Download Chapter 3 Financial Instruments, Financial Markets, and Financial

Lecture 1
Financial Systems, Markets, Institutions,
Instruments and Crisis.
Introduction
 The international financial system exists to facilitate
the design, sale, and exchange of a broad set of
contracts with a very specific set of characteristics.
 We obtain financial resources through this system:
 Directly from markets, and
 Indirectly through institutions.
Introduction

Indirect Finance: An institution stands between lender
and borrower.
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Direct Finance: Borrowers sell securities directly to
lenders in the financial markets.
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We get a loan from a bank or finance company to buy a car.
Direct finance provides financing for governments and
corporations.
Asset: Something of value that you own.
Liability: Something you owe.
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The Balance Sheet
 The balance sheet is a snapshot of the firm’s assets
and liabilities at a given point in time
 Assets are listed in order of decreasing liquidity
 Ease of conversion to cash without significant loss of
value
 Balance Sheet Identity
 Assets = Liabilities + Stockholders’ Equity
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U.S. Corporation Balance Sheet –
Table 2.1
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Income Statement
 The income statement is more like a video
of the firm’s operations for a specified
period of time
 You generally report revenues first and
then deduct any expenses for the period
 Matching principle – GAAP says to
recognize revenue when it is fully earned
and match expenses required to generate
revenue to the period of recognition
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U.S. Corporation Income Statement - Table
2.2
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Financial Management Decisions
 Capital budgeting
 What long-term investments or projects should the
business take on?
 Capital structure
 How should we pay for our assets?
 Should we use debt or equity?
 Working capital management
 How do we manage the day-to-day finances of the
firm?
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Forms of Business Organization
 Three major forms in the United States
 Sole proprietorship
 Partnership
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General
Limited
 Corporation
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S-Corp
Limited liability company
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Goal Of Financial Management
 What should be the goal of a corporation?
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize the current value of the company’s
stock?
 Does this mean we should do anything and
everything to maximize owner wealth?
 Sarbanes-Oxley Act
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The Agency Problem
 Agency relationship
 Principal hires an agent to represent its interests
 Stockholders (principals) hire managers (agents) to
run the company
 Agency problem
 Conflict of interest between principal and agent
 Management goals and agency costs
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Financial system survey in three
steps:
Financial instruments or securities
1.
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Stocks, bonds, loans and insurance.
What is their role in our economy?
Financial Markets
2.
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New York Stock Exchange, Nasdaq.
Where investors trade financial instruments.
Financial institutions
3.

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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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:
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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.
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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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Money
 Any generally accepted means of payment for
delivery of goods or the settlement of debt
 Legal money
 notes and coins
 Customary money
 IOU money based on private debt of the individual

