Financial Instruments, Financial

Markets and Financial Institutions

 Introduction
The international financial system exists to facilitate the design, sale, and
exchange of a broad set of contracts with a very specific setof characteristics.

We obtain financial resources through this

system:
Directly from markets, and
Indirectly through institutions.
 Introduction
Indirect Finance:
An institution stands between lender and borrower.
(We get a loan from a bank or finance company to buy a car.)

Direct Finance:
Borrowers sell securities directly to lenders in the financial markets.
(Direct finance provides financing for governments and corporations.)

Asset: Something of value that you own.

Liability: Something you owe.

How funds Direct Finance

flow through
financial
system?
A financial system is an
economic arrangement wherein
financial institutions facilitate the
transfer of funds and assets
between borrowers, lenders, and
investors
Financial development is linked to economic
growth.

The role of the financial system is to facilitate

production, employment, and consumption.

Resources are funneled through the system

so resources flow to their most efficient uses.
 Financial
Financial Financial
Instruments
Markets Institutions
or Securities
(Stocks, bonds, loans New York Stock
and insurance.) Exchange, Nasdaq.

Where investors What they are and

What is their role
trade financial what they do?
in our economy?
instruments?

We will survey the financial system in three steps:

 The written legal obligation of one
Financial party to transfer something of value,

Instruments:
usually money, to another party at
some future date, under certain
conditions.
The enforceability of the obligation is important.
Financial instruments obligate one party (person,
company, or government) to transfer something to
another party.
Financial instruments specify payment will be made
at some future date.
Financial instruments specify certain conditions
under which a payment will be made.
Uses of Financial Instruments
Three functions:
Act as a means of
payment
Employees take stock options as
payment for working.
Allow for the transfer of
Act as stores of value
risk
Financial instruments generate increases Futures and insurance contracts allows
in wealth that are larger one person to transfer risk
than from holding money. to another.
Financial instruments can be used to
transfer purchasing power
into the future.
 Characteristics of Financial Instruments
These contracts are very complex and costly at the same time.
(Standardization of financial instruments overcomes potential costs of complexity. Most
mortgages feature a standard application with standardized terms.)

Financial instruments also communicate information,

summarizing certain details about the issuer.
Mechanisms exist to reduce the cost of monitoring the behavior of counterparties. (A
counterparty is the person or institution on the
other side of the contract.)

Financial instruments are designed to handle the problem of

asymmetric information.
The solution to high cost of obtaining information is to standardize both the instrument
and the information about the issuer.
 Underlying Versus Derivative Instruments
Two fundamental classes of financial instruments are the following:

Underlying Instruments Derivative Instruments

are used by savers/lenders to
transfer resources directly to
investors/borrowers.
This improves the efficient
allocation of resources.
Examples: stocks and bonds
are those where their value and
payoffs are “derived” from the
behavior of the underlying
instruments.
Examples: Future and options
(The primary use is to shift risk
among investors.)
Financial
Markets:
Financial markets are places where
financial instruments are bought and sold.
Which acts as a economy’s central
nervous system.
Enable both firms and individuals to find financing for
their activities.
Promote economic efficiency and ensures that
resources are available to those who put them to
their best use and keep transactions costs low.
The Role of Financial Markets

Liquidity: Information: Risk sharing:

Ensure owners can buy and sell Pool and communication Provide individuals a place to buy
financial information about issuers and sell risk.
instruments cheaply. of financial instruments.

Keeps transactions costs low.

Distinguish between Categorize by the Group based on
markets where new way they trade: the type of
financial instruments instrument they
are sold and where they trade:
are resold or traded:

Primary or Store value

Centralized or Transfer
Secondary
or not of Risk
Markets

The Structure of Financial Markets

 Primary versus Secondary Markets
Two fundamental classes of financial instruments are the following:
Primary Market Secondary Market
is one in which a borrower are those where people can
obtains funds from a lender buy and sell existing
by selling newly issued securities.
securities.
Occurs out of the public views. Buying a share of IBM stock is not
purchased from the company, but
An investment bank determines the from another investor in a
price, purchases the securities, and secondary market.
resells to clients.
These are the prices we hear about in
This is called underwriting and is usually the news.
very profitable.
 Characteristics of a Well-Run Financial Market
Must be designed to keep transaction costs low.
Information the market pools and communicates must be
accurate and widely available.
Borrowers promises to pay lenders much be credible.
Borrowers promises to pay lenders much be credible.
Because of these criteria, the governments are an essential part of financial markets as
they enforce the rules of the game.

Countries with better investor protections have bigger and deeper financial markets.
Financial Also known as financial intermediaries.
Firms that provide access to the financial

Intitutions: markets, both to savers (who wish to

purchase financial instruments directly)
and to borrowers (who want to issue them).

Healthy financial institutions open the flow of

resources, increasing the system’s efficiency.

Examples: banks, insurance companies, securities firms,

and pension funds.
The Role of Financial Markets
To reduce transaction
To reduce the
costs by specializing in
information costs of To give savers ready
the issuance of
screening and access to their funds.
standardized
monitoring borrowers.
securities.
They curb asymmetries, helping
resources flow to
most productive uses.
 Depository Insurance Pension
institutions companies funds

take deposits and accept premiums, which invest individual and company
contributions in stocks, bonds,
make loans. they invest, in return for
and real estate in order to
promising compensation provide payments to retired
workers.

The Structure of the Financial Industry

 Finance Government-
Securities sponsored
firms companies
enterprises

Brokers, investment raise funds directly in are federal credit

banks, underwriters, the financial markets in agencies that provide
and mutual fund order to make loans to loans directly for
companies. individuals and firms. farmers and home
mortgagors.

The Structure of the Financial Industry

Flow of
Access to Financial Markets

Funds
through
Financial
Institutions
“If you can learn to create a state of mind that
is not affected by the market’s behaviour,
the struggle will cease to exist “
Mark Douglas