L2

Financial Instruments, Financial Markets, and Financial Institutions

Two ways you can access financial markets:

 Direct finance:
A method of financing where borrowers borrow funds directly from the financial
market without using a third-party service (financial intermediary)
Example:
Companies’ issues stocks to raise capital in the stock market
Government or companies sell debt securities (Bond) to borrow funds

 Indirect Finance:
An institutional stand in between the lender and borrower.
Bank channels funds from lenders to borrowers. They are called financial
intermediaries
Example:
Banks, insurance companies, pension funds

What is the difference between asset and a liability?

An asset are resources owned by a business and a liability is what you owe.

What is the Structure of the Financial Industry?

We can divide intermediaries into two broad categories:
– Depository institutions,
• Take deposits and make loans
• What most people think of as banks

– Non-depository institutions.
• Include insurance companies, securities firms, mutual fund
companies, hedge funds, private equity or venture capital firms,
finance companies, and pension funds.

Types of financial institutions:

1. Depository initiations – Make loans from deposits (Indirect Finance)
2. Insurance companies – Provide compensations to policy holders (Indirect Finance)
3. Pension funds – Invest for retired workers (Indirect Finance)
4. Securities firms – Trade in stocks and bonds for customers (Direct Finance)
5. Finance companies – Raise funds to make loans (Direct Finance)
6. Mutual funds –Shares sold to households, business, and Government agencies
(Indirect Finance)
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How is financial development linked to economic growth?

 Financial access promotes both economic equality and economic growth.
The role of the financial system is to facilitate production, employment, and
consumption.
Resources are funnelled through the system so resources flow to their most efficient
uses.

 Finance allows countries to mobilise domestic savings effectively, lowering

transactions costs.
Efficient means of payments broadens the markets for goods and services and,
facilitates a greater division of labour.

Which country is the most developed financial system?

- Hong Kong
- Singapore
- USA

How are financial instruments valued?

Four fundamental characteristics influence the value of a financial instrument:
1. Size of the payment:
– Larger payment - more valuable.
2. Timing of payment:
– 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: Financial Markets are
– Made when we need them - more valuable. places where
financial instruments
are bought and sold.

What is the role of financial markets?

1. Market liquidity:
(Liquidity is the ease by which asset that can be changed into cash for payment)
– 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
 risk sharing enables us to time our purchases so that we can buy now and pay
later
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What is the structure of financial markets?

 A primary financial market is one in which a borrower obtains funds from a lender by
selling newly issued securities. (Is where stocks are issued for the first time)
 Secondary financial markets are those where people can buy and sell existing
securities. (Is where existing shares are resold)

Debt & Equity VS Derivative Markets

Used to distinguish between markets where debt and equity are traded and those where
derivative instruments are traded.

 Debt markets are markets for loans, mortgages, and bonds.

 Equity markets are the markets for stocks.
 Derivative markets are the markets where investors trade instruments like future,
options, and swaps. (Is an instrument whose value depends on another asset)

Funds flowing through the financial systems

What are 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.

This means:
– The enforceability of the obligation is important (legal contract).
– Obligate one party (person, company, or government) to transfer something
to another party.
– Specific when the payment would be made in which it has specific conditions.
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How are Financial Instrument used?

Three Functions:
– Financial instruments act as a means of payment (like money).
Employees take stock options as payment for working.
– Financial instruments act as stores of value (like money).
Financial instruments can be used to transfer purchasing
power into the future.
– Financial instruments allow for the transfer of risk (unlike money).
Futures and insurance contracts allow one person to transfer
risk to another.

We organize financial instruments by how they are used:

Primarily used as store of value…
1. Bank loans
Borrowers obtain resources from a lender to be repaid in the future.

2. Bonds
A form of loan issued by corporation or government, it ca be bought and sold
in financial markets

3. Home mortgages:
Home buyers usually need to borrow using the home as collateral for the
loan.
A specific asset the borrower pledges to protect the lender’s interests.

4. Stocks
The holder owns a small piece of the firm and entitled to part of its profits.
Firms sell stocks to raise money.
Primarily used as a stores of wealth

5. Asset-backed securities:
Gives investors a share of income based on the value of specific assets such
as home, mortgages, and student loans.

Financial Instrument 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.
A price is always specified.
This is a type of derivative instrument.
 Future contract helps you to guarantee the price of a good or service or
another so as to protect your investment and you can make profit So, you are
insuring against loss - the risk that the price of a product would fall.