cecchettichapter3 - Chapter 03 Financial Instruments...

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Chapter 03 - Financial Instruments, Financial Markets, and Financial Institutions Chapter 3 Financial Instruments, Financial Markets, and Financial Institutions Chapter Outline 1. The informal arrangements that were the mainstay of the financial system centuries ago have since given way to the formal financial instruments of the modern world. 2. Today, the international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a very specific set of characteristics. 3. We obtain the financial resources we need through this system in two ways: directly from lenders and indirectly from financial institutions called financial intermediaries. 4. In the latter (called “indirect finance”) a financial institution (like a bank) borrows from the lender and then provides funds to the borrower. If someone borrows money to buy a car, the car becomes his or her asset and the loan a liability. 5. In direct finance, borrowers sell securities directly to lenders in the financial markets. Governments and corporations finance their activities this way. 6. The securities become assets to the lenders who buy them and liabilities to the borrower who sells them. 7. Financial development is inextricably linked to economic growth. 8. There aren’t any rich countries that have very low levels of financial development. 3-1
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Chapter 03 - Financial Instruments, Financial Markets, and Financial Institutions I. Financial Instruments A financial instrument 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. 1. The fact that a financial instrument is a written legal obligation means that it is subject to government enforcement; the enforceability of the obligation is an important feature of a financial instrument. 2. The “party” referred to can be a person, company, or government. 3. The future date can be specified or can be when some event occurs. 4. Financial instruments generally specify a number of possible contingencies under which one party is required to make a payment to another. 1. Uses of Financial Instruments 1. Stocks, loans, and insurance are all examples of financial instruments. 2. As a group, they have three functions or uses: a. They can act as a means of payment. b. They can be stores of value. c. They allow for the taking of risk. 3. Most financial instruments involve some sort of risk transfer. a. Characteristics of Financial Instruments: Standardization and Information 2. Financial instruments are complex contracts. 3. Standardized agreements are used in order to overcome the potential costs of complexity. 4. Because of standardization, most of the financial instruments that we encounter on a day-to-day basis are very homogeneous.
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