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Unformatted text preview: ______________________________________________________________________________________ 34 CHAPTER 3: FINANCIAL INSTRUMENTS, FINANCIAL MARKETS, AND FINANCIAL INSTITUTIONS A. T HE B ASICS Core Principles 3 and 4 combine in this chapter to help us understand the importance of information and markets in the financial system. Also on prominent display are the Core Principles 1 and 2 that time has value and that risk requires compensation. In chapter 1, a financial system with six key ingredients was described. These were money, financial instruments, financial markets, financial institutions, regulatory agencies, and a central bank. The first of these, money, was the subject of chapter 2. In this chapter, the next three ingredients are analyzed. First, financial instruments are defined. Second, an outline of the markets in which financial instruments trade is presented, followed by a discussion of how these markets are organized around the information they contain. Third, financial firms that connect savers and borrowers financial institutions are discussed. Financial instruments are defined as written, legal obligations of one party to transfer something of value to another party at some future date, under certain conditions. Notice that four of our Core Principles are present in this definition. Time is involved, since the payment is to be made in the future. Risk is involved as the payments to be made may depend on certain conditions. Information about the issuer of the financial instrument is needed to decide if this issuer is creditworthy. (See Your Financial World : Your Credit Rating on text page 162 in chapter 7, and you can see how you may already be involved in the information collection process by financial institutions.) Finally, financial instruments often trade in financial markets. Financial markets, according to Core Principle 4, help determine prices and allocate resources. Resource allocation and price determination occur in markets in at least three ways. First, markets with many buyers and sellers help provide liquidity, so that agents can quickly and cheaply buy and sell financial assets. Liquidity provided by markets helps the economy efficiently allocate resources, since agents can vote on companies and technologies by moving funds to promising possibilities from those deemed to be less promising. If agents could not quickly and cheaply reallocate their funds, investing in almost any company would be much less attractive. Second, markets communicate information. Other things given, higher priced financial assets are viewed more favorably by investors than lower priced assets, based on investor assessments of current and prospective company profits, industry conditions, and so on. With millions of buyers and sellers, these assessments, as reflected in company share prices, convey a consensus on the value of the company. Third, part of the trading in financial assets is aimed at risk sharing. For example, agents who buy or sell options on stocks or commodities are managing exposure to risk. Chapter 3: Financial Instruments, Financial Markets and Financial Institutions...
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- Spring '05