Financial Markets - Lecture notes Account

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Accounting (Philippine Christian University)

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Chapter 1: Introduction and Overview of with maturities of with
Financial Markets one maturities of more
year or less. than
one year.
financial markets-The arenas
through which funds flow. Money and Capital Market
primary markets-Markets in which Instruments
corporations raise funds through new
issues of Securities. MONEY MARKET INSTRUMENTS
Primary markets are markets in which Treasury bills —short-term obligations
users of funds (e.g., corporations) raise issued by the U.S. government.
funds through new issues of financial Federal funds —short-term funds
instruments, such as stocks and bonds. transferred between financial institutions
usually for no more
Types of Financial Markets than one day.
Primary Markets —markets in which Repurchase agreements —agreements
corporations raise funds through new involving the sale of securities by one
issues of securities. party to another
Secondary Markets —markets that trade with a promise by the seller to repurchase
financial instruments once they are issued. the same securities from the buyer at a
Money Markets —markets that trade specified date
debt securities or instruments with and price.
maturities of less than one year. Commercial paper —short-term
Capital Markets —markets that trade unsecured promissory notes issued by a
debt and equity instruments with company to raise
maturities of more than one year. short-term cash.
Foreign Exchange Markets —markets in Negotiable certificate of deposit —bank-
which cash flows from the sale of issued time deposit that specifies an
products or assets denominated in a interest rate and
foreign currency are transacted. maturity date and is negotiable, (i.e., can
Derivative Markets —markets in which be sold by the holder to another party).
derivative securities trade. Banker’s acceptance —time draft
payable to a seller of goods, with payment
initial public offerings guaranteed by a
(IPOs)- The first public issue of Bank.
financial instruments by a firm.
derivative security- A financial CAPITAL MARKET INSTRUMENTS
security Corporate stock —the fundamental
whose payoffs are linked to other, ownership claim in a public corporation.
previously issued securities. Mortgages —loans to individuals or
businesses to purchase a home, land, or
Money Markets versus Capital Markets other real property.
money markets capital markets Corporate bonds —long-term bonds
Markets that trade Markets that trade
issued by corporations.
debt debt (bonds) and
Treasury bonds —long-term bonds
securities or equity
issued by the U.S. Treasury.
instruments (stocks) instruments

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State and local government bonds — corporations (policyholders) from adverse
long-term bonds issued by state and local events. Life insurance companies provide
governments. protection in the event of untimely death,
U.S. government agencies —long-term illness, and retirement. Property casualty
bonds collateralized by a pool of assets insurance protects against personal
and issued by injury and liability due to accidents, theft,
agencies of the U.S. government. fire, and so on.
Bank and consumer loans —loans to Securities firms and investment banks
commercial banks and individuals. —financial institutions that help firms
issue securities
derivative security Markets- The markets and engage in related activities such as
in which derivative securities trade. securities brokerage and securities trading.
derivative security-An agreement between Finance companies —financial
two parties to exchange a standard intermediaries that make loans to both
quantity of an asset at a predetermined individuals and businesses. Unlike
price on a specified date in the future. depository institutions, finance companies
do not accept deposits but instead rely on
financial institutions- Institutions that short- and long-term debt for funding.
perform the essential function of Mutual funds —financial institutions that
channeling funds from those with surplus pool financial resources of individuals and
funds to those with shortages of funds. companies and invest those resources in
diversified portfolios of assets.
Types of Financial Institutions Hedge funds —financial institutions that
Commercial banks —depository pool funds from a limited number (e.g.,
institutions whose major assets are loans less than 100) of wealthy (e.g., annual
and whose major incomes of more than $200,000 or net
liabilities are deposits. Commercial banks’ worth exceeding $1 million) individuals
loans are broader in range, including and other investors (e.g., commercial
consumer, banks) and invest these funds on their
commercial, and real estate loans, than are behalf, usually keeping a large proportion
those of other depository institutions. (commonly 20 percent) of any upside
Commercial return and charging a fee (2%) on the
banks’ liabilities include more nondeposit amount invested.
sources of funds, such as subordinate Pension funds —financial institutions
notes and that offer savings plans through which
debentures, than do those of other fund participants accumulate savings
depository institutions. during their working years before
Thrifts —depository institutions in the withdrawing them during their retirement
form of savings associations, savings years. Funds originally invested in and
banks, and credit unions. Thrifts generally accumulated in a pension fund are exempt
perform services similar to commercial from current taxation.
banks, but they tend to concentrate their
loans in one segment, such as real estate direct transfer- A corporation sells its
loans or consumer loans. stock or debt directly to investors without
Insurance companies —financial going through a financial institution.
institutions that protect individuals and

