Here we have different types of institution in the finance market.

1. Financial Instruments, Financial
Markets,
and Financial Institutions

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. The Financial System:
Roadmap
 Financial Instruments
 Financial Markets
 Financial Institutions

4. Preliminaries:
Definitions
Assets & Liabilities
 Asset: Something of value that you own
 Liability: Something you owe.

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.
Example: student loan

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

9. 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

10. Assume you have $1,000 and would like to
invest in the stock market. In a good
economy (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?
ICE:

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

12. Financial Instruments:
Examples
Primarily used to Transfer Risk
 Insurance Contracts
 Futures Contracts
 Options

13. Financial Markets:
Definition
Places where financial instruments
are bought and sold.

14. 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.

15. Importance of Financial Markets
2-15
 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.

16. Importance of Financial Markets
2-16
 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.

17. Structure of Financial Markets
2-17
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 end

18. Structure of Financial Markets
2-18
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?)

19. Structure of Financial Markets
2-19
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

20. Structure of Financial Markets
2-20
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

21. Classifications of Financial Markets
2-21
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

22. Financial Markets:
Characteristics
Well functioning markets have
Low transaction costs
Communicate accurate information
Protect Investors

23. Flow of Funds through
Financial Institutions

24. 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.

25. Asymmetric Information:
Adverse Selection and Moral Hazard
2-25
 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

26. Types of Financial Intermediaries
2-26

27. Size of Financial Intermediaries