CHAPTER 3

Financial Markets And

Instruments
 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.
 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.
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.
 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.
 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
 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.
 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

 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.

 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.

 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.
 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.”
 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?
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.
Instruments of the Money
Market
 Commercial Paper

 Negotiable CDs

 U.S. Treasury Bills

 Repurchase Agreements

 Eurodollars

 Federal Funds

 Banker's Acceptances
 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

 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
Treasury Bill Price vs Time to
Maturity
 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.
 Bid and Asked Prices for
Treasury Notes and Bonds
 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.
 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
 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).
 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.