1

Chapter 3

Financial Markets And Instruments

©Thomson/South-Western 2006

2

Investment: The Source Economic Growth

Saving allows people to transfer their economic resources from consumption now to the opportunity to consume goods in the future.

The investment in capital goods makes labor more efficient, allowing for more output and consumption later on.

Capital goods depreciate, so investment must occur each year to replace lost capital.

The greater the proportion of current output saved and invested, the more rapid will be a nation’s rate of long-term economic growth.

3

Financial Markets And The Flow Of Funds

Financial institutions and markets provide the mechanism for this transfer of funds from savers to investors.

Both borrowers and savers exist among households, business firms, state and local government units, and foreign entities.

Financial markets allow savers’ funds to be matched with borrowers’ needs.

4

Table 3-1

5

Figure 3-1

6

Financial Markets Direct Capital Markets

shares of stock bonds other debt instruments

Indirect Capital Markets involve financial intermediaries as financial middlemen

banks money markets mutual funds life insurance companies

Financial intermediaries raise money by issuing secondary claims on themselves.

7

An Example of Financial Intermediation

A commercial bank issues a savings account to an individual and uses the proceeds to fund a loan to a local farmer to purchase a new tractor.

The primary claim is the bank’s loan agreement with the farmer; the secondary claim is the savings account.

In this case, the bank serves as a “middleman” between the saver and the farmer.

8

Attributes Of Financial Instruments

Liquidity the ease with which an asset may be converted into

money

Risk the possibility that the owner of an asset will be unable to

recover the full value of funds originally invested Default risk Market risk Interest Rate Risk

Yield the rate of return on an asset, expressed as a percentage

per year

9

Liquidity, Risk, and Yield: Their Relationship

Liquidity and yield relate inversely—the less liquid an asset is, the more the investor will demand to compensate for ILLIQUIDITY.

Risk and yield relate positively—the more risk investors take on, the more return they expect.

Liquidity and risk relate inversely—the more liquid an asset is, the less risky it will be because the investor can get out easily.

10

Classification Of Financial Markets

Debt and equity markets

Primary and secondary markets

Auction/Public outcry and over-the-counter markets

Cash and derivative markets

Money and capital markets

11

Debt Markets

A debt instrument agrees to pay a specific amount of money at some specified future date. Examples:

all forms of U.S. government securities Government and corporate bonds Mortgages short-term money market instruments

Bondholders are paid first in case of bankruptcy.

12

Equity Markets

Equities are financial claims that give the owner a right to share in the net income of the corporate issuer.

Main equity instruments are corporation-issued common stocks.

Stockholders stand to gain when profits are high.

13

Primary Markets

Primary markets offer new issues, usually through investment banks and/or underwriting syndicates.

When a corporation decides to issue new

bonds or shares of stock, the company engages an investment bank, an institution that specializes in providing information and counsel to companies on financial analysis and issues.

14

Secondary Markets Secondary markets trade previously issued

(second-hand) securities. The New York Stock Exchange Over-the-Counter (OTC) Markets The U.S. government securities markets

Secondary markets provide: primary markets with liquidity a continuing flow of information about company

conditions (through stock prices) and bond yields. Can be “organized/public outcry/physical” or

“over-the-counter.”

15

Cash Versus Derivative Markets

Cash markets involve transactions in which the buyer pays the seller for the asset up front or arranges to pay the seller upon delivery (grain markets; stock trades)

Derivative instruments are so named because their value derives from the value of the underlying asset.

Futures: what will the price of the Japanese yen be in October of next year?

Options: how much will it cost me to lock in the opportunity to sell Japanese yen next October at today’s price?

16

Money Versus Capital Markets

Money markets trade in short-term debt (less than one year maturity) instruments, typically in massive quantities. Issued by governments, banks, and other private

firms High degree of liquidity and relatively low default

risk.

Capital markets exchange longer-term securities issued by government and private concerns.

17

Instruments of the Money Market

Commercial Paper

Negotiable CDs

U.S. Treasury Bills

Repurchase Agreements

Eurodollars

Federal Funds

Banker's Acceptances

18

Instruments of the Capital Market

Corporate Stocks Corporate Bonds

Mortgages

U.S. Treasury Bonds and Notes

U.S. Government Agency Securities

State and Local Government Bonds

19

Discount Rates and Prices Let the face value of a bond be $1000, r be the

discount (interest) rate and P, the price. Then:

360

))((10001000

360

1000

1000

maturitytodaysrP

maturitytodaysx

Pr

20

Treasury Bill Price vs Time to Maturity

21

Treasury Notes and Bonds Treasury notes have maturities of one to ten years. Bonds are longer-term instruments—usually 10-30

years. Both are issued through three methods:

Auction Same as Treasury bills.

Exchange The Treasury offers existing owners of maturing notes and bonds

a choice of several new issues. Subscription

The public is first notified of the coupon rate and other pertinent features of a new issue, and investors subscribe for their desired amounts.

When oversubscribed each investor gets a pro rata share.

22

Bid and Asked Prices for Treasury Notes and Bonds

23

Yield Formula

The current yield refers simply to the annual payment (coupon) divided by the price. Stated algebraically, the current yield is

Yc=R/P where

Yc is the current yield,

R is the annual coupon payment in dollars, P is the market price.

24

Yield to Maturity Formula The yield-to-maturity is the average yield over the life

of the security if it is held to maturity.

P

NCRYm

)/(

whereYm is yield-to-maturityR is the annual coupon payment in dollarsC is the capital gain (+) or loss (-) realized at maturityN is the number of years remaining to maturity P is the current price of the security

25

Treasury Inflation Protection Securities (TIPS)

A form of U.S. Government debt designed to protect investors against inflation

Comprise about 5 percent of the market.

Known as TIPS, Treasury Inflation Protected Securities.

Pay out income each year based on the coupon rate; principal is indexed to the nation's consumer price index (CPI).

26

Non-marketable Government Debt

Most non-marketable debt is the government account series. Most of this is sold only to government agencies and trust

funds, which are legally mandated to invest only in U.S. government securities (e.g. Social Security Trust Fund, Federal Employee Retirement Fund, the Bank Insurance Fund).

More than $2,900 billion was outstanding in 2004. U.S. savings bonds cannot be traded to others.

Series EE bonds ($25 to $10,000) Series HH bonds pay interest only ( $500, $1,000, and

$5,000, and $10,000) Interest income earned on Series EE and HH savings

bonds is not subject to state or local income tax.