Financial Instruments

and Markets

CHAPTER 5
 Financial intermediation
In a barter economy, investment—the purchase of productive
equipment, such as physical structures, machines, and inventories—
can be undertaken through personal saving.
When an economy evolves from a barter to a money standard, it
becomes easier for people to separate the act of saving from the act
of investment.
A money economy encourages saving and investment, and it
facilitates the
transfer of purchasing power from savers to investors. These
advantages promote economic growth and a rising living standard
for the community.
 Financial intermediation
As economies moved from barter to money, the stage was set for a
new business: banking.
By connecting savers (ultimate lenders) with investors (ultimate
borrowers), banks could facilitate the transferal of purchasing
power. Banks provided a ‘middleperson’ service—for a fee. of
course.
As the economy and the financial system developed, other financial
institutions (or financial intermediaries) emerged.
Today, governments, commercial banks, savings and loan
associations, mutual savings banks, credit unions, insurance
companies, pension funds, and mutual funds are all in the business
of transferring funds from savers to investors.
 Financial intermediation
This process has come to be known as financial intermediation. The
process of financial intermediation has spawned(produced) a
variety of financial assets, or financial instruments, such as stocks,
bonds, mortgages, mutual funds, and repurchase agreements.
Channeling Saving to Borrowing
Financial markets perform the function of channeling saving funds to borrowing.
Two basic economic groups are households and businesses.
As a group, however, households are net savers; and as a group, businesses are net
borrowers.
Financial Intermediaries
Direct Finance
◦ Borrowers and lenders deal directly with each other.

Indirect Finance
◦ An Institution stands between lender and borrower.

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Financial Disintermediation
The reverse of the financial intermediation process is financial
disintermediation
Savers take funds out of deposit accounts and invest directly.
Savers does it directly
Why disintermediation occur
Disintermedation occurs when inflation rates are high but bank interest
rate are stagnant (usually due to govt control).bank some investors or
savers don’t want to involved
New relationships develop between agent,broker,etc
Financial Instruments

A financial instrument is the written legal obligation of one

party to transfer something of value – usually money – to
another party at some future date, under certain conditions,
such as stocks, loans, or insurance.

A variety of financial instruments are available to individuals

and firms in today's world
Financial Instruments

Serve as a: Means of payment (Like Money), Store of Value (Like

Money), allow for the trading of risk
1. Securities
Securities are printed documents proving ownership or
creditorship in a business organization or public body
such as local, state, or federal government.
A security is a negotiable instrument that represents a financial claim
and can take the form of ownership (such as stocks) or debt agreement
(such as bonds).
The securities market allow businesses and individual investors to trade
the securities issued by public corporations.
Financial Instruments

TYPES OF SECURITIES
All securities convey the same basic information: the
identity of the borrower, the amount to be paid when the
instrument matures, and the amount of interest and
when it is to be paid.
Financial Instruments

2. Equity Instruments
Shares of ownership in a firm are equity instruments, or shares
of stock in the company. These ownership shares may be preferred stock
or common stock shares.
3. Debt Instruments
Direct debt obligations of individuals or firms that borrow are debt
instruments.
There are a variety of debt instruments; we highlight only a few:
1. Commercial paper 4. Junk bonds
2. Corporate bonds 5. Government securities
3. Convertible bonds 6. State and local bonds called municipal bonds
 Financial Instruments

4. Asset-Backed Securities:
Securities that represent shares of the market value of a pooled grouping of
assets are known as asset-backed securities. E.g. mortgage-backed security,
which is a share in the value of a group of home mortgages.
5. Hedging Instruments
An instrument that permits an individual or firm to ensure against asset price
fluctuations is a hedging instrument.
Function of financial
intermediaries
Indirect finance
◦ facilitate borrowing and lending
Lower transaction costs
◦ Economies of scale, develop expertise
◦ Liquidity services ( but bank charges premium)
Reduce risk
◦ Risk Sharing (e.g. insurance companies)
◦ Diversification
Alleviate ‘asymmetric information problem’
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 Asymmetric information
Adverse selection
◦ Adverse selection is a problem that arises for a buyer of a good, service, or asset
when the buyer has difficulty assessing the quality of this item before purchase.
◦ loan market:
risky borrower are more likely to be ‘selected’

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Asymmetric information – Cont’d
Moral hazard
◦ Moral hazard is said to exist in a market if, after the signing of a contract or
transaction:
1. one party changes behavior which might have undesirable results;
2. only imperfectly able to monitor/control
◦ insurance, stock market: engage in
undesirable (risky) activities

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 Financial Institutions

Financial institutions, which intermediate between us and other borrowers,

including other households and business firms

There are three types of institutions that operate as banks. These are
i. Depository institution,
ii. Non depository institution and
iii. Federal Govt financial institution.
i. Depository institution
Depository institutions are financial intermediaries that issue
debt instruments they call deposits. Depository institutions also issue
deposits denominated in foreign currencies.

