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Chapter 06Chapter 06 Understanding Financial Markets and Institutions

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Markets

Overview of markets and Payroll taxeshttp://money.cnn.com/?hpt=sitenav

Manage flow of funds– Two major market dimensions

• Primary versus secondary markets• Money versus capital markets

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Primary Markets• Used by corporations and governments

• Used to issue new financial instruments– Stocks– Bonds

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Primary Market Transfer of Funds

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Secondary Markets

• Benefit investors and issuers– Securities traded after issue– Provide liquidity and diversification

benefits for investors– Security valuation information for issuers

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Secondary Market Transfer of Funds

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Money Markets vs. Capital Markets

• Money markets trade debt securities or instruments with maturities of one year or less

• Capital markets trade stocks and long- term debt with maturities greater than one year

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Money Market vs. Capital Market Maturities

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Other Markets

• Foreign Exchange Markets– Trade currency for immediate delivery

(spot) or for some future delivery– Subject to foreign exchange risk due to

currency fluctuations

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Other Markets

• Derivatives– Highly leveraged financial securities

linked to underlying security – Potentially high-risk– Used for hedging and speculating

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Financial Institutions

• Banks

• Thrifts

• Insurance companies

• Mutual funds

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Financial Institutions

• Perform economic functions‒ Monitor costs

‒ Provide liquidity

‒ Price risk

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Funds Flow with Financial Institutions

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Interest Rates

• Affected by economic conditions

• Nominal rate quoted most often

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Nominal Interest• Factors that affect rate

– Inflation– Real interest rate– Default and liquidity risk– Provisions of security issuer– Term to maturity

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Inflation • Percentage increase in cost of goods or

services over given period of time

• Actual or Expected inflation rate– Interest rates increase in response to inflation

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Inflation

• Annual inflation calculation using Consumer Price Index (CPI)

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Nominal Rates vs. Inflation

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Default or Credit Risk• Risk that issuer fails to pay promised interest

and principal

• Investors demand higher interest with higher default risk

• U.S. Treasury securities are generally considered to be free of default risk

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Default Risk Premium Calculation

DRPj = ijt - iTt

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Corporate Bond Default Risk Premiums

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Three Yield-Curve Theories

• Unbiased Expectations • Liquidity Premium • Market Segmentation

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Yield Curve Shapes

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Forecasting Interest Rates • As interest rates rise, investment portfolios

values fall• Forecasts important to corporate and

individual financial wealth

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