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Liquidity-The ease with which an asset policy actions impact the rest of the
can be converted into cash at its fair financial system and the economy in
market value. general.
price risk-The risk that an asset’s sale Credit allocation —FIs are often viewed
price will be lower than its purchase price. as the major, and sometimes only, source
of financing for a particular sector of the
indirect transfer-A transfer of funds economy, such as farming and residential
between suppliers and users of funds real estate.
through a financial intermediary. Intergenerational wealth transfers —
FIs, especially life insurance companies
Services Performed by Financial and pension funds, provide savers with the
Intermediaries ability to transfer wealth from one
generation to the next.
Monitoring costs —Aggregation of funds Payment services —The efficiency with
in an FI provides greater incentive to which depository institutions provide
collect a firm’s information and monitor payment services directly benefits the
actions. The relatively large size of the FI economy.
allows this collection of information to be
accomplished at a lower average cost delegated monitor-An economic agent
(economies of scale). appointed to act on behalf of smaller
Liquidity and price risk —FIs provide investors in collecting information and/or
financial claims to household savers with investing funds on their behalf.
superior
liquidity attributes and with lower price asset transformers-Financial claims
risk. issued by an FI that are more attractive to
Transaction cost services —Similar to investors than are the claims directly
economies of scale in information issued by corporations.
production costs, an
FI’s size can result in economies of scale Diversify-The ability of an economic
in transaction costs. agent to reduce risk by holding a number
Maturity intermediation —FIs can of securities in a portfolio.
better bear the risk of mismatching the
maturities of their economies of scale-The concept that cost
assets and liabilities. reduction in trading and other transaction
Denomination intermediation —FIs services results from increased efficiency
such as mutual funds allow small when FIs perform these services.
investors to overcome
constraints to buying assets imposed by Etrade-Buying and selling shares
large minimum denomination size. on the Internet.
Services Benefiting the Overall Chapter 2 Determinants of Interest
Economy: Rates
Money supply transmission —
Depository institutions are the conduit Nominal interest rates are the interest
through which monetary rates actually observed in financial
markets.

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loanable funds theory-A theory of interest
rate determination that views equilibrium lump sum payment-A single cash flow
interest rates in financial markets as a occurs at the beginning and end of the
result of the supply and demand for investment horizon with no other cash
loanable funds. flows exchanged.
Annuity-A series of equal cash flows
Factors That Cause the Supply and received at fixed intervals over the
Demand Curves for Loanable Funds to investment horizon.
Shift
effective or equivalent annual return-
Supply of Funds Rate earned over a
-Wealth. 12-month period taking the compounding
-Risk. of interest into account.
-Near-Term Spending Needs.
Chapter 3 Interest Rates and
Factors Affecting Nominal Interest Security Valuation
Rates coupon interest rate-Interest rate used to
Inflation —the continual increase in the calculate the annual cash flow the bond
price level of a basket of goods and issuer promises to pay the bond holder.
services.
Real Interest Rate —nominal interest Required rate of return —interest rate an
rate that would exist on a security if no investor should receive on a security given
inflation were expected. its risk. Required rate of return is used to
Default Risk —risk that a security issuer calculate the fair present value on a
will default on the security by missing an security.
interest or principal payment. Expected rate of return —interest rate an
Liquidity Risk —risk that a security investor expects to receive on a security if
cannot be sold at a predictable price with he or she buys the security at its current
low transaction costs at short notice. market price, receives all expected
Special Provisions —provisions (e.g., payments, and sells the security at the end
taxability, convertibility, and callability) of his or her investment horizon.
that impact the security holder beneficially Realized rate of return —actual interest
or adversely and as such are reflected in rate earned on an investment in a financial
the interest rates on securities that contain security. Realized rate of return is a
such provisions. historical (ex post) measure of the interest
Term to Maturity —length of time a rate.
security has until maturity.
coupon bonds-Bonds that pay interest
forward rate-An expected rate (quoted based on a stated coupon rate. The
today) on a security that originates at interest, or coupon, payments per year are
some point in the future. generally constant over the life of the
bond.
compound interest-Interest earned on an
investment is reinvested. zero-coupon bonds-Bonds that do not pay
simple interest-Interest earned on Interest.
an investment is not reinvested.

