BUSINESS

FINANCE
WEEK 2: THE FINANCIAL
INSTRUMENTS, INTERMEDIARIES,
AND MARKETS

PROF. JESS MAR RS T. FRANCISCO, MBA

PRAYER
REVIEW:
• Business finance, its definition and
role the risk involved in business
finance.
• Difference between shareholders and
directors and what the things that
directors are being accounted for.
“A man who pays his bills on
time is soon forgotten.”
- Oscar Wilde
WEEK 2:
THE FINANCIAL INSTRUMENTS,
INTERMEDIARIES, AND MARKETS

OBJECTIVES: The learners can

distinguish a financial institution from
the financial instrument and financial
market.
It is through a country’s financial system that entities with
funds allocate those funds to those who have potentially
more productive ways to deploy those funds, potentially
leading to faster growth for a country’s economy.

A financial system makes possible a more efficient transfer

of funds is by overcoming the information asymmetry
problem between those with funds to invest and those
needing funds.
In general, information asymmetry means that one party to
a transaction has more or superior information than the
other party, resulting in an imbalance of power in a
transaction.

In terms of a financial system, information asymmetry can

lead to an inefficient allocation of financial resources.
The financial system has three components: (1) financial
markets, (2) financial intermediaries, and (3) regulators of
financial activities.
THE FINANCIAL ASSETS/FINANCIAL
INSTRUMENTS
An ASSET is defined as any resource that is expected to
provide future benefits and, hence, has economic value.

Assets can be divided into two categories: tangible assets

and intangible assets.
Financial assets are intangible assets where typically the
future benefits come in the form of a claim to future cash.
Another term used for a financial asset is a financial
instrument.

Certain types of financial instruments are referred to as

securities and generally include stocks and bonds.

When we refer to an asset, we typically mean a financial

asset.
For every financial instrument, there is a minimum of two
parties.

The party that has agreed to make future cash payments is

called the issuer;

the party that owns the financial instrument and therefore

the right to receive the payments made by the issuer is
referred to as the investor.
Financial assets serve two principal economic functions.

First, they allow the transference of funds from those

entities who have surplus funds to invest to those who need
funds to invest in tangible assets.

Second, they permit the transference of funds in such a way

as to redistribute the unavoidable risk associated with the
cash flow generated by tangible assets among those
seeking and those providing the funds.
However, the claims held by the final wealth holders
generally differ from the liabilities issued by those entities
that are the final demanders of funds because of the
activity of entities operating in financial systems, called
financial intermediaries, who seek to transform the final
liabilities into different financial assets preferred by the
public.
THE DEBT VS. EQUITY INSTRUMENTS
A financial instrument can be classified by the type of
claims that the investor has on the issuer.

A financial instrument in which the issuer agrees to pay the

investor interest plus repay the amount borrowed is a debt
instrument.

A debt instrument also referred to as an instrument of

indebtedness, can be in the form of a note, bond, or loan.

The interest payments that must be made by the issuer are

fixed contractually.
For example, in the case of a debt instrument that is
required to make payments in U.S. dollars, the amount can
be a fixed dollar amount or it can vary depending upon
some benchmark.

That is, the dollar interest amount need not be a fixed

dollar amount but may vary with some benchmarks. The
key point is that the investor in a debt instrument can
realize no more than the contractual amount.

For this reason, debt instruments are often referred to as

fixed-income instruments.
In contrast to a debt obligation, an equity instrument
specifies that the issuer pays the investor an amount based
on earnings, if any, after the obligations that the issuer is
required to make to investors of the firm’s debt instruments
have been paid.

Common stock and partnership shares are examples of

equity instruments.
Some financial instruments fall into both categories in
terms of their attributes. This financial instrument has the
attribute of debt because typically the investor is only
entitled to receive a fixed contractual amount.

Preferred stock, a financial instrument issued in the United

States, is an example.

Another “combination” instrument is a convertible bond,

which allows the investor to convert debt into equity under
certain circumstances.
THE FINANCIAL MARKETS
A financial market is a market where financial instruments
are exchanged. The more popular term used for the
exchanging of financial instruments is that they are
“traded.”

Financial markets provide the following three major

economic functions:

• Price discovery
• Liquidity
• Reduced transaction costs
Price discovery means that the interactions of buyers and
sellers in a financial market determine the price of the
traded asset.

