Chapter 3

Financial Instruments, Financial

Markets,
and Financial Institutions
 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?

3-2
 The Financial System:
Roadmap
Financial Instruments
Financial Markets
Financial Institutions

3-3
 Preliminaries:
Definitions

Assets & Liabilities

Asset: Something of value that you own
Liability: Something you owe.
Question: to a bank, what is its assets?
Liability?

3-4
 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.
Example: student loan

Why do we need financial

instruments?
3-5
 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

3-6
 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

3-7
 Financial Instruments:
Classes
Underlying
Used to transfer resources
Examples: stocks and bonds

Derivative
Value derived from underlying
instruments
Examples: Futures and options

3-8
 Financial Instruments:
How to price financial
instruments?
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

3-9
 Assume you have $1,000 and would
like to invest in the stock market. In
a good economy ICE:
(20% likelihood),
you can make about 20% of return. In
a normal economy (50% likelihood),
your return could be 5%. But in a
crisis, you are going to lose 5%. You
can borrow another $1000 from your
friend at 3% of interest rate. What is
your return under each economic
condition, with and without the loan?

3-10
 Financial Instruments:
Examples
Primarily Used as Stores of Value
 Bank Loans
 Bonds
 Home Mortgages
 Stocks
 Asset-backed securities

3-11
 Financial Instruments:
Examples
Primarily used to Transfer Risk
 Insurance Contracts
 Futures Contracts
 Options

3-12
 Financial Markets:
Definition

Places where financial instruments

are bought and sold.

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.

3-14
 Importance of Financial
Markets
This is important. For example, if you save
$1,000, but there are no financial markets,
then you can earn no return on this – might as
well put the money under your mattress.
However, if a carpenter could use that money
to buy a new saw (increasing her
productivity), then she’d be willing to pay you
some interest for the use of the funds.

2-15
Importance of Financial
Markets
Financial markets are critical for producing
an efficient allocation of capital, allowing
funds to move from people who lack
productive investment opportunities to
people who have them.
Financial markets also improve the well-
being of consumers, allowing them to time
their purchases better.

2-16
 Structure of Financial
Markets
1. Debt Markets
 Short-Term (maturity < 1 year)
 Long-Term (maturity > 10 year)
 Intermediate term (maturity in-between)
 Represented $41 trillion at the end of 2007.

2. Derivative market: Financial claims based on

underlying
instruments are bought and sold for payment
at a future date

3. Equity Markets
 Pay dividends, in theory forever
 Represents an ownership claim in the firm
 Total value of all U.S. equity was $18 trillion at the
2-17
Structure of Financial
Markets
1. Primary Market
 New security issues sold to initial buyers
 Typically involves an investment bank who
underwrites the offering

2. Secondary Market
 Securities previously issued are bought
and sold
 Examples include the NYSE and Nasdaq
 Involves both brokers and dealers (do you
know the difference?)

2-18
Structure of Financial
Markets
Even though firms don’t get any money,
per se, from the secondary market, it
serves two important functions:
• Provide liquidity, making it easy to buy
and sell the securities of the companies
• Establish a price for the securities

2-19
Structure of Financial
Markets
We can further classify secondary
markets as follows:
1. Exchanges
 Trades conducted in central locations
(e.g., New York Stock Exchange)

2. Over-the-Counter Markets
 Dealers at different locations buy and sell
 Best example is the market for Treasury
securities

NYSE home page

[Link] 2-20
Classifications of Financial Markets
We can also further classify markets by
the maturity of the securities:
1. Money Market: Short-Term (maturity < 1
year)
2. Capital Market : Long-Term (maturity > 1
year) plus equities

2-21
 Financial Markets:
Characteristics
Well functioning markets have
Low transaction costs
Communicate accurate
information
Protect Investors

3-22
 Flow of Funds through
Financial Institutions

3-23
 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.

3-24
 Asymmetric Information:
Adverse Selection and Moral Hazard
 Financial intermediaries reduce adverse selection and
moral hazard problems, enabling them to make profits.
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse
outcomes are ones most likely to seek loans and be
selected
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely
that won’t pay loan back
Financial intermediaries reduce adverse selection
and moral hazard problems, enabling them to
make profits 2-25
Intermediaries

2-26
Size of Financial
Intermediaries
 Videos to watch (optional)
Wall Street trader's NYSE Trading Floor Tour
[Link]
[Link]

NASDAQ on AWS - Customer Success Story

[Link]

Introduction to The NASDAQ

[Link]

CBOT Trading Soybean market pit trading

[Link]

MGEX - The final minute of trading in the pits, forever.

[Link]

Ira, Fixed Income Capital Markets, BNP Paribas CIB, New York
[Link]
3-28
[Link]