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premium bond-A bond in which the modified duration-Duration divided by 1
present value of the bond is greater than plus the interest rate
its face value. Convexity-The degree of curvature
discount bond-A bond in which the of the price–interest rate curve around
present value of the bond is less than its some interest rate level.
face value.
Par value —when the coupon rate on a market efficiency-The process by which
bond is equal to the required rate of return financial security prices move to a new
on the bond, the fair present value is equal equilibrium when interest rates or a
to the face value of the bond. security specific characteristic changes.
par bond-A bond in which the
present value of the bond is equal to its Chapter 4 The Federal Reserve System,
face value. Monetary Policy, and Interest Rates
yield to maturity-The return or yield the
bond holder will earn on the bond if he or Federal Open Market Committee
she buys it at its current market price, (FOMC)-The major monetary policy-
receives all coupon and principal making body of the Federal Reserve
payments as promised, and holds the bond System.
until maturity.
Interest rate —there is a negative relation open market operations-Purchases and
between interest rate changes and present sales of U.S. government and federal
value (or price) changes on financial agency securities by the Federal Reserve.
securities. As interest rates increase,
security prices decrease at a decreasing Functions Performed by the Federal
rate. Reserve Banks
Time remaining to maturity —the shorter Assistance in the conduct of monetary
the time to maturity for a security, the policy —Federal Reserve Bank presidents
closer the price is to the face value of the serve on the Federal Open Market
security. The longer the time to maturity Committee (FOMC). FRBs set and change
for a security, the larger the price change discount rates.
of the security for a given interest rate Supervision and regulation —FRBs
change. The maturity effect described have supervisory and regulatory authority
above increases at a decreasing rate. over the activities of banks located in their
Coupon rate —the higher a security’s district.
coupon rate, the smaller the price change Consumer protection and community
on the security for a given change in affairs —FRBs write regulations to
interest rates. implement many of the major consumer
protection laws and establish programs to
Duration is the weighted - average time promote community development and fair
to maturity on a financial security using and impartial access to credit.
the relative present values of the cash Government services —FRBs serve as
flows as weights. the commercial bank for the U.S.
Elasticity-The percentage change in the Treasury. New currency issue —FRBs
price of a bond for a given change in are responsible for the collection and
interest rates. replacement of damaged currency from
circulation.

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Check clearing —FRBs process, route, Federal Reserve Board Trading Desk from
and transfer funds from one bank to the FOMC that specifies the money
another as checks supply target.
clear through the Federal Reserve System.
Wire transfer services —FRBs and their repurchase agreements-Open market
member banks are linked electronically transactions in which the Trading Desk
through the Federal Reserve purchases government securities with an
Communications System. agreement that the seller will repurchase
Research services —each FRB has a staff them within a stated period of time.
of professional economists who gather,
analyze, and interpret economic data and Capital Injections. Direct injections of
developments in the banking sector in capital by central governments were the
their district and economy wide. main mechanism used to directly support
bank balance sheets.
discount rate-The interest rate on
loans made by Federal Reserve Banks to Chapter 5 Money Markets
depository institutions.
discount window-The facility through money markets-Markets that trade debt
which Federal Reserve Banks issue loans securities or instruments with maturities
to depository institutions. of less than one year.

Reserves-Depository institutions’ opportunity cost-The forgone interest cost

vault cash plus reserves deposited at from the holding of cash balances when
Federal Reserve Banks. they are received.
monetary base-Currency in circulation
and reserves (depository institution default risk-The risk of late or
reserves and vault cash of commercial nonpayment of principal or interest.
banks) held by the Federal Reserve.
Money Market Instruments
required reserves-Reserves the Federal
Reserve requires banks to hold. Treasury bills-Short-term obligations
excess reserves-Additional reserves banks of the U.S. Government issued to cover
choose to hold. government budget deficits and to
refinance maturing government debt.
fed funds rate-The interest rate on Federal funds —short-term funds
short-term funds transferred between transferred between financial institutions
financial institutions, usually for a period usually for no more than one day.
of one day. Repurchase agreements —agreements
involving the sale of securities by one
Federal Reserve Board party to another with a promise to
Trading Desk-Unit of the Federal repurchase the securities at a specified
Reserve Bank of New York through date and price.
which open market operations are Commercial paper —short-term
conducted. unsecured promissory notes issued by a
company to raise short-term cash.
policy directive-Statement sent to the

