Financial Instruments, Financial Instruments, Markets and InstitutionsMarkets and Institutions

Summary of Classification of Summary of Classification of FinancialFinancial Markets Markets

Classification by nature of claim.Classification by nature of claim.– Debt market; Equity marketDebt market; Equity market

Classification by maturity of claim.Classification by maturity of claim.– Money market; Capital marketMoney market; Capital market

Classification by seasoning of claimClassification by seasoning of claim..– Primary market; Secondary marketPrimary market; Secondary market

Classification by immediate delivery or future Classification by immediate delivery or future deliverydelivery– Cash or spot market; Derivative marketCash or spot market; Derivative market

Classification by organizational structureClassification by organizational structure– Auction market; Over-the-counter market; Intermediated marketAuction market; Over-the-counter market; Intermediated market

Financial Instruments and Financial Instruments and MarketsMarkets

Primary MarketsPrimary Markets– Market for issuing a Market for issuing a new securitynew security and distributing to and distributing to

saver-lenders.saver-lenders.– Investment BanksInvestment Banks—Information and marketing —Information and marketing

specialists for newly issued securities.specialists for newly issued securities.

Secondary MarketsSecondary Markets– Market where existing securities can be exchangedMarket where existing securities can be exchanged

New York Stock ExchangeNew York Stock ExchangeAmerican Stock ExchangeAmerican Stock ExchangeOver-the-counter (OTC) marketsOver-the-counter (OTC) markets

Bonds Represent BorrowingBonds Represent Borrowing

Agreement by issuer to pay interest on specified Agreement by issuer to pay interest on specified dates and redeem the bond upon maturity.dates and redeem the bond upon maturity.ConsolConsol– Bond with no maturity date, pay interest foreverBond with no maturity date, pay interest forever

Coupon SecuritiesCoupon Securities– Make interest payments – usually semiannually.Make interest payments – usually semiannually.

Zero-couponZero-coupon– Make no interest payments. Make no interest payments. – Sold at price well below face value. Sold at price well below face value.

Tax ExemptTax Exempt– Interest earned is not taxed.Interest earned is not taxed.

Stock Represents OwnershipStock Represents Ownership

StockholdersStockholders– Owns part of the corporation and receives Owns part of the corporation and receives

dividendsdividends from the issuer. from the issuer.

Capital GainsCapital Gains– Difference between price initially paid and Difference between price initially paid and

amount received when stock is sold.amount received when stock is sold.

Types of Corporate StockTypes of Corporate Stock

Preferred StockPreferred Stock– Fixed dividends, priority over common stockFixed dividends, priority over common stock

Common StockCommon Stock– Variable dividends, based on company’s Variable dividends, based on company’s

profits.profits.

ConvertibleConvertible– Preferred stock that can be converted into Preferred stock that can be converted into

common stock at a stated pricecommon stock at a stated price

Measures of Trends in Common Measures of Trends in Common Stock PricesStock Prices

Standard & Poor’s 500 Stock IndexStandard & Poor’s 500 Stock Index– Based on prices of 500 individual stocksBased on prices of 500 individual stocks

NASDAQ Composite IndexNASDAQ Composite Index– Based on all stocks listed in NASDAQBased on all stocks listed in NASDAQ

Dow Jones Industrial AverageDow Jones Industrial Average– Based on price of 30 “blue-chip” stocksBased on price of 30 “blue-chip” stocks

Both stocks and bonds represent a Both stocks and bonds represent a claim to a stream of payments in the claim to a stream of payments in the future.future.– BondsBonds—Interest payment and face value at —Interest payment and face value at

maturitymaturity– StocksStocks—Dividends and sales price when sold—Dividends and sales price when sold

