Chapter 3: Financial Instruments, Markets and Institutions

1. Chapter 3: Financial Instruments, Markets and Institutions • Financial Instruments • Financial Markets • Financial Institutions

2. People who need funds • borrowers/issuer/seller • People who have funds to give • lenders/savers/buyers

3. 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

4. Direct finance • Borrowers sell securities directly to lenders • e.g. corporate and Treasury bonds

6. 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

7. 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

8. my mortgage • I am the borrower (liability) • the bank is the buyer/holder (asset) • the bank has a claim on my house

9. 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

10. 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

11. 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

12. examples (p. 43/44 or 46/47) • bank loans • stocks • bonds • home mortgages • asset-backed securities • option and futures contracts • insurance policies

13. 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…

14. 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”

15. Debt vs. Equity Markets • debt security • cash flows are fixed • bonds, loans • equity security • cash flow variable, residual • common stock

16. Exchanges vs. OTC Markets • exchange • buying & selling of securities in physical location • NYSE • OTC (over-the-counter) • dealers in many locations buy & sell securities

17. Money vs. Capital Markets • money market • short-term debt securities (up to 1 yr.) • highly liquid, low risk • capital market • longer-term debt • equity

20. III. Financial Institutions aka. financial intermediaries Why have them? • Transactions costs • search costs to find borrower & lender • contract costs • economies of scale

21. Risk sharing • intermediaries are experts at bearing risk • Asset transformation • short-term to long-term • illiquid to liquid

22. Types of intermediaries • Depository institutions • “banks” • accept deposits, make loans

23. 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

24. Nondepository institutions • insurance companies • pension funds • finance companies • Mortgage, auto, office equipment • Securities firms • gov’t-sponsored enterprises (GSEs)

25. Subprime mortgage meltdown • Hit several types of financial institutions: • finance companies • Countrywide • securities firms • Citigroup, Merrill Lynch • GSEs • Fannie Mae, Freddie Mac