Chapter 4

INSTITUTIONS & INSTRUMENTS

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2 OBJECTIVE OF CHAPTER
! ! ! What is the role of different financial institutions? Why do we have so many different financial assets? Who are the major players in the financial world?

2.1 CHAPTER OUTLINE

#

An overview of issues:
! ! Interaction of buyers & sellers Market participants and their role R providers & users of capital R facilitators " financial intermediaries " investment banks " brokers R investors R government Role of exchanges

Types of instruments/assets1 traded on these markets

Where are the instruments traded (Chapter 5)

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INTERACTION OF BUYERS & SELLERS

People who want to sell Xytz

People who want to buy Xytz

How are they going to find each other? Problem: Search is expensive & inefficient Solution: Need facilitator: mechanisms & institutions

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PRIMARY MARKET
DIRECT SEARCH: Funds ($) Savers New securities USING A FACILITATOR: Savers Facilitators Borrowers Borrowers

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SECONDARY MARKET
NO FACILITATOR
Buy Security:
$ Investor 1 Security Sell Security: Security Investor 2 $
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Exchange

Exchange

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SECONDARY MARKET
Role of a Broker

Investor 1

Broker

Investor 2

Funds Securities Exchange

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Why would facilitators be willing to provide the service?

Obviously they would only for a fee ! primary market services: investment banking & financial intermediation ! secondary market brokerage services

Additional NEEDS for Small Investors

! ! affordable diversification Y need mutual funds life insurance & retirement plans

Additional Needs for Institutional Investors

! Need to manage risk associated with fluctuations in interest rates & foreign currency, if applicable. Other

Y need for Exotics & Acrobatics: Derivatives Q spot vs. futures and forwards markets e.g. For a wedding in two months: " buy cake on day of ceremony (spot) vs. " order today for delivery, say, in two months

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Thus, futures and forward contracts can be used to reduce risk associates with unforseen events by looking into an agreement today for the future delivery of a specific asset at a specific time, place, quantity and quality. Q options: The right, but not the obligation, to take a specific action in the future. In finance, the actions refer to: " to buy a specific asset at a discount " to sell a specific asset at an agreed upon price

Markets do not always function perfectly. Y Some government involvement; Securities and Exchange Commission (SEC).

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FINANCIAL INSTITUTIONS
Based on Service provided

Financial Intermediaries

Investment Banks

Financial Acrobatics

Brokers

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3 FINANCIAL MARKETS
3.1 WHAT IS A MARKET? A mechanism by which investors (firms, individuals, government) exchange assets (real, financial) 3.2 CLASSIFICATIONS OF FINANCIAL MARKETS # Primary vs. Secondary new capital raised vs exchange of ownership # Some major types based on types of assets: ! money markets: for assets < 1-year maturity Commercial paper, CD, T-bills, money-market mutual funds ! capital markets: R equity (world, national, and regional) R debt > 1-year maturity mortgage markets Players: lending institutions & mortgage brokers. Consumer credit markets Venture/"Vulture" Capital (VC) market for start up companies Q seed money & managerial advice are given Q equity capital, not debt

! !

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Derivatives: options, futures, forwards

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4 TYPES OF ASSETS
4.1 MOTIVATION: A variety of assets exist due to differences in investment horizons of the participants (providers of financing & users of financing). Thus, some investors are only willing to lend (borrow) short while others long. Moreover, investors have varying appetites for risk.

4.2 MONEY MARKET SECURITIES # # # # # T-bills CDs, CP, Banker's Acceptances Prime rate Federal Funds rate Discount rate - at Feds discount window - opportunity cost # LIBOR: London Interbank Offer Rate

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4.3 FIXED-INCOME SECURITIES

# TERMINOLOGY: A promised stream of fixed CFs2. The promissory agreement (IOU) is traded on an exchange. " Borrower/issuer of IOU: Promises to pay future CFs for current CF. Saver/lender/buyer of IOU: Receives the promised CFs for current CF.

"

So what are these two sides of the bond transaction implicitly doing?

# # # #

T-Notes: Treasury-notes with 1< maturity # 10 years T-Bonds: 10 < maturity # 30 years Corporate bonds Municipal bonds: "munis"; most are exempt from Federal tax

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4.4 EQUITY SECURITIES Common stock

! ! ! ! Residual claim Limited liability Separation of ownership & management (agency problem) Voting rights; usually 1-share means 1-vote

Preferred Stock
! ! ! ! Preferred dividend; cumulative: failure not imply bankruptcy Dividend, unlike interest paid to bondholders, is not tax deductible Receive priority in the event that company is liquidated No voting rights

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4.5 MUTUAL FUNDS

# Definition: "Professionally" managed funds -- pooled individual investor contributions. Income generated from a pool is distributed pro rata to the participating investors.

Main Motivation
Small investors need affordable diversification Economic Role: Q ` buying/selling costs (brokerage commission), i.e., provide volume discount Q Provide affordable diversification for small investors Illustration: Your, say, $200 investment and thousands of other investors' can be pooled together to invest in a large number of stocks, i.e., diversify, and also take advantage of volume discount as the mutual fund is able to buy larger blocks of stocks than an individual.

. If you were to buy 1 share of 100 different companies at an average price of, say, $20, you still would need $2,000 for the investment. Moreover, you are at a disadvantage, compared to the mutual fund, as you cannot get volume discount.

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Other potential roles Q Provide "superior(!)" investment talent Q Spread cost of information gathering over many investors. Thus, cost per investor is lower. cash, money market instruments, bonds, stocks, real estate, derivatives, or a combination.

Asset base:

Additional Vocabulary S closed vs. open S load vs. no load Front end Back end

; 1-4 (

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6 SUMMARY
T Vocabulary primary vs. secondary markets, money markets, capital markets, mutual fund, T-bills, certificate of deposits (CD), commercial paper (CP), LIBOR, prime rate, discount rate, munis, T-bonds, common stock, preferred stock, facilitators, investment banks, brokers

FINANCIAL INTERMEDIARIES ! Commercial Banks ! Mutual Funds ! Pension Funds

CONCEPTS
# The importance of facilitators ! Investment Banks ! Financial Intermediaries Different assets exist because of differences in investment horizon and risk appetites of the investors. SOURCES OF LONG-TERM FINANCING ! Venture Capital (Seed Money) ! Bank Loans ! Debt & Equity

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7 Endnotes
1. Note that instruments and financial assets are used interchangeably. The word instruments comes from the fact that these assets have been issued as an instrument to achieve something. For instance, stocks are instruments that allow investors to participate in ownership of a company. From as firms perspective, they are instruments to raise money. 2. Note that the cash flows are constant; not their value.

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8 QUESTIONS

8.1 Agree/Disagree-Explain
1. Mutual funds have no advantage over individual investors in gathering information (company, economic, financial). Thus, they cannot reduce cost of information gathering. If your "superior talent" in picking stocks is equal to that of mutual fund GoGo Inc., then it would never make sense for you to invest in GoGo Inc. "Vulture capital" refers to the protection of the endangered bird. One of the roles of financial markets is to reduce transaction costs. Thus, mutual funds cannot reduce them farther.

2.

3. 4.

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Agree/Disagree-Explain

1.

. Although the information is publicly available, a mutual fund can reduce ering costs by spreading such costs over a large number of investors. Thus, cost per investor decreases. Disagree. reduction in information gathering costs. . It refers to "seed" money (venture capital): money needed for start up companies. Disagree Financial markets reduce transaction costs associated with finding (matching) buyers brokerage commissions.

3.

4.

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