978-1259285295 Chapter 3 Lecture Note Part 1

Unlock access to all the studying documents.

View Full Document

Chapter 03 – Financial Instruments, Financial Markets, and Financial Institutions

Chapter 3

Financial Instruments, Financial Markets,

and Financial Institutions

Chapter Overview

In this chapter the financial system is surveyed in three steps: 1) financial instruments or

securities are studied; 2) financial markets are considered; and 3) financial institutions are

examined.

Learning Objectives: Understand

Financial instruments

Financial markets

Financial institutions.

Important Points of the Chapter

The formal financial instruments of the modern world have their roots in the informal

arrangements that were the mainstays of the financial system centuries ago. Even in the most

primitive economies, people needed to borrow when their consumption needs exceeded their

income. Families or communities provided the lending with the understanding that if the needs

were reversed they would receive similar assistance. Today, the international financial system

exists to facilitate the design, sale, and exchange of a broad set of contracts and so fosters

production, employment, and consumption. Savings are funneled through the system so that

they can finance investment and the decisions of the people who do the saving direct the capital

to its most efficient uses, thus resulting in economic growth.

Application of Core Principles

Principle #2: Risk. Most financial instruments transfer risk between the buyer and seller. The

example of a wheat farmer selling a futures contract on his crop demonstrates that the farmer can

sell the instrument, setting the price that will be received for the crop regardless of how it turns

out, and so transfer the risk onto the buyer of the contract.

Principle #3: Information. Financial instruments communicate information by summarizing

certain essential information about the issuer. Financial instruments are designed to eliminate the

expensive and time-consuming process of collecting information on the issuer.

Principle #1: Time. The sooner a payment is made the more valuable is the promise that it will

be made. This is because a payment that is received can be invested and will begin to earn a

return immediately; if one has to wait to make the investment potential returns are lost.

Principle #2: Risk. The more likely it is that a payment will be made the more valuable is the

financial instrument.

3-1

Education.

Chapter 03 – Financial Instruments, Financial Markets, and Financial Institutions

Principle #4: Markets. Financial markets offer liquidity, pool and communicate information and

allow risk sharing.

Principle #3: Information. In well-run financial markets the information that is pooled and

communicated is accurate and widely available. If this were not so, the markets would not

generate the correct prices for the instruments, and those prices are the link between the financial

markets and the real economy. Hence if the prices are wrong the economy will not operate as

effectively as it could.

Principle #3: Information. Standardized securities reduce the information costs of screening and

monitoring borrowers. Financial institutions thus curb information asymmetries and the

problems that go along with them, helping to ensure that resources flow into their most

productive uses.

Teaching Tips/Student Stumbling Blocks

Here’s a good illustration of the benefits of a mutual fund; liken it to a deck of playing cards.

Would a consumer rather have one card in the deck or a piece of all the cards? This is

diversification.

Features in this Chapter

Lessons from the Crisis: Leverage

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. Modern economies rely heavily on borrowing to make

investments. The more leverage, however, the greater the risk of that an unexpected adverse

event will lead to bankruptcy. Financial institutions are highly leveraged, typically owning

assets of ten times their net worth. During the financial crisis, this number was upwards of 30

times from some firms, meaning that a small drop in the value of asset prices could lead to

bankruptcy. Firms that are too highly leveraged will often try to reduce their leverage –

deleverage – by selling assets and issuing securities to raise their net worth. However, the

financial system cannot deleverage all at the same time. When it does, asset prices fall even

further, leading to more deleveraging and a spiral downward of asset prices.

Your Financial World: Disability Income Insurance

Few people insure their most valuable asset, their ability to produce an income even though the

statistics say that the chances of becoming disabled are far greater than that of other calamities,

like your house burning down. The government provides some disability insurance through

Social Security and if you’re injured on the job and can’t work there is workers’ compensation

insurance. However, this may not be enough, so individuals should evaluate their needs and

consider whether they need to buy additional insurance. As noted in the text, surely this is one

risk you should transfer to someone else.

3-2

Education.

Chapter 03 – Financial Instruments, Financial Markets, and Financial Institutions

Tools of the Trade: Trading in Financial Markets

With today’s electronic markets you can enter an order and watch as it is executed. If you want

to buy, you enter a bid, and if yours is the highest bid and someone is willing to sell at that price,

you trade immediately. Otherwise, your bid goes into an order book to wait for a seller. If you

sent your order through the New York Stock Exchange, it would have to go through a specialist

who would match the orders. To keep the market liquid so that people can both buy and sell and

so that prices are not overly volatile, specialists often trade on their own account.

In the News: Wait a Second

On August 1, 2012, Knight Capital started to use a new software program to execute its trades.

