Financial Markets

People and organizations that need money are brought together with
those that have surplus funds in the financial markets.
Note that “markets” is plural; there are a great many different
financial markets, each one consisting of many institutions, in a
developed economy such as the US. Unlike physical (real) asset
markets, which are those for such products as wheat, autos, real
estate, computers, and machinery, financial asset markets deal
with stocks, bonds, mortgages, and other claims on real assets
with respect to the distribution of future cash flows.
In a general sense, the term financial market refers to a conceptual
“mechanism” rather than a physical location or a specific type of
organization or structure. We usually describe the financial markets as
being a system comprised of individuals and institutions, instruments,
and procedures that bring together borrowers and savers, no matter
the location. Different types of financial markets involve a variety of
investments and participants.

Importance of Financial Markets

The primary role of financial markets is to help bring together
borrowers and savers (lenders) by facilitating the flow of funds from
individuals and businesses that have surplus funds to individuals,
businesses, and governments that have needs for funds in excess of
their incomes.
In developed economies, financial markets help efficiently allocate
excess funds of savers to individuals and organizations in need of funds
for investment or consumption. The more efficient the process of funds
flow, the more productive the economy, both in terms of
manufacturing and financing.
By providing mechanisms by which borrowers and lenders get
together to transfer funds, the financial markets allow us to consume
amounts different than our current incomes.

Thus, financial markets provide us with the ability to transfer

income through time. When we borrow, for example, we sacrifice
future income to increase current income; when we save, or invest,
we sacrifice current income in exchange for greater expected income
in the future.

As adults, we go through three general phases that would not be

possible without financial markets:
1. Young adults desire to consume more than their incomes, so they
must borrow.
2. Older working adults earn more than their consumption needs, so
they save.
3. Retired adults use the funds accumulated in earlier years to at
least partially replace income lost due to retirement.

Without financial markets, consumption would be restricted to

income earned each year plus any amounts put aside (perhaps in a
coffee can) in previous years. As a result, our standard of living
would be much lower than is possible with financial markets.

TYPES OF FINANCIAL MARKETS

There are many different types of financial markets; we describe the
more common market classifications.

1. Debt versus equity markets. Debt markets are the markets where loans
are traded, whereas equity markets are the markets where stocks of
corporations are traded. A debt instrument is a contract that specifies the
amounts and schedule of when a borrower must repay funds.
2. Money versus capital markets. Money markets are the markets for
debt securities with maturities of one year or less, whereas capital
markets are the markets for intermediate and long-term debt and
corporate stocks. The primary function of the money markets is to
provide liquidity to businesses, governments, and individuals to meet
short-term needs for cash.

The debt market can be divided into more detailed, smaller markets. For
example, mortgage markets deal with loans on residential, commercial,
and industrial real estate and on farmland, whereas consumer credit
markets involve loans on autos, appliances, education, vacations, and so
forth.

3. Primary versus secondary markets. Primary markets are markets

in which corporations (and governments) raise new funds (capital,). The
corporation selling the newly created stock receives the proceeds from
the sale in a primary market transaction.

Secondary markets are markets in which existing, previously issued

(already outstanding) securities are traded among investors. Thus, if
Secondary markets also exist for mortgages, various other types of
loans, and other financial assets, the corporation (or government) whose
securities are traded is not involved in a secondary market transaction
and thus does not receive any funds from such a sale.

Whenever stock in a privately held corporation is offered to the public

for the first time, the company is said to be “going public.” The market
for corporations that go public is called the initial public offering (IPO)
market.
4. Public versus private markets. In private market transactions,
stocks, bonds, or other types of debt are traded among sophisticated
investors who generally are familiar with each other. As a result, the
deals can be structured to fit both parties’ (buyer and seller) needs. On
the other hand, transactions in the public markets are standardized
because securities traded in the public markets are traded among large
numbers of investors who do not know each other and cannot devote (or
afford) the time, effort, and cost necessary to ensure the validity of
specialized, or non-standardized, transactions such as those that occur in
the private markets. Having standardized trades increases the liquidity
and reduces the costs associated with transactions.

5. Spot versus futures markets. In spot markets the assets traded are
bought or sold for “on the spot” delivery (immediately or within a few
days), whereas futures markets are markets for delivery of assets at some
later date.

