Ch. 3: Financial Instruments, Financial Markets, and Financial Institutions - Money and Banking

There are two types of financial institutions: those that provide ___ services and those that ___ assets.

brokerage transform

But no system of trading is free of problems. On the minus side, electronic operations have proven prone to errors that threaten the existence of ___. In addition, amid the complex system of multiple, imperfectly linked exchanges, new trading patterns have arisen that render the entire system ___, raising serious worries among investors about the ___ of their stocks.

brokers fragile liquidity and value

While financial instruments are the means for transferring risk, financial markets are the place where we can do it. The markets allow us to ___, holding the ones we want and getting rid of the ones we don't want. Without the market, we wouldn't be able to ___.

buy and sell risks share risk

A number of mechanisms exist to reduce the cost of monitoring the behavior of the ___ to a financial arrangement.

counterparties

Financial instruments are designed to eliminate the expensive and time-consuming process of collecting such ___.

information

Financial institutions are the firms that provide access to the financial markets, both to ___ who wish to purchase financial instruments directly and to ___ who want to issue them.

savers borrowers

The lack of proper safeguards dampens people's ___ to invest. Thus, governments are an essential part of financial markets, because they set and enforce the rules of the game. While informal lending networks do develop and flourish spontaneously, they can accommodate only simple, ___. Because modern financial markets require a legal structure that is designed and enforced by the government, countries with better investor protections have bigger and deeper ___ than other countries.

willingness small-scale transactions financial markets

Transfer of risk from one person or company to another.

Transfer of Risk

Shouting bids and offers or using hand signals to make agreements.

"Open Outcry"

Financial Instruments Used Primarily as Stores of Value.

1. Bank Loans 2. Bonds 3. Home Mortgages 4. Stocks 5. Asset-Backed Securities

Financial Instruments Used Primarily to Transfer Risk.

1. Insurance Contracts 2. Future Contracts 3. Options 4. Swaps

The three functions financial instruments have.

1. Means of Payment 2. Store of Value 3. Transfer of Risk

The four fundamental characteristics that influence the value of a financial instrument:

1. Size 2. When 3. Likelihood 4. Circumstances

The pace of structural change has accelerated dramatically in the past few years, driven by ___. The former dramatically lowered the importance of physical location of an exchange - as new technology allowed the rapid low-cost transmission of orders across long distances - while the latter encouraged unprecedented cross-border mergers of exchanges, integrating larger pools of providers and users of funds.

1. ongoing technological advances in computing and communications 2. increasing globalization

A marketable security that tracks a basket of assets like an index fund.

Exchange Traded Fund (ETF)

Something of value that can be owned; a financial claim or property that serves as a store of value.

Asset

Pool the resources of individuals and companies and invest them in portfolios of bonds, stocks, and real estate.

Asset Management Firms

Shares in the returns or payments arising from specific assets, such as home mortgages, student loans, credit card debt, or even movie box-office receipts; investors purchase shares in the revenue that comes from these underlying assets; most prominent of these instruments are mortgage-backed securities (MBS); are an innovation that allows funds in one part of the country to find productive uses elsewhere; the availability of some sorts of financing no longer depends on local credit conditions.

Asset-Backed Securities (ABS)

A borrower obtains resources from a lender immediately in exchange for a promised set of payments in the future; the borrower, who can be either an individual or a firm, needs fund to make an investment or purchase, while the lender is looking for a way to store value into the future.

Bank Loans

A maturity of more than a year.

Bond Markets

A form of loan; in exchange for obtaining funds today, a corporation or government promises to make payments in the future; while ___ payments are often stated in fixed dollars, they need not be; unlike most bank loans, most ___ can be bought and sold in financial markets; like bank loans, ___ are used by the borrower to finance current operations and by the lender to store value.

Bonds

Financial intermediary that provides accounting and custody services, access to secondary markets, liquidity, loans, and advice; can find you a counterparty.

Broker

Can act as a broker and/or a dealer.

Broker-Dealer

Issue stocks and bonds for corporate customers, trade them, and advise customers. All these activities give customers access to the financial markets.

Brokers and Investment Banks

A financial market in which financial instruments are traded in a single physical location, usually through a system of "open outcry"; examples are the New Your Stock Exchange (NYSE), and the large exchanges in London and Tokyo.

Centralized Exchanges

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

Circumstances

The term used to describe specific assets a borrower pledges to protect the lender's interests in the event of nonpayment.

Collateral

The person or institution on the other side of a contract.

Counterparty

Two broad categories of intermediaries:

Depository Institutions Nondepository Institutions

Their value and payoffs are "derived" from the behavior of the underlying instruments; specify a payment to be made between the person who sells the instrument and the person who buys it; the amount of the payments depends on various factors associated with the price of the underlying asset; primary use is to shift risk among investors.

