Chapter 3: Financial Instruments, Markets and Institutions <ul><li>Financial Instruments </li></ul><ul><li>Financial Marke...
<ul><li>People who need funds </li></ul><ul><ul><li>borrowers/issuer/seller </li></ul></ul><ul><li>People who have funds t...
Indirect vs. Direct Finance <ul><li>Indirect finance </li></ul><ul><ul><li>Borrowers and lenders meet through a financial ...
<ul><li>Direct finance </li></ul><ul><ul><li>Borrowers sell securities directly to lenders </li></ul></ul><ul><ul><li>e.g....
 
I.  Financial Instruments <ul><li>aka. securities, financial assets </li></ul><ul><li>definition (p. 36 (1 st )  or 41 (2 ...
example <ul><li>shares of stock in Time Warner, Inc. </li></ul><ul><ul><li>shares of ownership in TW </li></ul></ul><ul><u...
<ul><li>my mortgage </li></ul><ul><ul><li>I am the borrower (liability) </li></ul></ul><ul><ul><li>the bank is the buyer/h...
uses of financial instruments <ul><li>means of payment </li></ul><ul><ul><li>but much less liquid than money </li></ul></u...
Valuing financial instruments <ul><li>sizing, timing & certainty of promised cash flows </li></ul><ul><li>Size: how much i...
<ul><li>Certainty: how likely its it that payments will be made? </li></ul><ul><ul><li>the likelier the payments the great...
examples  <ul><li>bank loans </li></ul><ul><li>stocks </li></ul><ul><li>bonds </li></ul><ul><li>home mortgages </li></ul><...
II.  Financial Markets <ul><li>where financial instruments are bought and sold </li></ul><ul><li>these markets provide </l...
Primary vs. Secondary Markets <ul><li>primary market </li></ul><ul><ul><li>newly issued securities </li></ul></ul><ul><ul>...
Debt vs. Equity Markets <ul><li>debt security </li></ul><ul><ul><li>cash flows are fixed </li></ul></ul><ul><ul><li>bonds,...
Exchanges vs. OTC Markets <ul><li>exchange </li></ul><ul><ul><li>buying & selling of securities in physical location </li>...
Money vs. Capital Markets <ul><li>money market </li></ul><ul><ul><li>short-term debt securities  (up to 1 yr.) </li></ul><...
 
 
III.  Financial Institutions <ul><li>aka. financial intermediaries </li></ul><ul><li>Why have them? </li></ul><ul><li>Tran...
<ul><li>Risk sharing </li></ul><ul><ul><li>intermediaries are experts at bearing risk </li></ul></ul><ul><li>Asset transfo...
Types of intermediaries <ul><li>Depository institutions </li></ul><ul><ul><li>“banks” </li></ul></ul><ul><ul><li>accept de...
<ul><li>Commercial banks </li></ul><ul><ul><li>largest in total assets </li></ul></ul><ul><ul><li>least restricted </li></...
<ul><li>Nondepository institutions </li></ul><ul><ul><li>insurance companies </li></ul></ul><ul><ul><li>pension funds </li...
Subprime mortgage meltdown <ul><li>Hit several types of financial institutions: </li></ul><ul><ul><li>finance companies  <...
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Banking

