© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

Chapter 3

Financial Instruments, Financial Markets,

and Financial Institutions

Dr. John V. Padua

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The Financial System:The Big Questions

1. What is a financial instrument and what is their role in the economy?

2. What are financial markets and how do they work?

3. What are financial institutions and why are they so important?

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The Financial System:Roadmap

• Financial Instruments• Financial Markets• Financial Institutions

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Preliminaries: Definitions

Types of Finance– Indirect: Institution stands between lender

and borrower.– Direct: Borrowers sell securities directly to

lenders in the financial markets

Assets & Liabilities– Asset: Something of value that you own– Liability: Something you owe.

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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.

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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

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Financial Instruments: Characteristics

– StandardizationOvercome the costs of complexity

Makes them easier to understand

– Communicate InformationSummarize essential information about

issuer Eliminate expense of collecting information

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Financial Instruments:Classes

– UnderlyingUsed to transfer resources

Examples: stocks and bonds

– DerivativeValue derived from underlying instrumentsExamples: Futures and options

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Financial Instruments:What Makes Them Valuable?

1. Size of the payment: Larger more valuable

2. Timing of payment: Sooner more valuable

3. Likelihood payment is made More likely more valuable

4. Conditions under with payment is made When you need it most more valuable

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Financial Instruments:Examples

Primarily Used as Stores of Value– Bank Loans– Bonds– Home Mortgages– Stocks

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Financial Instruments:Examples

Primarily used to Transfer Risk– Insurance Contracts– Futures Contracts

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Financial Markets:Definition

Places where financial instruments are bought and sold.

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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.

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Financial Market Structure:Primary vs. Secondary

Primary: Buy and Sell Newly Issued Securities

Secondary:Trade Existing Securities

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Financial Market Structure:Centralized, OTC, and ECNs

Centralized Exchange Physical location where trading takes place

Over-the-Counter Market (OTC) Networks of dealers connected electronically

Electronic Communications Network (ECN)

Electronic networks where buyers and sellers interact directly.

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Financial Market Structure:Debt, Equity, and Derivatives

Debt and Equity Markets: Financial claims are bought and sold for

immediate cash payment

Derivative Markets: Financial claims based on underlying instruments are bought and sold for payment at a future date

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Financial Markets:Characteristics

Well functioning markets have– Low transaction costs– Communicate accurate information– Protect Investors

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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.

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Financial Institutions:A Simplified Balance Sheet

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Financial Industry Structure: I

1. Depository Institutions: Take deposits and make loans

2. Insurance Companies Accept premiums, pay out based on events

3. Pension Funds Invest contributions, provide payments to retirees

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Financial Industry Structure: II

4. Security Firms Proved access to financial markets

5. Finance Companies Raise funds in financial markets, make

loans

6. Government Sponsored Enterprises Raise funds in financial markets, make

loans, provide guarantees.