MGT411 - Money & Banking - Lecture Handout 06

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FINANCIAL INSTRUMENTS & FINANCIAL MARKETS

  • Financial Instruments
  • Examples
  • Financial Markets
  • Roles
  • Structure
  • Financial Institutions

Examples of Financial Instruments

Primarily Stores of Value

  • Bank Loans
  • A borrower obtains resources from a lender immediately in exchange for a promised set of payments in the future
  • 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,
  • 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.

Primarily to transfer risk

  • 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.

Financial Markets

  • Financial Markets are the places where financial instruments are bought and sold.
  • Enable both firms and individuals to find financing for their activities.
  • 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 the society suffers at large

Role of Financial Markets

Liquidity Ensure that owners of financial instruments can buy and sell them cheaply and easily
Information Pool and communicate information about the issuer of a financial instrument
Risk Sharing Provide individuals with a place to buy and sell risk, sharing them with individuals

Financial markets need to be designed in a way that keeps transactions costs low

Structure of Financial Markets

Primary vs. Secondary Markets

  • In a primary market a borrower obtains funds from a lender by selling newly issued securities.
  • 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.
  • In the secondary markets people can buy and sell existing securities

Centralized Exchanges vs. Over-the-counter Markets

  • In the centralized exchange (e.g. Karachi Stock Exchange www.kse.com.pk ), the trading is done “on the floor”

Over-the-counter (or OTC)

  • OTC market are electronic networks of dealers who trade with one another from wherever they are located

Debt and Equity vs. 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)

Characteristics of a well-run financial market

  • Low transaction costs.
  • Information communicated must be accurate and widely available
  • If not, the prices will not be correct
  • Prices are the link between the financial markets and the real economy
  • Investors must be protected.
  • A lack of proper safeguards dampens people’s willingness to invest

Market size and investors protection

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