Download Chapter No. 3

Money, Banking, and Financial Markets
: Econ. 212
Stephen G. Cecchetti: Chapter 3
Financial Instruments, Financial
Markets, and Financial Institutions
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
 The informal arrangements that were the mainstay of the
financial system centuries ago have since given way to the
formal financial instruments of the modern world.
 Today, 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 the financial resources we need from this system in
two ways: directly from lenders and indirectly from financial
institutions called financial intermediaries.
 In the latter (called “indirect finance”) a financial institution
(like a bank) borrows from the lender and then provides funds
to the borrower. If someone borrows money to buy a car, the
car becomes his or her asset and the loan a liability.
 In direct finance, borrowers sell securities directly to lenders in
the financial markets. Governments and corporations finance
their activities this way.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
 The securities become assets to the lenders who buy them and
liabilities to the borrower who sells them.
 Financial development is inextricably linked to economic
growth.
 There aren’t any rich countries that have very low levels of
financial development.
I. 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.
 The fact that a financial instrument is a written legal obligation
means that it is subject to government enforcement; the
enforceability of the obligation is an important feature of a
financial instrument.
 The “party” referred to can be a person, company, or
government.
 The future date can be specified or can be when some event
occurs.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Uses of Financial Instruments
 Stocks, loans, and insurance are all examples of financial
instruments.
 As a group, they have three functions or uses:
 They can act as a means of payment.
 They can be stores of value.
 They allow for the taking of risk.
 Most financial instruments involved some sort of risk transfer.
Characteristics of Financial Instruments: Standardization and
Information
 Financial instruments are complex contracts.
 Standardized agreements are used in order to overcome the
potential costs of complexity.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Because of standardization, most of the financial
instruments that we encounter on a day-to-day basis are
very homogeneous.
Financial instruments generally specify a number of possible
contingencies under which one party is required to make a
payment to another.
Another characteristic of financial instruments is that they
communicate information.
Financial instruments summarize certain essential
information about the issuer.
Financial instruments are designed to handle the problem of
“asymmetric information”, which comes from the fact that
borrowers have some information that they don’t disclose to
lenders.
Underlying versus Derivative Instruments
 The two fundamental classes of financial instruments are
underlying instrument (sometimes called primitive securities)
and derivative instruments.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
 Stocks and bonds are examples of underlying instruments.
 Derivatives are so named because they take their value and
their payoffs are “derived from” the behavior of the underlying
instruments.
 Futures and options are examples of derivatives.
A Primer for Valuing Financial Instruments
 Four fundamental characteristics influence the value of a
financial instrument:
 the size of the payment that is promised
 when the promised payment is to be made
 the likelihood that the payment will be made
 the conditions under which the payment is to be made
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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People will pay more for an instrument that obligates the
issuer to pay the holder a greater sum. The bigger the size of
the promised payment, the more valuable the financial
instrument.
The sooner the payment is made the more valuable is the
promise to make it.
The more likely it is that the payment will be made, the more
valuable the financial instrument.
Payments that are made when we need them most are more
valuable than other payments.
Examples of Financial Instruments
 Financial instruments that are used primarily as stores of
value include:
 Bank loans: a borrower obtains resources from a lender
immediately in exchange for a promised set of payments in
the future.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Bonds: a form of a loan, whereby in exchange for
obtaining funds today a government or corporation
promises to make payments in the future.
Home mortgages: a loan that is used to purchase real
estate. The real estate is collateral for the loan, which
means it is a specific asset pledged by the borrower in
order to protect the interests of the lender in the event of
nonpayment. If payment is not made the lender can
foreclose on the property.
Stocks: an owner of a share owns a piece of the firm and is
entitled to part of its profits.
Asset-backed Securities: shares in the returns or
payments arising from specific assets, such as home
mortgages. Investors purchase shares in the revenue that
comes from these underlying assets. These are an
innovation that allows funds in one part of the country to
find productive uses elsewhere.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Financial instruments that are used primarily to transfer risk
include:
 Insurance contracts: the primary purpose is to assure that
payments will be made under particular (and often rare)
circumstances.