Derivative Instruments

The markets where investors trade instruments like futures, options, and swaps, which are designed primarily to transfer risk.

Derivative Markets

Financial intermediary that acts as a counterparty in a securities transaction.

Dealer

The markets for loans, mortgages, and bonds - the instruments that allow for the transfer of resources from lenders to borrowers and at the same time five investors a store of value for their wealth.

Debt Markets

Take deposits and make loans; are what most people think of as banks, whether they are commercial banks, savings banks, or credit unions.

Depository Institutions

A borrower sells a security directly to a lender.

Direct Finanace

Occasional cash payments.

Dividends

Enabled traders (or their brokers) to find counterparties who wish to trade in specific stocks, including those listed on an exchange; a financial markets organized as an electron network, such as Arca or Instinet

Electronic Communication Networks (ECNs)

The markets for stocks.

Equity Markets

Futures, option, and swaps

Examples of Derivative Instruments

Stocks and bonds that offer payments based solely on the issuer's status.

Examples of Underlying Securities or Instruments

Raise funds directly in the financial markets in order to make loans to individuals and firms; tend to specialize in particular types of loans, such as mortgage, automobile, or certain types of business equipment; while their assets are similar to a bank's, their liabilities are debt instruments that are traded in financial markets, not deposits.

Finance Companies

Firms, such as banks and insurance companies, 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.

Financial Institutions

The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under specified conditions.

Financial Instrument

The places where financial instruments are bought and sold; are the economy's central nervous system, relaying and reacting to information quickly, allocating resources, and determining prices; in doing so, they enable both firms and individuals to find financing for their activities; when they are working well, new firms can start up and existing firms can grow.

Financial Markets

by ensuring that resources are available to those who can put them to the best use, and by keeping the costs of transaction as low as possible, these markets promote economic efficiency; when they cease to function properly, resources are no longer channeled to their best possible use, and we all suffer.

Financial Markets

An agreement between two parties 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; always specifies the price at which the transaction will take place; is a type of derivative instrument, since its value is based on the price of some other asset; used to transfer risk of price fluctuation from one party to another.

Future Contracts

Federal credit agencies that provide loans directly for farmers and home mortgagors; they also guarantee programs that insure loans made by private lenders; aside from these, the government also provides retirement income and medical care to older adults through Social Security and Medicare. Pension funds and insurance companies perform these functions privately.

Government-Sponsored Enterprises (GSEs)

Do the same for small groups of wealthy investors. Customers own shares of the portfolios, so they face the risk that the assets will change in value. But portfolios are less risky than individual securities, and individual savers can purchase smaller units than they could if they went directly to the financial markets.

Hedge Funds

Can purchase and sell thousands of stocks in a matter of seconds.

High-Frequency Traders (HFTs)

A loan that is used to purchase real estate; in exchange for the funds, the borrower promises to make a series of payments; the house is collateral for the loan; most people who wish to purchase a home need to borrow some portion of the funds; if the payments aren't made, the lender can take the house.

Home Mortgages

An institution like a bank stand between the lender and the borrower.

Indirect Finance

Accept premiums, which they invest in securities and real estate (their assets) in return for promising compensation to policyholders should certain events occur (their liabilities).

Insurance Companies

The primary purpose of ___ is to ensure that payments will be made under particular, and often rare, circumstances. These instruments expressly to transfer risk from one party to another.

Insurance Contracts

Something you owe.

Liability

Payments that are more likely to be made are more valuable.

Likelihood

Debt instruments that are completely repaid in less than a year (from their original issue date).

Money Markets

The two types of debt instruments:

Money Markets Bond Markets

Bundle a large number of mortgages together into a pool in which shares are then sold; owners of these securities receive a share of the payments made by the homeowners who borrowed the funds.

Mortgage-Backed Securities (MBS)

Consist of passive investors, who do not seek to influence management.

Mutual Funds

Include insurance companies, securities firms, asset management firms that operate mutual funds and exchange-traded funds, hedge funds, private equity or venture capital firms, finance companies, and pension funds; each of these serves a very different function from a bank; some screen and monitor borrowers; others transfer and reduce risk; still other are primarily brokers.

Nondepository Institutions

Like future contract; are derivative instruments whose prices are based on the value of some underlying asset; give the holder the right, but not the obligation, to buy or sell a fixed quantity of the underlying asset at a predetermined price either on a specified date or at any time during a specified period.

Options

A financial market in which trades occur through networks of dealers connected together electronically; examples are Nasdaq.

Over-the-Counter (OTC) Markets

Invest individual and company contributions in stocks, bonds, and real estate (their assets) in order to provide payments to retired workers (their liabilities).

