financial markets, instruments, and market makers chapter 3 © 2003 south-western/thomson learning

Financial Markets,Instruments, and

Market Makers

Financial Markets,Instruments, and

Market Makers

Chapter 3

© 2003 South-Western/Thomson Learning

Learning ObjectivesLearning 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

Introducing Financial MarketsIntroducing Financial Markets

A market for financial claims (instruments) can be viewed as the process or mechanism that connects the buyers and sellers of claims regardless of where they happen to be physically

located.

A market for financial claims (instruments) can be viewed as the process or mechanism that connects the buyers and sellers of claims regardless of where they happen to be physically

located.

Financial markets distinguished based on type of security. Stock Market Bond Market Money Market

Treasury Bill Market Commercial Paper Market

Introducing Financial MarketsIntroducing Financial Markets

Financial markets distinguished based on term to maturity.

Money market includes Markets where securities with original maturities

of one year or less are tradedExample: Treasury Bills, commercial

paper and CDs.

Capital market includes Markets where securities with original maturities

of more than one year are traded Example : Treasury Bonds, stocks, mortgages,

corporate bonds.

Introducing Financial MarketsIntroducing Financial MarketsFinancial markets separated based on

the order of issue.

1. Primary market

2. Secondary market

Primary market : Security is initially sold for the first time. The primary market is where the public

(individuals or financial institutions) buy newly issued bonds or stocks from the firms issuing them.

Secondary market After the initial sale is completed. The

securities are then traded between investors in the secondary market.

Secondary market is essential for the functioning of the securities market. It helps in purchase and sale of securities conveniently at a low cost.

Secondary Market contd..

Secondary Market contd..

In the absence of secondary market, investors will individually have to find their buyers or sellers who would be willing to accept or pay the acceptable price. This will not only take time and cause inconvenience but also increase the cost of investing.

Firms will not be able to raise as much money, and therefore inhibit their growth and restrict capital expenditure.

Restricting growth in industries restricts the growth of the entire economy.

In short, smooth functioning and the quality of the secondary market is crucial for the economy.

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

Conceptual distinction:Selling of new securities in primary

market and trading of older securities in secondary market occur simultaneously.

Financial MarketsFinancial Markets

Financial markets separated based on time of delivery : Spot Market :

In spot markets, financial instruments trade instantaneously, and the spot price is the price of the financial instrument for immediate delivery.

Financial Futures and Forward Market : In the forward and futures market, commitment on price and

quality is made today for future delivery of the financial instrument or commodity.

In the futures market, quantities are standardized. Example: Currency, Commodities like oil, corn, etc.

In the forward market, transactions are customized. Hence the quantities are not standardized. Example : Currency

Futures and Forward MarketFutures and Forward Market

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

Money MarketMoney Market

Short-term credit market: where debt securities having original maturities of 1 year or less are traded

Money Market CharacteristicsMoney Market Characteristics Issued in large denominations

Usually $1 million or more Money market instruments have short

maturities Ranging from 1 day to 1 year

Money market instruments characterized by: Low liquidity risk (active resale market for most

money market securities) Low default risk…because issuer of the security

is almost default free (U.S. Govt, Banks and Large firms)

Does not occupy one particular geographic location (exchange market like for stocks, bonds etc) or trading floor

Money Market BenefitsMoney Market Benefits

More efficient source of credit for largest: Financial institutions Non-Financial corporations Governmental bodies

Mismatch of cash receipts and payments…they come in different times, hence require to be saved or borrowed for short term.

Money Market ParticipantsMoney Market Participants

Commercial banks and savings associations. Some of these banks are also primary dealers for U.S. securities.

Government Sponsored Enterprises The Federal Reserve Corporations and finance companies Pension funds and insurance companies Brokers and dealers…primarily help in

marketing these securities and stand ready to purchase these securities.

