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