MortgagesMortgages

Debt incurred in order to buy land or buildingDebt incurred in order to buy land or buildingAmortizedAmortized—principal and interest is gradually —principal and interest is gradually repaid over the life of loanrepaid over the life of loanFixed RateFixed Rate—Rate of interest is fixed—Rate of interest is fixedVariable-RateVariable-Rate—Rate of interest varies —Rate of interest varies depending on financial environmentdepending on financial environmentCash flow for lender is uncertainCash flow for lender is uncertain– Interest payments may vary - variable rate Interest payments may vary - variable rate

mortgagesmortgages– Home owner may prepay Home owner may prepay – Refinance a fixed mortgage if interest rates declineRefinance a fixed mortgage if interest rates decline

MortgagesMortgages

SecuritizationSecuritization—Individual mortgages may —Individual mortgages may be “pooled” and sold as a unit to reduce be “pooled” and sold as a unit to reduce uncertainty.uncertainty.

Mortgages may be insured by government Mortgages may be insured by government agenciesagencies– Federal Housing Authority (FHA)Federal Housing Authority (FHA)– Veterans Administration (VA)Veterans Administration (VA)

Options and Futures ContractsOptions and Futures Contracts

Contractual agreement between two parties to Contractual agreement between two parties to exchange an asset in the future at a stated priceexchange an asset in the future at a stated priceDerivative financial instrumentsDerivative financial instruments – Derive value from underlying assetsDerive value from underlying assets

LongLong– Buyer of the contract, receive commodity in the futureBuyer of the contract, receive commodity in the future

ShortShort– Seller of the contract, provide commodity in the futureSeller of the contract, provide commodity in the future

SpeculatorsSpeculators– Gamble on price fluctuations and hope to profitGamble on price fluctuations and hope to profit

HedgersHedgers– Eliminate the risk of price fluctuationsEliminate the risk of price fluctuations

The Capital MarketThe Capital Market

Exchange Exchange of long-term securities—in excess of long-term securities—in excess of one yearof one yearGenerally used to secure long-term financing for Generally used to secure long-term financing for capital investmentcapital investment– Stock marketStock market—Largest part of capital market and —Largest part of capital market and

held by private and institutional investorsheld by private and institutional investors– Corporate bond marketCorporate bond market—Held by insurance —Held by insurance

companies, pension and retirement fundscompanies, pension and retirement funds– Local and state government bondsLocal and state government bonds—Primarily held —Primarily held

for tax-exempt featurefor tax-exempt feature– Government securitiesGovernment securities—Held by commercial banks, —Held by commercial banks,

the Fed, individual Americans/foreigners, and dealersthe Fed, individual Americans/foreigners, and dealers

The Money MarketThe Money Market

Exchange of Exchange of short-term instruments—less than one short-term instruments—less than one yearyearHighly liquid, minimal risk Highly liquid, minimal risk Use of a temporary surplus of funds by banks or Use of a temporary surplus of funds by banks or businessesbusinesses– U.S. Treasury billsU.S. Treasury bills—short-term debts of US government—short-term debts of US government– Bank Certificates of DepositsBank Certificates of Deposits—liabilities of issuing bank, —liabilities of issuing bank,

interest bearing to corporations that hold theminterest bearing to corporations that hold them– Commercial paperCommercial paper—short-term liabilities of prime business —short-term liabilities of prime business

firms and finance companiesfirms and finance companies– Federal FundsFederal Funds—Exchange of excess/deficient reserves —Exchange of excess/deficient reserves

between banks on an overnight basis.between banks on an overnight basis.

Role of Financial Intermediaries Role of Financial Intermediaries

Act as agents in transferring funds from savers-Act as agents in transferring funds from savers-lenders to borrowers-spenders.lenders to borrowers-spenders.

Acquire funds by issuing their liabilities to public Acquire funds by issuing their liabilities to public and use money to purchase financial assetsand use money to purchase financial assets– Earn profits on difference between interest paid and Earn profits on difference between interest paid and

earnedearned– Diversify portfolios and minimize riskDiversify portfolios and minimize risk– Lower transaction costs Lower transaction costs – Competition lowers interest rates—beneficial to Competition lowers interest rates—beneficial to

economic growtheconomic growth

Economic Functions of Economic Functions of Financial MarketsFinancial Markets

Interactions of buyers and sellers Interactions of buyers and sellers determines price.determines price.– Price discovery process.Price discovery process.