Money Market Mutual Funds and individuals

For most part, U.S. federal Government has had budget deficits (except 1998 to 2001). That is expenses far exceeds revenues. These deficits are financed through debt.

As of the end of 2002, the federal government debt stands at $6.2 trillion of which $2.6 trillion is held by Federal Government (primarily Social Security Trust Fund) and $3.6 trillion is held by outside of federal government including foreign investors. About one third of outside loan is owned by foreign investors. Of the $3.6 trillion outside debt, the Federal Reserve System holds $604 billion.

FEDERAL GOVERNMENT DEBT

What is the difference between the debt and the deficit? The deficit is the fiscal year difference between what the Government takes in from taxes and other revenues, called receipts, and the amount of money the Government spends, called outlays. The items included in the deficit are considered either on-budget or off-budget. (The off-budget items are typically comprised of the two Social Security trust funds, old-age and survivors insurance and disability insurance, and the Postal-Service fund.) Generally, on-budget outlays tend to exceed on-budget receipts, while off-budget receipts tend to exceed off-budget outlays.

You can think of the total debt as accumulated deficits plus accumulated off-budget surpluses. The on-budget deficits require the Treasury to borrow money to raise cash needed to keep the Government operating. We borrow the money by selling Treasury securities like T-bills, notes, bonds and savings bonds to the public. Additionally, the Government Trust Funds are required by law to invest accumulated surpluses in Treasury securities. The Treasury securities issued to the public and to the Government Trust Funds (Intragovernmental Holdings) then become part of the total debt.

Money Market InstrumentsMoney Market Instruments

U.S. Treasury’s primary function is to role over the debt and to manage the ongoing mismatch in the timings of tax inflows and government expenditures.

To manage these tasks, the Treasury issues variety of securities in various denomination and various terms to maturity, long and short term.

U.S. TREASURY BILLSSold to a variety of different types of buyers with:

Low minimum denominations (In the past the par value was $10,000, but now it is $1000)

Sold on a discount basis

Most liquid and free of default risk.

Original issues are sold at regularly scheduled auctions

T Bills have maturities of 4 weeks (28 days), 13 weeks ( 91 days) or 26 weeks (182 days). In Feb 2001, the 52 week T bills were discontinued.

The biggest participants in the T Bill market are commercial banks, money market, mutual funds, Federal Reserve and individuals (not as much nondepository or nonfinancial corporation).

Existing T-bills can be sold in the secondary market through government securities dealers, who profit by buying at a slightly lower price and selling at an higher price.

For list of Treasury Primary Dealers, see Exhibit 10-2 presented in chapter 10.

“Primary Dealers” are large banks and securities brokers and dealers that trade Treasury securities directly with the New York Fed and are the main participants in the Treasury auctions.

To become a primary dealer, the firm must apply to the New York Fed and must demonstrate that it meets certain criteria. Brokers and dealers must have at least $50 million in regulatory capital. Foreign owned firms that meet the criteria can also apply to become a primary dealer.

T Bills are sold each week and the volumes of sale are announced each Tuesday by the Treasury.

Bids must be submitted to the Federal Reserve by Monday at 1:00 p.m. Eastern time. Results are typically announced on Tuesdays at 1:30 p.m. and the securities are issued 3 days later on Thursday.

Example : Bid quote : 3.90% ; Ask quote: 3.89% for 90 day bill. Bid price (Price at which dealer buys) = 100 – [(100*.039)/4] = 99.025 = $9902.50Ask price (Price at which dealer sells) =

100 – [(100*.0389)/4] = 99.0275 = $9902.75Profit of $0.25 per ‘T’ bill and the annualized yield will be 3.986%(PV = -9902.75, FV = 10,000, n=0.25, CPT i = 3.986)

Treasury Bidding processTreasury Bidding process Bids are of two types : competitive and

noncompetitive bids. Competitive bids specify both the quantity

desired and the discount rate (not the price) offered. Lower discount means higher price.

