Ch. 3 Financial Instruments, Financial Markets, and Financial Institutions

role of financial markets

1. Market Liquidity - ensure owners can buy and sell financial instruments cheaply 2. Information - pool and communicate information about issuers of financial instruments 3. Risk Sharing - provide individuals a place to buy and sell risk

3 functions of financial instruments

1. act as a means of payment (like money), employees take stock options as payment for working 2. act as stores of value (like money), can be used to transfer purchasing power into the future 3. allow for the transfer of risk (unlike money), futures and insurance contracts allow for this

portfolio

A collection of financial assets

centralized exchange

A financial market in which financial instruments are traded in a single physical location.

Asset-backed security

A security whose cash flows come from an underlying pool of financial securities that "back" it.

broker

a wholesaler who does not take title to goods and whose function is to bring buyers and sellers together and assist in negotiation

dealer

an agent who buys and sells securities from inventory

future contract

an agreement to buy or sell at a specific date in the future at a predetermined price

direct finance

borrowers sell securities directly to lenders in the financial markets

over-the-counter markets

decentralized secondary markets where dealers stand ready to buy and sell securities electronically

electronic communication networks

electronic market bringing buyers/sellers together without the use of a broker or dealer

intermediary

financial institution

indirect finance

financial intermediaries/institutions stands between lender and borrower

equity market

financial market where stocks are bought and sold

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

money markets

include short-term, highly liquid, and relatively low-risk debt instruments

derivative instrument

instruments where their value and payoffs are 'derived' from the behavior of the underlying instruments

debt market

is the markets for loans, mortgages, and bonds

primary financial market

market in which a borrower obtains funds from a lender by selling newly issued securities

secondary financial market

markets where people can buy and sell existing securities

Government Sponsored Enterprises

organizations such as FANNIE MAE and FREDDIE MAC, which are authorized and supported by the US government to operate a secondary mortgage market for residential loans

financial markets

perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds

counterparty

person or institution on the other side of a contract

collateral

something pledged as security for repayment of a loan, to be forfeited in the event of a default.

bond market

the collective buying and selling of bonds; most bond trading is done over the counter, rather than in organized exchanges

leverage

the use of borrowed money to supplement existing funds for purposes of investment

financial instrument

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

underlying instrument

used by savers/lenders to transfer resources directly to investors/borrowers

liability

Anything for which a person or firm is legally bound or responsible.

asset

Anything of value that is owned

mortgage-backed securities

Bonds that represent claims to all or part of the monthly mortgage payments from the pools of mortgage loans made by leaders to borrowers to help them purchase residential property.

capital markets

Markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year