Chapter 3

Financial Instruments, Markets, and Institutions

Federal Reserve
affects the supply of money

Quantitative 1. Open Market Operations

2. Reserves
3. Discount Rate

affects aggregate levels of income, production, employment, price

Qualitative 1. Regulation Q
2. Margin Requirements
3. Moral Session
4. Min. Down Pmt.

affects ownership mix of money and credit, changes the

distribution of spending and income among sectors of economy

Options to DSU/SSU
- DSU (Borrower)--Three Options:
- Reduce Dollar balances
- Dissave by selling financial securities they own
- Borrowing by issuing new financial securities on themselves
- SSU (Saver)--Three Options
- Build up their dollar balances
- Reduce their debt by buying back securities
- Lend by buying securities issued by DSU
Financial Markets: Allow for the exchange of financial assets such as stocks/bonds.

Financial Institutions: Facilitate flow of funds from individuals, corp's, or govt. from surplus spenders
to deficits spenders

Financial/Real Sector
Financial Asset
Real Asset

Primary Security: IOU flows directly between borrower/lender

Secondary Security: Liability of financial institution

Securities Traded in Financial market

Equity: represents ownership (stock)
Debt: represents IOU (bonds)

Types of financial markets

Broad Classifications:
Money Market
Lower return
More liquid
Capital Market

Primary Market---- New issues

Secondary Market—transfer of ownership
provides for primary market:
(1) information on pricing
(2) liquidity

More Detailed Classifications:

Stock
Bond
Mortgage
Futures*
Options*
Spot
Auctions
Negotiations
Organized
Over-the-Counter

*Derivative securities-- are financial securities whose values are derived from the values of underlying
assets.
Options:--Puts and calls

Common Properties of derivatives:

1.Allow one to speculate on movements in underlying assets without the cost of purchasing the
asset--high financial leverage
2.Can be used to hedge existing investments
Examples of Money Market Instruments:
T-Bills
Zero-coupon securities
Traded on basis of yield not price
Bid/Asked yields
Book entry
Sold on auction
Competitive
Stop-out price
Noncompetitive
Fed Funds
Reserve balances
Overnight
Telephone trades
Rate
Commercial Paper
Unsecured promissory note of large, natl known corporate firms
Maturities < 270 days
Min. denomination $25000
Credit Ratings
Not registered with SEC
Standby Line of Credit
Some secured
BA
Draft on commercial bank, generally payable to the exporter, based on funds that will be deposited
at the bank by the importer by the maturity date
Acceptance
Sell
Keep
Letter of Credit
Fee
Secondary market
Retail CDs
Time deposit
NCDs
Large time deposits
Min. denomination $1 million
Credit quality--issuing institution
Term CDs
Repos
ST collateralized loans in which the borrower sells securities to the lender with a provision to
repurchase them on a specified date at a specified price
Reverse repos/matched-sale-purchase agreement
Overnight to a few days
Rate-below Fed Funds
Trustee
Eurodollar deposits
Deposits at foreign offices of US or foreign banks denominated in dollars rather than the local
currency
Generally Time deposits
Examples of Capital Market Instruments
Treasury notes & bonds
Notes--original maturity 1-10 years
Bonds-original maturity greater than 10 years
Multiples of $1000
Auction
Dutch Auction
Book entry
Strips
Interest and principal separated
Government Agency
Govt Natl Mortg. Assoc
Federal housing Authority (FHA)
Export-Import Bank
Government-Sponsored Agencies
Fed Home Loan Banks
Fed Home Loan Mortgage Commercial
Federal Natl Mortgage Assoc (Fannie Mae)
Farm Credit System
Student Loan Marketing Assoc (Sallie Mae)
Resolution Funding Corp (REFCO)
Corporate bonds
Fixed rate
Maturity
Special features
Call
Convertibility
Collateral
Ratings
Foreign bonds
Yankee bonds
Eurodollar bonds
Municipal bonds
Issued by state and local government
Coupon income exempt from federal income tax
Often sold as serial bond
Sold
Competitive bid
Negotiation
Types
GO
Revenue
Volatile market
Mortgages
Largest type of debt
Mortgage types
Securitization
Pass-through
Ginnie Mae
Fannie Mae
FHA
VA
CMO
Equity
No maturity
Residual claim on earnings and assets
Types
Preferred
Common

Role of Financial Intermedaries

1. Transaction Costs ---reduce costs
2. Diversification
3. Production of information
a. consumers & small businesses creditworthiness

Stimulate Savings:

Stimulate Borrowings:

Types of Financial Intermediaries (Institutions)

Depository
Commercial Banks
-Dually chartered
-insured (FDIC) BIF
- A/L composition
- Major asset--Commercial loans
- Major liability-Time deposits

Thrifts: Non-Bank Depository

S/L's
-dually chartered
-insured SAIF
-A/L Structure
- Major asset--residential mortg
- Major liability—Time deposits

Credit Union
fastest growing segment
NCUSIF
A/L Composition
-Major Asset---Personal loans
-Major liability—time deposits

Mutual Savings Bank

-New England
-Only Sate Chartered
-A/L Composition
Major Asset--- Consumer loans & bond portfolio
Major liability--Time
Non-Depository
Insurance Co.
Law of large #'s
Uninsurable risk

Life Ins
-Tax Code
-Equities
 -Managed Pension Funds
-Organization
A/L Composition
Major Asset-LT taxable Corporate and mortgages
Major liability—Insurance Reserve (Policies)

Casualty Ins.
-Certainty
-A/L Composition
Major Asset—Intermediate tax-exempt bonds
Major liability—Insurance Reserve (Policies)
Finance Co.
Consumer finance Co's (Morris Plan banks)
Sales Finance Co (GMAC)
Bus. Finance Co.
A/L Composition
Major Asset—loans
Major Liability—Commercial Paper & debt on themselves

Investment Co.
Types
Open-end Co.
Closed-end Fund
Advantages
Disadvantages
Money Market Funds

Pension Funds
-Defined Benefit
-Defined Contribution
Major Types
403b
403k
Problems
Keogh Plans
IRA's
Private Pension Plans
ERISA