After accounting for non-competitive bids, the Treasury accepts the highest competitive bids first and works it way down until it has generated the amount of funds from competitive bids that it needs (this method is known as Uniform-price Method).

The Treasury then applies the lowest accepted bid (also called as stop-out yield) to all competitive bids that are accepted and to all noncompetitive bids. Competitive bids are still submitted, because noncompetitive bids can be up to a maximum of $1 million.

Noncompetitive bids include only the number of bills desired. They are guaranteed to receive the amount of T bills requested at the market determined price and discount yield. Noncompetitive bids are limited to $1 Mn maximum

per bidder, therefore only small firms and individuals participate in this manner.

To avoid transaction costs, noncompetitive bids can be made by individuals directly to the Federal Reserve Bank or U.S. Treasury. Transactions through brokers or dealers could reduce the yield.

U.S. Treasury Bills – Auction MethodsMultiple-Price Method

Seller accepts bids prior to selling securitiesSales awarded beginning with highest bidderBuyers end up paying different prices for same securities based upon their respective bids

Treasury discontinued this method in November 1998Stop-Out Yield

Lowest accepted bid yield in securities auctionUniform Price Method continued since November

1998Seller accepts bids prior to selling securities

Sales awarded beginning with highest bidderBuyers pay same price for securities based on stop-out yield

CERTIFICATES of DEPOSIT (CDs) Debt instruments issued by commercial banks

with: Minimum denomination of $100,000, but $1 Mn is more

typical Maturities range from 1 week to 12 months, generally

though the maturity is 1 to 3 months. Fixed interest rate Return the principal at maturity

Debt instruments issued by commercial banks that may be: Negotiable (tradable) Non-negotiable (not tradable)

Most negotiable CDs are sold directly by a bank to an investor. However, brokers and dealers do assist with the sale of negotiable CDs and typically deal in round lots of $25 Mn.

Negotiable Certificates of Deposit (CDs) Interest rates on negotiable CDs tend to be higher

than T-bill rates: CD holders exposed to default risk - only a

portion of deposit ($100,000) is insured Unlike T-bills, earnings on CDs subject to

state/local income taxes Secondary market for CDs much thinner than

T-bills, making negotiable CDs less liquid than T-bills

Commercial paper Unsecured, short-term promissory

notes as alternative to short-term bank loans.

Primary benefit to largest & most creditworthy issuers is that cost of borrowing is lower than at a commercial bank.

Most commercial papers are backed by the line of credit. This would mean that, bank guarantees the payment and should the issuer default, the bank will pay on maturity. Reduces default risk

Commercial paper Financial companies and non-bank

financial companies like GM Acceptance Corporation, Ford Motor Credit, GE Credit etc. are responsible for issuing these papers.

78% of financial companies and 22% of non-financial companies issue this paper.

75% of the issues are sold through dealers and 25% of the issues are sold through direct placement.

Commercial paper Characteristics largely defined by

legislation and issuers’ attempt to avoid costly disclosure requirements mandated for other types of securities

Expensive requirements avoided if these are met: Paper issued must mature in less than 270

days Paper must be issued in large denomination

so that it is not typically purchased directly by public

Proceeds must be used to fund current transactions


Bankers’ Acceptances Instruments created in course of financing international

trade A banker’s acceptance is a bank draft (guarantee of

payment) issued by a firm and payable on some future date. For a fee, the bank on which the draft is drawn stamps it as “accepted”, thereby guaranteeing that the draft will be paid even in the event of default by the firm.

The exporter takes the draft, and presents it to its bank or some other investor. The exporter’s bank or the investor, most likely will pay the exporter immediately for a fee. The exporter’s bank or the investor can then, before the date, resell the draft at a discount in the secondary market or it can hold the instrument until maturity as an investment.

Importer Exporter

American Bank

(Importer’s Bank)

Japanese Bank

Exporter’s Bank

Investor or the same exporter’s bank.

