This document provides an overview of financial instruments. It defines a financial instrument as a real or virtual document representing a legal agreement involving monetary value. Financial instruments can be divided into cash instruments, which are directly influenced by markets, and derivative instruments, which derive their value from underlying assets. The main types are debt-based instruments like bonds and equity-based instruments like stocks. Financial markets allow these instruments to be traded, providing liquidity, sharing risk, and communicating information to promote economic efficiency. Financial institutions help resources flow through the financial system by specializing in issuing standardized securities and screening borrowers.

1. Dr. C.V. Suresh Babu

2. • Objectives
• Introduction
• What is a Financial Instrument?
• Understanding Financial Instrument
• Types of Financial Instrument
• Financial Markets
• Role of Financial Markets

3. Objectives
• A financial instrument is a real or virtual document representing a legal
agreement involving any kind of monetary value.
• Financial instruments may be divided into two types: cash instruments and
derivative instruments.
• Financial instruments may also be divided according to an asset class, which
depends on whether they are debt-based or equity-based.
• Foreign exchange instruments comprise a third, unique type of financial
instrument.

4. 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.

5. What Is a Financial Instrument?
• Financial instruments are assets that can be
traded, or they can also be seen as packages of
capital that may be traded.
• Most types of financial instruments provide
efficient flow and transfer of capital all
throughout the world's investors.
• These assets can be cash, a contractual right to
deliver or receive cash or another type of
financial instrument, or evidence of one's
ownership of an entity.

6. Understanding Financial Instruments
• Financial instruments can be real or virtual documents representing a
legal agreement involving any kind of monetary value.
• Equity-based financial instruments represent ownership of an asset.
• Debt-based financial instruments represent a loan made by an investor to the
owner of the asset.
• Foreign exchange instruments comprise a third, unique type of financial
instrument.
• Different subcategories of each instrument type exist, such as
preferred share equity and common share equity.

8. Cash Instruments
• The values of cash instruments are directly influenced and
determined by the markets. These can be securities that are easily
transferable.
• Cash instruments may also be deposits and loans agreed upon by
borrowers and lenders.

9. Derivative Instruments
• The value and characteristics of derivative instruments are based on the vehicle’s
underlying components, such as assets, interest rates, or indices.
• An equity options contract, for example, is a derivative because it derives its
value from the underlying stock. The option gives the right, but not the
obligation, to buy or sell the stock at a specified price and by a certain date. As
the price of the stock rises and falls, so too does the value of the option although
not necessarily by the same percentage.
• There can be Over-the-counter (Otc) derivatives or exchange-traded derivatives.
OTC is a market or process whereby securities–that are not listed on formal
exchanges–are priced and traded.

10. Types of Asset Classes of Financial Instruments
Financial instruments may also be divided according to an asset class,
which depends on whether they are
• Debt-based or
• Equity-based.

11. Debt-Based Financial Instruments
• Short-term debt-based financial instruments last for one year or less. Securities
of this kind come in the form of T-bills and commercial paper. Cash of this kind
can be deposits and Certificates of deposit (CDs).
• Exchange-traded derivatives under short-term, debt-based financial instruments
can be short-term interest rate futures. OTC derivatives are forward rate
agreements.
• Long-term debt-based financial instruments last for more than a year. Under
securities, these are bonds. Cash equivalents are loans. Exchange-traded
derivatives are bond futures and options on bond futures. OTC derivatives are
interest rate swaps, interest rate caps and floors, interest rate options, and exotic
derivatives.

12. Equity-Based Financial Instruments
• Securities under equity-based financial instruments are stocks.
Exchange-traded derivatives in this category include stock options
and equity futures. The OTC derivatives are stock options and exotic
derivatives.

13. Special Considerations
• There are no securities under foreign exchange. Cash equivalents
come in spot foreign exchange, which is the current prevailing rate.
Exchange-traded derivatives under foreign exchange are currency
futures. OTC derivatives come in foreign exchange options, outright
forwards, and foreign exchange swaps.

14. 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.
• Most mortgages feature a standard application with standardized terms.
• Financial instruments also communicate information, summarizing certain details about the
issuer.
• Continuous monitoring of an issuer is costly and difficult.
• 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 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.

15. 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 generate increases in wealth that are larger than from holding 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.

16. Funds Flowing through the Financial System

17. 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:
• They ensure resources are available to those who put them to their best use.
• They keep transactions costs low.

19. The Role of Financial Markets
1. 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.

21. The Structure of Financial Markets
1. Distinguish between markets where new financial instruments are
sold and where they are resold or traded: primary or secondary
markets.
2. Categorize by the way they trade: centralized exchange or not.
3. Group based on the type of instrument they trade: as a store of
value or to transfer risk.

22. Primary versus Secondary Markets
• A primary market is one in which a borrower obtains funds from a
lender by selling newly issued securities.
• Occurs out of the public views.
• An investment bank determines the price, purchases the securities, and
resells to clients.
• This is called underwriting and is usually very profitable.

23. Primary versus Secondary Markets
• Secondary financial markets are those where people can buy and sell
existing securities.
• Buying a share of IBM stock is not purchased from the company, but from
another investor in a secondary market.
• These are the prices we hear about in the news.

24. Centralized Exchanges, OTC’s, and ECN’s
• 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.
• Electronic communication networks (ECN’s) - electronic system
bringing buyers and sellers together without the use of a broker or
dealer.

25. Debt and Equity versus Derivative Markets
• Used to distinguish between markets where debt and equity are
traded and those where derivative instruments are traded.
• Equity markets are the markets for stocks.
• Derivative markets are the markets where investors trade instruments
like futures and options.

26. 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.

27. 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.

28. Characteristics of a Well-Run Financial Market
• Because of these criteria, the governments are an essential part of
financial markets as they enforce the rules of the game.
• Countries with better investor protections have bigger and deeper financial
markets.

29. 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.
• Healthy financial institutions open the flow of resources, increasing the system’s
efficiency.

30. 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.

31. 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
• Non-depository institutions.
• Include insurance companies, securities firms, mutual fund companies, etc.

32. 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.
4. Securities firms include brokers, investment banks, underwriters, and mutual fund companies.
• 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.
• Hedge funds do the same for small groups of wealthy investors.
5. Finance companies raise funds directly in the financial markets in order to make loans to individuals and firms.
• Finance companies tend to specialize in particular types of loans, such as mortgage, automobile, or business
equipment.
6. Government-sponsored enterprises are federal credit agencies that provide loans directly for farmers and home
mortgagors.
• Guarantee programs that insure loans made by private lenders.
• Provides retirement income and medical care through Social Security and Medicare.

33. Flow of Funds through Financial Institutions