Financial Markets,

Instruments, and
Market Makers
Chapter 3

© 2003 South-Western/Thomson Learning

 Learning Objectives
 Classifying financial markets
 Primary & secondary
 Money and capital
 Spot and futures
 Definitions & characteristics of financial
market instruments
 Functions of market makers
 Connection of various sectors of financial
markets

Slide 2
 Introducing Financial Markets

A market for financial claims

(instruments) can be viewed
as the process or mechanism
that connects the buyers and
sellers of claims.

Slide 3
 Introducing Financial Markets

 Money market includes

 Markets where securities with original
maturities of one year or less are traded

 Capital market includes

 Markets where securities with original
maturities of more than one year are
traded

Slide 4
 Introducing Financial Markets
 Primary market
 Security is initially sold for the first time

 Secondary market
 Further trading

Conceptual distinction:
Selling of new securities in primary
market and trading of older securities
in secondary market occur
Slide 5
simultaneously.
 Financial Markets
 Financial futures
 Financial forward markets

These fulfill two basic functions:

 Reduce risk associated with future price
changes
 Facilitates speculation - the buying or selling
of securities in hopes of profiting from future
price changes

Slide 6
Money Market Instruments

 U.S. Treasury Bills (T-bills)

 Short term government debt instruments
 Typical maturities of 3-12 months

 Negotiable Certificates of Deposit (CDs)

 Debt instrument sold by depository institution
 Pays annual interest payments equal to fixed % of
original purchase price
 Can be resold in secondary market
 Minimum denomination of $100,000 (in practice, to trade
in secondary market the minimum is $2,000,000)

Slide 7
Money Market Instruments

 Commercial paper
 Short-term debt instrument issued by
corporations
 Supported by backup line of bank credit

 Bankers’ Acceptances
 Instruments created in course of financing
international trade

Slide 8
Money Market Instruments

 Repurchase Agreements
 Short-term agreements in which seller
 Sells government security to buyer
 Agrees to buy government security back on later date at
higher price

 Federal Funds
 Overnight loans between depository
institutions of their deposits at the Fed
 Eurodollars
 Dollar-denominated deposits held in banks
outside the United States
Slide 9
Exhibit 3–2
The Money Market

Slide 10
Exhibit 3–3
Bankers’
Acceptances

Slide 11 Source: Adapted from Ann-Marie Meulendyke, U.S. Monetary Policy and Financial Markets (New York:
Federal Reserve Bank of New York, 1989), p. 80.
Capital Market Instruments

The capital market raises the

funds needed by DSUs to
carry out their spending and
investment plans.

Slide 12
Exhibit 3–4
The Principal Capital Market Instruments: Amount
Outstanding, End of the Year (in Billions of Dollars)

a Excludes federally sponsored mortgage pools.

b As of June 30, 2001.
Source: Federal Reserve Flow of Funds Accounts, Z1, 2nd Quarter 2001, September 18, 2001; Federal Reserve Bulletin, various issues; Banking and Monetary Statistics
1941–1970.

Slide 13
Exhibit 3–5
The Capital Market

Slide 14
Capital Market Instruments

 Stocks
 Equity claims
 Represent ownership of net income and assets
of corporation
 Preferred stock
 Pays fixed dividend; in event of bankruptcy, preferred
stock owners entitled to be paid first
 Common stock
 Pays variable dividend depending on profits left over
after
 preferred stockholders have been paid
 retained earnings set aside
Slide 15
Capital Market Instruments

 Mortgages
 Loans to purchase
 Single-multiple family residential housing
 Land
 Other real structures
… land or structures serve as collateral for loan

 Corporate Bonds
 Long-term bonds
 Issued by corporations
 Usually have excellent credit ratings
 Maturities range from 2 – 30 years
Slide 16  Not as liquid as other securities
Capital Market Instruments

 U.S. Government Securities

 Long-term debt instruments
 Maturities of 2 – 30 years
 Issued by U.S. Treasury to finance deficits of federal
government

 U.S. Government Agency Securities

 Long-term bonds issued by various
government agencies that support
 Commercial, residential, & agricultural real estate
lending
Slide 17
 Student loans
Capital Market Instruments

 State and local government bonds

(municipals)

Long-term instruments issued by state and local

governments to finance expenditures on schools,
roads, college dorms and the like.

 Revenue bonds - finance specific projects

 General obligation bonds - backed by full faith
and credit of issuer

Slide 18
Role of Market Makers

 Function as coordinators who link buyers

and sellers of financial instruments.
 Help maintain a smoothly functioning,
orderly financial market.
 Receive, process, interpret and
disseminate information to potential
buyers and sellers.

Slide 19
Exhibit 3–
6
Market
Makers

Slide 20
Market Makers

 Broker arranges trades between

 Buyers
 Sellers
 Dealer
 Arranges trades between buyers and
sellers
 Is the principal in transactions
 Purchases and holds securities sold by
investors

Slide 21
Why Market Makers Make Markets
 Expected profits
 Mainly from revenue generated by price it charges
for conducting a transaction
 Number of transactions engaged in
 Capital gains or losses associated with inventory
of securities
 Fee for
 Brokerage fee or commission charge for each
transaction
 Function of spread between Bid Price (buy
securities) and Asked Price (sell securities) and
number of transactions
Slide 22
Market Making and Liquidity

Transactions costs and liquidity

affect portfolio decisions

Slide 23
Exhibit 3–7
The Marketing and
Subsequent Trading of
a Corporate Bond

Slide 24