Chapter 3: Financial Instruments,

Markets and Institutions

• Financial Instruments
• Financial Markets
• Financial Institutions
• People who need funds
 borrowers/issuer/seller
• People who have funds to give
 lenders/savers/buyers
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
• Direct finance
 Borrowers sell securities directly
to lenders
 e.g. corporate and Treasury bonds
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
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
• 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 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
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
• 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)

• bank loans
• stocks
• bonds
• home mortgages
• asset-backed securities
• option and futures contracts
• insurance policies
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…
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”
Debt vs. Equity Markets
• debt security
 cash flows are fixed
 bonds, loans
• equity security
 cash flow variable, residual
 common stock
Exchanges vs. OTC Markets

• exchange
 buying & selling of securities in
physical location
 NYSE
• OTC (over-the-counter)
 dealers in many locations buy &
sell securities
Money vs. Capital Markets
• money market
 short-term debt securities (up to 1
yr.)
 highly liquid, low risk
• capital market
 longer-term debt
 equity
 U.S. Tbills
Money Market
3% CDs
9% 4%
20%
0% Commercial
Paper
Banker's
Acceptances
Repos

Federal
39% 25%
Funds
Eurodollars
 Capital Market
4% 8% Stock
11% Mortgages

U.S. bonds

Municipal
18% 59% bonds
Loans
III. Financial Institutions

aka. financial intermediaries

Why 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
Types of intermediaries

• 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
• Nondepository institutions
 insurance companies
 pension funds
 finance companies
• Mortgage, auto, office equipment
 Securities firms
 gov’t-sponsored enterprises
(GSEs)
Subprime mortgage meltdown
• Hit several types of financial institutions:
 finance companies
• Countrywide
 securities firms
• Citigroup, Merrill Lynch
 GSEs
• Fannie Mae, Freddie Mac