Tutorial Notes 3

Financial Instruments, Financial Markets, and Financial institutions

Direct finance: a borrower sells a security directly to a lender.
Indirect finance: an institution like a bank stands between the lender and the
borrower.

A Financial Instrument: such as a stock, a loan, and insurance 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.
legal obligation= subject to government enforcement.
party= by party it means a person, company, or government.
Ex: if you get a car loan, you are obligated to make monthly payments of a
particular amount to the lender.

Uses of Financial Instruments

A Comparison between Money Functions and Financial Instruments Functions:

Money Functions Financial Instruments Functions

1- Means of Payment 1- Means of Payment
2- Unit of account 2- Store of Value
3- Store of Value 3- Transfer of Risk

Financial instruments offer two of the three uses of money.

They are used primarily as stores of value and means of trading risk. They
are less likely to be used as means of Payment, although many of them can
be.
A means of Payment is something that is generally accepted as payment
for goods or services or repayment of debt, for ex: (we cant pay for
groceries with shares of stock but we can use it as means of payment in
some other cases such as the willingness of employees to accept a
companys stock as payment for working)

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 As stores of value, financial instruments like stocks and bonds are thought
to be better than money. Over time they generate increases in wealth that
are bigger than those we can obtain from holding money in most of its
forms (as a compensation for higher levels of risk). Also as stores of value,
many financial instruments can be used to transfer purchasing power into
the future.
Financial Instruments can transfer risk between the buyer and the seller.
Ex 1: A wheat futures contracts allows the farmer to transfer the risk to
someone else. A wheat future contract is a financial instrument in which
two parties agree to exchange a fixed quantity of wheat on a prearranged
future date at a specified price.
Ex 2: Insurance contracts transfers risk from individuals to an insurance
company

The Fundamental Classes of Financial Instruments:
There are two basic classes of financial instruments: underlying and
derivative:
Underlying instruments: are used to transfer resources directly from one
party to another. For ex: stocks and bonds that offer payments
based solely on the issuers status.
Derivative instruments derive their value from the behavior of an
underlying instrument. For ex: futures and options the amount of
payment depends on various factors associated with the price of the
underlying asset.

Characteristics that affect the value of financial instruments
The payments promised by a financial instrument are more valuable:
The larger they are (Size of the payment) People are ready to pay more
for an instrument that obligates the issuer to pay the holder $1000 than for
one that offers a payment of $100.
The sooner they are made (Timing of payment) Receiving $100
tomorrow is different from receiving $100 next year. If you receive a
payment immediately, you have an opportunity to invest or consume it
right away. Time has value.
The more likely they are to be made (Likelihood payment is made).
If they are made when they are needed most (Conditions under which
payment is made) we buy car insurance to receive a payment if we have
an accident, so we can repair the car.
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 Examples of Financial Instruments
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.

o Financial Instruments used Primarily as Stores of Value

Bank loans
Borrower obtains resources from a lender to be repaid in the future.
The borrower, who can be either an individual or a firm, needs funds to
make an investment or purchase, while the lender is looking for a way to
store value into the future.

Bonds
A form of a loan issued by a corporation or government.
Unlike most bank loans, most bonds can be bought and sold in financial
market.
Like bank loans, bonds are used by the borrower to finance current
operations and by the lender to store value.

Stocks
The holder owns a small piece of the firm and entitled to part of its profits.
Firms sell stocks to raise money as well as a way of transferring the risk of
ownership to someone else.
Buyers of stocks use them primarily as stores of wealth.

o Financial Instruments used Primarily as Transfers of Risk

Insurance contracts.
These instruments exist to transfer risk from one to another

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.

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 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.

Financial Markets
Financial Markets: are the places where financial instruments are bought
and sold.
The role of Financial Markets: Financial markets serve three roles in our
economic system. (Imp)
1. Liquidity
Offer savers and borrowers liquidity so that they can buy and sell financial
instruments cheaply and easily.
Liquidity as we defined it before: is the ease with which an asset can be
turned into money without loss of value. If someone had an emergency and
needed money immediately, he would be able to sell his stocks and benefit
from the liquidity in financial markets.
Without financial markets, selling the assets we own would be extremely
difficult & stocks would become less attractive investments.
Related to liquidity is the fact that financial markets need to be designed in
a way that keeps transactions costs the cost of buying and selling- low.
This process refers to that you must pay a broker to complete the purchase
or sale on your behalf. While this service cant be free, it is important to
keep its cost relatively low. (unlike the housing market in which transaction
costs are high once you add together everything you pay agents, bankers,
and lawyers, you have spent almost 10 percent of the sale price of the
house to complete the transaction so the housing market is not very
liquid.

2. Information:
Financial markets pool and communicate information about the issuer of
financial instruments, summarizing it in form of a price. (when the company
has good prospects for future growth and profits the stock price would

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 be high & when the borrower is likely to repay the bond the bond price
would be high and vice versa.

