I.  THE FINANCIAL SECTOR:  AN INTRODUCTION

II. FINANCIAL INSTRUMENTS: AN INTRODUCTION

"Regular" financial instruments are called underlying financial instruments (or debt and equity instruments), which are the type we've discussed so far and involve basic transfers of money or assets from one party to another.
-- A more complicated type of financial instruments are derivative financial instruments, which are more complicated and are based on an underlying financial instrument.
-- Quick example:  Stocks are underlying financial instruments.  Stock options (e.g., to buy shares of a stock at a particular price on some future date) are derivative financial instruments.

In the case of debt securities (tradable financial instruments that pay interest), we can break them down into two categories according to their maturity length:

MONEY MARKET INSTRUMENTS ("short-term," defined as maturing in < 1 year)
-- Prominent examples include--
--- COMMERCIAL PAPER-- short-term corporate debt.  Commercial paper is similar to bonds, in the sense of being formal, short-term IOUs promising that a certain sum of money plus interest will be paid back.  Unlike bonds, the holding period is very short, and corporation agrees to pay the money bank even earlier ("on demand"), if asked.
--- TREASURY BILLS -- short-term debt issued by the federal government to help finance its current and past deficits
--- short-term "municipal" (state and local government) debt
-- Less prominent examples include some other types of borrowed money, like repurchase agreements (money borrowed using a Treasury bill as collateral) and eurodollars (dollars borrowed from foreign entities).

BONDS ("long-term," defined as maturing in >= 1 year) 
--  A bond is a formal debt/IOU with a maturity length of one year or more.
--- CORPORATE BONDS;
--- TREASURY BONDS, issued by the federal government to finance the national debt;
--- MUNICIPAL BONDS, issued by state and local governments to finance large, long-term capital projects (e.g., hospitals, highways, schools).

(Bonds are also counted in another category of financial instruments, called capital-market instruments, which also is for long-term instruments but which also includes non-interest-bearing assets like stocks, as well as debts that are not publicly traded, like mortgage loans, consumer loans, and business loans.)

DERIVATIVE INSTRUMENTS (which derive their value from the behavior of an underlying financial instrument) are a different animal altogether, and their time horizons can be very short or quite long.
-- Perhaps the oldest type of derivatives are futures contracts, whereby one party agrees to sell another party a certain amount of a good at a definite price at a future date.  For commodities whose prices often fluctuate (e.g., crops, oil), these contracts are important ways of reducing risk.  More recently, these kinds of contracts have been used with financial instruments.  Some examples from the world of stocks:
-- Futures contracts specify that a sale of a set number of shares of a particular stock will be sold from one party to another at a particular date.  A person might purchase such a contract so as to avoid risks due to price fluctuations, or a person might purchase the contract as a way of making a bet that the stock's price will rise (or fall) in the meantime.
-- Options contracts (call options to buy a set number of shares at a set price at a set date, put options to sell...) are also common, and less risky to purchase, because you have the option of not making that future trade if the prices have not moved in your favor.

Financial markets are like the "central nervous system" of the economy, says Cecchetti's textbook.  Stock, bond, and other financial markets respond to a host of factors that others in the economy might easily overlook.  And their reactions are easily readable in the form of price movements -- e.g., of  individual stocks and the stock-market averages, interest rates on Treasury and corporate bonds, mortgage rates.

Financial markets are also vitally important to an economy's development, because of the role they play in allocating resources to their most profitable and productive uses.  In a well-developed financial market, financial instruments become streamlined and standardized in their characteristics, making it a lot easier for potential buyers to know what they're getting.  When this happens, more people will want to purchase financial assets, and firms can finance their investment more easily.  This is good for household portfolios and for the economy's long-term growth.

Financial instruments are bought and sold in both PRIMARY and SECONDARY MARKETS.
-- PRIMARY FINANCIAL MARKET: where newly issued financial assets are bought and sold (e.g., companies sell new stock or bonds to finance investment in new physical capital, i.e., plant and equipment)
-- SECONDARY FINANCIAL MARKET: where previously issued financial assets are bought and sold. The stock market is by and large a secondary financial market, with new issues accounting for less than 1% of total shares outstanding. (Although not directly connected with new investment, having a secondary financial market surely  raises the level of investment, and hence raises the stock of physical capital, because it makes stocks and bonds a lot more liquid, since you can resell them any time you want.)

IV.  FINANCIAL INSTITUTIONS: AN INTRODUCTION

FINANCIAL INSTITUTION -- a firm that provides access to financial markets, both to savers who want to own financial instruments and to borrowers who want to issue them. 
-- Financial institutions are sometimes called FINANCIAL INTERMEDIARIES (businesses that connect savers with borrowers), since they serve as middlemen, or mediate, between individuals, firms, and financial markets. 
---- FINANCIAL INTERMEDIATION or INDIRECT FINANCE is the process of obtaining funds or investing funds through third-party institutions like banks and mutual funds.  As a source of funds for American businesses, indirect finance is far more common than direct finance. For every dollar that firms raise by borrowing directly from households or selling stocks directly to households, they raise about $20 through indirect finance -- bank loans, selling bonds and stocks to mutual funds, pension funds, insurance companies, etc.   In future units we'll examine the reasons why in detail.  For now, the short answer is that lending your money to a business firm is generally cheaper and safer with a financial institution serving as middleman than if you do it on your own.

Types of financial institutions:

1. Depository institutions (BANKS, CREDIT UNIONS, SAVINGS & LOAN ASSOCIATIONS)
-- Their main liabilities (sources of funds) are deposits, and their main assets are loans.

2. Insurance companies 
-- They collect premiums (regular payments) from policy-holders, and pay compensation to policy-holders if certain events occur (e.g., fire, theft, sickness).
-- They invest the premiums in securities and real estate, and these are their main assets.

3. Pension funds
-- They collect contributions from current workers and make payments to retired workers.
-- Like insurance companies, they invest the contributions in securities and real estate, and these are their main assets.

4. Securities firms (provide firms and individuals with access to financial markets)
-- This category covers a wide array of financial institutions:
-- INVESTMENT BANKS: sell new securities for companies. Unlike regular banks, they don't hold deposits, or make loans. (They hold zero assets/liabilities.)   Closely related are underwriters, which not only sell the new securities but pledge to purchase some or all of any unsold shares.
-- BROKERS: buy/sell old securities on behalf of individuals.
-- MUTUAL-FUND COMPANIES: pool the money of small savers (individuals), who buy shares in the fund, and invest that money in stocks, bonds, and/or other assets.  These are popular because they allow small savers relatively easy and cheap access and also enable them to reduce risk by holding a diversified portfolio.
-- Hedge funds:  pool the money of a small number of wealthy individuals and institutions and invest in various financial instruments, notably derivatives.
5. Finance companies
-- Like banks, they use people's savings to make loans to businesses and households, but instead of holding deposits, they raise the cash to make these loans by selling bonds and commercial paper.
-- They tend to specialize in certain types of loans, e.g., automobile (GMAC) or mortgage loans.

6. Government-sponsored enterprises (federal credit agencies)
-- Some of these provide loans directly, such as to farmers and home buyers.
-- Some, such as the Federal National Mortgage Association (FNMA, "Fannie Mae"), guarantee or buy up private loans, notably mortgage and student loans.
-- Some, such as the Social Security Administration, administer social insurance programs.