Chapter 3: Financial Instruments, Financial Markets,

Chapter 3: Financial Instruments, Financial Markets, and Financial Institutions

Well-functioning financial markets are an essential part of any modern healthy economy. It is through these markets that funds are offered by the lenders/savers who have excess funds and purchased by the borrowers/spenders who need those funds. These borrowers and lenders may meet directly (known as direct finance) or through financial intermediaries (known as indirect finance). The diagram on page 24 says it all:

Lenders and borrowers meet directly (the blue arrows at the bottom) or through a financial intermediary (the orange arrows at the top). Through these markets the funds flow that allow for the development of new products/ideas, the expansion of the production of existing products, and consumer spending on "big ticket" items like houses, cars, and college tuition. Without these markets, firms may be unable to expand production or invent new products and consumers will be unable to afford certain products.
Financial Instruments
The transfer of available funds takes place through the buying and selling of financial instruments or securities. Your book offers the following definition of a financial instrument (36):
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.
This is a mouthful, but breaking it down, we see several key features. First, this is a binding, enforceable contract under the rule of law, protecting potential buyers. Second, there is the transfer of value between two parties, where a party can be a bank, insurance company, a government, a firm, or an individual. The future dates may be very specific (like a monthly mortgage payment) or may be quite uncertain and depend on certain events (like an insurance policy).
Financial instruments, like money, can function as a means of payment or a store of value. As a means of payment, financial instruments fall well short of money in terms of liquidity, divisibility, and acceptance. However, they are considered better stores of value since they allow for greater increases in wealth over time, but with higher levels of risk. A third function of these instruments is risk transfer. For certain instruments, buyers are shifting risk to the seller, and are basically paying the seller to assume certain risks. Insurance policies are a prime example of this.
Most financial instruments are standardized in that they have the same obligations and contract for buyers. Google stock shares are the same obligation, regardless of buyer. Car loan and mortgage loans contracts use uniform legal language, differing only in specific loan amounts and terms. This standardization reduces costs (since the same types of contracts are used over and over) and makes it easier for buyers and sellers to trade these instruments over and over. In addition to this standardization, financial instruments must provide certain relevant information about the issuer, the characteristics and the risks of the security. This information requirement is a way to even the playing field among different parties and reduce unfair advantages.
Back in chapter 1, I mention that the size, timing and certainty of cash flows are all important in determining the value of a financial instrument:

• How much is promised? $1000? $10,000? $1 million? The larger amount promised, the greater the value.
• When is it promised? In 30 days? 1 year? Over 10 years? The sooner the payments are promised, the greater the value.
• How likely is it the payments will be made? How creditworthy is the issuer of the financial instument? If the issuer is the U.S. government, payment is considered a certainty. If the issuer is my brother-in-law, well good luck with that... The more certain the payments, the greater the value.
• Under what conditions are the payments made? For some instruments, payment is contingent on an event, like a fire, or car accident. The more needed the payment, the greater the value.

