Financial

Markets
LECTURES 3-4

1
Contents
1. Financial Markets
2. Roles of Financial Markets
3. Structure of Financial Markets
4. Money Markets
5. Money Market Instruments
6. Capital Markets
7. Capital Market Instruments
8. Derivatives Markets
9. Internationalization of Financial Markets
Flows of Funds Through the
Financial System
Financial Markets
Financial markets are markets in which funds are moved from
people who have an excess of available funds (and lack of investment
opportunities) to people who have investment opportunities (and lack
of funds).
Financial markets (such as bond and stock markets) are markets in
which securities are traded.
Roles of Financial Markets
Perform the essential function of channeling funds from
economic players that have saved surplus funds to those that have
a shortage of funds
Direct finance: borrowers borrow funds directly from lenders in
financial markets by selling them securities.
Roles of Financial Markets
They contribute to increase the production and the
efficiency in the overall economy.
Financial markets provide liquidity
Financial markets also improve the wealth of
individual participants by providing investment
returns to lender-savers and profit and/or use
opportunities to borrower-spenders

Study found the the relationship between

financial markets and real activity.
Roles of Financial Markets
Pro - Argument 1
Financial markets could extend a borrowers financial
capacity and improve the efficiency of trade.
With well-developed financial markets investors can be provided with
the necessary funds for their projects.
Financial markets contribute to economic development through
enhancing physical capital accumulation (Gurley and Shaw,1955)
Roles of Financial Markets
Pro - Argument 2
Stock market liquiditythe ability to trade equity easilyis
important for growth.
Although many profitable investments require a long-run
commitment of capital, savers do not like to relinquish control of
their savings for long periods.
Liquid equity markets ease this tension by providing an asset to
savers that they can quickly and inexpensively sell.
Simultaneously, firms have permanent access to capital raised
through equity issues. (Bencivenga, Smith, and Starr ,1996 and
Levine , 1991)
Roles of Financial Markets
Contra - Argument
Mayer (1988) argues that even large stock markets are
unimportant sources of corporate finance.
Devereux and Smith (1994) emphasize that greater risk sharing
through internationally integrated stock markets can actually
reduce saving rates and slow economic growth.
Structure of Financial
Markets
Debt and Equity Markets

Primary and Secondary Markets

Stock Exchanges

Over-the-Counter (OTC) Markets

Structure of Financial
Markets
Money and Capital Markets
Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and equity instruments
Cash or spot vs. futures markets
Private vs. public markets
Debt and Equity Markets
A firm an obtain funds in a financial markets in two ways:
- issuing a debt instrument (e.g. a bond or a mortgage)
- issuing equities, such as common stock.
Bond vs. common stock
A bond (a debt instrument) is a contractual agreement by the
borrower to pay the holder of the instrument fixed dollar amounts
at regular intervals (interest and principal payments) until a
specified date (the maturity date), when a final payment is made.
short-term (maturity < a year) ; Long-term (ten years or longer);
Intermediate-term
Equities are claims to share in the net income (income after
expenses and taxes) and the assets of a business. Equity often
make periodic payments (dividends) to their holders and are
considered long-term securities because they har no maturity
date.
Residual claimant
Primary vs. Secondary
Markets
Primary markets are financial markets in which new
issues of a security are sold to initial buyers by the
corporation or government agency borrowing the
funds.
underwriting, initial public offering

Secondary markets are markets in which existing

securities are traded among investors
Role of secondary market
Exchanges vs. OTC markets

Exchanges are markets where buyers and sellers of

securities (or their agents or brokers) meet in one
central location to conduct trades

Over-the-counter (OTC) markets are markets, in which

dealers at different locations who have an inventory of
securities stand ready to buy and sell securities over
the counter to anyone who comes to them and is
willing to accept their prices
Money vs. Capital Markets

Money markets are markets for shortterm, highly liquid

debt securities
Capital markets are markets for intermediate- and
long-term debt and corporate stocks
Private vs. Public Markets
Private Markets are markets where
transactions are negotiated between two
parties

Public markets are markets in which

standardized contracts are traded in
organized exchanges
The Money Markets
The securities in the money market are short term with high
liquidity; therefore, they are close to being money.
Money market securities are usually sold in large denominations
($1,000,000 or more)
They have low default risk

They mature in one year or less from their

issue date, although most mature in less
than 120 days
Why do we need money
markets?
Investors in Money Market: Provides a
place for warehousing surplus funds for
short periods of time.

Borrowers from money market provide

low-cost source of temporary funds.
MM Rates
Participants of MMs
Instruments of Money
Markets
MM Intruments
Treasury Bills

- are the short-term debt intruments of the US

goverments (1-,3- or 6- month maturities)
- no interest payment, but initially be sold at a discount
price (lower price than the set amount paid at maturity)
- no possibility of default.
Treasury Bills
Discount rate (DR)
Often quoted on short-term loans and money market
securities (such as Treasury bills)
Fed Funds

Short-term funds transferred (loaned or borrowed)

between financial institutions, usually for a period of
one day.

