASDAQ

 ECNs or electronic communication

networks offer yet a third option for buyers
and seller to find each other directly with
no dealer or broker

Debt vs. Equity vs. Derivative Markets

debt instruments, like a bond or a bank

loan, involve a promise by the borrower to
pay the lender.
fixed payments at specified intervals until a
final date
The time until all payments are made is
known as thematurity

 Short-termdebt securities have a maturity of

up to 1 year. This part of the debt market is also
known as themoney market.
Intermediate-termdebt securities have a
maturity of between 1 and 10 years.
Long-termdebt securities have a maturity of 10
years or more.

 Equity instruments
shares of common stock
claims on the earnings and assets of a
corporation
Entitled to the percentage that you are
holding

 the size and timing of the payments are not fixed.

Some equities securities entitle the owner to periodic
payments (known asdividends) but these payments
are not guaranteed. This means that equity holders
benefit from a firm's profitability in a way that debt
holders do not.
there is no maturity date for equity securities so they
are considered long-term securities
stock holders are consideredresidual claimantsin
the event of bankruptcy.

 Derivatives markets
value from other underlying assets

 Financial Institutions
Depository Institutions
Non-depository Institutions

 Depository Institutions
Commercial banks- include commercial loans,
consumer loans, mortgages, U.S. government
bonds, municipal bonds.
Savings and Loan Associations- originally
restricted to offering savings accounts and CDs and
making mortgage loans(Mutual Savings banks)
Credit Unions- are nonprofit and credit union
membership is organized around a particular group,
such as company employees, a union, or even a
church parish

 Non-depository Institutions
Life insurance companies- buyer of corporate
bonds and mortgages (long term)
Fire and casualty insurance-less predictable
than life insurance. assets are more liquid than life
insurance companies, municipal bonds, corporate
bonds, stocks, and U.S. government bonds

 Pension funds- private or government (SSS,

GSIS), assets are more long term
Finance companies- raise funds by using
commercial paper, then use these funds to make
business loans, construction loans, auto loans
and other consumer loans
-ex. GE Finance Company

 Securities firms- brokers, investment

banking/underwriting and mutual funds
Mutual funds- for diversification purposes
Money market mutual funds- buy money
market instruments, like interest bearing
checking account

 GSEs or Government-sponsored
enterprises- Fannie Mae (home
mortgages), Sallie Mae, Freddie Mac