Pages 43-44 go over some common financial instruments.
Financial Markets
There is not one financial market, but rather many markets, each dealing with a particular type of financial instrument. But all financial markets perform crucial functions. By providing a mechanism for quickly and cheap buying and selling of securities, financial markets offer liquidity. Financial markets allow the interaction of buyers and sellers to determine the price and the price conveys important information about the prospects of the issuer. Finally, financial markets are the mechanism for buying and selling the instruments that transfer risks between buyers and sellers.
We can classify financial markets into narrower categories based on the type of assets traded, their characteristics, or even the location of markets.
Primary vs. Secondary Markets
The primary market is like the new car market. The financial instruments sold in the primary market are brand new, or new issues. They are sold to the buyer by the issuer. The secondary market is like the used car market (or as car dealers like to say "previously-owned vehicle"). The securities sold in the secondary market are being resold by previous buyers for the second, tenth, or fortieth time.
Financial intermediaries play a role in both markets. In the primary market, investment banks assist a business in selling a new issue to the public. Investment banks underwrite new securities, meaning that they buy the new issue from the business and sell it to the public. Investment banks charge fees for this service, along with any profits from reselling the issue at a higher price. Underwriting is big business. The largest underwriters of new equity securities include Merril Lynch, Salomon Smith Barney, and Goldman Sachs.
Even in the secondary market, financial intermediaries are an important part of a well-functioning market. Securities brokers facilitate trade by match buyers with sellers. For this they charge a commission on each match (or trade).
Securities dealers act as the buyer and seller by continuously quoting a price at which they will buy a security (the bid price) and the price at which they will sell the security (the ask price). The bid price is lower than the ask price (the difference is known as the bid-ask spread), and this is how dealers make their money. Dealers own an inventory of the securities in which they deal. Since dealers stand ready to be the buyer or seller for a security, dealers are said to "make a market" in that security, and dealers are often referred to as "market-makers". If a buyer is looking for a seller, the dealer acts as the seller. If a seller is looking for a buyer, the dealer acts as a buyer. This way there is always a buyer and seller, so there is always a market.
Why have a secondary market? Keep in mind that the better the secondary market, the better the primary market. Why? Because if securities are easily bought and sold, then they will be more popular in the first place. The ease of which a security is converted to cash is known as its liquidity. High liquidity is considered a good feature. If, for example, Microsoft stock is easy to buy and sell in the secondary market (highly liquid) then it will be popular in the primary market.
Exchanges vs. OTC Markets
Secondary markets can be classified by where or how the trading of securities takes place. When buying and selling occurs in a central, physical location, then securities are traded on an exchange. The New York Stock Exchange is probably the best-known example. The NYSE had an average daily volume of over 1 billion shares traded. London and Tokyo also have large exchanges. The NYSE depends on a specialist system, where a firm is charged with maintaining an orderly market for each individual stock traded on the exchange.
The alternative to an exchange is trading by geographically dispersed buyers and sellers, linked by computer. This is known as an over-the-counter (OTC) market. The name originated from pre-computer days when securities and money were literally exchanged over countertops by buyers and sellers. Today OTC markets link buyers and sellers electroncially through dealers. The OTC markets depend on dealers who make a market in various securities. Debt securities are traded in OTC markets (although some bond trading does occur on the NYSE), while stocks are traded on exchanges and large OTC markets, like the NASDAQ. The largest companies typically have their stocks trade on an exchange, but overall the NASDAQ has a larger transaction volume.
ECNs or electronic communication networks offer yet a third option for buyers and seller to find each other directly with no dealer or broker. Examples include Instinet and Archipelago.
In the Spring of 2005 the NYSE announced a merger between the NYSE and Archipelago. It has yet to be approved, but it will be interesting to see how this will affect the specialist system. Some argue it will be phased out in favor of electronic order matching.
Debt vs. Equity vs. Derivative Markets
Recall that debt instruments, like a bond or a bank loan, involve a promise by the borrower (the seller/issuer of the debt instrument) to pay the lender (the owner/buyer of the debt instrument) fixed payments at specified intervals until a final date. The time until all payments are made is known as the maturity of a debt security. For example, most mortgages have a maturity of 30 years when first created. We can further classify the debt market by maturity:

• Short-term debt securities have a maturity of up to 1 year. This part of the debt market is also known as the money market.
• Intermediate-term debt securities have a maturity of between 1 and 10 years.
• Long-term debt securities have a maturity of 10 years or more.

Equity instruments, like shares of common stock, are claims on the earnings and assets of a corporation. If you own 5% of the shares of a company, then you are entitles to 5% of the earnings and assets of that company once creditors are satisfied. Equity securities differ from debt in that

• the size and timing of the payments are not fixed. Some equities securities entitle the owner to periodic payments (known as dividends) but these payments are not guaranteed. This means that equity holders benefit from a firm's profitability in a way that debt holders do not.
• there is no maturity date for equity securities so they are considered long-term securities.
• stock holders are considered residual claimants in the event of bankruptcy. This means that all debt holders must be paid first before stock holders receive anything. This makes equity securities somewhat riskier than debt securities. For example, many internet startups went bankrupt in 2001. The assets were sold but did not even cover all of the debts so stock holders got nothing. zip. zero. nada.

