Financial Instruments, Financial Markets, and Financial Institutions

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Chapter 3

• Financial Instruments, Financial Markets, and
  Financial Institutions

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Function of Financial Markets

• Allows transfers of funds from person or business
  without investment opportunities (Lender-Savers)
  to one who has them (Borrower-Spenders)
• Improves economic efficiency

• Lender-Savers
• Households
• Business firms
• Government
• Foreigners

• Borrower-Spenders
• Business firms
• Government
• Households
• Foreigners

3
Importance of Financial Markets

• Markets are critical for producing an efficient
  allocation of capital
• Contributes to higher production and efficiency
  for the overall economy
• Providing investment returns to lender-savers
• Use opportunities to borrower-spenders
• Improves society as a whole

4
Segments of Financial Markets

• Direct Finance
• Borrowers borrow directly from lenders in
  financial markets
• A firm can issue bonds (debt) which are claims on
  the borrowers future income or assets
• Indirect Finance
• Borrowers borrow indirectly from lenders via
  financial intermediaries
• A firm receives a loan from a commercial bank

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Financial and Economic Development
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Financial Instruments

• Characteristics
• Standardization
• Communicate Information
• Classes of Financial Instruments
• Primary underlying Instruments
• Derivative Instruments
• Value derived from the behavior of Underlying
  instruments.
• Examples of Financial Instruments
• Bank Loans
• Stocks, Bonds
• Home Mortgages, Asset-backed securities
• Insurance, Options, Futures contracts
• Allows the transfer of risk

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Financial Markets

• Role of Financial Markets.
• Offer liquidity to borrowers and savers.
• Pool and communicate Information.
• Allow risk sharing
• Characteristics of a well-run financial market
• Low transaction costs.
• Information communicated must be accurate.
• Investors must be protected.

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Types of Markets

• Primary Market Where firms raise new capital
• IPO, SEO, Private Placements, Bond issuance etc
• Investment banking
• Secondary Market Where existing claims trade
  between investors (just passing around pieces of
  paper)
• NASDAQ, NYSE, AMEX, CBOE, LSE, Bourse etc.
• In economic terms, enables the trading of TIME
  RISK
• Capital Market Refers to a market in
  longer-maturity financial assets (stocks and
  long-term bonds)
• Money Market A market in short-term debt
  instruments such as t-bills and commercial paper
  (Think of your money market account)

Money market securities
Capital market securities
Time to maturity (years)
Notes/bonds
Stock/equity
Commercial paper treasuries
0
1
30
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Classifications of Financial Markets

• Primary Market
• New security issues sold to initial buyers
• Secondary Market
• Securities previously issued are bought and sold
• Exchanges
• Trades conducted in central locations
• New York Stock Exchange
• Over-the-Counter Markets
• Dealers at different locations buy and sell
• NASDAQ

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Classifications of Financial Markets

• Debt Markets
• Money Market
• Short-Term (maturity lt 1 year)
• Capital Market
• Long-Term (maturity gt 1 year)
• Equity Markets
• Common Stock
• Preferred Stock

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Market Size and Investor Protection
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Financial Institutions

• Role of Financial Institutions
• 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.

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Financial Institutions
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Financial Institutions
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Function of Financial Intermediaries (FIs)

• Financial Intermediaries
• Engage in process of indirect finance
• Help facilitate the transfer of funds between
  borrowers and lenders.
• More important source of finance than securities
  markets
• Needed because of transactions costs and
  asymmetric information
• Since we have financial markets why are FIs
  needed?
• There are 25 million companies in the US
• Less than 0.1 of these companies are publicly
  traded
• Most firms do not have access to financial
  markets (too expensive)
• FIs provide these firms with capital at a lower
  cost
• Due to expertise and economies of scale

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Function of Financial Intermediaries

• FIs can help reduce the exposure of investors to
  risk, through a process known as risk sharing
• FIs buy assets with greater risk from one party
  and create and sell assets with lesser risk to
  another party
• This process is referred to as asset
  transformation, because in a sense risky assets
  are turned into safer assets for investors

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Types of Financial Intermediaries (FIs)

• Depository
• Commercial Banks, Thrifts, Credit Unions, Savings
  and Loan
• Earn interest rate spreads
• Non Depository
• Investment companies (mutual funds), Pension
  funds, Insurance, Investment banking (earn fees)
• Finance companies
• Corporations that have financial arms such as,
  GMAC, GE Capital, Visa, Master Card (earn
  interest rate spreads and fees)
• Government Sponsored Enterprises (GSE)
• Ginnie Mae, Freddie Mac, Fannie Mae (securitize
  assets)
• Information collectors Analysts, Rating
  agencies, Auditors (earn fees)
• Market makers dealers
• Brokers, Specialist firms (earn bid-ask spreads
  and trading fees)