Borrowing and lending of bank reserves on deposit

with the Federal Reserve

Used by banks to meet short-term needs, to meet

reserve requirements.
Repurchase Agreements

These work similar to the market for fed

funds, but nonbanks can participate.
A firm sells Treasury securities, but
agrees to buy them back at a certain
date (usually 314 days later) for a
certain price.
Negotiable Certificates of
Deposit
A bank-issued security that
documents a deposit and specifies
the interest rate and the maturity
date
Denominations range from
$100,000 to $10 million
Commercial Paper

Unsecured promissory notes, issued by corporations,

that mature in no more than 270 days.

There are two major types of commercial

paper.
Direct paper is issued mainly by large finance
companies and bank holding companies directly
to the investor.
Dealer paper, or industrial paper, is issued by
security dealers on behalf of their corporate
customers (mainly nonfinancial companies and
smaller financial companies).
Bankers Acceptances

An order to pay a specified amount to the

bearer on a given date if specified
conditions have been met, usually delivery
of promised goods.
These are often used when buyers /
sellers of expensive goods live in different
countries.
Eurodollars

Eurodollars represent Dollar denominated

deposits held in foreign
banks.
The market is essential since many foreign
contracts call for payment is U.S. dollars due to
the stability of the dollar, relative to other
currencies
Comparing Money Market
Securities
CAPITAL MARKETS

Capital market instruments

are debt and equity
instruments with maturities of
greater than one year.
Bonds
A bond is a promise to make periodic
coupon payments and to repay principal
at maturity; breech of this promise is an
event of default
Carry original maturities greater than one
year so bonds are instruments of the
capital markets
Issuers are corporations and government
units
Treasury Bonds

T-notes and T-bonds issued by the U.S. treasury to

finance the national debt and other federal government
expenditures
Backed by the full faith and credit of the U.S.
government and are default risk free
Pay relatively low rates of interest (yields to maturity)
Given their longer maturity, not entirely risk free due
to interest rate fluctuations
Coupon securities: Pay coupon interest
(semiannually), notes have maturities from 1-10 yrs,
bonds 10-30 yrs
Municipal Bonds (Munis)

Securities issued by state and local governments to

fund either temporary imbalances between operating
expenditures and receipts or to finance long-term
capital outlays for activities such as school
construction, public utility construction or transportation
systems
Tax receipts or revenues generated are the source of
repayment
Attractive to household investors because interest
(but not capital gains) are tax exempt
Corporate Bonds

All long-term bonds issued by

corporations
Minimum denominations publicly
traded corporate bonds is $1,000
Generally pay interest
semiannually
Bond Ratings

Bonds are rated by the issuers default

risk
Large bond investors, traders and
managers evaluate default risk by
analyzing the issuers financial ratios and
security prices
Two major bond rating agencies are
Moodys and Standard & Poors (S&P)
Bonds assigned a letter grade based on
perceived probability of issuer default
Stocks

Two types of corporate stock exist

Common stock
- the fundamental ownership claim in a public
corporation
Preferred stock
- a hybrid security that has characteristics of
both bonds and common stock
Mortgages

Mortgages are loans to individuals or

businesses to purchase a home, land, or other
real property
Many mortgages are securitized
securities are packaged and sold as assets
backing a publicly traded or privately held debt
instrument
Four basic categories of mortgages issued
home, multifamily dwelling, commercial, and
farm
Derivative markets

Derivative markets are the markets where

investors trade derivative instruments like
futures and options
Derivatives (or contingent claims) are
securities whose value depends on the value
of some other underlying security.
Derivatives include forwards, futures, options
and swaps.
Financial Market Rates
Interest Rates
- An interest rate is a promised rate of return, and there are
as many different interest rates as there are distinct kinds of
borrowing and lending

Rates of return of risky assets

Many assets do not carry a promised rate of return
Let us consider how to measure the rate of return on such
risky assets
Financial assets normally generate two types of return for
investor: periodic income (dividends or interest payments)
and price change (capital gain/loss)
A holding period return is the return earned from holding an
asset for a single specified period of time.
Financial Market Rates
Rates of return of risky assets
Many assets do not carry a promised rate of return
Let us consider how to measure the rate of return on
such risky assets
Financial assets normally generate two types of return
for investor: periodic income (dividends or interest
payments) and price change (capital gain/loss)
A holding period return is the return earned from
holding an asset for a single specified period of time.
Internationalization of Financial
Markets

Foreign Bonds: sold in a foreign country and

denominated in that countrys currency
Eurobond: bond denominated in a currency
other than that of the country in which it is sold
Eurocurrencies: foreign currencies deposited
in banks outside the home country
Eurodollars: U.S. dollars deposited in foreign
banks
outside the U.S. or in foreign branches of U.S.
banks
Further Readings:
Gurley, J., and E. Shaw (1955), Financial Aspects of Economic Development, American
Economic Review, Vol. 45, 515-537
Bencivenga, Valerie R., Bruce D. Smith, and Ross M. Starr. 1996. "Equity Markets
Transactions Costs, and Capital Accumulation: An Illustration." The World Bank Economic
Review 10(2):241-65.
Levine, Ross. 1991. "Stock Markets, Growth, and Tax Policy." Journal of Finance 46(4,
September):1445-65
Mayer, Colin. 1988. "New Issues in Corporate Finance." European Economic Review 32:1167-
88
Devereux, Michael B., and Gregor W. Smith. 1994. "International Risk Sharing and
Economic Growth." International Economic Review 35(4, August):535-50.