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CHAPTER 3

FUNDAMENTALS OF

FINANCIAL MARKETS

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Examples of Capital Market Claims Corporate Stock Bonds Mortgages

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Net Financial Position ofMajor Sectors of the EconomyYear-End 1998 (In $Billions)

NET FINANCIAL POSITION

SECTOR FINANCIAL

ASSETS

LIABILITIES EXCESS

(A-L)DEFICIT

(L-A)Households and Nonprofits $30,121 $6250 $23,871Nonfinancial business 7,221 8,904 $1,683State and local governments 1,130 1,236 106U.S. Governments 438 4,544 4,106All Financial Sectors 31,759 31,045 714Foreign (Rest of World) 5,410 2,667 2,743Total $76,079 $54,646 $27,328 $5,895

Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, March 12, 1999.

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Capital Market Dept and Equity Outstanding (In $Billions)

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

$45,000

1994 1995 1996 1997 1998

Bil

lio

ns

of

Do

lla

rs

Mutual Fund Shares

Corporate Equity

Other Loans and Advances

Open Market Paper

Bank Loans

Consumer Credit

Mortgages

Corporate and ForeignBondsState and Local Securities

U.S. Government Securities

Source: Board of Governors, Federal Reserve System, Flow of Funds Accounts, Federal Reserve Bulletin.

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Capital Market Efficiency

Allocational efficiency relates to whether or not funds are being channeled to their most productive (highest-valued) use.– Are businesses with risky, but potentially

productive technology, able to find financing?– Allocational efficiency depends upon high

informational and operational efficiency.

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Capital Market Efficiency (continued)

When market participants are able to obtain sufficient,timely, and accurate information about the relative values of securities, the market is said to have high informational efficiency.– Timely, accurate information assists market

participants in allocating funds to the most productive use (allocational efficiency).

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Capital Market Efficiency (concluded)

– The various levels of market efficiency discussed in finance relate to informational efficiency.

– In a market with high informational efficiency, prices embody all relevant information about securities.

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Capital Market Efficiency (concluded)

A market is operationally efficient if the costs of conducting transactions are as low as possible.– If broker/dealers are earning normal profit returns

(adequate based on risk assumed), the market is operationally efficient.

– Operational efficiency is dependent upon the competitiveness (ease of entry/exit) of broker/dealers.

– Allocational efficiency is directly related to the level of operational efficiency in any market.

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Overview of the Money Market

Short-term debt market -- most under 120 days A few high quality borrowers Many diverse investors Informal market centered in New York City Standardized securities -- one security is a close

substitute for another

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Overview of the Money Market (concluded)

Good marketability -- secondary market Large, wholesale open-market transactions Many brokers and dealers are competitively

involved in the money market. Payment in Federal Funds -- immediately

available funds. Physical possession of securities seldom made --

centralized safekeeping.

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Economic Role of Money Market (MM) The money market is a market for liquidity

– Liquidity is stored in MM by investing in MM securities.

– Liquidity is bought in MM by issuing securities (borrowing).

There are few high-quality borrowers and many diverse MM investors.

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Characteristics of Money Market Instruments Low default risk Short maturity High marketability

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Selected Money Market Instruments Outstanding(December 31, 1998)

INSTRUMENT AMOUNT OUTSTANDING

($ IN BILLIONS)U.S. Treasury securities $1,181.6 Treasury bills 662.8 Others under 1 year 518.8Negotiable certificates ofdeposit

805.0

Commercial paper 1,161.0Banker’s acceptances 11.5Repurchase agreements 877.7

Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, March 12, 1999 and The Bureau of Public Debt, Monthly Statement of Public Debt, January 31, 1999.

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Characteristics of Money Market Instruments

INSTRUMENT

TYPICAL

MATURITY MARKETABILITY

DEFAULT

RISK

U.S. Treasury bills and other securities maturing withinone year

13 to 52 weeks Excellent None

Federal agency securities, maturing within a year (FNMA, FHLMC, etc.)

Up to 1 year Good Very Low

Commercial paper (unsecured IOUs of major corporations, maturity under 270 days)

1 to 270 days Limited Low

Negotiable certificates of deposit (of major banks) 14 to 180 days Good LowBankers’s acceptances (company IOUs guaranteed by major banks)

30 to 180 days Good Low

Federal Funds (overnight or short-term loans of immediately available funds, usually transferred via the Federal Reserve System)

1 to 7 days Excellent Low

Repurchase agreements (overnight or short-term loans arranged by selling government securities along with an agreement to repurchase them at a higher price later)

1 to 15 days Good Low

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Money Market Balance Sheet Position of Major Participants

COMMERCIAL

BANKS

FEDERAL

RESERVE

SYSTEM

TREASURY

DEPARTMENT

INVESTMENT

BANKS,DEALERS,

AND BROKERS CORPORATIONS

INSTRUMENT A L A L A L A L A LTreasury bills Agency securities Negotiable CDs Commercial paper Banker’s acceptances Federal Funds Repurchase agreements

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Types of Financial Markets

Markets may be differentiated by when a security is sold.– The initial financing of the DSU is the primary

market; subsequent resale of the financial claims of the DSU are traded in the secondary markets.

– Primary markets are important from a real saving/investment perspective; secondary markets provide liquidity and portfolio rebalancing capacity for the investor.

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Types of Financial Markets (continued)

Markets may be differentiated by how or where they are traded.– Organized exchanges provide a physical meeting

place and communication facilities.– Securities may trade off the exchange in the over-

the-counter (OTC) market. OTC markets have no central location.

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Types of Financial Markets (continued)

Markets may be differentiated by maturity.– High quality short-term (less than one-year) debt

securities are issued and traded in the money market.

– Long-term (greater than one-year) securities are issued and traded in the capital market.

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Types of Financial Markets (continued)

Spot and futures markets--variation in timing of delivery and payment. – Items traded in the market for immediate delivery

and payment are traded in the spot market. – When delivery at a specific price(payment) is not

"spot," a "futures” or “forward” market transaction has occurred.

» Futures contracts are traded on organized exchanges.

» Forward contracts are traded over the counter.

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Types of Financial Markets (continued)

Option markets trade contracts specifying price and conditional delivery of a quantity of asset for a specific period of time.– A call option is an option to buy; a put is an option

to sell.– Options are traded on major security and

commodity exchanges as well as in various over-the-counter markets.

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Types of Financial Markets (concluded)

Foreign exchange markets.– Foreign exchange, the value of one currency

relative to another, is traded in the foreign exchange market.

– Foreign exchange is traded in the spot, forward, futures, and option markets.