Equivalently, they determine the required return that

participants in the financial market demand to buy a
financial instrument.
Second, financial markets provide a forum for investors to
sell a financial instrument and are said to offer investors
“liquidity.”

This is an appealing feature when circumstances arise that

either force or motivate an investor to sell a financial
instrument.
The third economic function of a financial market is that it
reduces the cost of transacting when parties want to trade a
financial instrument.

In general, one can classify the costs associated with

transacting into two types: search costs and information
costs. Search costs in turn fall into categories: explicit costs
and implicit costs.
THE FINANCIAL INTERMEDIARIES
Despite the important role of financial markets, their role
in allowing the efficient allocation for those who have funds
to invest and those who need funds may not always work as
described earlier.

As a result, financial systems have found the need for a

special type of financial entity called a financial
intermediary when there are conditions that make it
difficult for lenders or investors of funds to deal directly
with borrowers of funds in financial markets.
The role of financial intermediaries is to create more
favorable transaction terms than could be realized by
lenders/investors and borrowers dealing directly with each
other in the financial market.

This is accomplished by financial intermediaries in a two-

step process: (1) obtaining funds from lenders or investors
and (2) lending or investing the funds that they borrow to
those who need funds.
The funds that a financial intermediary acquires become,
depending on the financial claim, either the liability of the
financial intermediary or equity participants of the
financial intermediary.

The funds that a financial intermediary lends or invests

become the asset of the financial intermediary.
This asset transformation provides at least one of three
economic functions:

• Maturity intermediation.
• Risk reduction via diversification.
• Cost reduction for contracting and information
processing.
Other services can be provided by financial intermediaries.
They include:

• Facilitating the trading of financial assets for the

financial intermediary’s customers through brokering
arrangements.
• Facilitating the trading of financial assets by using its
capital to take a position in a financial asset the financial
intermediary’s customer wants to transact in.
• Assisting in the creation of financial assets for its
customers and then either distributing those financial
assets to other market participants.
• Providing investment advice to customers.
• Manage the financial assets of customers.
• Providing a payment mechanism.
MATURITY INTERMEDIATION

In our example of the commercial bank, two things should be

noted.

First, the maturity of the deposits made by lenders at the

commercial bank is typically short-term. As explained later, banks
have deposits that are payable upon demand or have a specific
maturity date, but most are less than three years.

Second, the maturity of the loans made by a commercial bank may

be considerably longer than three years. Think about what would
happen if commercial banks did not exist in a financial system.
Now put commercial banks back into the financial system.

By issuing its financial claims, the commercial bank in

essence transforms a longer-term asset into a shorter-term
one by giving the borrower a loan for the length of time
sought and the depositor (lender) a financial asset for the
desired investment horizon.

This function of a financial intermediary is called maturity

intermediation.
The implications of maturity intermediation for financial
systems are twofold.

The first implication is that lenders/investors have more

choices concerning the maturity for the financial
instruments in which they invest and borrowers have more
alternatives for the length of their debt obligations.

The second implication is that because investors are

reluctant to commit funds for a long period, they require
long-term borrowers to pay a higher interest rate than
short-term borrowing.
RISK REDUCTION VIA DIVERSIFICATION

Suppose that the mutual fund invests the funds received from
investors in the stock of a large number of companies. By doing so,
the mutual fund diversifies and reduces its risk. Investors with a
small sum to invest would find it difficult to achieve the same
degree of diversification because of their lack of sufficient funds to
buy shares of a large number of companies.

This economic function performed by financial intermediaries of

transforming more risky assets into less risky ones is called
diversification.
REDUCING THE COSTS OF CONTRACTING AND
INFORMATION PROCESSING

Investors purchasing financial assets must develop the

skills necessary to evaluate their risk and return attributes.

Investors who want to make a loan to a consumer or

business need to have the skill to write a legally enforceable
contract with provisions to protect their interests.
In addition to the opportunity cost of the time to process
the information about the financial asset and its issuer, the
cost of acquiring that information must also be considered.

Such costs are referred to as information processing costs.

The costs associated with writing loan agreements are

referred to as contract costs. Another aspect of contracting
costs is the cost of enforcing the terms of the loan
agreement.
In the case of loan agreements, either standardized
contracts can be prepared, or legal counsel can be part of
the professional staff to write contracts involving more
complex transactions.

