Chapter 3 Financial Instruments,

Financial Markets, and

Financial Institutions

Schoenholtz, Cecchetti (2015), Money, Banking, and Financial Markets,

Fourth Edition, Mc Graw Hill.
 Introduction
• Financial development is linked to economic
growth.
• The role of the financial system is to facilitate
production, employment, and consumption.
• Resources are funneled through the system so
resources flow to their most efficient uses.

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 Introduction
We will survey the financial system in three steps:
1. Financial instruments or securities
– Stocks, bonds, loans and insurance.
– What is their role in our economy?
2. Financial Markets
– New York Stock Exchange, Nasdaq.
– Where investors trade financial instruments.
3. Financial institutions
– What they are and what they do.

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 Financial Instruments
Financial Instruments: The written legal obligation
of one party to transfer something of value,
usually money, to another party at some future
date, under certain conditions.
– The enforceability of the obligation is important.
– Financial instruments obligate one party (person,
company, or government) to transfer something to
another party.
– Financial instruments specify payment will be made
at some future date.
– Financial instruments specify certain conditions
under which a payment will be made.
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 Uses of Financial Instruments
• 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 generate increases in wealth that are
larger than from holding 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 allows one person to transfer
risk to another.

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• The use of borrowing to finance part of an
investment is called leverage.
– Leverage played a key role in the financial crisis of
2007-2009.
• How did this happen?
– The more leverage, the greater the risk that an
adverse surprise will lead to bankruptcy.
• The more highly leveraged, the less net worth.

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• How did this happen? (cont.)
– Some important financial institutions, during the
crisis, were leveraged at more than 30 times their
net worth.
– When losses are experienced, firms try to
deleverage to raise net worth.
• When too many institutions deleverage, prices fall,
losses increase, net worth falls more.
– This is called the “paradox of leverage”.

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 Underlying Versus Derivative
Instruments
• Two fundamental classes of financial
instruments.
– Underlying instruments are used by
savers/lenders to transfer resources directly to
investors/borrowers.
• This improves the efficient allocation of resources.
• Examples: stocks and bonds.

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 Underlying Versus Derivative
Instruments
• Derivative instruments are those where their
value and payoffs are “derived” from the
behavior of the underlying instruments.
– Examples are futures and options.
– The primary use is to shift risk among investors.

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 A Primer for Valuing Financial
Instruments
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 payment is made:
– More likely to be made - more valuable.
4. Conditions under with payment is made:
– Made when we need them - more valuable.

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 A Primer for Valuing Financial
Instruments
We organize financial instruments by how
they are used:
• Primarily used as stores of value
1. Bank loans
• Borrower obtains resources from a lender to
be repaid in the future.
2. Bonds
• A form of a loan issued by a corporation or
government.
• Can be bought and sold in financial markets.
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 A Primer for Valuing Financial
Instruments
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.

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 A Primer for Valuing Financial
Instruments
5. Asset-backed securities
• Shares in the returns or payments arising from
specific assets, such as home mortgages and student
loans.
• Mortgage-backed securities bundle a large number of
mortgages together into a pool in which shares are
sold.
– Securities backed by sub-prime mortgages played an
important role in the financial crisis of 2007-2009.

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 A Primer for Valuing Financial
Instruments
Primarily used 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.
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 A Primer for Valuing Financial
Instruments
3. Options
• Derivative instruments whose prices are based on the
value of an underlying asset.
• Give the holder the right, not obligation, to buy or sell
a fixed quantity of the asset at a pre-determined
price on either a specific date or at any time during a
specified period.
• These offer an opportunity to store value
and trade risk in almost any way one would
like.
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 Financial Markets
• Financial markets are places where financial
instruments are bought and sold.
• These markets are the economy’s central
nervous system.
• These markets enable both firms and
individuals to find financing for their activities.
• These markets promote economic efficiency:
– They ensure resources are available to those who
put them to their best use.
– They keep transactions costs low.
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The Role of Financial Markets
1. Liquidity:
– Ensure owners can buy and sell financial
instruments easily and quickly .
– 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.

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 The Structure of Financial Markets
1. Distinguish between markets where new
financial instruments are sold and where
they are resold or traded: primary or
secondary markets.
2. Categorize by the way they trade:
centralized exchange or not.
3. Group based on the type of instrument they
trade: as a store of value or to transfer risk.

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 Primary versus Secondary Markets
• A primary market is one in which a borrower
obtains funds from a lender by selling newly
issued securities.
– Occurs out of the public views.
– An investment bank determines the price,
purchases the securities, and resells to clients.
• This is called underwriting and is usually very
profitable.