(2)

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(1) Purchase Order

(5) Shipment of Goods

(3) Approved Letter of credit

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Shi

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(7) Shipping docs(9

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BANKERS

ACCEPTANCE

(8) Accepted B/A

Money Market InstrumentsMoney Market Instruments Federal (Fed) Funds

When institutions anticipate insufficient reserves, they often turn to Federal (fed) funds market.

Here they can borrow reserves from other institutions on an overnight basis.

Institutions with excess reserves can turn to the fed funds market to loan these reserves and earn interest.

Fed Funds Fed funds are lent on an overnight basis in

denominations of $5 million or more

Fed Funds Rate: Interest rate charged on overnight loans of

reserves among commercial banks. One bank charges another bank for overnight loans of reserves. The fed fund rate is influenced by the demand for funds in the federal funds market

Discount rate discount rate is not automatic it is set by

the Fed, which mostly depends on the economic conditions in the market.

Interest rate charged and set by the Fed to another depository institution borrowing loans to meet reserve requirement.

Federal Funds Depository institutions, when in short of required

reserve may borrow directly from the Fed (at the discount rate), through the “discount window” or from other depository institutions at the Fed Fund Rate.

Federal funds are overnight loans between depository institutions of their deposits (reserves) at the Fed.

The depository institution with excess reserves lends, at an interest, to the depository institution with less reserves.

Financial market participants watch the federal funds rate very closely to judge the tightness of credit in the financial system.

When the fed fund rate is high, it means reserves are in short supply (also unanticipated early withdrawals by the customer’s of the bank) and vice versa.

The Federal Reserve System can also affect the Fed Fund rate through its open market operation. The Federal Reserve will buy treasury security when

it wants to decrease fed fund rate. When the federal reserve buys treasury security,

money goes from Fed to the economy/bank as deposits. Deposits in banks increase. Bank’s balance of excess reserve will increase does causing the downward pressure on Fed Fund rate.

Excess reserve is reserve over and above the required reserve, available with bank to lend to other banks. If no bank are willing to borrow then this reserve will lie idle with bank earning no interest.

Vice versa when the Federal Reserve wants to increase the Fed Fund Rate, it will sell Treasury security.


Repurchase Agreements The same shortage of reserves that leads banks

to borrow funds in the federal funds market leads some banks to engage in repurchase agreements.

Short-term agreements in which seller Sells government security to buyer, and simultaneously Agrees to buy government security back on later date at

higher price

In effect, the seller has borrowed funds for a short term and the buyer has made a secured loan, where the government security is used as a collateral.

Repos are like collateralized loans, hence are charged lower interest rate than the Fed fund rate.

Reverse Repurchase Agreements or Matched Sale-Purchase (MSP) Agreement – looked from the lender’s perspective

Repurchase agreement viewed from perspective of of the lender or the initial buyer of the govt.security.

Reverse repos are short-term agreements in which: Buyer (dealer or the Fed) buys a government security from

seller

Agrees to sell it back on a later date at a higher price

When the Fed is involved in the repo, the term use is Matched Sale-Purchase Agreement.

Matched sale–purchase transactions are typically arranged in Treasury bills. The Federal Reserve selects a bill in which it has a substantial holding and invites dealers to state an interest rate at which they are willing to purchase the bills for same-day delivery and to sell them back for delivery on a subsequent day. It then accepts the most advantageous (lowest rate) bids to the point that sufficient reserves are withdrawn.

Repos can be sold by a dealer or direct placement.

Transaction amount on 1-15 days maturity is generally $25 Mn and above. Transaction amount on 1,3,6 months maturity is generally $10 Mn.

Short term repos can be renewed or arranged on a continuous basis.

No secondary market exist for repos.

days ofnumber

360

price purchace

price purchace - price selling rate RP

The rate of return or the coupon rate on the underlying collateralized security has no bearing on the repo rate. Repo rate is the rate the dealer will charge for buying the security.