The investment professionals can monitor to activities of

the borrower to assure compliance with the loan
agreement’s terms and where there is any violation take
action to protect the interests of the financial intermediary.
THE CLASSIFICATION OF FINANCIAL
MARKETS
CLASSIFICATION OF A COUNTRY’S FINANCIAL
MARKETS

From the perspective of a given country, its financial

market can be broken down into an internal market and an
external market.
The internal market, which is also referred to as the
national market, is made up of two parts: the domestic
market and the foreign market.

The domestic market is where issuers domiciled in the

country issue securities and where those securities are
subsequently traded.

The foreign market is where securities of issuers not

domiciled in the country are sold and traded.
The other sector of a country’s financial market is the
external market.

This is the market where securities with the following two

distinguishing features are trading: (1) at issuance they are
offered simultaneously to investors in several countries; and
(2) they are issued outside the jurisdiction of any single
country.
MONEY MARKET

The money market is the sector of the financial market that

includes financial instruments that have a maturity or
redemption date that is one year or less at the time of
issuance.

Typically, money market instruments are debt instruments

and include Treasury bills, commercial paper, negotiable
certificates of deposit, repurchase agreements, and
bankers’ acceptances.
Treasury bills (popularly referred to as T-bills) are short-
term securities issued by the U.S. government; they have
original maturities of either four weeks, three months, or
six months.

Commercial paper is a promissory note—a written promise

to pay—issued by a large, creditworthy corporation or a
municipality.
Certificates of deposit (CDs) are written promises by a bank to pay
a depositor. Nowadays, they have original maturities from six
months to three years. Negotiable certificates of deposit are CDs
issued by large commercial banks that can be bought and sold
among investors.

A Eurodollar CD is a negotiable CD for a U.S. dollar deposit at a

bank located outside the United States or in U.S. International
Banking Facilities. The interest rate on Eurodollar CDs is the
London Interbank Offered Rate (LIBOR), which is the rate at
which major international banks are willing to offer term Eurodollar
deposits to each other.
Another form of short-term borrowing is the repurchase agreement.

Rather than borrowing from a bank, a market participant can use

the bonds it has acquired as collateral for a loan. Specifically, the
lender will loan a certain amount of funds to an entity in need of
funds using the bonds as collateral.

This common lending agreement is referred to as a repurchase

agreement or repo because it specifies that the (1) the borrower sell
the bonds to the lender in exchange for proceeds; and (2) some
specified future date, the borrower repurchases the bonds from the
lender at a specified price.
The specified price, called the repurchase price, is higher
than the price at which the bonds are sold because it
embodies the interest cost that the lender is charging the
borrower.

The interest rate in a repo is called the repo rate. Thus, a

repo is nothing more than a collateralized loan. It is
classified as a money market instrument because the term
of a repo is typically less than one year.
Bankers’ acceptances are short-term loans, usually to
importers and exporters, made by banks to finance specific
transactions.

The bank’s acceptance of the draft is a promise to pay the

face amount of the draft to whoever presents it for
payment.
Since acceptances arise from specific transactions, they are
available in a wide variety of principal amounts.

Typically, bankers’ acceptances have maturities of less than

180 days. Bankers’ acceptances are sold at a discount from
their face value, and the face value is paid at maturity.
CAPITAL MARKET

The capital market is the sector of the financial market

where long-term financial instruments issued by
corporations and governments trade.

There are two types of capital market securities: those that

represent shares of ownership interest also called equity,
issued by corporations, and those that represent
indebtedness, issued by corporations and by the U.S., state,
and local governments.
A capital market debt obligation is a financial instrument
whereby the borrower promises to repay the maturity value
one year after issuance.

These debt obligations can be broken into two categories:

bank loans and debt securities. While at one time, bank
loans were not considered capital market instruments, in
recent years a market for the buying and selling of these
debt obligations has developed.
Debt securities include (1) bonds, (2) notes, (3) medium-
term notes, and (4) asset-backed securities. The distinction
between a bond and a note has to do with the number of
years until the obligation matures when the security is
originally issued.
DERIVATIVE MARKET

Financial markets are classified in terms of the cash

market and derivative markets. The cash market also
referred to as the spot market, is the market for the
immediate purchase and sale of a financial instrument.

In contrast, some financial instruments are contracts that

specify that the contract holder has either the obligation or
the choice to buy or sell another something at or by some
future date. The “something” that is the subject of the
contract is called the underlying.
Because the price of such contracts derives their value from
the value of the underlying, these contracts are called
derivative instruments, and the market where they are
traded is called the derivatives market.

