Chapter 3

Financial Instruments, Financial Markets,

and Financial Institutions

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 Learning Objectives
1. Explain what financial instruments are, how
they are used, and how they are valued.
2. Discuss the role and structure of financial
markets and identity the characteristics of a
well-run financial market.
3. Describe the role of financial institutions and
structure of the financial industry.

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 Introduction
• Direct Finance: Borrowers sell securities
directly to lenders in the financial markets.
– Direct finance provides financing for
governments and corporations.
• Indirect Finance: An institution stands
between lender and borrower.
– We get a loan from a bank or finance company to
buy a car.
• Asset: Something of value that you own.
• Liability: Something you owe.

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 Introduction
• 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.

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 Introduction
We will survey the financial system in three steps:
1. Financial instruments or securities
– Stocks, bonds, loans and insurance.
– What is their role in our economy?
2. Financial Markets
– New York Stock Exchange, Nasdaq.
– Where investors trade financial instruments.
3. Financial institutions
– What they are and what they do.
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 Figure 3.1: Funds Flowing
through the Financial System

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 Financial Instruments
Financial Instruments: The written legal obligation of
one party to transfer something of value, usually
money, to another party at some future date, under
specified 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 conditions under which a
payment will be made.
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 Uses of Financial
Instruments
• Three functions:
– Financial instruments act as a means of payment
(like money).
• Employees take stock options as payment for working.
– Financial instruments act as stores of value (like
money).
• Financial instruments can be used to transfer purchasing
power into the future.
– Financial instruments allow for the transfer of risk
(unlike money).
• Futures and insurance contracts allows one person to
transfer risk to another.
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• The use of borrowing to finance part of an
investment is called leverage.
– Leverage played a key role in the financial
crisis of 2007-2009.
• The more leverage, the greater the risk
that an adverse surprise will lead to
bankruptcy.
• During the crisis, some financial firms leveraged
more than 30 times their net worth.
• For those important firms, small declines in assets
made these firms vulnerable.

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• When losses are experienced, firms try
to deleverage to raise net worth.
• As many institutions deleveraged, prices fell,
losses increased, and net worth fell.
– This is called the “paradox of leverage”.
• Reinforces the leverage spiral
• Both spirals fed the cycle of falling prices and
widespread deleveraging - the hallmark of the
financial crisis of 2007-2009.

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 Characteristics of Financial
Instruments
• These contracts are very complex.
• This complexity is costly, and people do not
want to bear these costs.
• Standardization of financial instruments
overcomes potential costs of complexity.
• Financial instruments also communicate
information, summarizing certain details
about the issuer.

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 Characteristics of Financial
Instruments
• 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.
• The solution to the high cost of obtaining
information is to standardize both the instrument
and the information about the issuer.
• Financial instruments are designed to handle the
problem of asymmetric information.
– Borrowers have some information they don’t disclose to
lenders.

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 Underlying Versus Derivative
Instruments
• Underlying instruments are used by savers/lenders
to transfer resources directly to
investors/borrowers.
– This improves the efficient allocation of resources.
• Examples: stocks and bonds
• Derivative instruments are those where their value
and payoffs are “derived” from the behavior of the
underlying instruments.
– Examples are futures, options, and swaps.
– The primary use is to shift risk among investors.

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A Primer for Valuing Financial
Instruments
Four fundamental characteristics influence the
value of a financial instrument:
1. Size of the payment:
– Larger payment - more valuable.
2. Timing of payment:
– Payment is sooner - more valuable.
3. Likelihood that payment is made:
– More likely to be made - more valuable.
4. Conditions under with payment is made:
– Made when we need them - more valuable.
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 A Primer for Valuing
Financial Instruments
We organize financial instruments by how they
are used:
• Primarily used as stores of value
1. Bank loans
– Borrower obtains resources from a lender to be
repaid in the future.
2. Bonds
– A form of a loan issued by a corporation or
government.
– Can be bought and sold in financial markets.
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 A Primer for Valuing
Financial Instruments
[Link] mortgages
– Home buyers usually need to borrow
using the home as collateral for the loan.
• A specific asset the borrower pledges to
protect the lender’s interests.
[Link]
– The holder owns a small piece of the firm
and entitled to part of its profits.
– Firms sell stocks to raise money.
– Primarily used as a stores of wealth.
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 A Primer for Valuing
Financial Instruments
[Link]-backed securities
– Shares in the returns or payments arising
from specific assets, such as home
mortgages and student loans.
• Mortgage-backed securities bundle a large
number of mortgages together into a pool
in which shares are sold.
• Securities backed by subprime mortgages
played an important role in the financial crisis
of 2007-2009.