Within a minute, the program had sent buy and sell orders that cost Knight $440 million. Most

trades are carried out by computer without a glitch and with cost savings. Several drawbacks to

computer trading include software glitches and systemic risks. Suggested improvements include

sully testing automated trading software, voluntary guidelines, and circuit breakers that can halt

trading.

Lessons from the Crisis: Interbank Lending

Interbank lending is a critical foundation of modern financial markets. In normal times, banks

lend to each other in large volumes at low costs for periods ranging from overnight to a few

months. These loans smooth the functions of markets by allowing banks to offset the fandom

ebbs of flows of deposits and loans. If banks did not have access to these loans, they would hold

more cash to insure against unanticipated changes in deposits or loan demand. The financial

crisis of 2007-2009 triggered much greater and more prolonged strains on interbank lending.

The government stepped in, however, to add liquidity and guarantee bank debt and the strains

eventually eased. These crises are not isolated. In 2012, many banks in European countries

became unable to borrow.

Lessons from the Crisis: Shadow Banks

Over the past few decades, financial intermediation and leverage in the United States has shifted

away from traditional banks and toward other financial institutions not subject to government

regulation, including brokerages, consumer and mortgage finance firms, insurers, and

bank-created asset-management firms. These firms are often called shadow banks because they

3-3

Education.

Lessons of the Article: Information technology lowers the costs of financial transactions,

making securities more liquid and the financial system more efficient. But securities trading

is now so rapid that further speed gains have diminishing benefits for the economy, while the

introduction of untested technologies can undermine trading and cause intermediaries to fail.

The article highlights the potential conflict between the incentives of firms that seek a

competitive edge through faster trading of stocks and the economy’s need for a robust system

of exchange.

Chapter 03 – Financial Instruments, Financial Markets, and Financial Institutions

provide services that compete with or substitute for those supplied by traditional banks.

Financial innovation leading to broader markets, lower information costs, and new profit

opportunities all encouraged the development of new financial instruments and institutions.

Over time, leverage in the financial system as a whole increased, and the new financial

instruments made it easier to conceal leverage and risk-taking. The financial crisis of 2007-2009

transformed shadow banking and the future of shadow banking remains uncertain.

Your Financial World: Shop for a Mortgage

Getting the cheapest mortgage you can find will save you more money than a year’s worth of

bargain hunting in stores. Real estate agents can provide lists of mortgage providers in your

area, and there are websites that publish quotes for mortgages. Not all of the firms offering

mortgages are banks; some are mortgage brokers, firms that have access to pools of funds that

are earmarked for use as mortgages. It should make no difference to you where the funds come

from; a mortgage is a mortgage. But shop before you sign on the dotted line, and if you let

brokers know that you are shopping around, you may get a better deal.

Additional Teaching Tools

Writing in The Wall Street Journal (May 27, 2004), Kaja Whitehouse reports that a financial

publishing firm (Moneypaper, Inc., based in Rye, New York) has launched an online gift registry

that allows brides and grooms to receive gifts of stock. Called giftsofstock.com, the plan focuses

on DRIPs or dividend reinvestment plans, whereby anyone with one or more shares can reinvest

the dividends and so increase their holdings. But buying the initial shares can be expensive,

which is where the registry comes in. Users of the site can choose from among 56 different

stocks. The companies were picked because they have no costs (or low costs) associated with

setup or additional cash investments and because they are good long-term investments. It costs

about $20 to buy the stock and register it in the recipient’s name.

Virtual Tools

Do you own U.S. savings bonds? Find out what your savings bond is worth and keep a record of

your portfolio at this website from the U.S. Treasury Department:

http://www.treasurydirect.gov/BC/SBCPrice

Visit the homepage of the NYSE at:

http://www.nyse.com/

Visit NASDAQ at:

http://www.nasdaq.com/

You can find a mortgage calculator (as well as other information) on this site from lending

tree.com:

https://www.lendingtree.com/mortgage-calculator

3-4

Education.

Chapter 03 – Financial Instruments, Financial Markets, and Financial Institutions

Did you know you can also purchase historical stocks and bonds as gifts? Visit:

http://www.scripophily.net/

For More Discussion

Have students discuss the average person’s portfolio of assets (does he or she have a checking

account? Mutual fund shares?). Evaluate the pros and cons of those items.

Chapter Outline

1. The informal arrangements that were the mainstay of the financial system centuries ago

have since given way to the formal financial instruments of the modern world.

2. Today, the international financial system exists to facilitate the design, sale, and exchange

of a broad set of contracts with a very specific set of characteristics.

3. We obtain the financial resources we need through this system in two ways: directly from

lenders and indirectly from financial institutions called financial intermediaries.

4. In the latter (called “indirect finance”) a financial institution (like a bank) borrows from

the lender and then provides funds to the borrower. If someone borrows money to buy a

car, the car becomes his or her asset and the loan a liability.

