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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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Chapter 3

Chapter 3

Financial Instruments, Financial Markets, and Financial Institutions

The financial system the big questions
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?

The financial system roadmap
The Financial System:Roadmap

  • Financial Instruments

  • Financial Markets

  • Financial Institutions

Preliminaries definitions
Preliminaries: Definitions

Assets & Liabilities

  • Asset: Something of value that you own

  • Liability: Something you owe.

    Question: to a bank, what is its assets? Liability?

Financial instruments definition
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?

Financial instruments uses
Financial Instruments: Uses

  • Means of PaymentPurchase goods and services

  • Store of ValueTransfer purchasing power into the future

  • Transfer of RiskTransfer risk to from one person to another

Financial instruments characteristics
Financial Instruments: Characteristics

  • Standardization Overcome the costs of complexity

    Makes them easier to understand

  • Communicate InformationSummarize essential information about issuer Eliminate expense of collecting information

Financial instruments classes
Financial Instruments:Classes

  • Underlying Used to transfer resources Examples: stocks and bonds

  • DerivativeValue derived from underlying instruments Examples: Futures and options

Financial instruments how to price financial instruments
Financial Instruments:How to price financial instruments?

  • Size of the payment:Larger  more valuable

  • Timing of payment:Sooner  more valuable

    3. Likelihood payment is madeMore likely  more valuable

  • Conditions under with payment is madeWhen you need it most  more valuable

Chapter 3


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?

Financial instruments examples
Financial Instruments:Examples

Primarily Used as Stores of Value

  • Bank Loans

  • Bonds

  • Home Mortgages

  • Stocks

  • Asset-backed securities

Financial instruments examples1
Financial Instruments:Examples

Primarily used to Transfer Risk

  • Insurance Contracts

  • Futures Contracts

  • Options

Financial markets definition
Financial Markets:Definition

Places where financial instruments are bought and sold.

Financial markets roles
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.

Importance of financial markets
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.

Importance of financial markets1
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.

Structure of financial markets
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.

Structure of financial markets1
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?)

Structure of financial markets2
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

Structure of financial markets3
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

Classifications of financial markets
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

Financial markets characteristics
Financial Markets:Characteristics

Well functioning markets have

  • Low transaction costs

  • Communicate accurate information

  • Protect Investors

Flow of funds through financial institutions
Flow of Funds throughFinancial Institutions

Financial institutions their role
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.

Asymmetric information adverse selection and moral hazard
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

Videos to watch optional
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

Hws page p66 questions 4 5 10 12 13 and 14
HWs:Page P66, questions 4, 5, 10, 12, 13 and 14.