6. World, national, regional, and local markets. Depending on an

organization’s size and scope of operations, it might be able to borrow
all around the world, or it might be confined to a strictly local, even
neighborhood, market. For this reason, some stocks and bonds are sold
worldwide in markets such as the New York Stock Exchange, whereas
others are sold in markets that are regional, such as the Chicago Stock
Exchange.
Here are the major classes of financial intermediaries:
1. Commercial banks, which are the traditional “department stores of
finance,” serve a wide variety of customers. Historically, commercial
banks were the major institutions that handled checking accounts and
through which the Federal Reserve System expanded or contracted the
money supply. Banks also perform investment banking and related
activities; insurance sales and underwriting.
2. Savings and loan associations (S&Ls), which have traditionally
served individual savers and residential and commercial mortgage
borrowers, take the funds of many small savers and lend this money to
home buyers and other types of borrowers. Because the savers obtain a
degree of liquidity that would be absent if they bought the mortgages or
other securities directly, perhaps the most significant economic function
of S&Ls is to “create liquidity” that otherwise would be lacking. Savers
benefit by being able to invest their savings in more liquid, better
managed, and less risky accounts (investments), whereas borrowers bene
fit from the economies of scale that allow them to obtain more capital at
lower costs than would otherwise be possible.
3. Credit unions are cooperative associations whose members have a
common bond, such as being employees of the same occupation or firm.
Members savings are loaned only to other members, generally for auto
purchases, home improvements, and mortgages. Credit unions often are
the cheapest source of funds available to individual borrowers.
4. Pension funds are retirement plans funded by corporations or
government agencies for their workers and administered primarily by the
trust departments of commercial banks or by life insurance companies.
Pension funds invest primarily in long-term financial instruments, such
as bonds, stocks, mortgages, and real estate.
5. Life insurance companies take savings in the form of annual
premiums, then invest these funds in stocks, bonds, real estate, and
mortgages, and ultimately make payments to the beneficiaries of the
insured parties. Most life insurance companies also offer a variety of
tax-deferred savings plans designed to provide benefits to participants
when they retire.
6. Mutual funds are investment companies that accept money from
savers and use these funds to buy various types of financial assets such
as stocks, long-term bonds, and short-term debt instruments. These
organizations pool funds and thus reduce risks through diversification.
Different funds are designed to meet the objectives of different types of
savers. For example, income funds are for those who prefer current
income, growth funds are for savers who are willing to accept significant
risks in the hopes of higher returns, and still other funds are used as
interest-bearing checking accounts (money market funds).

MONEY MARKET FUND

A mutual fund that invests in short-term, low-risk securities and allows
investors to write checks against their accounts.

Physical Stock Exchanges

Physical security exchanges are tangible, “material” entities. Each of the
larger exchanges occupies its own building, has specifically designated
members, and has an elected governing body—its board of governors.
Members are said to have “seats” on the exchange, although everybody
stands up. These seats, which are bought and sold, give the holder the
right to trade on the exchange.

Organized Investment Networks—The Over-the- Counter (OTC)

Market
If a security is not traded on a physical stock exchange, it has been
customary to say it is traded in the over-the-counter market, which is an
intangible trading system that consists of a network of brokers and
dealers around the country. An explanation of the term over-the-
counter will help clarify how the market got its name. As noted earlier,
the physical stock exchanges operate as auction markets, where buy and
sell orders come in more or less simultaneously and exchange members
match these orders. If a stock is traded less frequently, perhaps
because it is the stock of a new or a small firm, few buy and sell orders
come in, and matching them within a reasonable length of time would be
difficult. To avoid this problem, some brokerage firms maintain
inventories of such stocks. These firms buy when individual investors
want to sell and sell when investors want to buy. At one time the
inventory of securities was kept in a safe, and the stocks, when bought
and sold, literally were passed over the counter.

Brokers and dealers who make up the over-the-counter market are

members of a self-regulating body known as the National Association of
Security Dealers (NASD), which licenses brokers and oversees trading
practices. The computerized trading network used by NASD is known as
the NASD Automated Quotation System (Nasdaq).

As information technology has evolved, so have the choices to investors

as to how to trade securities. Today most stocks and bonds can be
traded electronically using trading systems known as electronic
communications networks (ECN). ECNs are electronic systems that
transfer information about securities transactions to facilitate the
execution of the orders. ECNs automatically match the buy and sell
orders by price for a large number of investors.

THE COST OF MO
NEY DEPENDS ON:
1. PRODUCTION OPORTUNITIES
The returns available within an economy from investment in productive
(cash-generating) assets. (This will determine the demand for money).

2. TIME PREFERENCES FOR CONSUMPTION

The preferences of consumers for current consumption as opposed to
saving for future consumption. (This will determine the supply of money)

3. RISK
In a financial market context, the chance that a financial asset will not
earn the return promised.
4. INFLATION
The tendency of prices to increase over time.

INTEREST RATE LEVELS

Figure 2—2 (below) shows how supply and demand interact to
determine interest rates in two financial markets.

Market A- lower risk interest rate 8%

Market B- higher risk interest rate 10%

If the demand for funds declines, as it typically does during business

recessions, the demand curves in Figure 2—2 will shift to the left (and
will lower interest rates), as shown with line D2 in Market A.
In general, we can say that the cost of using money provided by
investors is based on the supply of, and the demand for, the available
funds, regardless of whether those funds are in the form of debt or
equity (stock).
 Visualize what would happen if the supply of funds tightens: The
supply curve, S1, would shift to the left, and this would raise interest
rates and lower the level of (demand for) borrowing.

FINANCIAL MARKETS ARE INTERDEPENDENT.