e.g. bank deposit.
©McGraw-Hill Companies, 2010
Money and its functions
 Medium of exchange
 money provides a medium for the exchange of goods
and services which is more efficient than barter
 Unit of account
 a unit in which prices are quoted and accounts are kept
 Store of value
 money can be used to make purchases in the future
 Standard of deferred payment
 a unit of account over time: this enables borrowing and
lending
©McGraw-Hill Companies, 2010
Modern banking
 A financial intermediary
 an institution that specialises in bringing lenders
and borrowers together
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e.g. a commercial bank, which has a government licence
to make loans and issue deposits
including deposits against which cheques can be written
 Clearing system
 a set of arrangements in which debts between banks
are settled
©McGraw-Hill Companies, 2010
A beginner’s guide to the financial
markets
 Financial asset
 a piece of paper entitling the owner to a specified
stream of interest payments over a specified period
 Cash
 notes and coins, paying no interest
 the most liquid of all assets
 Bills
 Short-term financial assets paying no interest directly
but with a known date of repurchase by the original
borrower at a known price.
 highly liquid
©McGraw-Hill Companies, 2010
A beginner’s guide to the financial
markets (2)
 Bonds
 longer term financial assets – less liquid because there is more
uncertainty about the future income stream
 Perpetuities
 an extreme form of bond, never repurchased by the original
issuer, who pays interest forever
 e.g. Consols
 Gilt-edged securities
 government bonds in the UK
 Company shares (equities)
 entitlements to receive corporate dividends
 not very liquid
©McGraw-Hill Companies, 2010
Credit creation by banks
 Commercial banks need to hold only a proportion
of assets as cash reserves.
 This enables them to create credit by lending.
 Example:
 Assume banks use a reserve ratio of 10 per cent.
 Suppose, initially, the non-bank private sector
has wealth of £1000 held in cash:
©McGraw-Hill Companies, 2010
Financial crises
 A financial panic is a self-fulfilling prophecy. Believing a
bank will be unable to pay, people rush to get their money
out. But this makes the bank go bankrupt.
 In a solvency crisis, an institution’s assets have become less
than its liabilities.
 In a liquidity crisis, an institution is temporarily unable to
meet immediate requests for payment.
©McGraw-Hill Companies, 2010
The subprime crisis
 A subprime mortgage is a housing loan to a low-income
high-risk person.
 Most of these mortgages were at variable interest rates:
although initially low and ‘affordable’, they could
subsequently be raised
 US house prices peaked in 2006. As they then fell, lenders
became worried and began to raise mortgage interest rates,
driving many of the poor to default.
 Suddenly, these subprime mortgages were worth a lot less
than had been thought.
©McGraw-Hill Companies, 2010
Securitisation
 Securitisation transformed this into a global problem.
Financiers had bundled lots of individual subprime
mortgages into large bundles and sold them on to new
buyers in London, Frankfurt and Mumbai.
 The market was convinced that although one poor
subprime household might default, they would not all do
so together.
 However buyers of securitized mortgages had
miscalculated.
©McGraw-Hill Companies, 2010
The Credit Crisis
 It was quite likely that circumstances could arise in which
all subprime borrowers got into trouble at the same time.
 And so they did. As US house prices fell sharply, banks
found their assets worth much less than they had
thought.
 As the solvency of banks came into question, people
became reluctant to lend to banks, and banks themselves
became reluctant to lend to anyone else
©McGraw-Hill Companies, 2010
Top World’s Biggest Financial
Crises Ever
 Panic of 1819, a U.S. recession with bank failures; culmination of U.S.'s first
boom-to-bust economic cycle
 Panic of 1825, a pervasive British recession in which many banks failed, nearly
including the Bank of England
 Panic of 1837, a U.S. recession with bank failures, followed by a 5-year
depression
 Panic of 1847, United Kingdom
 Panic of 1857, a U.S. recession with bank failures
 Panic of 1866, Europe
 Panic of 1873, a U.S. recession with bank failures, followed by a 4-year
depression
 Panic of 1884, United States and Europe
 Panic of 1890, mainly affecting the United Kingdom and Argentina
 Panic of 1893, a U.S. recession with bank failures
 Black Monday (stock crashes 22% 1987)
 Credit Crisis of 1772
 1907 Banker's Panic
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Top World’s Biggest Financial
Crises Ever
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German Hyperinflation, 1918-1924
OPEC Oil Price Shock (1973)
Wall Street Crash
The Great Depression
1998 Russian Crises
1997 Asian Crises
Japan’s "Lost Decade," 1990-2000
Financial crises of 2008
Subprime mortgage crisis in the U.S. starting in 2007
2008 United Kingdom bank rescue package
2009 United Kingdom bank rescue package
2008–2009 Belgian financial crisis
2008–2012 Icelandic financial crisis
2008–2009 Russian financial crisis
2008–2009 Ukrainian financial crisis
2008–2012 Spanish financial crisis
2008–2011 Irish banking crisis
European Sovereign Debt Crisis, 2009 onward
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Black Monday
 In the finance world, The Black Monday refers to the
time of October 19, 1987. During that day, there was a
widespread stock market crash all around the world.
The beginning of this crash originated in Honk Kong
and eventually spread to Europe. Ultimately, the
United States was affected as well. The Dow Jones
dropped by 22.1%, and it took almost 2 years to reach
even the previous high of 1987
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1907 Banker's Panic
 The Panic of 1907 saw the Dow drop almost 50% from
the high of the previous year. It was triggered by the
usual suspects: over-expansion and poor speculation.
The stock market crashed in March, and a second
crash in October led to a run on banks and every trust
in New York, notably causing the massive National
Bank of North America to fail.
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Credit Crisis 1770
 This crisis originated in London and spread to other
parts of Europe, such as Netherlands. Ironically, it
had been preceded by a period of great prosperity
for Britain. The mid 1760s and 1770s saw a credit
boom which spurred greater manufacturing and
industrial activity. The period of 1770 to 1772 was
politically very stable for Britain and its colony,
America. However, there was a deeper systemic
problem that prevailed under the surface of this
prosperity. Speculative practices thrived to generate
more credit, and this led to a false feeling of
optimism in the market. On June 8, 1772, the fleeing
of one of the partners of the Banking House “Neal,
James, Fordyce and Down” due to failure to repay
debts led to panic.
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Japan’s "Lost Decade," 19902000
 The collapse of the Japanese asset bubble in 1991 led to a
prolonged period of low growth, which has since been
extended to incorporate the decade since the year 2000.
The original lost decade was caused by an unsustainable
level of speculation, large amounts of credit and low
interest rates (sound familiar?). When the government
stepped in to control this, credit became much harder to
obtain, and capital investment dropped significantly.
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Dot-Com Bubble
 This speculative bubble related to internet based
companies saw massive rises in equity stock values of
industrialized nations from 1997-2000. This bubble began
because of easy credit availability in 1997-1998. These startup companies wanted to establish a high market share by
establishing more coverage. This meant that many of the
services were freely provided, and large operational losses
were actually occurring. They wanted to establish a brand
and then charge profitable rates. The phrase “Get large or
get lost” operated in the minds of company founders.
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European Sovereign Debt Crisis,
2009 onward
 This is the most recent of the crises on our list, and no
one is yet certain about when, or how, it is going to
end. Markets have grown increasingly concerned
about the ability of nations, particularly Greece,
Ireland, Spain, Portugal, and Italy, to pay their debts,
and the exposure of international banks to these
potentially toxic debts has played a large part in the
enormous market falls of recent days — some of the
worst on record.
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Financial crises of 2008
 This crises was considered the worst one since the Great
Depression itself. This easy availability of credit propelled
greater demand for housing and a bubble started. However,
once this ended, there was a big crash in housing prices.
Mortgage values now exceeded the values of houses
bought. A great level of lending to less credit worthy
borrowers had also prevailed, called sub-prime lending.
The existence of financial instruments like Collateralized
Mortgage obligations (CMOs) allowed the effect to spread
to the entire financial market. Financial innovations led to
far greater risk taking appetite. However, the eventual
collapse of trust in the market froze lending activity.
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