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• The biggest risk we all face is becoming
disabled and losing our earning capacity.
– Insuring against this should be one of our
highest priorities.
• It is important to assess to make sure you
have enough insurance.
• Disability insurance is one way to transfer
that risk to someone else.

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 Financial Instruments Used
Primarily to Transfer Risk
1. Insurance contracts.
– Primary purpose is to assure that payments
will be made under particular, and often rare,
circumstances.
2. Futures contracts.
– An agreement between two parties to
exchange a fixed quantity of a commodity or
an asset at a fixed price on a set future date.
– A price is always specified.
– This is a type of derivative instrument.

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 Financial Instruments Used
Primarily to Transfer Risk
3. Options
– Derivative instruments whose prices are
based on the value of an underlying asset.
– Give the holder the right, not obligation,
to buy or sell a fixed quantity of the asset
at a pre-determined price on either a
specific date or at any time during a
specified period.

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 Financial Instruments Used
Primarily to Transfer Risk
4. Swaps
– Agreements to exchange two specific cash flows
at certain times in the future.
– Come in many varieties reflecting differences in
maturity, payment frequency, and underlying
cash flows.

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 Financial Markets
• Financial markets are places where financial
instruments are bought and sold.
• These markets are the economy’s central
nervous system.
• These markets enable both firms and
individuals to find financing for their activities.
• These markets promote economic efficiency.

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The Role of Financial
Markets
1. Market liquidity:
– Ensure owners can buy and sell financial
instruments cheaply.
– Keeps transactions costs low.
2. Information:
– Pool and communication information about
issuers of financial instruments.
3. Risk sharing:
– Provide individuals a place to buy and sell risk.

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 The Structure of Financial
Markets
1. Distinguish between primary or secondary
markets.
2. Categorize by the way they trade.
3. Group based on the type of instrument they
trade.

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 Primary versus Secondary
Markets
• A primary financial market is one in which a
borrower obtains funds from a lender by
selling newly issued securities.
• Secondary financial markets are those where
people can buy and sell existing securities.

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• Trading is what makes financial markets work.
• You can place a market order.
• You can place a limit order.
• Executing a trade requires someone on the
other side.
– Can seek help of a broker who can facilitate access
to an electronic trading system known as an
Electronic Communication network (ECN).

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• For a well-known stock, the NYSE is another
place from which to order.
– Liquidity may be supplemented by designated
market makers (DMMs).
• The system combines the buy (sell) orders of
different customers at each price.
– We can see the aggregate supply (demand) of the
stock at that price.

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 Secondary-Market Trading in
Stocks
• Historically there were:
• Centralized exchanges - buyers and sellers meet
in a central, physical location.
• Over-the-counter markets (OTS’s) - decentralized
markets where dealers stand ready to buy and
sell securities electronically.
• More recently, there are electronic
communication networks (ECN’s):
• Electronic system bringing buyers and sellers
together without the use of a broker or dealer.
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 Secondary-Market Trading in
Stocks
• Pace of structural change has accelerated
dramatically
1. Ongoing technological advances in computing
and communications
• Physical location of exchange less important
2. Increased globalization
• Encouraged more cross-border mergers of
exchanges.

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 Secondary-Market Trading in
Stocks
Decentralized electronic exchanges has benefits
– Customers can see their orders
– Orders happen quickly
– Can trade 24 hours a day
– Low cost
– Reduces operational risk, like when the NYSE was
inaccessible for days after 9-11.