 Futures contracts: an agreement to exchange a fixed
quantity of a commodity, such as wheat or corn, or an
asset, such as a bond, at a fixed price on a set future date.
It is a derivative instrument since its value is based on the
price of some other asset. It is used to transfer the risk of
price fluctuations from one party to another.
 Options: derivative instruments whose prices are based on
the value of some underlying asset; they give the holder the
right (but not the obligation) to purchase a fixed quantity
of the underlying asset at a predetermined price at any
time during a specified period.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
II. Financial Markets
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Financial markets are the places where financial instruments are bought
and sold.
They enable both firms and individuals to find financing for their
activities.
They promote economic efficiency by ensuring that resources are
placed at the disposal of those who can put them to best use. When they
fail to function properly, resources are no longer channeled to their best
possible use and we all suffer.
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This section looks at the role of financial markets and the
economic justification for their existence.
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The Role of Financial Markets
Financial markets serve three roles in our economic system:
1. they offer savers and borrowers liquidity;
2. they pool and communicate information;
3. and they allow risk sharing.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Financial markets need to be designed in a way that keeps
transactions costs low.
The Structure of Financial Markets
 There are lots of financial markets and many ways to
categorize them.
 There are three possibilities for grouping financial markets:
1. Primary versus secondary markets: in a primary market a
borrower obtains funds from a lender by selling newly
issued securities. Most of the action in primary markets
goes on out of public view. Most companies use an
investment bank, which will determine a price and then
purchase the company’s securities in preparation for resale
to clients; this is called underwriting. We hear more about
the secondary markets where people can buy and sell
existing securities; these are the prices reported in the
news.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
1. Centralized Exchanges versus Over-the-Counter Markets:
Secondary financial markets are either centralized exchanges
(like the New York Stock Exchange) or an over-the-counter
(or OTC) market, which are electronic networks of dealers
who trade with one another from wherever they are located
(NASDAQ, for example). There are advantages and
disadvantages to the OTC markets: if one section shuts down
the rest can continue to work. But they are not failsafe, and
errors can happen.
2.
Debt and Equity versus Derivative Markets: equity markets
are the markets for stocks, which are usually traded in the
countries where the companies are based. Debt instruments
can be categorized as money market (maturity of less than
one year) or bond markets (maturity of more than one year).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Characteristics of a well-run financial market
 Well-run financial markets exhibit a few essential
characteristics that are related to the role we ask them to play
in our economies.
1. They must be designed in a way that keeps transactions
costs low.
2. The information the market pools and communicates must
be both accurate and widely available. If not, the prices
will not be correct. Those prices are the link between the
financial markets and the real economy.
3. Investors must be protected; a lack of proper safeguards
dampens people’s willingness to invest, and so
governments are an essential part of financial markets.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
III. Financial Institutions
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Financial institutions are the firms that provide access to the
financial markets; they sit between savers and borrowers and
so are known as financial intermediaries. Examples include
banks, insurance companies, securities firms and pension
funds.
A system without financial institutions would not work very
well for three reasons:
1. Individual transactions between saver-lenders and
borrower-spenders would be extremely expensive.
2. Lenders need to evaluate the creditworthiness of borrowers
and then monitor them to ensure that they don’t run away
with the funds, and individuals are not equipped to do this.
3. Most borrowers want to borrow long term, while lenders
favor short-term loans.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
The Role of Financial Institutions
1. Financial institutions reduce transaction costs by
specializing in the issuance of standardized securities.
2. They reduce the information costs of screening and
monitoring borrowers to ensure that they are creditworthy
and that they use the proceeds of a loan or security issue
properly.
3. Financial institutions curb information asymmetries and
the problems that go along with them, helping to ensure
that resources flow into their most productive uses.
4. Financial institutions make long-term loans but allow
savers ready access to their funds.
5. They provide savers with financial instruments that are
both more liquid and less risky than the individual stocks
and bonds that savers would purchase directly in financial
markets.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
The Structure of the Financial Industry
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Financial institutions or intermediaries can be divided into
two broad categories called depository and non-depository
institutions.
