Week 10-financial instruments and markets Flashcards
What are the 8 elements of the financial system?
1) money
2) financial markets
3) financial instruments
4) financial institutions
5) regulatory agencies
6) central banks
7) governments and international organisations
8) families/households
9) TRUST
What is money? Income? Wealth? Liquidity? Maturity?
• Money is an asset (something that has value) that is generally accepted at face value as payment for goods and services or repayment of debt.
• Income is a flow of earnings over time
• Wealth is the value of stock of assets minus liabilities
• Liquidity is a measure of the ease with which an asset can bought or sold, i.e. turned into a means of payment
– The more costly it is to convert an asset into money, the less liquid it is
• Maturity is the end of the contract/loan
What are the 3 characteristics of money?
- It is a means of payment (most important)
• People insist on payment in money.
– Barter requires a “double coincidence of wants”.
• Money is easier and finalizes payments so no
further claim on buyers and sellers. - It is a unit of account
• Money is used to quote prices and record debts
‐ it is a standard of value.
• For example, pounds per kilo
• Using one currency makes relative price
comparisons easier. - It is a store of value
• A means of payment has to be durable and capable of transferring purchasing power from one day to the next.
• Paper currency does degrade, but is accepted at face value in transactions.
• Other forms of wealth are also a store of value: stocks, bonds,
houses, etc.
• Although other stores of value are sometimes better than money, we hold money because it is liquid.
Debit card or credit card?
A debit card works by removing funds immediately from your account.
A credit card makes a deferred payment.
– If not paid on time, there is a late fee.
– If not paid fully, there is interest on the debt.
– But if you do pay on time and fully, it is an interest free loan for a period of time.
– Credit cards allow you to build a credit history
What are financial instruments?
Financial Instruments are contracts: A 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 obligate one party (person, company, or government) to transfer something to another party in exchange for a specified payment, some at a future date
- Financial instruments specify certain conditions under which a payment will be made
- Financial instruments based on promises and consequently trust: trust at the core of the financial system
What are bank loans? Home mortgages? Insurance contracts?
Bank loans
• Borrower obtains resources from a lender to be repaid in the future.
Home mortgages
• Home buyers usually need to borrow using the home
as collateral for the loan.
– A specific asset the borrower pledges to protect the lender’s interests.
Insurance contracts
• Primary purpose is to assure that payments will be
made under particular, and often rare, circumstances
What are underlying instruments?
- Underlying instruments are used by savers/lenders to transfer resources directly to investors/borrowers.
– This improves the efficient allocation of resources
– Examples: bonds and stocks (shares)
What are derivative instruments?
- Derivative instruments are those where their value and payoffs are “derived” from the behavior of the underlying instruments.
– The primary use is to shift risk among (transfer risk)
-ex: options and futures
Describe the following underlying instrument:
- stocks/shares
- bonds (fixed-income securities)
- asset-backed securities
Stocks/shares (equities)
– No promise of return, only residual claim on assets. Limited liability
• The holder owns a small piece of the firm and entitled to part of its profits.
• Firms sell stocks to raise money.
• Primarily used as a stores of wealth.
Bonds (also called fixed‐income securities)
– They promise fixed future payments (contractual obligation)
• A form of a loan issued by a corporation or government.
• Can be bought and sold in financial markets.
Asset‐backed securities
• Shares in the returns or payments arising from specific assets, such as home mortgages and student loans.
• Mortgage backed securities bundle a large number of mortgages together into a pool in which shares are sold.
– Securities backed by sub‐prime mortgages played an important role in the financial crisis of 2007‐20
Describe the following derivative instruments
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.
• This is a type of derivative instrument.
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.
Describe debt and equity vs Derivative markets
• In debt and equity markets, actual claims are bought and sold for immediate cash payments. • In derivative markets, investors make agreements that are settled later.
What are financial markets?
Financial markets are places where financial instruments are bought and
sold.
• These markets are the economy’s “oil in the wheel”
• These markets enable both firms and individuals to find financing for their
activities.
• These markets trade instruments based on promises and trust: trust at
the core of financial markets
Describe the to financial markets
money market, capital market
• Money market
– Maturity less than one year, mostly debt instruments issued by
governments and large corporations
– Highly liquid: Quickly convertible to cash
– Globally integrated
• Capital market
– Maturity greater than a year, equities and debt instruments
What are the 5 characeristics of a well-run financial market?
– They promote economic efficiency by ensuring resources are available
to those who put them to their best use.
– Must be designed to keep transaction costs low.
– Information the market pools and communicates must be accurate and widely available.
– Borrowers promises to pay lenders must be credible.
– Because of these criteria, governments are an essential part of financial markets as they enforce the rules of the game.
What are interest rates? What are the free factors on which they depend?
– The promised rate of return – Depends upon: (i) Unit of account (ii) Maturity (iii) Default Risk
