Lecture 2 Chpt 3 d2l 2011-2

Lecture 2 Chpt 3 d2l 2011-2 - Fin 320 Chapter 3: Financial...

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Fin 320 Chapter 3: Financial Instruments, Financial Markets and Financial Institutions Lecture 2
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Introduction 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. We obtain financial resources through this system: Directly from markets, and Indirectly through institutions.
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Preliminaries: Definitions Types of Finance Indirect: Institution stands between lender and borrower. Direct: Borrowers sell securities directly to lenders in the financial markets Asset: Something of value that you own Liability: Something you owe.
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Funds Flowing through the Financial System
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Financial Instruments: Definition A written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions.
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Financial Instruments: Uses Means of Payment Store of Value Transfer of Risk Most financial instruments involve some sort of risk transfer
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The use of borrowing to finance part of an investment is called leverage. Leverage played a key role in the financial crisis of 2007-2009. How did this happen? The more leverage, the greater the risk an adverse surprise will lead to bankruptcy. The more highly leveraged, the less net worth
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How did this happen? (cont.) Some important financial institutions, during the crisis, were leveraged at more than 30 times their net worth. When losses are experienced, firms try to deleverage to raise net worth. Too many institutions deleverage, prices fall, losses increase, net worth falls more. This is called the “paradox of leverage”.
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Financial institutions are more highly leveraged than households or firms American households are roughly 1¼ times net worth Nonfinancial firms the value is around two Some important financial firms leveraged more than thirty times their net worth A small 3% decline of asset prices could lead to bankruptcy
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Financial Instruments: Characteristics Standardization Overcome the costs of complexity Makes them easier to understand Communicate Information Summarize essential information about issuer Reduce the expense of collecting information Financial instruments are designed to handle the problem of asymmetric information .
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Financial Instruments: Classes Underlying Used to transfer resources Examples: stocks and bonds Derivative Value derived from underlying instruments Examples: Futures and options
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Conceptual Problem #4 The Chicago Mercantile Exchange has announced the introduction of a financial instrument that is based on rainfall in the state of Illinois. The standard agreement states that for each inch of rain over and above the average rainfall for a particular month, the seller will pay the buyer $1,000. Who could benefit from buying such a contract? Who could benefit from selling it?
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Lecture 2 Chpt 3 d2l 2011-2 - Fin 320 Chapter 3: Financial...

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