Chapter 3

Financial Instruments, Financial Markets, and

Financial Institutions

© 2021 McGraw-Hill. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill.
 Learning Objectives

1. Explain what financial instruments are, how they are used, and how
they are valued.

2. Discuss the role and structure of financial markets and identity the
characteristics of a well-run financial market.

3. Describe the role of financial institutions and structure of the

financial industry.

© 2021 McGraw-Hill. All Rights Reserved. 1-2

 Introduction
• Direct Finance: Borrowers sell securities directly to lenders in the
financial markets.
– Direct finance provides financing for governments and corporations.
– E.g., borrowing from your family or a friend; they own the asset (loan)

• Indirect Finance: An institution stands between lender and borrower.

– E.g. An institution such as Bank stands in between the lender and the borrower

• Asset: Something of value that you own.

• Liability: Something you owe.
– E.g., You get a loan from a bank/finance company to buy a car.
– The car becomes your asset and the loan becomes your liability

• Today, even direct finance often involves a financial institution

(intermediator), such as stockbrokers or an investment bank.
3-3
© 2021 McGraw-Hill. All Rights Reserved.
Figure 3.1: Funds Flowing through the Financial System

3-4
© 2021 McGraw-Hill. All Rights Reserved.
 Introduction
• Financial development is linked to economic growth.
o The role of the financial system is to facilitate production, employment, and
consumption.
o Resources are funneled through the system so resources flow to their most
efficient uses.

• We will survey the financial system in three steps:

o Financial instruments or securities
─ Stocks, bonds, loans and insurance, used to transfer recourses and risks
─ What is their role in our economy?
o Financial Markets
─ New York Stock Exchange, DFM, Nasdaq.
─ Where investors trade financial instruments.

o Financial institutions
─ What they are and what they do
3-5
© 2021 McGraw-Hill. All Rights Reserved.
 Financial Instruments
• Financial Instruments: The written legal obligation of one party to
transfer something of value (usually money) to another party at some
future date, under specified conditions - under which a payment will be made.
o E.g., Cash, bonds, Loans, Stocks, Mortgages, Insurance policies).
o Often called Securities or tradable

Uses/Functions of Financial Instruments

• Three functions:
o Financial instruments act as a means of payment (like money).
• Employees take stock options as payment for working.
o Financial instruments act as stores of value (like money).
• Financial instruments can be used to transfer purchasing power into the
future.
o Financial instruments allow for the transfer of risk (unlike money).
• Futures and insurance contracts allows one person to transfer risk to
another. 3-6
 Reading: Page 49

• 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.

• The more leverage, the greater the risk that an adverse surprise will lead to
bankruptcy.
• During the crisis, some financial firms leveraged more than 30 times their net worth.
• For those important firms, small declines in assets made these firms vulnerable.

• When losses are experienced, firms try to deleverage to raise net worth.
• As many institutions deleveraged, prices fell, losses increased, and net worth
fell.
– This is called the “paradox of leverage”.
• Reinforces the leverage spiral
• Both spirals fed the cycle of falling prices and widespread deleveraging - the
hallmark of the financial crisis of 2007-2009.

© 2021 McGraw-Hill. All Rights Reserved. 3-7

Characteristics of Financial Instruments
• As is obvious from its definition, these contracts are very complex (E.g., Just take a look
at your insurance policy)
• This complexity is costly, and people do not want to bear these costs.
• Thus,
o Standardization of financial instruments overcomes potential costs of
complexity.
o Financial instruments also communicate information, summarizing certain
details about the issuer – the holder doesn’t want to have to watch the issuer too closely.
o 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.
― E.g., If you obtain a car loan from a Bank, you are the Bank’s counterparty, and the bank is
yours.

o The solution to the high cost of obtaining information is to standardize both

the instrument and the information about the issuer.
o Financial instruments are designed to handle the problem of asymmetric
information.
― Borrowers have some information they don’t disclose to lenders.
― E.g., Instead of buying a bakery machine, baker may spent the loan on vacation
3-8
Underlying Versus Derivative Instruments

Two fundamental classes of financial instruments:

• Underlying instruments are used by savers/lenders to transfer

resources directly to investors/borrowers.
― This improves the efficient allocation of resources.
― E.g., stocks and bonds

• Derivative instruments are those where their value and payoffs

are “derived” from the behavior of the underlying instruments.
― E.g., are futures, options, and swaps.
― The primary use is to shift risk among investors.

© 2021 McGraw-Hill. All Rights Reserved. 1-9

A Primer for Valuing Financial Instruments (FIs)

Four fundamental characteristics influence the value of a financial

instrument:

1. Size of the payment that is promised:

― The larger the payment, the more valuable.

2. Timing of payment (when the promised payment it to be made):

― Payment is sooner - more valuable.

3. Likelihood that payment is made:

― More likely to be made - more valuable.

4. Conditions under with payment is made:

― Made when we need them - more valuable.
― E.g., No one buys insurance that pays off when good things happen.
© 2021 McGraw-Hill. All Rights Reserved. 3-10
Examples of Financial instruments:
Let us look at some of the most common verity of FIs. Let us organize
them by how they are used:
FIs used primarily as a stores of value include:
1. Bank loans
― A borrower obtains resources from a lender immediately
in exchange for a promised set of payments in the future.
―Here the lender is looking for a way to store value in the future.

2. Bonds
― A form of a loan issued by a corporation or government.
― Can be bought and sold in financial markets.

3. Home mortgages
― Home buyers usually need to borrow using the home as collateral for loan.
― Collateral is a specific asset the borrower pledges to protect the lender’s
interests. 3-11
4. Stocks
― The holder owns a small piece of the firm and entitled to be part of its profits.
― Firms sell stocks to raise funds/money – to enlarge operation and/or transfer risk.
― Buyers of stocks use them primarily as a stores of wealth.