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Negotiable certificates of deposit —bank- Eurodollar market-The market in
issued time deposit that specifies an which Eurodollars trade.
interest rate and maturity date and is
negotiable (saleable on a secondary Eurodollar CDs Dollar-denominated
market). deposits in non-U.S. Banks.
Banker’s acceptances —time drafts
payable to a seller of goods, with payment Eurocommercial paper Eurosecurities
guaranteed by a bank. issued in Europe by dealers of commercial
paper without involving a bank.
Treasury bill auctions-The formal
process by which the U.S. Treasury sells Chapter 6 Bond Markets
new issues of Treasury bills.
Equity (stocks) and debt (notes, bonds,
Federal funds-Short-term funds and mortgages) instruments with
transferred between financial institutions, maturities of more than one year trade in
usually for a period of one day. capital markets.
federal funds rate-The interest rate for
borrowing fed funds. capital markets-Markets that trade debt
(bonds and mortgages) and equity (stocks)
correspondent banks-Banks with instruments with maturities of more than
reciprocal accounts and agreements. one year.

repurchase agreement-An agreement Bonds are long-term debt obligations

involving the sale of securities issued by corporations and government
by one party to another with a promise to units.
repurchase the securities at a
specified price and on a specified date. Bond markets are markets in which
reverse repurchase agreement-An bonds are issued and traded. They are
agreement involving the purchase of used to assist in the transfer of funds from
securities by one party from another with individuals, corporations, and government
the promise to sell them back. units with excess funds to corporations
and government units in need of long-term
commercial paper-An unsecured short- debt funding.
term promissory note issued by a
company to raise short-term cash, often Treasury notes and Bonds-Long-term
to finance working capital requirements. securities issued by the U.S. Treasury to
finance the national debt and other federal
negotiable certificate of deposit-A bank- government expenditures.
issued, fixed maturity, interest-bearing
time deposit that specifies STRIP-A Treasury security in which the
an interest rate and maturity date and periodic interest payment is separated
is negotiable. from the final principal payment.
bearer instrument-An instrument in
which the holder at maturity receives the accrued interest-That portion of the
principal and interest. coupon payment accrued between the last
coupon payment and the settlement day.

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municipal bonds-Securities issued by the coupon payments are mailed to the
state and local (e.g., county, city, school) registered owner.
Governments Term Bonds— bonds in which the entire
issue matures on a single date.
general obligation bonds-Bonds backed Serial Bonds— bonds that mature on a
by the full faith and credit of the issuer. series of dates, with a portion of the issue
paid off on each.
revenue bonds-Bonds sold to finance Mortgage Bonds— bonds that are issued
a specific revenue generating project, to finance specific projects that are
backed by cash flows from that pledged as collateral for the bond issue.
project. Equipment Trust Certificates— bonds
collateralized with tangible non–real
firm commitment underwriting-The estate property (e.g., railcars and
issue of securities by an investment bank airplanes).
in which the investment bank guarantees Debentures— bonds backed solely by the
the issuer a price for newly issued general credit of the issuing firm and
securities by buying the whole issue at a unsecured by specific assets or collateral.
fixed price from the issuer. It then seeks to Subordinated Debentures— unsecured
resell these securities to suppliers of funds debentures that are junior in their rights to
(investors) at a higher price. mortgage
bonds and regular debentures.
best-efforts offering-The issue of Convertible Bonds— bonds that may be
securities in which the investment bank exchanged for another security of the
does not guarantee a price to the issuer issuing firm at
and acts more as a placing or distribution the discretion of the bond holder.
agent on a fee basis related to its success Stock Warrants— bonds that give the
in placing the issue. bond holder an opportunity to purchase
common stock at
private placement-A security issue a specified price up to a specified date.
placed with one or a few large institutional Callable Bonds— bonds that allow the
buyers. issuer to force the bond holder to sell the
bond back to the issuer at a price above
corporate bonds-Long-term bonds the par value (at the call price).
issued by corporations. Sinking Fund Provisions— bonds that
include a requirement that the issuer retire
bond indenture-The legal contract that a certain amount of the bond issue each
specifies the rights and obligations of the year.
bond issuer and the bond holders.
junk bond-Bond rated as speculative or
Bond Characteristics less than investment grade (below Baa by
Bearer Bonds— bonds on which coupons Moody’s and BBB by S&P) by bond-
are attached. The bond holder presents the rating agencies.
coupons to the issuer for payments of
interest when they come due. Eurobonds are long-term bonds issued
Registered Bonds— with a registered and sold outside the country of the
bond, the owner’s identification
information is recorded by the issuer and

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currency in which they are denominated
(e.g., dollar-denominated bonds issued in
Europe or Asia).

Foreign bonds are long-term bonds

issued by firms and governments outside
of the issuer’s home country.

sovereign bonds-Government-issued,
foreign currency denominated debt.

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