Pension Funds

Includes a number of stocks and bonds as well as various forms of money; a well-designed ___ has a lower overall risk than any individual stock or bond; an investor constructs it by buying and selling financial instruments in the marketplace.

Portfolio

A borrower obtains funds from a lender by selling newly issued securities; businesses are primary users to raise the resources they need to grow; governments use them to finance ongoing operations; most of the action occurs out of public view; most companies use an investment bank.

Primary Financial Market

The Structure of Financial Markets

Primary versus Secondary Markets Centralized Exchanges versus Over-the-Counter Markets Debt and Equity versus Derivatives Markets

Also serve wealthy investors: They acquire controlling stakes in a few firms and manage them actively to boost the return on investment before reselling them.

Private Equity Firms and Venture Capital Firms

Where people can buy and sell existing securities; prices are the ones we hear about in the news.

Secondary Financial Markets

Include brokers, investment banks, underwriters, asset management firms, private equity firms, and venture capital firms.

Securities Firms

Payments that are larger are more valuable.

Size

Owns a small piece of the firm and is entitled to part of its profits; a way of raising funds to enlarge operations as well as a way of transferring the risk of ownership to someone else; buyers use them primarily as stores of wealth.

Stocks

Loans to borrowers who are less likely to repay than borrowers of conventional mortgages; played an important role in the financial crisis of 2007-2009.

Subprime Mortgages

Agreements to exchange two specific cash flows at certain time in the future; come in many varieties, reflecting differences in maturity, payment frequency, and underlying cash flows; the cash flows and other contractual arrangements usually are designed so that there is no upfront fee.

Swaps

A rule-based program for automatically executing hundreds or thousands of trades.

Trading Algorithm

The cost of buying and selling.

Transaction Cost

Payments that are made sooner are more valuable.

Timing

Used by savers/lenders to transfer resources directly to investors/borrowers; sometimes called primitive securities.

Underlying Instruments

The two fundamental classes of financial instruments:

Underlying Instruments Derivative Instruments

The bank examines the company's financial health to determine whether the proposed issue is sound. Assuming that it is, the bank will determine a price and then purchase the securities in preparation for resale to clients; usually very profitable, both for the lenders and the share purchasers.

Underwriting

In addition to simply summarizing information, financial instruments are designed to handle the problem of ___, which comes from the fact that borrowers have some information they don't disclose to lenders. Thus, the financial system is set up to gather information on borrowers before giving them resources and to monitor their use of the resources afterward. These specialized mechanisms were developed to handle the problem of ___.

asymmetric information asymmetric information

Another characteristic of financial instruments is that they communicate ___, summarizing certain essential details about the issuer.

information

Not only would the two sides have difficulty finding each other, but even if they did, writing the contract to effect the transaction would be very costly. Lenders need to evaluate the ___ of borrowers and then monitor them to ensure that they don't abscond with the funds. Individuals are not specialists in monitoring. Most borrowers want to borrower for the ___, while lenders favor more ___ loans.

creditworthiness long term short-term

A useful way to think of the structure of financial markets is to distinguish between markets where ___ are traded and those where ___ are traded.

debt and equity derivative instruments

To put it another way, in ___, actual claims are bought and sold for immediate cash payment; in ___, investors make agreements that are settled later.

debt and equity markets derivative markets

Today, the international financial system exists to facilitate the ___ of a broad set of contracts with a very specific set of characteristics.

design, sale, and exchange

Without financial markets and the institutional structure that supports them, selling the assets we own would be extremely ___. Thus, we cannot overstate the importance of ___ for the smooth operating of an economy.

difficult liquidity

Under ___, the asset holder has a direct claim on the borrower. In the case of ___, the asset holder own a claim on a financial institution (like a bank or mutual fund) that, in turn, owns a claim on the borrower.

direct finance indirect finance

Indeed, such financial development is inextricably linked to ___. A country's financial system has to expand as its level of economic activity ___, or the country will ___.

economic growth rises stagnate

The job of intermediaries is to produce and use the information that make modern finance ___. As a result, users and providers of funds can better satisfy their ___, and economies can ___.

effective needs expand

Such a system (where financial institutions didn't exist) would be unlikely to work very well, for a number of reasons. First, individual transaction between saver-lenders and spender-borrowers would likely be extremely ___.

expensive

As finance grows increasingly sophisticated and complex, virtually all transactions take on some indirect flavor. Today, even direct finance usually involves a ___ in some fashion.

financial institution or intermediary

Because financial institutions sit between savers and borrowers, they are also known as ___, and what they do is known as ___. Banks, insurance companies, securities firms, and pension funds are all ___. These institutions are essential; any disturbance to the services they provide will have severe adverse effects on the economy.

