Chapter 3 Financial Markets And Instruments ThomsonSouthWestern 2006

Chapter 3 Financial Markets And Instruments ©Thomson/South-Western 2006 1

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. 2

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. 3

Table 3 -1 4

Figure 3 -1 5

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. 6

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. 7

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 8

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. 9

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 10

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. 11

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. 12

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. 13

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. ” 14

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? 15

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. 16

Instruments of the Money Market § Commercial Paper § Negotiable CDs § U. S. Treasury Bills § Repurchase Agreements § Eurodollars § Federal Funds § Banker's Acceptances 17

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 18

Discount Rates and Prices § Let the face value of a bond be $1000, r be the discount (interest) rate and P, the price. Then: 19

Treasury Bill Price vs Time to Maturity 20

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. 21

Bid and Asked Prices for Treasury Notes and Bonds 22

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. 23

Yield to Maturity Formula § The yield-to-maturity is the average yield over the life of the security if it is held to maturity. 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 24

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). 25

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. 26