Derivatives markets trade securities that derive there value from other underlying assets. The derivatives markets is primarily a way for buyers and sellers to transfer risks that occur due to fluctuating asset prices. This market has seen tremendous growth in the past two decades.
Financial Institutions
Financial intermediaries can be subdivided into three categories based on their liabilities (how they get their funds) and their assets (how they use their funds).
Depository Institutions
These institutions are often collectively referred to as banks. All institutions in this category accept deposits and make loans. We will focus on this group because they play a large role in monetary policy.
Commercial banks' primary liabilities are deposits (checking accounts, savings accounts and CDs) and their primary assets include commercial loans, consumer loans, mortgages, U.S. government bonds, municipal bonds. They are the largest type of financial intermediary, as measured by the total value of their assets. (See table 2, page 36.)
Savings and Loan Associations were created in the 1930s and originally restricted to offering savings accounts and CDs and making mortgage loans. In the 1980s these restrictions were relaxed to allow greater asset and liability choices, making S&Ls very similar to commercial banks.Mutual Savings banks are very similar to S&Ls, with the only distinction being that mutual savings banks are owned by the depositors.
Credit Unions are the smallest of the depository institutions. They take deposits and primarily make consumer loans. Credit unions are distinguished by two features: They are nonprofit and credit union membership is organized around a particular group, such as company employees, a union, or even a church parish.
Nondepository Institutions
Life insurance companies receive premiums in return for protection from the risk of death. Mortality rates are predictable, so the timing and size of payouts for these companies are also predictable. Life insurance companies also sell a variety of investment products as well, such as annuities and guaranteed investments contracts (GICs). Life insurance companies are the largest buyer of corporate bonds, and invest heavily in mortgages as well. They hold very little stock or municipal bonds.
Fire and casualty insurance companies receive premiums in return for protection from the risk of property damage/loss, liability, and disability. The size and time of their payouts are less predictable, since natural disasters such as a major earthquake or bad hurricane season can greatly affect the amount of property damage that occurs in a given year. Because of this, their assets are more liquid than life insurance companies. They hold municipal bonds, corporate bonds, stocks, and U.S. government bonds.
Pension funds may be privately-sponsored or government-sponsored, but in either case they provide retirement income in return for contributions from employees and employers during their working years. Pension funds receive very favorable tax treatment at the federal level. Again, the payouts are predictable, so assets are long term such as corporate bonds and stocks.
Finance companies have taken much of the consumer and commercial loan business away from depository institutions. These companies raise funds by issuing commercial paper (they do NOT accept deposits). They then use these funds to make business loans, construction loans, auto loans and other consumer loans. For example, all 3 major U.S. auto companies, GM, Ford, and Chrysler have finance companies to help consumers finance auto purchases. Other finance companies specialize in credit cards.
Securties firms include brokers, investment banking/underwriting and mutual funds. Mutual funds sell shares to individuals and use those funds to purchase and manage a diversified portfolio of stocks and/or bonds. The value of the shares fluctuates with the value of the underlying portfolio. Why not just buy stock directly? Because through mutual funds, investors can diversify with little initial capital, receive professional management of their investments, and save on transactions costs. These advantages explain why the number of mutual funds has grown from less than 500 in 1980 to over 6000 today. Mutual funds vary according to their investment objectives and the type of securities they hold. Some funds focus on a particular sector, like technology or health care, while some focus on U.S. government bonds or municipal bonds. Money market mutual funds have features like both a mutual fund and a checking account. These funds sell shares, fixed at a price of $1, and use those shares to buy money market instruments. These funds then pay regular dividends in the form of additional shares. These funds also have restricted check writing privileges. They operate like an interest bearing checking account with a large minimum deposit. They have taken away funds from banks by competing for depositors.
GSEs or Government-sponsored enterprises are federal credit agencies that were created to supply credit to farmers or home buyers or even for student loans. Examples of these include Fannie Mae (home mortages) and Sallie Mae (studens loans). Note that these two enterprises are not government agencies, but are privately held firms created through government charters and special access to government services.