Chapter 3. Financial Instruments, Financial Markets, and Financial Institutions. 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?
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Financial Instruments, Financial Markets, and Financial Institutions
Assets & Liabilities
Question: to a bank, what is its assets? Liability?
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?
Makes them easier to understand
3. Likelihood payment is madeMore likely more valuable
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?
Primarily Used as Stores of Value
Primarily used to Transfer Risk
Places where financial instruments are bought and sold.
Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:
We can further classify secondary markets as follows:
NYSE home pagehttp://www.nyse.com
We can also further classify markets by the maturity of the securities:
Well functioning markets have
1.Before transaction occurs
2.Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected
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
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