Chapter 3: Financial Instruments, Chapter 3: Financial Instruments, Markets and InstitutionsMarkets and InstitutionsChapter 3: Financial Instruments, Chapter 3: Financial Instruments, Markets and InstitutionsMarkets and Institutions

• Financial Instruments

• Financial Markets

• Financial Institutions

• Financial Instruments

• Financial Markets

• Financial Institutions

• People who need funds borrowers/issuer/seller

• People who have funds to give lenders/savers/buyers

• People who need funds borrowers/issuer/seller

• People who have funds to give lenders/savers/buyers

Indirect vs. Direct FinanceIndirect vs. Direct FinanceIndirect vs. Direct FinanceIndirect 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

• Indirect finance Borrowers and lenders meet

through a financial intermediary (e.g. bank)

Loan is a liability for borrower, and asset for a bank

• Direct finance Borrowers sell securities directly

to lenders e.g. corporate and Treasury bonds

• Direct finance Borrowers sell securities directly

to lenders e.g. corporate and Treasury bonds

I. Financial InstrumentsI. Financial InstrumentsI. Financial InstrumentsI. 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

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

exampleexampleexampleexample

• 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

• 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

• my mortgage I am the borrower (liability) the bank is the buyer/holder

(asset) the bank has a claim on my house

• my mortgage I am the borrower (liability) the bank is the buyer/holder

(asset) the bank has a claim on my house

uses of financial instrumentsuses of financial instrumentsuses of financial instrumentsuses 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

• 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

Valuing financial instrumentsValuing financial instrumentsValuing financial instrumentsValuing 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

• 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

• 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

• 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

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

• bank loans

• stocks

• bonds

• home mortgages

• asset-backed securities

• option and futures contracts

• insurance policies

• bank loans

• stocks

• bonds

• home mortgages

• asset-backed securities

• option and futures contracts

• insurance policies

II. Financial MarketsII. Financial MarketsII. Financial MarketsII. 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…

• 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…

Primary vs. Secondary MarketsPrimary vs. Secondary MarketsPrimary vs. Secondary MarketsPrimary 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”

• primary market newly issued securities

-- investment banking

• secondary market brokers match buyers and sellers dealers act as buyers and sellers

-- “market-makers”

Debt vs. Equity MarketsDebt vs. Equity MarketsDebt vs. Equity MarketsDebt vs. Equity Markets

• debt security cash flows are fixed bonds, loans

• equity security cash flow variable, residual common stock

• debt security cash flows are fixed bonds, loans

• equity security cash flow variable, residual common stock

Exchanges vs. OTC MarketsExchanges vs. OTC MarketsExchanges vs. OTC MarketsExchanges vs. OTC Markets

• exchange buying & selling of securities in

physical location NYSE

• OTC (over-the-counter) dealers in many locations buy &

sell securities

• exchange buying & selling of securities in

physical location NYSE

• OTC (over-the-counter) dealers in many locations buy &

sell securities

Money vs. Capital MarketsMoney vs. Capital MarketsMoney vs. Capital MarketsMoney vs. Capital Markets

• money market short-term debt securities (up to 1

yr.) highly liquid, low risk

• capital market longer-term debt equity

• money market short-term debt securities (up to 1

yr.) highly liquid, low risk

• capital market longer-term debt equity

Money Market

20%

25%39%

9%0%

4%3%

U.S. Tbills

CDs

CommercialPaperBanker'sAcceptancesRepos

FederalFundsEurodollars

Capital Market

4% 8%11%

18% 59%

Stock

Mortgages

U.S. bonds

MunicipalbondsLoans

III. Financial InstitutionsIII. Financial InstitutionsIII. Financial InstitutionsIII. Financial Institutions

aka. financial intermediariesWhy have them?

• Transactions costs search costs to find borrower &

lender contract costs economies of scale

aka. financial intermediariesWhy have them?

• Transactions costs search costs to find borrower &

lender contract costs economies of scale

• Risk sharing intermediaries are experts at

bearing risk

• Asset transformation short-term to long-term illiquid to liquid

• Risk sharing intermediaries are experts at

bearing risk

• Asset transformation short-term to long-term illiquid to liquid

Types of intermediariesTypes of intermediariesTypes of intermediariesTypes of intermediaries

• Depository institutions “banks” accept deposits, make loans

• Depository institutions “banks” accept deposits, make loans

• 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

• 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

• Nondepository institutions insurance companies pension funds finance companies

• Mortgage, auto, office equipment

Securities firms gov’t-sponsored enterprises

(GSEs)

• Nondepository institutions insurance companies pension funds finance companies

• Mortgage, auto, office equipment

Securities firms gov’t-sponsored enterprises

(GSEs)

Subprime mortgage meltdownSubprime mortgage meltdownSubprime mortgage meltdownSubprime mortgage meltdown

• Hit several types of financial institutions: finance companies

• Countrywide

securities firms• Citigroup, Merrill Lynch

GSEs• Fannie Mae, Freddie Mac

• Hit several types of financial institutions: finance companies

• Countrywide

securities firms• Citigroup, Merrill Lynch

GSEs• Fannie Mae, Freddie Mac