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CH3 - Chapter 3 Financial Instruments Financial Markets and...

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Chapter 3 Financial Instruments, Financial Markets, and Financial Institutions Chapter Overview In this chapter the financial system is surveyed in three steps: 1) financial instruments or securities are studied; 2) financial markets are considered; and 3) financial institutions are examined. Reading this chapter will prepare students to: Define and describe financial instruments. Explain the factors that affect the value of financial instruments. Evaluate how essential financial markets are to the operation of an economic system. Categorize financial markets. Describe a well-functioning financial market. Explain the brokerage and asset transformation functions performed by financial institutions. Important Points of the Chapter The formal financial instruments of the modern world have their roots in the informal arrangements that were the mainstays of the financial system centuries ago. Even in the most primitive economies, people needed to borrow when their consumption needs exceeded their income. Families or communities provided the lending with the understanding that if the needs were reversed they would receive similar assistance. Today, the international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts and so fosters production, employment, and consumption. Savings are funneled through the system so that they can finance investment and the decisions of the people who do the saving direct the capital to its most efficient uses, thus resulting in economic growth. Application of Core Principles Principle #2: Risk (page 38) Most financial instruments transfer risk between the buyer and seller. The example of a wheat farmer selling a futures contract on his crop demonstrates that the farmer can sell the instrument, setting the price that will be received for the crop regardless of how it turns out, and so transfer the risk onto the buyer of the contract. Principle #3: Information (page 39) Financial instruments communicate information by summarizing certain essential information about the issuer. Financial instruments are designed to eliminate the expensive and time-consuming process of collecting information on the issuer. Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 28
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Chapter 3 Financial Instruments, Financial Markets, and Financial Institutions Principle #1: Time (page 42) The sooner a payment is made the more valuable is the promise that it will be made. This is because a payment that is received can be invested and will begin to earn a return immediately; if one has to wait to make the investment potential returns are lost. Principle #2: Risk (page 42) The more likely it is that a payment will be made the more valuable is the financial instrument.
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