The primary role of derivative instruments is to provide a

transactionally efficient vehicle for protecting against
various types of risk encountered by investors and issuers.
PRIMARY MARKET

When a financial instrument is first issued, it is sold in the

primary market. This is the market in which new issues are
sold and new capital is raised. So, it is the market whose
sales directly benefit the issuer of the financial instrument.
Issuance of securities must comply with securities laws.
The primary market can be classified as the public market
and the private placement market.
PUBLIC MARKET ISSURANCE

The public market offering of new issues typically involves

the use of an investment bank. Another method of offering
new issues is through an auction process.
PRIVATE PLACEMENT MARKET

There are different regulatory requirements for securities

that are issued to the general investing public and those
that are privately placed.

Regulations specify that (1) in general, the securities cannot

be offered through any form of general advertising or
general solicitation that would prevail for public offerings,
and (2) securities can only be sold to what the SEC refers to
as “accredited” investors.
SECONDARY MARKET

A secondary market is one in which financial instruments

are resold among investors. No new capital is raised and
the issuer of the security does not benefit directly from the
sale. Trading takes place among investors. Investors who
buy and sell securities on the secondary markets may
obtain the services of stock brokers, individuals who buy or
sell securities for their clients.
MARKET STRUCTURE: PRICE DETERMINATION
MECHANISMS

Secondary markets are categorized based on how they are

traded, referred to as market structure. There are two
overall market structures for trading financial instruments:
order-driven and quote-driven.
Market structure is meaning the mechanism by which
buyers and sellers interact to determine price and quantity.
In an order-driven market structure, buyers and seller
orders submit their bids through their broker who relays
these bids to a centralized location, where bids are matched
and the transaction is executed an order-driven market is
also referred to as an auction market.
In a quote-driven market structure, intermediaries (market
makers or dealers) quote the prices at which the public
participants trade. Market makers provide a bid quote (to
buy) and an offer quote (to sell) and realize revenues from
the spread between these two quotes.
EXCHANGE VS. OVER-THE-COUNTER SECONDARY
MARKETS

Secondary markets are also classified in terms of organized

exchanges and over-the-counter (OTC) markets.
Exchanges are central trading locations where financial
instruments are traded.

The financial instruments must be those that are listed by

the organized exchange. By list, it is meant the financial
instrument must satisfy requirements set forth by the
exchange.
In contrast, an OTC market is generally where unlisted
financial instruments are traded. For common stock, there
are listed and unlisted stocks. Although there are bonds
that are listed, typically they are unlisted and therefore
trade on an exchange. The same is true of loans. The
foreign exchange market is an OTC market.
MARKET EFFICIENCY

Investors do not like risk and they must be compensated for

taking on risk—the larger the risk, the more the
compensation. An important question about financial
markets, which implies the different strategies that
investors can pursue, is: Can investors earn a return on
financial assets beyond that necessary to compensate them
for the risk? Economists refer to this excess compensation
as an abnormal return.
Whether this can be done in a particular financial market is
an empirical question. If a strategy is identified that can
generate abnormal returns, the attributes that lead one to
implement such a strategy are referred to as a market
anomaly.

An efficient market is defined as a financial market where

asset prices rapidly reflect all available information. This
means that all available information is already impounded
in an asset’s price, so investors should expect to earn a
return necessary to compensate them for their opportunity
cost, anticipated inflation, and risk.
That would seem to preclude abnormal returns. But
according to Fama (1970), there are the following three
levels of efficiency:

• Weak form efficient

• Semi strong form efficient
• Strong form efficient
In the weak form of market efficiency, current asset prices
reflect all past prices and price movements.

In the semi-strong form of market efficiency, the current

asset prices reflect all publicly available information.

In the strong form of market efficiency, asset prices reflect

all public and private information.
MARKET PARTICIPANTS

There is a large number of players in the financial system

who buy and sell financial instruments. The Federal
Reserve, in information about the financial markets, that it
publishes quarterly, classifies players into nine sectors.
These sectors are:

• Households
• Governments
• Non-financial corporations
• Depository institutions
• Insurance companies
• Asset management fi rms
• Investment banks
• Non-profit organizations
• Foreign investors
ASSESSMENT
REMINDERS
QUIZ AND OUTPUT
ASSIGNMENT VIA
MOODLE

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THE FINANCIAL
INSTRUMENTS,
INTERMEDIARIES, AND
MARKETS (PART 2)