Chapter 3 Financial Instruments Markets and Institutions KEY

Chapter 3 Financial Instruments, Markets, and Institutions

KEY WORDS AND CONCEPTS • • • Financial Markets Financial Intermediaries Primary Market Secondary Market Securities – Bonds – Stock Dividends Common Stock Copyright © 2004 Pearson Addison-Wesley. All rights reserved. Preferred stock 3 -2

KEY WORDS AND CONCEPTS • Mortgages • Collateral • Derivatives or Derivative financial instruments • Capital Market • Money Market • Financial Intermediaries Banks Mutual Fund Companies Life Insurance Savings and Loans Credit Unions Investment Banks Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -3

Flow of Funds • Financial system provides a way to transfer (move) money from saverlenders to borrower-spenders. – Savers benefit—earn interest – Investors benefit—access to money with greater risk (chinese – Economy benefits—bringing savers and borrowers together Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -4

Flow of Funds (Cont. ) P. 32 • Funds flow indirectly from lenders [households] through financial intermediaries [banks or insurance companies] or directly through financial markets [stock exchange/bond markets] to borrowers [business firms, government, or other households] (See next slide and figure 3. 1) Set up a market in class (need 4 students) based on next 2 slides Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -5

Savers/Lenders Borrowers/ Spenders Direct Finance Indirect Finance Money + Fed = Monetary Policy Financial Markets Copyright © 2004 Pearson Addison-Wesley. All rights reserved. Financial Intermediaries 3 -6

Figure 3. 1 Flow of funds from lenders to borrowers P. 32 Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -7

Financial Instruments & Markets p. 33, 34 • Primary Markets – Market for a new security to saver-lenders. – Investment Banks—Sell new securities. • Secondary Markets – Market where securities can be bought and sold • New York Stock Exchange • American Stock Exchange • Over-the-counter (OTC) markets • Shanghai Exchange • Hong Kong Exchange Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -8

Financial Instruments & Markets p. 34 • Bonds – Issued (sold) by governments or companies that need money to pay for projects or finance a company. – Bonds represent borrowing – Different types of bonds • Coupon bonds • Zero coupon bonds • Tax exempt bonds Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -9

Financial Instruments & Markets p. 35 • Stocks mean Ownership • Stockholder owns part of the corporation and receives dividends 红 利 (Hónglì) – from the issuer. – No government stock—individuals cannot “own” part of the government Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -10

Financial Instruments & Markets p. 35 – Types of Corporate stocks • Preferred Stock—Fixed dividends, priority over common stock • Common Stock—Variable dividends, based on company’s profits. • Stock is exchanged (buy and sell) in secondary market Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -11

STOCK CERTIFICATE Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -12

Financial Instruments & Markets (cont) • Both stocks and bonds [securities] are a claim to a stream of payments [cash flows] in the future – Bonds—Interest payment and face value at maturity – Stocks—Dividends and sales price when sold Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -13

Financial Instruments & Markets p 36, 37 • Mortgages involve Real Estate (land house) – Debt (loan) to buy land and/or building, which is collateral (security) for the lender. – Fixed Rate—Rate of interest is fixed – Variable-Rate—Rate of interest varies depending on financial environment Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -14

Financial Instruments & Markets p 37. 38 • Options and Futures Contracts – An agreement between two parties to exchange a third asset in the future at a stated price • Often called Derivatives because they derive 导出 (Dǎochū) value from other assets Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -15

Financial Instruments & Markets p. 39 • The Capital Market – Exchange of long-term securities—longer than one year – Generally used to secure long-term financing for capital investment • Stock market—Largest part of capital market • House mortgages • Corporate bond market—Held by insurance companies, pension and retirement funds • Local and state government bonds • Government securities – held by the Chinese government for example Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -16

Financial Instruments & Markets p. 40 • The Money Market – Exchange of short-term financial instruments—less than one year – Highly liquid, low risk – Use of a temporary extra amount of funds by banks or businesses • • U. S. Treasury bills—short-term debts of US government Bank Certificates of Deposit Commercial Paper Federal Funds—Exchange of excess/deficient reserves between banks on an overnight basis. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -17

Financial Intermediaries: Purposes and Profile • Role of Financial Intermediaries – Help moving funds from savers-lenders to borrowers-spenders. – Get funds by issuing their liabilities to public and use money to purchase financial assets • Earn profits on difference between interest paid and earned • Diversify 多元化 (Duōyuán huà) portfolios and minimize risk • Lower transaction costs • Competition lowers interest rates— beneficial to economic growth Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -18