Depository institutions (commercial banks, savings banks, and
credit unions) take deposits and make loans.
Non-depository institutions include insurance companies,
securities firms, mutual fund companies, finance companies,
and pension funds.
1. Insurance companies accept premiums, which they invest
in securities and real estate in return for promising
compensation to policyholders should certain events occur
(like death, property losses, etc.).
2. Pension funds invest individual and company contributions
into stocks, bonds and real estate in order to provide
payments to retired workers.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
3. Securities firms (include brokers, investment banks, and
mutual fund companies): brokers and investment banks issue
stocks and bonds to corporate customers, trade them, and
advise clients. Mutual fund companies pool the resources of
individuals and companies and invest them in portfolios of
bonds, stocks, and real estates.
4. Finance Companies: raise funds directly in the financial
markets in order to make loans to individuals and firms.
5. Government Sponsored Enterprises: public credit agencies
that provide loans directly for farmers and home mortgages,
as well as guarantee programs that insure the loans made by
private lenders. The government also provides retirement
income and medical care to the elderly (and disabled) through
Social Security and Medicare.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Task No. 1.
1.
Collect data about the growth of different measures of money
and growth of GDP in Kuwait 1990-2005
2. Graph your data to show how strong is the relationship
between the two variables.
3. Collect data about growth of different measures of money and
inflation 1990-2005.
4. Graph your data to show how strong is the relationship
between the two variables.
5. Write a short report about the results
6. Hint: to collect data, go to:
7. www.cbk.gov.kw
8. Go to publications section and select quarterly bulletin. Go to
tables section and open the relevant table.
9. To collect old data go to the Archive in the publication section
and select the relevant issues.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Lessons of Chapter 3

Financial instruments are crucial to the operation of the economy.
 Financial arrangements can be both formal and informal. Industrial economies
are dominated by formal arrangements.
 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.
 Financial instruments are used primarily as stores of value and as a means of
trading risk. They are less likely to be used as means of payment, although
many of them can be.
 Financial instruments are most useful when they are simple and standardized.
 There are two basic classes of financial instruments: underlying and derivative.
i. Underlying instruments are used to transfer resources directly from one party to
another.
ii. Derivative instruments derive their value from the behavior of an underlying
instrument.
 The payments promised by a financial instrument are more valuable:
i.
ii.
iii.
iv.
the larger they are;
the sooner they are made;
the more likely they are to be made; and/or
if they are made when they are needed most.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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i.
ii.
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Common examples of financial instruments include:
Those that serve primarily as stores of value, including bank loans, bonds,
mortgages, stocks, and asset-backed securities.
Those that are used primarily to transfer risk, including futures and options.
Financial markets are essential to the operation of our economic system.
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i.
ii.
iii.
Financial markets:
offer savers and borrowers liquidity, so that they can buy and sell financial
instruments easily.
pool and communicate information through prices.
allow for the sharing of risk.
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i.
ii.
iii.
There are several ways to categorize financial markets:
primary markets that issue new securities versus secondary markets where
existing securities are bought and sold;
physically centralized exchanges versus dealer-based electronic systems (over-thecounter markets); and
debt and equity markets, where instruments that are used primarily for financing
are traded, versus derivative markets, where instruments that are used to transfer
risk are traded.
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i.
A well-functioning financial market is characterized by:
low transactions costs and sufficient liquidity;
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
ii. accurate and widely available information; and
iii. legal protection of investors against the arbitrary seizure of their property.
 Financial institutions perform the functions of brokerage and asset transformation
 In their role as brokers, they provide access to financial markets.
 In transforming assets, they provide indirect finance.
 Indirect finance reduces transaction and information costs.
 Financial institutions, also known as financial intermediaries, help individuals
and firms to transfer and reduce risk.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Key Terms
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Asset
asset-backed security
bond market
centralized exchange
Collateral
counterparty
debt market
derivative instrument
direct finance
electronic communications network (ECN)
equity market
financial instrument
financial institutions
indirect finance
Liability
money market
over-the-counter marketportfolio
primary financial market
secondary financial market
Specialist
underlying instrument
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University