Provides a mechanism to sell.Provides a mechanism to sell.– Liquidity.Liquidity.

Reduces transactions costs.Reduces transactions costs.– Search costs.Search costs.– Information costs.Information costs.

Commercial BanksCommercial Banks

Most prominent financial institutionMost prominent financial institution

Range in size from huge (BankAmerica) to small (local Range in size from huge (BankAmerica) to small (local banks)banks)

Major sources of funds Major sources of funds – used to be demand deposits of publicused to be demand deposits of public– now rely more on “other liabilities”now rely more on “other liabilities”– also accept savings and time depositsalso accept savings and time deposits

Uses of fundsUses of funds– short-term government securitiesshort-term government securities– long-term business loanslong-term business loans– home mortgageshome mortgages

Life Insurance CompaniesLife Insurance Companies

Insure against deathInsure against death

Receive funds in form of premiumsReceive funds in form of premiums

Use of funds is based on mortality Use of funds is based on mortality statistics—predict when funds will be statistics—predict when funds will be neededneeded

Invest in long-term securities—high yieldInvest in long-term securities—high yield– Long-term corporate bondsLong-term corporate bonds– Long-term commercial mortgagesLong-term commercial mortgages

Pension and Retirement FundsPension and Retirement Funds

Concerned with long runConcerned with long runReceive funds from working Receive funds from working individuals building “nest-egg”individuals building “nest-egg”Accurate prediction of future use of Accurate prediction of future use of fundsfundsInvest mainly in long-term corporate Invest mainly in long-term corporate bonds and high-grade stockbonds and high-grade stock

Mutual FundsMutual Funds

Stock or bond market related Stock or bond market related institutionsinstitutions

Pool funds from many peoplePool funds from many people

Invest in wide variety of securities—Invest in wide variety of securities—minimize riskminimize risk

Money Market Mutual FundsMoney Market Mutual Funds

Individuals purchase shares in the fundIndividuals purchase shares in the fund

Fund invests in highly liquid short-term Fund invests in highly liquid short-term money market instrumentsmoney market instruments– Large-size negotiable CD’sLarge-size negotiable CD’s– Treasury billsTreasury bills– High-grade commercial paperHigh-grade commercial paper

Savings and Loan Associations Savings and Loan Associations (S&L’s)(S&L’s)

Traditionally acquired funds through savings Traditionally acquired funds through savings depositsdepositsUsed funds to make home mortgage loansUsed funds to make home mortgage loansNow perform same functions as commercial Now perform same functions as commercial banksbanks– issue checking accountsissue checking accounts– make consumer and business loansmake consumer and business loans

Commercial and Consumer Commercial and Consumer Finance CompaniesFinance Companies

Acquire funds primarily by selling short Acquire funds primarily by selling short term loans (commercial paper)term loans (commercial paper)

Lend money for consumer purchases or Lend money for consumer purchases or business firms to finance inventoriesbusiness firms to finance inventories

Property and Casualty Property and Casualty Insurance CompaniesInsurance Companies

Insure homeowners and businesses against Insure homeowners and businesses against losseslosses

Receive premiumsReceive premiums

Need to be fairly liquid due to uncertainty of Need to be fairly liquid due to uncertainty of claimsclaims

Purchase a variety of securitiesPurchase a variety of securities– high-grade stocks and bondshigh-grade stocks and bonds– short-term money market instruments for liquidityshort-term money market instruments for liquidity

Credit UnionsCredit Unions

Organized as cooperatives for people with Organized as cooperatives for people with common interestcommon interest

Members buy shares [deposits] and can Members buy shares [deposits] and can borrowborrow

Changes in the law in 1980 broadened Changes in the law in 1980 broadened their powerstheir powers– checking [share] accountschecking [share] accounts– make long-term mortgage loansmake long-term mortgage loans