Chapter 3 Financial Instruments Financial Markets and Financial Institutions

1. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Chapter 3
Financial Instruments,
Financial Markets,
and Financial Institutions
Dr. John V. Padua

2. 3-2
The Financial System:
The Big Questions
1. What is a financial instrument and
what is their role in the economy?
2. What are financial markets and how
do they work?
3. What are financial institutions and
why are they so important?

3. 3-3
The Financial System:
Roadmap
• Financial Instruments
• Financial Markets
• Financial Institutions

4. 3-4
Preliminaries:
Definitions
Types of Finance
– Indirect: Institution stands between lender
and borrower.
– Direct: Borrowers sell securities directly to
lenders in the financial markets
Assets & Liabilities
– Asset: Something of value that you own
– Liability: Something you owe.

5. 3-5
Financial Instruments:
Definition
A written legal obligation of one party
to transfer something of value,
usually money, to another party
at some future date,
under certain conditions.

6. 3-6
Financial Instruments:
Uses
–Means of Payment
Purchase goods and services
–Store of Value
Transfer purchasing power into the future
–Transfer of Risk
Transfer risk to from one person to another

7. 3-7
Financial Instruments:
Characteristics
–Standardization
Overcome the costs of complexity
Makes them easier to understand
–Communicate Information
Summarize essential information about issuer
Eliminate expense of collecting information

8. 3-8
Financial Instruments:
Classes
–Underlying
Used to transfer resources
Examples: stocks and bonds
–Derivative
Value derived from underlying instruments
Examples: Futures and options

9. 3-9
Financial Instruments:
What Makes Them Valuable?
1. Size of the payment:
Larger → more valuable
2. Timing of payment:
Sooner → more valuable
3. Likelihood payment is made
More likely → more valuable
4. Conditions under with payment is made
When you need it most → more valuable

10. 3-10
Financial Instruments:
Examples
Primarily Used as Stores of Value
– Bank Loans
– Bonds
– Home Mortgages
– Stocks

11. 3-11
Financial Instruments:
Examples
Primarily used to Transfer Risk
– Insurance Contracts
– Futures Contracts

12. 3-12
Financial Markets:
Definition
Places where financial instruments
are bought and sold.

13. 3-13
Financial Markets:
Roles
–Liquidity:
Ensure owners can buy and sell
financial instruments cheaply.
–Information:
Pool and communication information about
issuers of financial instruments.
–Risk sharing:
Provide individuals a place to buy and sell risk.

14. 3-14
Financial Market Structure:
Primary vs. Secondary
Primary:
Buy and Sell Newly Issued Securities
Secondary:
Trade Existing Securities

15. 3-15
Financial Market Structure:
Centralized, OTC, and ECNs
Centralized Exchange
Physical location where trading takes place
Over-the-Counter Market (OTC)
Networks of dealers connected electronically
Electronic Communications Network (ECN)
Electronic networks where buyers and sellers
interact directly.

16. 3-16
Financial Market Structure:
Debt, Equity, and Derivatives
Debt and Equity Markets:
Financial claims are bought and sold for
immediate cash payment
Derivative Markets:
Financial claims based on underlying
instruments are bought and sold for
payment at a future date

17. 3-17
Financial Markets:
Characteristics
Well functioning markets have
–Low transaction costs
–Communicate accurate information
–Protect Investors

18. 3-18
Financial Institutions:
Their Role
• Reduce transactions cost by specializing in
the issuance of standardized securities
• Reduce information costs of screening and
monitoring borrowers.
• Issue short term liabilities and purchase long-
term loans.

19. 3-19
Financial Institutions:
A Simplified Balance Sheet

20. 3-20
Financial Industry Structure: I
1. Depository Institutions:
Take deposits and make loans
2. Insurance Companies
Accept premiums, pay out based on events
3. Pension Funds
Invest contributions, provide payments
to retirees

21. 3-21
Financial Industry Structure: II
4. Security Firms
Proved access to financial markets
5. Finance Companies
Raise funds in financial markets, make loans
6. Government Sponsored Enterprises
Raise funds in financial markets, make loans,
provide guarantees.