5. Asset-backed securities (ABS)

― Shares in the returns or payments arising from specific assets, such as home
mortgages and student loans.
― Mortgage-backed securities (MBS) bundle a large number of mortgages
together into a pool in which shares are sold.
o Securities backed by Subprime mortgages played an important role in the
financial crisis of 2007-2009 (Read Page 161, 4th paragraph).
o Subprime mortgages are loans to borrowers who are less likely to repay
then borrowers of conventional mortgages.
https://www.youtube.com/watch?v=t70Mjl174_U
https://www.investopedia.com/terms/s/subprime_mortgage.asp

© 2021 McGraw-Hill. All Rights Reserved. 3-12

 Reading: Page 52

• The biggest risk we all face is becoming disabled and

losing our earning capacity.
– Insuring against this should be one of our highest priorities.

• It is important to assess to make sure you have enough

insurance.

• Disability insurance is one way to transfer that risk to

someone else.

© 2021 McGraw-Hill. All Rights Reserved. 3-13

Financial Instruments Used Primarily to Transfer Risk
1. Insurance contracts.
– Primary purpose is to assure that payments will be made under particular,
and often rare, circumstances.
2. Futures contracts.
– An agreement between two parties to exchange a fixed quantity of a
commodity or an asset at a fixed price on a set future date.
o A price is always specified.
o This is a type of derivative instrument, as its value is based on the price
of some other asset.
https://www.youtube.com/watch?v=CC9VeHrI3Es

4. Swaps
– Agreements to exchange two specific cash flows at certain times in the future.
– Might involve the exchange of payments based on fixed rate of interest for
payment based on a rate of fluctuating interest rate.
– Come in many varieties reflecting differences in maturity, payment frequency,
and underlying cash flows
https://www.youtube.com/watch?v=-aXRZ6xN3bk 3-14
3. Options
– Like futures contracts, options are derivative instruments whose prices
are based on the value of an underlying asset.
– Give the holder the right (not obligation) to buy or sell a fixed quantity of
the asset at a pre-determined price on a specific date or at any time
during a specified period.

3-15
 Financial Markets
• Financial markets:
o are places where financial instruments are bought and sold.
o are the economy’s central nervous system.
o enable both firms and individuals to find financing for their activities.
o promote economic efficiency.

The Role of Financial Markets

1. Market 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. 3-16
© 2021 McGraw-Hill. All Rights Reserved.
The Structure of Financial Markets (FMs)
Many types of FMs (e.g., Stock market, Bond market, Credit market, Currency trading,
Options, Futures, New securities, …). There are three possibilities of grouping FMs:
1. Distinguish between primary or secondary markets
2. Categorize by the way they trade
3. Group based on the type of instrument they trade
o Centralized exchange or not (see Table 3.4 at page 55)

Primary versus Secondary Markets

• A primary financial market is one in which a borrower obtains funds from a lender by
selling newly issued securities.
• Secondary financial markets are those where people can buy and sell existing securities.

Debt and Equity versus Derivative Markets

• Used to distinguish between markets where debt and equity are traded and those
where derivative instruments are traded.
o Debt markets are markets for loans, mortgages, and bonds.
o Equity markets are the markets for stocks.
o Derivative markets are the markets where investors trade instruments like futures,
options, and swaps. 3-17
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.
• Lenders must be able to enforce their right of repayment quickly
and at low cost.

© 2021 McGraw-Hill. All Rights Reserved. 3-18

 Financial Institutions
• Financial Institutions:
o are 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.
o Also known as financial intermediaries, as they sit between savers and borrowers.
o E.g., banks, insurance companies, securities firms, and pension funds.

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.
o They curb asymmetries, helping resources flow to most productive uses.
• To give savers ready access to their funds.
3-19
Figure 3.2: Flow of Funds through Financial Institutions

20
© 2021 McGraw-Hill. All Rights Reserved.
The Structure of the Financial Industry
• We can divide intermediaries into two broad categories:
o Depository institutions,
― Take deposits and make loans
― What most people think of as banks.

o Non-depository institutions.
―Include insurance companies, securities firms, mutual
fund companies, hedge funds, finance companies, and
pension funds.

• See next slide for a list of major groups of financial institutions:

© 2021 McGraw-Hill. All Rights Reserved. 3-21

List of major groups of financial institutions:
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, mutual fund
companies private equity firms, and venture capital firms.
• 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 - passive investing.
• Hedge funds do the same for small groups of wealthy investors.
• Private equity and venture capital firms also serve wealthy investors by acquiring
controlling stakes in a few firms and manage them actively.
5. Finance companies raise funds directly in the financial markets in order to make
loans to individuals and firms.
6. Government-sponsored enterprises (GSEs) are federal credit agencies that
provide loans directly for farmers and home mortgagors.
© 2021 McGraw-Hill. All Rights Reserved. 3-22
5. Finance companies raise funds directly in the financial markets in order to
make loans to individuals and firms.
6. Government-sponsored enterprises (GSEs) are federal credit agencies that
provide loans directly for farmers and home mortgagors.

© 2021 McGraw-Hill. All Rights Reserved. 3-23

 Reading: Page 66

• Financial access promotes both economic

equality and economic growth

• Finance allows countries to mobilize domestic

savings effectively, lowering transaction costs
o Efficient means of payment broadens the markets
for goods and services and facilitates a greater
division of labor

© 2021 McGraw-Hill. All Rights Reserved. 3-24