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 Primary versus Secondary Markets
• Secondary financial markets are those where
people can buy and sell existing securities.
– Buying a share of IBM stock is not purchased from
the company, but from another investor in a
secondary market.
– These are the prices we hear about in the news.

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 Centralized Exchanges, OTCs, and
ECN’s
• Centralized exchanges - a marketplace where buyers and
sellers transact with each other via an intermediary, or a
central authority, that facilitates all transactions (ex:
NYSE, Nasdaq, Binance, Coinbase).
• Over-the-counter markets (OTC’s) - decentralized
markets where brokers and dealers stand ready to buy
and sell securities electronically (ex: forex, bonds,
derivatives)
• Electronic communication networks (ECN’s) - electronic
system bringing buyers and sellers together without the
use of a broker or dealer (ex: Instinet, SelectNet).
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• Trading is what makes financial markets work.
• Placing an order in a stock market has the
following characteristics:
– The stock you wish to trade.
– Whether you wish to buy or sell.
– The size of the order - number of shares.
– The price you would like to trade.

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• You can place a market order.
– Your order is executed at the most favorable price
currently available.
• You can place a limit order:
– Places a maximum on the price to buy or a
minimum price to sell.

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 Debt and Equity versus Derivative
Markets
• Used to distinguish between markets where
debt and equity are traded and those where
derivative instruments are traded.
• Debt markets are the markets for loans,
mortgages, and bonds.
• Equity markets are the markets for stocks.
• Derivative markets are the markets where
investors trade instruments like futures and
options.
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 Debt and Equity versus Derivative
Markets

• In debt and equity markets, actual claims are

bought and sold for immediate cash payments.
• In derivative markets, investors make agreements
that are settled later.
• Debt instruments categorized by the loan’s maturity
– Repaid in less than a year - traded in money markets.
– Maturity of more than a year - traded in bond markets.

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• Liquid, interbank loans are the marginal
source of funds for many banks, with their
cost guiding other lending rates.
• The financial crisis of 2007-2009 strained
interbank lending.
– Anxious banks preferred to hold their liquid assets
in case their own needs arose.
– They also were concerned about the safety of
their trading partners.

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• The rising cost and reduced availability of
interbank loans created a vicious circle of:
– increased caution,
– greater demand for liquid assets,
– reduced willingness to lend, and
– higher loan rates.

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 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.
• Also known as financial intermediaries.
– Examples: banks, insurance companies, securities firms, and pension
funds.
• Healthy financial institutions open the flow of resources,
increasing the system’s efficiency.

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 The Role of Financial Institutions
• To reduce transaction costs by specializing in
the issuance of standardized securities.
• To reduce the information costs of screening
and monitoring borrowers.
– They curb asymmetries, helping resources flow to
most productive uses.
• To give savers ready access to their funds.

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• Financial intermediation and leverage in the
US have shifted away from traditional banks
and toward other financial institutions less
subject to government regulations.
– Brokerages, insurers, hedge funds, etc.
• These have become known as shadow banks.
– Provide services that compete with banks but do
not accept deposits.
– Take on more risk than traditional banks and are
less transparent.

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• The rise of highly leveraged shadow banks,
combined with government relaxation of rules
for traditional banks, permitted a rise of
leverage in the financial system as a whole.
– This made the financial system more vulnerable to
shocks.

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• The financial crisis transformed shadow
banking.
– The largest US brokerages failed, merged, or
converted themselves into traditional banks to
gain access to funding.
• The crisis has encouraged the government to
examine any financial institution that could,
by risk taking, pose a threat to the financial
system.

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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, etc.

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The Structure of the Financial Industry
1. Depository institutions take deposits and
make loans.
2. Insurance companies accept premiums,
which they invest, in return for promising
compensation to policy holders under
certain events.
3. Pension funds invest individual and
company contributions in stocks, bonds,
and real estate in order to provide
payments to retired workers.
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The Structure of the Financial Industry
4. Securities firms include brokers,
investment banks, underwriters, and
mutual fund companies.
– Brokers and investment banks issue stocks and
bonds to corporate customers, trade them,
and advise customers.
– Mutual-fund companies pool the resources of
individuals and companies and invest them in
portfolios.
– Hedge funds do the same for small groups of
wealthy investors.
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The Structure of the Financial Industry
5. Finance companies raise funds directly in the
financial markets in order to make loans to
individuals and firms.
– Finance companies tend to specialize in
particular types of loans, such as mortgage,
automobile, or business equipment.

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The Structure of the Financial Industry
6. Government-sponsored enterprises are
federal credit agencies that provide loans
directly for farmers and home mortgagors.
– Guarantee programs that insure loans made by
private lenders.
– Provides retirement income and medical care
through Social Security and Medicare.

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Figure 3.2: Flow of Funds through
Financial Institutions

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