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Chapter 3

Financial Markets And


Instruments

Thomson/South-Western 2006

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 nations rate of long-term
economic growth.
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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.
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Table 3-1

Figure 3-1

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.
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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 banks 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.
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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
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Liquidity, Risk, and Yield: Their


Relationship
Liquidity and yield relate inverselythe less liquid
an asset is, the more the investor will demand to
compensate for ILLIQUIDITY.
Risk and yield relate positivelythe more risk
investors take on, the more return they expect.
Liquidity and risk relate inverselythe more liquid
an asset is, the less risky it will be because the
investor can get out easily.
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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

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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.


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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.

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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.
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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.
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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 todays price?
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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.
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Instruments of the Money Market


Commercial Paper
Negotiable CDs
U.S. Treasury Bills
Repurchase Agreements
Eurodollars
Federal Funds
Banker's Acceptances
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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
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Discount Rates and Prices


Let the face value of a bond be $1000, r be the
discount (interest) rate and P, the price. Then:

1000 P
360
r=
x
1000
days to maturity
1000(r )(days to maturity )
P = 1000
360
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Treasury Bill Price vs Time to


Maturity

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Treasury Notes and Bonds


Treasury notes have maturities of one to ten years.
Bonds are longer-term instrumentsusually 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.
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Bid and Asked Prices for


Treasury Notes and Bonds

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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.

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Yield to Maturity Formula


The yield-to-maturity is the average yield over the
life of the security if it is held to maturity.

R + (C / N )
Ym =
P

where
Ym is yield-to-maturity
R is the annual coupon payment in dollars
C is the capital gain (+) or loss (-) realized at maturity
N is the number of years remaining to maturity
P is the current price of the security

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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).
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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.
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