3. Risk Sharing:
Allow for the sharing of risk. The markets allow us to buy and sell risks,
holding the ones we want and getting rid of the ones we dont want.

The Structure of Financial Markets
There are several ways to categorize financial markets:
We can distinguish between markets where new financial instruments are sold and those
where they are resold, or traded. Second, we can categorize the markets by the way they
trade financial instruments- whether on a centralized exchange or not. And third, we can
group them based on the type of instrument they trade- those that are used primarily as a
store of value or those that are used to transfer risk.

1. Primary versus Secondary Market

Primary market is the market where newly issued securities are sold.
in which a borrower obtains funds from a lender by selling newly issued
securities.
Most of action in primary markets occurs out of public view.
While some companies that want to raise, funds go directly to the financial
markets themselves, most use an investment bank. The investment bank
examines the companys financial health to determine whether the
proposed issue is sound, then the bank underwrites the shares which
means he will determine a price and then purchase the securities in
preparation for resale to clients.
Secondary financial markets are the markets where people can buy and
sell existing securities. If you want to buy a share of stock in Microsoft
Company, you wont get it from the company itself. Instead, youll buy it in
a secondary market from another investor.
2. The organization of secondary markets for stocks and other securities is
changing rapidly. Historically, there have been two types:
Centralized exchanges: They are secondary markets where dealers meet in
a central, physical location.

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 Over-the-counter markets: They are decentralized secondary markets
where dealers stand ready to buy and sell securities electronically.

3. Debt and equity versus Derivative markets
Debt markets: Debt markets are the markets for loans, mortgages, and bonds-
the instruments that allow for the transfer of resources from lenders to
borrowers and at the same time give investors a store of value for their wealth.
Equity markets: equity markets are the markets of stocks.
Derivative markets: Derivative markets are the Markets where investors trade
instruments like futures, options, and swaps, which are designed primarily to
transfer risk.
In debt and equity markets, actual claims are bought and sold for
immediate cash payment; in derivative markets, investors make
agreements that are settled later.

Characteristics of a well-run financial market

A well-functioning financial market is characterized by:
Low transactions costs and sufficient liquidity.
Accurate and widely available information.
Legal protection of investors against the arbitrary seizure.

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 Test Bank 3

1. In indirect finance:
A) lenders loan to borrowers.
B) an institution borrows from the lender and provides funds to the borrower.
C) occurs between a borrower and lender, with or without an intermediary.
D) the borrower is required to have collateral.

2. Financial instruments are used:

A) as a unit of account, as a store of value, and as a means of payment.
B) as a unit of account, as a means of payment, and to transfer risk.
C) as a store of value, as a means of payment, and to transfer risk.
D) as a unit of account, as a store of value, and to transfer risk.

3. Which of the following increases the value of a financial instrument?

A) smaller payments.
B) payments made further in the future.
C) payments that are made when we need them.
D) payments that are less likely to be made.

4. Financial markets serve which three purposes?

A) Financial markets allow risk sharing, pool and communicate information, and
offer stability.
B) Financial markets allow risk sharing, offer stability, and offer liquidity.
C) Financial markets offer stability, pool and communicate information, and offer
liquidity.
D) Financial markets allow risk sharing, pool and communicate information, and
offer liquidity.

5. Financial institutions:
A) provide access to the financial markets.
B) are also known as financial intermediaries.
C) include banks, insurance companies, securities firms, and pension funds.
D) include all of the above.

6. Debt markets:
A) are markets for money.
B) are markets for bonds, loans, and mortgages.
C) are markets for stocks.
D) are markets for either stocks or bonds.

7. Centralized exchanges:
A) are electronic systems that bring buyers and sellers together for electronic

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 execution.
B) are markets where claims based on an underlying asset are traded for payment
at a later date.
C) are markets where financial claims are bought and sold for immediate cash
payment.
D) are secondary markets where buyers and sellers meet in the same location.

8. Debt and equity markets:

A) are markets where financial claims are bought and sold for immediate cash
payments.
B) are decentralized secondary markets where dealers stand ready to buy and sell
securities electronically.
C) are markets where newly issued securities are sold.
D) are centralized markets where buyers and sellers meet in a specific location.

9. Considering the value of a financial instrument, the sooner the promised payment is
made:
A) The less valuable is the promise to make it since time is valuable.
B) The greater the risk, therefore the promise has greater value.
C) The more valuable is the promise to make it.
D) The less relevant is the likelihood that the payment will be made.

10. Which of the following financial instruments is used mainly to transfer risk?
A) Asset-backed securities.
B) Bonds.
C) Options.
D) Stocks.

11. A primary financial market is:

A) A market just for corporate stocks.

B) A market only for AAA rated Securities.
C) The New York Stock Exchange.
D) One in which newly issued securities are sold.

