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Lecture 4: Financial instruments and regulation

Lecture 4: Financial instruments and regulation. Mishkin chapter 2 – part C Page 28-32, 42-47. Role in the financial system. Indirect finance. Financial Intermediaries (e.g. bank). Lender. Borrower. Money. Money. Financial instrument A (e.g. saving account). Financial instrument B

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Lecture 4: Financial instruments and regulation

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  1. Lecture 4: Financial instruments and regulation Mishkin chapter 2 – part C Page 28-32, 42-47

  2. Role in the financial system Indirect finance Financial Intermediaries (e.g. bank) Lender Borrower Money Money Financial instrument A (e.g. saving account) Financial instrument B (e.g. student loans) Regulation Financial instruments (e.g. bond, stock) Financial markets Money Direct finance

  3. Financial instruments • A financial instrument (also called security) is a claim on the issuer’s future income or assets. • Financial assetsvs. real assets • Classification: • Money market instrumentsand capital market instruments • Bonds(debt instruments) and stocks (equity)

  4. Bank Money Money Lender Borrower Financial Instrument B: e.g. Deposit Financial Instrument A: e.g. Mortgage loan • Financial instrument A is ‘issued’ by the borrower and is essentially a claim on borrower’s future income or asset. Financial instrument B is ‘issued’ by the Bank and is essentially a claim on Bank’s future income or asset.After financial instrument A is issued and sold to the Bank, it becomes a financial asset of the Bank.After financial instrument B is issued and sold to the lender, it becomes a financial asset of the lender, the liability of the Bank. back

  5. Financial asset vs. real asset • Real assets: houses, equipments, human resources, etc. • Financial assets: claims against real assets. • Generally, borrowers obtain funds from lenders by selling newly issued claims ("IOU's") against their (borrower’s) real assets. • IOUs are essentially financial assets. graph

  6. Money market instruments • Money market instrument is shorter-term security generally with one year or less remaining to maturity. • Treasury bill, commercial paper, CDs, etc. • Many are held by institutions like banks, insurance companies and mutual funds, less often by individuals.

  7. Capital market instruments • More than one year to maturity. • Stock, residential mortgages, long-term bonds, consumer loans, etc.

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  9. Bonds • A bond is a debt security/instrument that promises to make payments periodically for a specified period of time. • Bond price is closely (negatively) related to interest rate. • Default risk: the possibility that the issuer (borrower) fail to pay back.

  10. Stocks • A share of stock is a claim on the net income and assets of the corporation. • Holders of common stocks: • earn from price appreciation and dividends. • have ownership interest in the company proportional to shares owned: • ‘residual claimant’ • have voting rights, or ‘vote with feet’. • Stock prices are volatile.

  11. Regulation in the financial system • More regulation than in other industries. • Why need regulation? • information (efficiency concern) • bankruptcy (stability concern) • control of monetary policy (optimality concern)

  12. How would regulations help? • Increase the information available to investors: • SEC forces listed corporations to disclose information • reduce insider trading • Ensure the soundness of financial intermediaries, fight against bankruptcy, prevent financial panics: • Restrictions on entry (chartering), reporting requirements, restrictions on assets and activities, deposit insurance, limits on competition, etc.

  13. Recap • Financial instrument • Money market instrument vs. capital market instrument • Bonds vs. stocks • Why is regulation in financial system so important? How would regulation help?

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