After the shift to D2, the risk premium would initially increase to 4
percent—the existing 10 percent return in Market B less the new
equilibrium return of 6 percent in Market A. In all likelihood, this much
higher risk premium would induce some of the lenders in Market A
to shift to Market B, which in turn would cause the supply curve in
Market A to shift to the left (or up) and the supply curve in Market
B to shift to the right. The transfer of capital between markets would
raise the interest rate in Market A and lower it in Market B, thereby
bringing the risk premium back closer to the original level of 2 percent.
Risk Free Rate (KRF) = Real Risk Free Rate (k*) + Inflation Premium (IP)
Quoted rate (k) = k* + IP + DRP +LP + MRP
kRF = k* + IP = Nominal risk free rate

Here k* stands for real risk free rate if inflation is expected to be zero.

IP stands for inflation premium

DEFAULT RISK PREMIUM (DRP)

The difference between the interest rate on a Government Treasury bond and a
corporate bond of equal maturity and marketability.

LIQUIDITY PREMIUM (LP)

A premium added to the rate on a security if the security cannot be
converted to cash on short notice and at close to the original cost.

INTEREST RATE RISK

The risk of capital losses to which investors are exposed because of
changing interest rates.
MATURITY RISK PREMIUM (MRP)
A premium that reflects interest rate risk; bonds with longer maturities have
greater interest rate risk.
REINVESTMENT RATE RISK
The risk that a decline in interest rates will lead to lower income when bonds
mature and funds are reinvested.

Treasury bills/bonds generally have almost no DRP and LP.

Governments are not expected to default as they have the ability
to raise additional re
quired funds by increasing taxes and printing currency notes.
Also, generally, Treasury bills/bonds are actively traded in the
secondary markets so can be easily converted into cash. Hence
carry almost no Liquidity Premium (LP). However interest rates
on Treasury bills/bonds will have an element of Maturity
Risk Premium (MRP).
ie for Treasury bills/bonds Quoted rate (k) = k* + IP + MRP

TERM STRUCTURE OF INTEREST RATES

The relationship between long- and short-term rates, which is known

as the term structure of interest rates, is important to corporate
treasurers, who must decide whether to borrow by issuing long- or
short-term debt, and to investors, who must decide whether to buy
long- or short-term bonds. Thus, it is important to understand (1) how
long- and short-term rates are related to each other and (2) what causes
shifts in their relative positions.
Using various sources of information, we can construct the term
structure of interest rates for a particular date.
WHAT ARE YIELD CURVES?
It is graph showing the relationship between yields and maturities of securities.
SEE YIELD CURVES FOR PARTICULAR DATES ON NEXT PAGE

Why Do Yield Curves Differ?

Remember k = k* + IP + Risk premium
- In this equation the factor that is likely to change most is IP.
- k*(real risk free rate) is relatively stable from period to period.
- Changes in investors’ attitudes towards risk are slow as they evolve
over time.
-inflation expectations represent an important factor in determining
the current interest rates, and thus the shape of the yield curve.

“Normal” Yield Curve

An upward sloping yield curve.

Inverted (“Abnormal”) Yield Curve

A downward sloping yield curve.

LIQUIDITY PREFERENCE THEORY

The theory that, all else equal, lenders (investors) prefer to make
short-term loans rather than long-term loans; hence, they will lend
short-term funds at lower rates than long-term funds.

REASON: Short-term securities are less sensitive to changes in

interest rates and provide greater investment flexibility than longer-
term securities. Investors will, therefore, generally accept lower
yields on short-term securities, and this leads to relatively low short-
term rates.

Borrowers, on the other hand, generally prefer long-term debt.

REASON: Short-term debt exposes them to the risk of having to
refinance the debt under adverse conditions. Accordingly,
borrowers want to “lock into” long-term funds, which means
they are willing to pay a higher rate, other things held constant,
for long-term funds than for short-term funds, which also leads to
relatively low short term rates.

Note: The reinvestment rate risk is lower on a long-term bond than on a

short-term bond because only the interest payments (rather than interest
plus principal) on the long-term bond are exposed to reinvestment rate
risk.
OTHER FACTORS THAT INFLUENCE INTEREST RATE LEVELS
Factors other than those discussed in the previous sections also influence
both the general level of interest rates and the shape of the yield curve.
The four most important factors are:

(1) Central Bank’s policy,

(2) the level of the federal budget deficit,

(3) the foreign trade balance, and

(4) the level of business activity

Interest Rate Levels and Stock Prices
Interest rates have two effects on corporate profits. First, because
interest is a cost, the higher the rate of interest, the lower a firm’s
profits, other things held constant. Second, interest rates affect the
level of economic activity, and economic activity affects corporate
profits. Interest rates obviously affect stock prices because of their
effects on profits, but, perhaps even more important, they have an
effect due to competition in the market place between stocks and
bonds. If interest rates rise sharply, investors can get higher returns
in the bond market, which induces them to sell stocks and to transfer
funds from the stock market to the bond market. A
massive sale of stocks in response to rising interest rates obviously
would depress stock prices.