Chapter 3: Financial Instruments, Markets and Institutions

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Chapter 3 Financial Instruments, Markets and
Institutions

• Financial Instruments
• Financial Markets
• Financial Institutions

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• People who need funds
• borrowers/issuer/seller
• People who have funds to give
• lenders/savers/buyers

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Indirect vs. Direct Finance

• Indirect finance
• Borrowers and lenders meet through a financial
  intermediary (e.g. bank)
  
• Loan is a liability for borrower, and asset for a
  bank

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• Direct finance
• Borrowers sell securities directly to lenders
• e.g. corporate and Treasury bonds

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I. Financial Instruments

• aka. securities, financial assets
• definition (p. 36 (1st) or 41 (2nd))
• written legal obligation of one party to
  transfer something of value, usually money, to
  antoher party at some future date, under certain
  conditions
• a security is an asset for the buyer/lender,
• but a liability for the issuer/borrower/seller

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example

• shares of stock in Time Warner, Inc.
• shares of ownership in TW
• a claim on the earnings/assets of TW
• a liability for Time Warner
• an asset for me

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• my mortgage
• I am the borrower (liability)
• the bank is the buyer/holder (asset)
• the bank has a claim on my house

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uses of financial instruments

• means of payment
• but much less liquid than money
• store of value
• better than money over time, but also greater
  risk
  
• transfer of risk
• buyer transfers risk to seller
• e.g. insurance policies, futures contract

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Valuing financial instruments

• sizing, timing certainty of promised cash
  flows
  
• Size how much is promised?
• the larger the cash flows, the greater the value
• Timing when is it promised?
• the sooner the cash flows are received, the
  greater the value

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• Certainty how likely its it that payments will
  be made?
  
• the likelier the payments the greater the value
• Under what conditions?
• e.g. insurance, derivatives
• payments when we need them the most are more
  valuable

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examples (p. 43/44 or 46/47)

• bank loans
• stocks
• bonds
• home mortgages
• asset-backed securities
• option and futures contracts
• insurance policies

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II. Financial Markets

• where financial instruments are bought and sold
• these markets provide
• liquidity for buying/selling
• information through prices
• risk-sharing among buyers/sellers
• classified in various ways

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Primary vs. Secondary Markets

• primary market
• newly issued securities
• -- investment banking
• secondary market
• brokers match buyers and sellers
• dealers act as buyers and sellers
• -- market-makers

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Debt vs. Equity Markets

• debt security
• cash flows are fixed
• bonds, loans
• equity security
• cash flow variable, residual
• common stock

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Exchanges vs. OTC Markets

• exchange
• buying selling of securities in physical
  location
  
• NYSE
• OTC (over-the-counter)
• dealers in many locations buy sell securities

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Money vs. Capital Markets

• money market
• short-term debt securities (up to 1 yr.)
• highly liquid, low risk
• capital market
• longer-term debt
• equity

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III. Financial Institutions

• aka. financial intermediaries
• Why have them?
• Transactions costs
• search costs to find borrower lender
• contract costs
• economies of scale

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• Risk sharing
• intermediaries are experts at bearing risk
• Asset transformation
• short-term to long-term
• illiquid to liquid

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Types of intermediaries

• Depository institutions
• banks
• accept deposits, make loans

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• Commercial banks
• largest in total assets
• least restricted
• Savings Loans
• originally restricted to savings deposits and
  mortgages
  
• less restricted today
• Credit Unions
• consumer loans
• nonprofit, organized around a group

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• Nondepository institutions
• insurance companies
• pension funds
• finance companies
• Mortgage, auto, office equipment
• Securities firms
• govt-sponsored enterprises (GSEs)

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Subprime mortgage meltdown

• Hit several types of financial institutions
• finance companies
• Countrywide
• securities firms
• Citigroup, Merrill Lynch
• GSEs
• Fannie Mae, Freddie Mac