Financial Intermediaries: Purposes and Profile • Financial Institutions in Profile—focus on liabilities and assets – Commercial Banks • Most common type of institution • Range in size from huge (Bank of America, ICBC) to small banks (Bank of Xinzheng) • Major source of funds used to be demand deposits of public, but now rely more on “other liabilities (funds)” • Also accept savings and time deposits—interest earning Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -19

Financial Intermediaries: Purposes and Profile (Cont. ) P. 43, 44 – Commercial Banks (Cont. ) • Purchase wide variety of assets –short-term government securities –long-term business loans –Home mortgages MAIN PURPOSE AND SOURCE OF REVENUE FOR BANKS – LOANS, LOANS!!! Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -20

Financial Intermediaries: Purposes and Profile (Cont. ) p. 44 • Financial Institutions in Profile (Cont. ) – Life Insurance Companies • Insure against death • Receive funds in form of premium payments • Use of funds is based on mortality statistics— predict when funds will be needed • Invest in long-term securities—high yield – long-term corporate bonds – Long-term commercial mortgages Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -21

Financial Intermediaries: Purposes and Profile (Cont. ) p. 44 • Financial Institutions in Profile (Cont. ) – Pension and Retirement 退休 Tuìxiū Fund Companies • Saving for the future • Invest in long-term corporate bonds & good stocks. – Mutual Fund Companies • Stock or bond market related institutions • Pool funds from many people • Invest in wide variety of securities—minimize risk Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -22

Financial Intermediaries: Purposes and Profile (Cont. ) p. 45 • Financial Institutions in Profile (Cont. ) – Money Market Mutual Funds • Individuals purchase shares in the fund • Fund invests in highly liquid short-term money market instruments – large-size negotiable CD’s – Treasury bills – high-grade commercial paper Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -23

Financial Intermediaries: Purposes and Profile (Cont. ) p. 45 • Financial Institutions in Profile (Cont. ) – Savings and Loan Associations [S&L’s] • Get funds through savings deposits • Use funds to make home mortgage loans • Perform same functions as commercial banks – issue checking accounts (demand deposits) – make consumer and business loans – Commercial and Consumer Finance Companies • Lend money for consumer purchases or business firms to help them grow their business Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -24

Financial Intermediaries: Purposes and Profile (Cont. ) p. 45 • Financial Institutions in Profile (Cont. ) – Property and Casualty Insurance 保� (Bǎoxiǎn) Companies • Insure homeowners and businesses against losses • Receive premiums • Need to be liquid due to uncertainty of claims Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -25

Financial Intermediaries: Purposes and Profile (Cont. ) P. 45, 46 • Financial Institutions in Profile (cont) – Credit Unions • Organized as cooperatives for people with common interest • Members buy shares [deposits] and can borrow • Changes in the law in 1980 broadened their powers –checking [share] accounts –make long-term mortgage loans Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -26

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -27

CHAPTER SUMMARY p. 32 • Direct Finance – Funds flow directly from savers/borrowers through financial markets (for example, the stock exchange) • Indirect Finance – Funds flow through financial intermediaries like banks. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -28

CHAPTER SUMMARY p. 34, 35 • FINANCIAL INSTRUMENTS: Securities – Broad name for all types of stocks and bonds. Bonds – Governments or companies are borrowing funds (debt) to finance projects or growth. Stocks – Investing in a company means ownership. May get dividends. Securities (bonds and stocks) represent a claim to future payments. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -29

CHAPTER SUMMARY p. 36 -38 • FINANCIAL INSTRUMENTS (CONT): Mortgages – Borrowing to buy land or buildings or houses Derivatives – Financial instruments that derive their value from other assets. Options and Futures – Agreements between two people to exchange an asset in the future for a certain price. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -30

CHAPTER SUMMARY p. 33, 34, 38 -40 • FINANCIAL MARKETS Primary Markets – New securities that have never been issued or sold Secondary Markets – Existing securities Capital Market – Long term financial instruments for more than a year p. 38, 39 Money Market – Short term less financial instruments less than a year. P 38 and 40 Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -31

CHAPTER SUMMARY • FINANCIAL INTERMEDIARIES & INSTITUTIONS (Companies) 1. Commercial Banks 2. Life Insurance Companies 3. Pension Fund Companies 4. Mutual Fund Companies 5. Savings and Loan 6. Credit Unions Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 3 -32