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Chapter 3

Financial Instruments, Financial Markets, and Financial Institutions

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2008

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?
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The Financial System: Roadmap


Financial Instruments Financial Markets Financial Institutions

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Preliminaries: Definitions
Types of Finance
Indirect: Institution stands between lender and borrower. Direct: Borrowers sell securities directly to lenders in the financial markets

Assets & Liabilities


Asset: Something of value that you own Liability: Something you owe.
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Funds Flowing through the Financial System

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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.

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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

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Builders of big building transfer the risk of a terrorist attack to someone else. Without terrorism insurance they dont build Following 9/11 they couldnt get it because no one knew how to price it The government stepped in as it does for natural disasters
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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

Risk
Higher the risk, higher the return

Liquidity
The ability to transfer an instrument into cash

Yield
Return in some future date Closely related to risk

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Financial Instruments: What Makes Them Valuable?


1. Size of the payment:
2. Timing of payment:
Larger more valuable Sooner more valuable More likely more valuable

3. Likelihood payment is made


4. Conditions under with payment is made
When you need it most more valuable

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Financial Markets: Definition


Places where financial instruments are bought and sold.

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Financial Markets: Characteristics


Well functioning markets have Low transaction costs Communicate accurate information Protect Investors

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Investors provide capital when they know they can get it back. Disparities in investor protection help explain differences in financial development. Without investor protection a countrys financial system does not develop. This hampers growth.

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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 longterm loans.

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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.
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Financial Instruments: Classes


Underlying
Used to transfer resources Examples: stocks and bonds

Derivative
Value derived from underlying instruments Examples:
Futures and forwards Options and Swaps
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Financial Market Structure: Debt, Equity, and Derivatives


Debt and Equity Markets (Underlying Market): Financial claims are bought and sold for immediate cash payment
Derivative Markets: Financial claims based on underlying instruments are bought and sold for payment at a future date
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Financial Market Structure: Primary vs. Secondary


Primary Market:
Buy and Sell Newly Issued Securities i.e. through investment banks by issuing prospectus for subscription of shares.

Secondary Market:
Trade Existing Securities. i.e. through Stock Exchanges and overthe-counter markets.

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Financial Market Structure: Centralized, OTC, and ECNs


Centralized Exchange
Physical location where trading takes place

Over-the-Counter Market (OTC)


Networks of dealers connected electronically and usually deal in customized contracts.

Electronic Communications Network (ECN)


Electronic networks where buyers and sellers interact directly.

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Financial Market Structure: Money Market vs. Capital Markets


Money Market:
A market for trading short term (less than one year), high quality securities Examples: Treasury Bills, Commercial Papers etc.

Capital Market:
The markets designed to transfer ownership of Long Term (over one year) debt and equity securities Examples: Corporate Bonds and Common Stock

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Other Definitions of Financial Markets


Call Money Markets
The market where day-to-day surplus funds, mostly of banks, are traded in. Short Term in nature with maturities varying between one day to a fortnight. Highly Liquid Inter-bank Money Market, i.e. KIBOR & LIBOR

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Other Definitions of Financial Markets


Treasury Bills (T-Bills) Market
A T-Bill is a particular kind of finance bill or a promissory note issued by the govt. of any country. A bill which does not arise from any genuine transaction in goods is called a finance bill. Absence of risk of default and assured yield Highly liquid because T-bills are claims against the govt.
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Other Definitions of Financial Markets


Commercial Bills Market
The financial instrument that is traded in the bills market is Bill of Exchange. B/E is used for financing a transaction in goods that takes some time to complete. According to Negotiable Instruments Act 1881: A B/E is a written instrument containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person, or to the bearer of the instrument. Can change ownership, i.e. it is transferable. High liquidity Also known as Bankers Acceptance in USA
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Classification of Bills of Exchange


Classification with respect to TIME: At sight / Demand Bills vs. Usance / Time Bills
At sight / Demand Bills: Payable at sight or on presentation or not mentioning any time. Usance Bills: payable at a specified later / future date.

Classification with respect to Location: Inland vs. Foreign Bills

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Other Definitions of Financial Markets


Markets for Commercial Paper CPs are unsecured and are backed only by the general credit standing of the issuing companies. Are negtiable by endorsement and delivery. Highly safe and liquid instruments Buyers of CPs are usually banks, liquid business concerns, and non-bank financial institutions.
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Industrial Securities Markets


Ordinary Shares Bonds Debentures Etc.

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Assignment 1:
Write detailed note on the Money Markets and Capital Markets in Pakistan. (Include the major participants and instruments being traded as well)

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Financial Instruments: Examples


Primarily Used as Stores of Value
Bank Loans Bonds Home Mortgages Stocks Asset-backed securities

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Financial Instruments: Examples


Primarily used to Transfer Risk
Insurance Contracts Futures Contracts Options

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Financial Industry Structure: I


1. Depository Institutions:
Take deposits and make loans

2. Insurance Companies
Accept premiums, pay out based on events

3. Pension Funds
Invest contributions, provide payments to retirees

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Financial Industry Structure: II


4. Security Firms
Proved access to financial markets

5. Finance Companies
Raise funds in financial markets, make loans

6. Government Sponsored Enterprises


Raise funds in financial markets, make loans, provide guarantees.

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Chapter 3

End of Chapter

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2008