5. Economists formerly distinguished sharply between direct finance and indirect finance,

but as finance has grown increasingly complex, virtually all transactions take on some

indirect nature.

6. In direct finance, borrowers sell securities directly to lenders in the financial markets.

Governments and corporations finance their activities this way.

7. The securities become assets to the lenders who buy them and liabilities to the borrower

who sells them.

8. Financial development is inextricably linked to economic growth.

9. There aren’t any rich countries that have very low levels of financial development.

I. Financial Instruments

A financial instrument is the written legal obligation of one party to transfer something of

value—usually money—to another party at some future date, under certain conditions.

1. The fact that a financial instrument is a written legal obligation means that it is

subject to government enforcement; the enforceability of the obligation is an

important feature of a financial instrument.

2. The “party” referred to can be a person, company, or government.

3. The future date can be specified or can be when some event occurs.

3-5

Education.

Chapter 03 – Financial Instruments, Financial Markets, and Financial Institutions

4. Financial instruments generally specify a number of possible contingencies under

which one party is required to make a payment to another.

Uses of Financial Instruments

1. Stocks, loans, and insurance are all examples of financial instruments.

2. As a group, they have three functions or uses:

a. They can act as a means of payment.

b. They can be stores of value.

c. They allow for the taking of risk.

3. Most financial instruments involve some sort of risk transfer.

A. Characteristics of Financial Instruments: Standardization and Information

1. Financial instruments are complex contracts.

2. Standardized agreements are used in order to overcome the potential costs of

complexity.

3. Because of standardization, most of the financial instruments that we encounter on a

day-to-day basis are very homogeneous.

4. Another characteristic of financial instruments is that they communicate information.

5. Financial instruments summarize certain essential information about the issuer.

6. Financial instruments are designed to handle the problem of “asymmetric

information,” which comes from the fact that borrowers have some information that

they don’t disclose to lenders.

B. Underlying versus Derivative Instruments

1. The two fundamental classes of financial instruments are underlying instrument

(sometimes called primitive securities) and derivative instruments.

2. Stocks and bonds are examples of underlying instruments.

3. Derivatives are so named because they take their value and their payoffs are “derived

from” the behavior of the underlying instruments.

4. Futures and options are examples of derivatives.

C. A Primer for Valuing Financial Instruments

1. Four fundamental characteristics influence the value of a financial instrument:

a. the size of the payment that is promised

b. when the promised payment is to be made

c. the likelihood that the payment will be made

d. the conditions under which the payment is to be made

3-6

Education.

Chapter 03 – Financial Instruments, Financial Markets, and Financial Institutions

2. People will pay more for an instrument that obligates the issuer to pay the holder a

greater sum. The bigger the size of the promised payment, the more valuable the

financial instrument.

3. The sooner the payment is made the more valuable is the promise to make it.

4. The more likely it is that the payment will be made, the more valuable the financial

instrument.

5. Payments that are made when we need them most are more valuable than other

payments.

D. Examples of Financial Instruments

1. Financial instruments that are used primarily as stores of value include:

a. Bank loans: a borrower obtains resources from a lender immediately in exchange

for a promised set of payments in the future.

b. Bonds: a form of a loan, whereby in exchange for obtaining funds today a

government or corporation promises to make payments in the future.

c. Home mortgages: a loan that is used to purchase real estate. The real estate is

collateral for the loan, which means it is a specific asset pledged by the borrower

in order to protect the interests of the lender in the event of nonpayment. If

payment is not made the lender can foreclose on the property.

d. Stocks: an owner of a share owns a piece of the firm and is entitled to part of its

profits.

e. Asset-backed Securities: shares in the returns or payments arising from specific

assets, such as home mortgages. Investors purchase shares in the revenue that

comes from these underlying assets. These are an innovation that allows funds in

one part of the country to find productive uses elsewhere.

2. Financial instruments that are used primarily to transfer risk include:

a. Insurance contracts: the primary purpose is to assure that

payments will be made under particular (and often rare) circumstances.

b. Futures contracts: an agreement to exchange a fixed quantity of a

commodity, such as wheat or corn, or an asset, such as a bond, at a fixed price on

a set future date. It is a derivative instrument since its value is based on the price

of some other asset. It is used to transfer the risk of price fluctuations from one

party to another.

c. Options: derivative instruments whose prices are based on the

value of some underlying asset; they give the holder the right (but not the

obligation) to purchase a fixed quantity of the underlying asset at a predetermined

price at any time during a specified period.

d. Swaps: agreements to exchange two specific cash flows at certain

times in the future.

3-7

Education.

Chapter 03 – Financial Instruments, Financial Markets, and Financial Institutions

3-8

Education.