360

days of number rate RP invested funds earnedInterest

Two differences between repo and fed fund market :

1. In the repo market, depository and non-depository institutions can participate. Pension funds, state and local governments, nonfinancial corporation, security dealers can participate. In the Fed fund market only depository institutions can participate.

2. In repo market, funds and collateralized securities are transferred simultaneously. In the fed fund market, only fund is transferred between institutions.

Money Market InstrumentsMoney Market InstrumentsEURODOLLARS Dollar-denominated deposits held in banks outside the

United States are called Eurodollars deposits. Example: An American holds a U.S. dollar denominated

deposit in a bank outside U.S. Dollar-denominated deposit liabilities exempt from U.S.

banking regulations Since 1981, non-U.S. residents can hold eurodollar deposits

within the borders of the U.S. at financial institutions called International Banking Facilities (IBFs). International Banking Facilities (IBFs)

Financial institutions in U.S. Cater to needs of foreign individuals, corporation,

and/or governments Allow non-U.S. residents to hold unregulated

Eurodollar deposits

Eurodollars are exempt from U.S. banking regulations.

The foreign branch of a U.S. bank receiving Eurodollar deposit avoids non-interest bearing reserve requirement

The advantages allow Eurodollar-accepting institutions to pay higher rates of interest to their depositors and charge lower rates of interest to their borrowers.

Typical denomination range from $250,000 to $10 Mn.

Eurodollar deposits were initially held as non-negotiable, fixed rate time deposits.

However, they are now negotiable, therefore, secondary market exists.

When interest rates in the domestic market increases, investors will invest in local market at higher rate and the demand for euro-dollar deposits will decline. When interest rates in the local market declines, borrowers will borrow in the local market and invest in euro-dollar market.

London Interbank Bid Rate (LIBID)Interest rate at which the London banks are willing to borrow Eurodollar.

London Interbank Offered Rate (LIBOR)Interest rate at which the London banks are willing to loan Eurodollars.

The Anatomy of Eurodollar Borrowing


MONEY MARKET MUTUAL FUNDS (MMMFs) Short-term investment pools use

proceeds they raise from selling shares to invest in various money market instruments.

Exhibit 3–2The Money Market

M1 = currency + checking deposits

M2 = M1 + savings deposits, money market deposit accounts, overnight repurchase agreements, eurodollars, and small time deposits. non- institutional money market mutual funds

M3 = M2 + institutional money market mutual funds, large time deposits, and repurchase agreements and eurodollars lasting more than one day.

Capital Market Instruments Capital Market Instruments

The capital market raises the funds needed by DSUs to carry out

their spending and investment plans.

The capital market raises the funds needed by DSUs to carry out

their spending and investment plans.

Exhibit 3–4The 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.

Exhibit 3–5The Capital Market


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


Mortgages Loans to purchase

Single-multiple family residential housingLandOther real structures

… land or structures serve as collateral for loan

Government has created two government-sponsored enterprises, Federal National Mortgage Association (Fannie Mae)Federal Home Loan Mortgage Corporation (Freddie Mac)

that sell bonds and use the proceeds to purchase mortgages.

A third government agency, Government National Mortgage Association (Ginnie Mae) insures the timely payment of principal and interest on mortgages.

Corporate Bonds Long-term bonds

Issued by corporationsMaturities range from 2 – 30 years

Interest is paid twice a year

U.S. Government Securities Long-term debt instruments

Maturities of 2 – 30 years (now Treasury issues only 10 year ‘T’ bonds)

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 Student loans

Some of these securities are guaranteed by the federal government, and some are not.


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. Proceeds from these projects will be used to pay back the interest and principal.

General obligation bonds - backed by full faith and credit of issuer. Taxes can be increased to pay the interest and principal on GBOs.

financial markets, instruments, and market makers chapter 3 © 2003 south-western/thomson learning

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