financial intermediaries intermediation financial intermediaries

Broker institutions give households and corporations access to ___. Institutions that transform assets take ___ to households. They use the proceeds to make loans and purchase stocks, bonds, and real estate. That is their transformation function.

financial markets and direct finance deposits or investments or issue insurance contracts

Is a borrower likely to repay a bond? The more likely repayment is, the ___ the price of the bond. Obtaining the answers to these questions is time consuming and costly. Most of us just don't have the resources or know-how to do it. Instead, we turn to the financial markets to summarize the information for us so that we can look it up on a website.

higher

Lenders would surely require compensation for the ___ of long-term loans, driving up the price of borrowing.

illiquidity

The solution to the high cost of obtain information on the parties to a financial instrument is to standardize both the instrument and the information provided about the ___. We can also hire a specialist whom we all trust to do the monitoring. The institutions that have arisen over the years to support the existence of financial instruments provide an environment in which everyone can feel secure about the behavior of the ___ to an agreement.

issuer counterparties

Financial markets serve three roles in our economic system. They offer savers and borrowers ___; they pool and communicate ___; and they allow ___.

liquidity information risk sharing

Related to liquidity is the fact that financial markets need to be designed in a way that keeps transaction costs ___.

low

Well-run financial markets exhibit a few essential characteristics that are related to the role we ask them to play in our economies. First, these markets must be designed to keep transaction costs ___. Second, the information the market pools and communicates must be both ___. If analyst do not communicate accurate assessments of the firms they follow, the markets will not generate the correct prices for the firms' stocks.

low accurate and widely available

Finally, the advent of multiple electronic exchanges and ECNs has not resulted in a single, integrated, and transparent US stock market. In such an ideal market, the best bid from any customer would instantly and costlessly be ___ against the best offer, and all parties could see the ___ of bids and offers prior to trading. Currently, a government rule known as the ___ requires brokers to provide the best prevailing prices to customers. Other government rules make all trades visible ___ they occ

matched entire schedule National Best Bid and Offer (BBBO) mechanism after

Financial markets pool and communicate information about the issuers of financial instruments, summarizing it in the form of a ___. Does a company have good prospects for future growth and profits? If so, its stock price will be ___; if not, its stock price will be ___.

price high low

A financial market could be created in which the loans and other securities could be resold, but that would create the risk of ___. All these problems would restrict the flow of resources through the economy. Healthy financial institutions open up the flow, directing it to the most productive investments and increasing the system's efficiency.

price fluctuations

However, not all bids and offers are visible ___ to a trade.

prior

The role of the financial system is to facilitate ___. In a prosperous economy, people have the means to pay for things, and resources flow to their most ___ uses. Savings are funneled through the system so that they can finance investment and allow the economy to ___. The decisions made by the people who do the saving direct the investment.

production, employment, and consumption efficient grow

Finally, investors need ___. For the financial system to work at all, borrowers' promises to pay lenders must be credible. Individuals must be assured that their investments will not simply be stolen. Lenders must be able to enforce their right to receive repayment (or to seize the collateral) quickly and at low cost. In countries that have weak investor investor protections, firms can behave ___, borrowing when they have no intention of repaying the funds and going unpunished.

protection deceptively

In addition, decentralization ___ a menacing operational risk that became evident on 9/11, a time before computers dominated the floor of the NYSE and people still depended on gathering there to trade.

reduces

Trading on decentralized electronic exchanges - rather than a physically central one - has advantages and disadvantages. On the plus side, customers can ___ the orders, the orders are executed ___, trading occurs ___ hours a day, and costs are ___.

see quickly 24 low

At the same time that they make long-term loans, financial institutions also give savers ready access to their funds. That is, they issue ___ liabilities to lenders while making ___ loans to borrowers. By making loans to many different borrowers at once, financial institutions can provide savers with financial instruments that are both more ___ and ___ risky than the individual stocks and bonds they would purchase directly in financial markets.

short-term long-term liquid less

In addition to concerns about fragility of the trading system as a whole, efforts to ___ electronic trading drain resources from more efficient uses. Yet microsecond gains in trading speed likely diminish the willingness of market makers to provide ___ because they don't wish to be "picked off" by well-equipped HFTs.

speed up liquidity

In fact, people on both sides of financial contracts shy away from specialized agreements. Instead, they use standardized financial instruments to overcome the potential cost of complexity. Because of ___, most of the financial instruments that we encounter on a day-to-day basis are very ___.

standardization homogeneous

Financial institutions reduce transaction costs by specializing in the issuance of ___. They reduce the information costs of screening and monitoring borrowers to make sure they are creditworthy and they use the proceeds of a loan or security ___. In other words, financial institutions curb ___ and the problems that go along with them, helping resources flow to their most ___ uses.

standardized securities issue properly information asymmetries productive