There are two basic types of depository institutions:

i. commercial banks and
ii. thrift institutions, which include savings and loan associations,
savings banks, and credit unions.
1.Commercial bank
banks that offer the entire range of banking services, such as checking
and savings accounts, loans, and financial advice
2.Thrift institution

savings and loan associations

financial institutions that hold customers’ funds in interest-bearing
accounts and invest mainly in mortgage loans
Credit unions
not-for-profit banks set up by organizations for their customers to use
ii. Non depository institution
Private financial institution they do not issue deposit
1. Insurance companies
These include life insurance and property and casualty insurance
companies. Life insurance companies, which rank third in asset size,
receive funds (premiums) that insure people against the financial
consequences of death.
2. Pension and retirement
These institutions are akin to life insurance companies; they can predict
with high accuracy what their annual payouts (pension annuities)
will be for long periods into the future.
 ii. Non depository institution
3. Mutual funds
◦ Sell shares to surplus units
◦ Use funds to purchase a portfolio of securities
◦ Some focus on capital market securities (e.g., stocks or bonds)
◦ Money market mutual funds concentrate on money market securities

4. Finance companies
financial institutions that offer
short-term loans to businesses and consumers, but at a much higher interest rate
than banks charge. These, in effect, are small loan companies. They issue a variety
of debt instruments of their own to finance small loans, most often to individuals or
to small businesses.
iii. Federal Govt. financial
institution
The federal government's presence in the financial markets has three
other sources:
(1 ) activities of "off-budget" agencies.
(2) operation of government-sponsored enterprises, and
(3) provision of federally guaranteed loans
Types of Financial Markets
Financial markets can be distinguished by the
maturity structure and trading structure of its
securities
Financial Markets

Financial instruments are traded both by individual households and

firms and by financial institutions in a wide variety of financial markets,
or markets for financial instruments.
PRIMARY AND SECONDARY FINANCIAL MARKETS
◦ Primary markets facilitate the issuance of new securities
◦ e.g., the sale of new corporate stock or new
Treasury securities
◦ Secondary markets facilitate the trading of existing securities
◦ e.g., the sale of existing stock
◦ Securities traded in secondary markets should be
liquid.
Primary market
A primary market is one in which a new security is bought and sold.

Small investors are not often able to purchase securities

Investors buy securities directly from the company issuing them
Companies issuing securities via the primary capital market hire
investment bankers to obtain commitments from large institutional
investors to purchased when it is offered first time.
Underwriting of a new securities
Secondary market
A secondary market is one in which existing securities are exchanged:
secondary markets are important to primary markets because they
make the instruments traded in the latter markets more liquid.

The transactions of the secondary market are generally done through

the medium of stock exchange.
The chief purpose of the secondary market is to create liquidity in
securities.
If an individual has bought some security and he now wants to sell it, he
can do so through the medium of stock exchange to sell or purchase
through . the medium of stock exchange requires the services of the
broker presently,
Features of Secondary Market
It Creates Liquidity
It Comes After Primary Market
It Has A Particular Place
It Encourages New Investments
Money versus capital
markets
◦ The flow of short-term funds is facilitated by money
markets 3 months to 1 yr

◦ The flow of long-term funds is facilitated by capital

markets
Capital market
◦ Long-term markets consisting of securities having maturities greater than one year
◦ Bonds, common stock, preferred stock, convertible securities
◦ These securities comprise a firm’s capital structure

The different types of financial instruments that are traded in the capital
markets are:
> equity instruments
> credit market instruments,
> insurance instruments,
> foreign exchange instruments,
> hybrid instruments and
> derivative instruments.
Money market
Offer short term security
High liquidity
Readily marketable
For example T. bills, small denomination certificate ,Repo, Now
Participants of money market
US treasury department
Fed reserve system
Commercial banks
Business
Investment companies
Insurance companies
pension
Financial Market
Another form of money market trading is in the
federal funds market, in which banks borrow from
and lend to each other the deposits (reserves) they
have at the Fed.
Types of Financial Markets (cont’d)
Organized versus over-the-counter markets:
◦ A visible marketplace for secondary market transactions is
an organized exchange
◦ Some transactions occur in the over-the-counter (OTC)
market (a telecommunications network)
Knowledge of financial markets is power:
◦ Decide which markets to use to achieve our investment
goals or financing needs
◦ Decide which markets to use as part of your job
◦ Avoid common mistakes in investing and borrowing
Recent innovations in
financial market
Dramatic development
Change in financial institution, markets instrument occur
Common aim is Try to reduce risk associated
Fluctuation interest rate
Recent innovations in
financial market
Mortgage Market
Newly issued residential mortgages is adjustable rate mortgage.
Very the interest during time period of loan
2.Bond Market
Zero coupon bond :return in the form of price appreciation rather than
coupon interest payments.
Collateralized mortgage obligation
Are similar to the real estate mortgage