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Banking

  1. 1. Chapter 3: Financial Instruments, Markets and Institutions <ul><li>Financial Instruments </li></ul><ul><li>Financial Markets </li></ul><ul><li>Financial Institutions </li></ul>
  2. 2. <ul><li>People who need funds </li></ul><ul><ul><li>borrowers/issuer/seller </li></ul></ul><ul><li>People who have funds to give </li></ul><ul><ul><li>lenders/savers/buyers </li></ul></ul>
  3. 3. Indirect vs. Direct Finance <ul><li>Indirect finance </li></ul><ul><ul><li>Borrowers and lenders meet through a financial intermediary (e.g. bank) </li></ul></ul><ul><ul><li>Loan is a liability for borrower, and asset for a bank </li></ul></ul>
  4. 4. <ul><li>Direct finance </li></ul><ul><ul><li>Borrowers sell securities directly to lenders </li></ul></ul><ul><ul><li>e.g. corporate and Treasury bonds </li></ul></ul>
  5. 6. I. Financial Instruments <ul><li>aka. securities, financial assets </li></ul><ul><li>definition (p. 36 (1 st ) or 41 (2 nd )) </li></ul><ul><li>= written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions </li></ul><ul><li>a security is an asset for the buyer/lender, </li></ul><ul><li>but a liability for the issuer/borrower/seller </li></ul>
  6. 7. example <ul><li>shares of stock in Time Warner, Inc. </li></ul><ul><ul><li>shares of ownership in TW </li></ul></ul><ul><ul><li>a claim on the earnings/assets of TW </li></ul></ul><ul><ul><li>a liability for Time Warner </li></ul></ul><ul><ul><li>an asset for me </li></ul></ul>
  7. 8. <ul><li>my mortgage </li></ul><ul><ul><li>I am the borrower (liability) </li></ul></ul><ul><ul><li>the bank is the buyer/holder (asset) </li></ul></ul><ul><ul><li>the bank has a claim on my house </li></ul></ul>
  8. 9. uses of financial instruments <ul><li>means of payment </li></ul><ul><ul><li>but much less liquid than money </li></ul></ul><ul><li>store of value </li></ul><ul><ul><li>better than money over time, but also greater risk </li></ul></ul><ul><li>transfer of risk </li></ul><ul><ul><li>buyer transfers risk to seller </li></ul></ul><ul><ul><li>e.g. insurance policies, futures contract </li></ul></ul>
  9. 10. Valuing financial instruments <ul><li>sizing, timing & certainty of promised cash flows </li></ul><ul><li>Size: how much is promised? </li></ul><ul><ul><li>the larger the cash flows, the greater the value </li></ul></ul><ul><li>Timing: when is it promised? </li></ul><ul><ul><li>the sooner the cash flows are received, the greater the value </li></ul></ul>
  10. 11. <ul><li>Certainty: how likely its it that payments will be made? </li></ul><ul><ul><li>the likelier the payments the greater the value </li></ul></ul><ul><li>Under what conditions? </li></ul><ul><ul><li>e.g. insurance, derivatives </li></ul></ul><ul><ul><li>payments when we need them the most are more valuable </li></ul></ul>
  11. 12. examples <ul><li>bank loans </li></ul><ul><li>stocks </li></ul><ul><li>bonds </li></ul><ul><li>home mortgages </li></ul><ul><li>asset-backed securities </li></ul><ul><li>option and futures contracts </li></ul><ul><li>insurance policies </li></ul>
  12. 13. II. Financial Markets <ul><li>where financial instruments are bought and sold </li></ul><ul><li>these markets provide </li></ul><ul><ul><li>liquidity for buying/selling </li></ul></ul><ul><ul><li>information through prices </li></ul></ul><ul><ul><li>risk-sharing among buyers/sellers </li></ul></ul><ul><li>classified in various ways… </li></ul>
  13. 14. Primary vs. Secondary Markets <ul><li>primary market </li></ul><ul><ul><li>newly issued securities </li></ul></ul><ul><ul><li>-- investment banking </li></ul></ul><ul><li>secondary market </li></ul><ul><ul><li>brokers match buyers and sellers </li></ul></ul><ul><ul><li>dealers act as buyers and sellers </li></ul></ul><ul><ul><li>-- “market-makers” </li></ul></ul>
  14. 15. Debt vs. Equity Markets <ul><li>debt security </li></ul><ul><ul><li>cash flows are fixed </li></ul></ul><ul><ul><li>bonds, loans </li></ul></ul><ul><li>equity security </li></ul><ul><ul><li>cash flow variable, residual </li></ul></ul><ul><ul><li>common stock </li></ul></ul>
  15. 16. Exchanges vs. OTC Markets <ul><li>exchange </li></ul><ul><ul><li>buying & selling of securities in physical location </li></ul></ul><ul><ul><li>NYSE </li></ul></ul><ul><li>OTC (over-the-counter) </li></ul><ul><ul><li>dealers in many locations buy & sell securities </li></ul></ul>
  16. 17. Money vs. Capital Markets <ul><li>money market </li></ul><ul><ul><li>short-term debt securities (up to 1 yr.) </li></ul></ul><ul><ul><li>highly liquid, low risk </li></ul></ul><ul><li>capital market </li></ul><ul><ul><li>longer-term debt </li></ul></ul><ul><ul><li>equity </li></ul></ul>
  17. 20. III. Financial Institutions <ul><li>aka. financial intermediaries </li></ul><ul><li>Why have them? </li></ul><ul><li>Transactions costs </li></ul><ul><ul><li>search costs to find borrower & lender </li></ul></ul><ul><ul><li>contract costs </li></ul></ul><ul><ul><li>economies of scale </li></ul></ul>
  18. 21. <ul><li>Risk sharing </li></ul><ul><ul><li>intermediaries are experts at bearing risk </li></ul></ul><ul><li>Asset transformation </li></ul><ul><ul><li>short-term to long-term </li></ul></ul><ul><ul><li>illiquid to liquid </li></ul></ul>
  19. 22. Types of intermediaries <ul><li>Depository institutions </li></ul><ul><ul><li>“banks” </li></ul></ul><ul><ul><li>accept deposits, make loans </li></ul></ul>
  20. 23. <ul><li>Commercial banks </li></ul><ul><ul><li>largest in total assets </li></ul></ul><ul><ul><li>least restricted </li></ul></ul><ul><li>Savings & Loans </li></ul><ul><ul><li>originally restricted to savings deposits and mortgages </li></ul></ul><ul><ul><li>less restricted today </li></ul></ul><ul><li>Credit Unions </li></ul><ul><ul><li>consumer loans </li></ul></ul><ul><ul><li>nonprofit, organized around a group </li></ul></ul>
  21. 24. <ul><li>Nondepository institutions </li></ul><ul><ul><li>insurance companies </li></ul></ul><ul><ul><li>pension funds </li></ul></ul><ul><ul><li>finance companies </li></ul></ul><ul><ul><ul><li>Mortgage, auto, office equipment </li></ul></ul></ul><ul><ul><li>Securities firms </li></ul></ul><ul><ul><li>gov’t-sponsored enterprises (GSEs) </li></ul></ul>
  22. 25. Subprime mortgage meltdown <ul><li>Hit several types of financial institutions: </li></ul><ul><ul><li>finance companies </li></ul></ul><ul><ul><ul><li>Countrywide </li></ul></ul></ul><ul><ul><li>securities firms </li></ul></ul><ul><ul><ul><li>Citigroup, Merrill Lynch </li></ul></ul></ul><ul><ul><li>GSEs </li></ul></ul><ul><ul><ul><li>Fannie Mae, Freddie Mac </li></ul></ul></ul>

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