Financial Markets

Facilitate transactions between borrowers and lenders

Lenders -- earn return on fundsBorrowers -- permits increased

flexibility for expenditure

Motivations for Borrowing

Consumers -- allows for non-synchronous patterns of desired consumption and income

Business -- financing short-term needs (e.g. inventories) and long-term investment projects

Government (Federal as well as State and Local)-- financing existing debt and new deficits

Types of “Borrowing”

Debt -- A contract to pay specified amounts over a predetermined time interval (e.g. bonds, bank loans)

Equity -- Purchases of shares of ownership (e.g. stock)

Direct Vs Indirect Finance

Direct Finance -- Borrower borrows directly from lender. Examples -- Personal transactions, Bonds

Indirect Finance -- Lender loans to Financial Intermediary, who then loans to borrowers. Examples -- Banks, Mutual Funds

Exchanges Versus “Over the Counter” Markets Exchange -- Buyers and sellers

meet in one central locationOver the Counter -- Trades made

from home or office, via computers.

Primary Versus Secondary Markets

Primary Markets -- Markets for new issues.

Secondary Markets -- Markets for issues sold before maturity

Money Vs Capital Markets

Money Market -- Market for bonds with maturity one year or less high denominations excellent secondary markets

Capital Market -- Market for long-term bonds and equity lower denominations lower volume -- relatively narrow secondary

markets

Interest: Compensation for Inconvenience

Inconvenience Interest RateSources of Inconvenience

Liquidity -- ability to convert instrument into a medium of exchange

Default Risk -- likelihood that borrower will not meet promised payments

Applications to Money Supply ComponentsSavings Deposits versus Time

Deposits Relative liquidity

Money Market Deposit Accounts (MMDA) versus Money Market Mutual Funds (MMMF) MMDA -- deposit insurance MMMF -- none, more default risk

Money Market Instruments

Group #1 -- Short-Term Bonds

Buyers (Lenders): Looking for a return, willing to tolerate various degrees of inconvenience.

Sellers (Borrowers): Issued by different entities for different reasons.

(1) Treasury Bills

Issued by the Federal Government, to finance national debt and new deficits

3 month, 6 month, and 1 year maturities

Zero default riskBest secondary market within group

Used by the Federal Reserve to perform Open Market Operations

Generally lowest interest rate of group

(2) Negotiable Certificates of Deposit (CDs)

Denominations: $100,000+Issued by banks to raise money for

loans.Represents cost of funds for banks --

changes in iCD induce changes in bank loan rates.

Low Default Risk -- deposit insuranceGood secondary market

(3) Commercial Paper (CP)

Issued by firms to finance short-term debt (e.g. inventories)

Flexible maturities.Rated according to default risk of

issuing company.Good secondary market.

(4) Bankers Acceptances

Issued by banks to carry out international transactions.

Characteristics similar to Negotiable CDs.

Overall -- Group #1

Close -- but not perfect -- substitutes

Interest rates --different due to “non-price differences” Liquidity (secondary market) Default Risk

Group #2 -- Banks Seeking Very Short-Term Funds

Eurodollars -- dollar denominated deposits in foreign banks (banks can borrow from these),

Repurchase Agreements (RP) -- banks selling one of their bonds to a deposit holding customer, with the promise to buy it back at a specific date and price.

Another Option

Federal Funds (FF) -- one bank borrowing from another bank, usually overnight. Key rate in monetary policy, Federal

Reserve “targets” iFF Cost of obtaining bank reserves “in the

market” Major increase in volume over the

years

Still Another OptionDiscount Window -- banks borrowing from the

Federal Reserve, paying the discount rate. only non-market determined rate, preset by

Federal Reserve small usage as borrowing source for short-

term reserve adjustment, due to expensiveness and attraction of alternatives

Typically, iDISC = 0.5% + Target iFF

Capital Market Instruments

Stocks -- equity, returns compete with bonds

Group #1 -- Long-Term Bonds

(1) Treasury Bonds

Issued by the Federal Government to finance debt

Zero default riskBest secondary market of bonds within

groupFinancial analysts track rates of

various maturities on a given date, a plot of which is called the “yield curve”

(2) US Government Agency Securities

Issued by the US government agencies to finance their operations (e.g. EPA)

Characteristics very similar to T-Bonds

(3) Corporate Bonds

Issued by corporations to finance investment projects

Rated according to default risk AAA -- least risky AA -- next grade A -- next grade BAA -- more risky Junk Bonds -- bonds rated below B

Corporate Bonds, continued

Narrow secondary marketTypical maturity -- 20 yearsDifference between BAA rate and AAA

rate called risk premium, economic interpretation: difference in

compensation required to take on increased default risk

tends to increase during economic slowdowns and recessions

(4) Municipal Bonds

Issued by State and Local Governments to finance projects in capital budget.

Positive default risk Narrow secondary marketTends to have lowest interest rate

within this groupInterest is exempt from taxes

The After-Tax Interest Rate

After-tax rate = (i)(1 - ), where is the marginal tax rate.

For Municipal Bonds, after-tax rate = pre-tax rate (since = 0)

Example: iCORP = 8.00%, = 0.28, After-tax rate = 8.00(1 - 0.28) = 5.76%

Compare with Municipal Bond rate.

Group #2 -- Bank Loans

“Issued” by various borrowers, “held” by banks.

Secured versus unsecured loans Secured Loans -- Has collateral (e.g.

consumer and commercial mortgages)

Unsecured Loans -- No collateral (e.g. credit cards)

(1) Mortgages

Loans to individuals or business to purchases housing, land, or building structure

Some default risk (e.g. sub-prime mortgages), but risky in other ways as well

Availability highly valued in American culture (tax system)

Secondary Markets -- Consumer Mortgages

Government National Mortgage Association (GNMA)

Federal National Mortgage Association (FNMA)

Federal Home Loan Mortgage Corporation (FHLMC)

Securitized Mortgages – bundling mortgages into a bond, then selling in the capital market

(2) Other Types of Bank Loans

Commercial Loans: Prime Rate -- interest rate given to firms with the lowest perceived default risk

Consumer Loans (e.g. auto loans)Credit Card Balances -- unsecured

high default riskShorter-term relative to mortgages,

tends to have no secondary market.

(3) US Savings Bonds

Issued by Federal Government to finance debt.

Low denominations, available to the small saver.

Zero default risk.Zero Coupon bond, double purchase price

payment at maturityTax advantages, particularly for use in

funding college education

What Makes Interest Rates Different?

Secondary Market MaturityDefault RiskTaxabilityAbove characteristics constitute

structural differences that bring about various degrees of inconvenience.