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Secondary-Market Trading in
Stocks
• But it also has risks
– The system has proven prone to errors.
• Trading algorithm a rule-based program for
automatically executing hundreds or thousands of
trades.
• High frequency traders (HFTs) can purchase or sell
thousands of stocks in seconds.
• We also see that efforts to speed up electronic
trading drain resources from other uses.
• Could diminish the willingness of market
makers to provide liquidity.
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• High-frequency trading (HFT) poses at least five
problems
1. It amplifies the risks of electronic operations.
2. The complex real-time interaction of HFT algorithms
can overwhelm trading platforms and disrupt the
markets.
3. The prevalence of HFT weakens the position of
market makers, who provide liquidity to traditional
investors.
4. Creates a temptation for front-running customer
orders, which damages investor confidence.
5. It can trigger a socially unproductive arms race.
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 Debt and Equity versus
Derivative Markets
• Used to distinguish between markets where
debt and equity are traded and those where
derivative instruments are traded.
• Debt markets are markets for loans,
mortgages, and bonds.
• Equity markets are the markets for stocks.
• Derivative markets are the markets where
investors trade instruments like futures,
options, and swaps.
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 Debt and Equity versus
Derivative Markets
• In debt and equity markets, actual claims are
bought and sold for immediate cash payments.
• In derivative markets, investors make
agreements that are settled later.
• Debt instruments categorized by the loan’s
maturity
– Repaid in less than a year - traded in money
markets.
– Maturity of more than a year - traded in bond
markets.

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 Characteristics of a Well-Run
Financial Market
• Essential 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.
– Lenders must be able to enforce their right of
repayment quickly and at low cost.

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• Financial intermediation and leverage in the
U.S. have shifted away from traditional banks
and toward other financial institutions less
subject to government regulations.
– Brokerages, insurers, hedge funds, etc.
• These have become known as shadow banks.
– Provide services that compete with banks but do
not accept deposits.
– Take on more risk than traditional banks and are
less transparent.

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• The rise of highly leveraged shadow banks,
combined with government relaxation of rules for
traditional banks, permitted a rise of leverage in
the financial system as a whole.
• Rapid growth in some financial instruments made
it easier to conceal leverage and risk-taking.
• The financial crisis of 2007-2009 transformed
shadow banking.
– Scrutinize any financial institution that could, by risk
taking, pose a threat to the financial system.
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 Financial Institutions
• Firms that provide access to the financial
markets, both
– to savers who wish to purchase financial
instruments directly and
– to borrowers who want to issue them.
• Also known as financial intermediaries.
– Examples: banks, insurance companies,
securities firms, and pension funds.

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 The Role of Financial
Institutions
• To reduce transaction costs by specializing
in the issuance of standardized securities.
• To reduce the information costs of screening
and monitoring borrowers.
– They curb asymmetries, helping resources flow
to most productive uses.
• To give savers ready access to their funds.

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The Structure of the Financial
Industry
• We can divide intermediaries into two
broad categories:
– Depository institutions
• Take deposits and make loans.
• What most people think of as banks.
– Nondepository institutions
• Include insurance companies, securities firms,
mutual fund companies, hedge funds, private equity
or venture capital firms, finance companies, and
pension funds.

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The Structure of the Financial
Industry
1. Depository institutions take deposits and
make loans.
2. Insurance companies accept premiums,
which they invest, in return for promising
compensation to policy holders under
certain events.
3. Pension funds invest individual and
company contributions in stocks, bonds,
and real estate in order to provide
payments to retired workers.
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The Structure of the Financial
Industry
4. Securities firms include brokers, investment
banks, underwriters, mutual fund companies,
private equity firms, and venture capital firms.
– Brokers and investment banks issue stocks and bonds
to corporate customers, trade them, and advise
customers.
– Mutual-fund companies pool the resources of
individuals and companies and invest them in
portfolios - passive investing.
– Hedge funds do the same for small groups of wealthy
investors.
– Private equity and venture capital firms also serve
wealthy investors by acquiring controlling stakes in a
few firms and manage them actively.
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The Structure of the Financial
Industry
5. Finance companies raise funds directly
in the financial markets in order to
make loans to individuals and firms.
6. Government-sponsored enterprises
(GSEs) are federal credit agencies that
provide loans directly for farmers and
home mortgagors.

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 Figure 3.2: Flow of Funds
through Financial Institutions

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• Financial access promotes both economic
equality and economic growth
• Finance allows countries to mobilize domestic
savings effectively, lowering transaction costs
– Efficient means of payment broadens the markets
for goods and services and facilitates a greater
division of labor

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