12. Equity markets:

A) Are markets of U.S. Treasury bonds.
B) Are markets for AAA rated bonds.
C) Are markets for stocks.
D) Are markets for either stocks or bonds.

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13. Derivative markets exist to allow for:
A) Reduced risk from volatile prices.
B) Direct transfers of common stocks for bonds.
C) Cash receipts from the sale of bonds.
D) Reduced information asymmetry.

14. _______ are decentralized secondary markets where dealers stand ready to buy and
sell securities electronically.
A) Debt Markets
B) Money Market
C) Over-the-counter markets
D) Primary Markets.

15. Which of the following can be described as involving indirect finance?

A) You make a loan to your neighbor.
B) A corporation buys a share of common stock issued by another corporation in the
primary market.
C) You buy a U.S. Treasury bill from the U.S. Treasury.
D) You make a deposit at a bank.

16. With ________ finance, borrowers obtain funds from lenders by selling them securities
in the financial markets.
A) active
B) determined
C) indirect
D) direct

17. Which of the following is NOT a financial instrument?

A) A share of General Motors stock
B) A tuition bill
C) A U.S. Treasury Bond
D) A home insurance policy

18. Tom purchases automobile insurance; the insurance contract is:

A) a form of money.
B) a financial instrument.
C) a transfer of risk from the insurance company to Tom.
D) None of the above.

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19. A derivative instrument:
A) gets its value and payoff from the performance of the underlying instrument.
B) is a high risk financial instrument used by highly risk-averse savers.
C) comes into existence after the underlying instrument is in default.
D) should be purchased prior to purchasing the underlying security.

20. Considering the value of a financial instrument, the longer the time until the promised
payment is made:
A) the less valuable is the promise to make it since time is valuable.
B) the greater the risk, therefore the promise has greater value.
C) the more valuable is the promise to make it.
D) None of the above.

21. Financial instruments are primarily used by the holder as a:

A) means of payment.
B) store of value.
C) unit of account.
D) None of the above is correct.

22. An increase in the size of the promised future payment on a security, holding other
things constant, will cause the price of the security to:
A) rise.
B) fall.
C) remain unchanged.
D) change in an unpredictable manner.

23. The price of a financial instrument will be higher when:

A) the promised payment is received later.
B) the promised payment is received sooner.
C) the probability of receiving the payment is reduced.
D) None of the above is correct.

24. Which of the following financial instruments is primarily used to transfer risk?
A) bonds
B) home mortgages
C) futures contracts
D) stocks

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25. Which of the following is a correct statement about financial markets?
A) They offer both savers and borrowers liquidity.
B) They provide for the transfer of risk.
C) They pool and communicate information.
D) All of the above are correct.

26. Newly issued securities are sold in:

A) primary markets.
B) secondary markets.
C) centralized exchanges only.
D) None of the above is correct.

27. An over-the-counter market is:

A) a form of centralized exchange.
B) a network of dealers connected electronically.
C) an illegal secondary market for stocks used primarily by those attempting to
evade taxes.
D) a primary market for stocks.

28. What is the distinction between debt and equity markets?

A) Debt markets are those that are used only by individuals and firms that are on the
verge of bankruptcy while equity markets provide more equitable borrowing terms
to those borrowers that have sound credit ratings.
B) Debt markets are used primarily by those that are buying financial instruments
using borrowed funds, while equity markets allow people to buy financial assets
using only their own funds.
C) Debt markets are the market for mortgages, loans, and bonds while equity
markets are the markets for stocks.
D) None of the above is correct.

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 Answers of Test Bank 3
1. B) an institution borrows from the lender and provides funds to the borrower.
2. C) as a store of value, as a means of payment, and to transfer risk.
3. C) payments that are made when we need them.
4. D) Financial markets allow risk sharing, pool and communicate information, and offer
liquidity.
5. D) include all of the above.
6. B) are markets for bonds, loans, and mortgages.
7. D) are secondary markets where buyers and sellers meet in the same location.
8. A) are markets where financial claims are bought and sold for immediate cash payments.
9. C) The more valuable is the promise to make it.
10. C) Options.
11. D) One in which newly issued securities are sold.
12. C) Are markets for stocks.
13. A) Reduced risk from volatile prices
14. C) Over-the-counter markets
15. D) You make a deposit at a bank.
16. D) direct
17. B) A tuition bill
18. B) a financial instrument.
19. A) gets its value and payoff from the performance of the underlying Instrument.
20. A) the less valuable is the promise to make it since time is valuable.
21. B) store of value.
22. A) rise.
23. B) the promised payment is received sooner.
24. C) futures contracts
25. D) All of the above are correct.
26. A) primary markets.
27. B) a network of dealers connected electronically.
28. C) Debt markets are the market for mortgages, loans, and bonds while equity markets
are the markets for stocks.

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