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Financial Instruments, Markets and Institutions. Summary of Classification of Financial Markets Classification by nature of claim. –Debt market; Equity.

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Presentation on theme: "Financial Instruments, Markets and Institutions. Summary of Classification of Financial Markets Classification by nature of claim. –Debt market; Equity."— Presentation transcript:

1 Financial Instruments, Markets and Institutions

2 Summary of Classification of Financial Markets Classification by nature of claim. –Debt market; Equity market Classification by maturity of claim. –Money market; Capital market Classification by seasoning of claim. –Primary market; Secondary market Classification by immediate delivery or future delivery –Cash or spot market; Derivative market Classification by organizational structure –Auction market; Over-the-counter market; Intermediated market

3 Financial Instruments and Markets Primary Markets –Market for issuing a new security and distributing to saver-lenders. –Investment BanksInformation and marketing specialists for newly issued securities. Secondary Markets –Market where existing securities can be exchanged New York Stock Exchange American Stock Exchange Over-the-counter (OTC) markets

4 Bonds Represent Borrowing Agreement by issuer to pay interest on specified dates and redeem the bond upon maturity. Consol –Bond with no maturity date, pay interest forever Coupon Securities –Make interest payments – usually semiannually. Zero-coupon –Make no interest payments. –Sold at price well below face value. Tax Exempt –Interest earned is not taxed.

5 Stock Represents Ownership Stockholders –Owns part of the corporation and receives dividends from the issuer. Capital Gains –Difference between price initially paid and amount received when stock is sold.

6 Types of Corporate Stock Preferred Stock –Fixed dividends, priority over common stock Common Stock –Variable dividends, based on companys profits. Convertible –Preferred stock that can be converted into common stock at a stated price

7 Measures of Trends in Common Stock Prices Standard & Poors 500 Stock Index –Based on prices of 500 individual stocks NASDAQ Composite Index –Based on all stocks listed in NASDAQ Dow Jones Industrial Average –Based on price of 30 blue-chip stocks

8 Both stocks and bonds represent a claim to a stream of payments in the future. –BondsInterest payment and face value at maturity –StocksDividends and sales price when sold

9 Mortgages Debt incurred in order to buy land or building Amortizedprincipal and interest is gradually repaid over the life of loan Fixed RateRate of interest is fixed Variable-RateRate of interest varies depending on financial environment Cash flow for lender is uncertain –Interest payments may vary - variable rate mortgages –Home owner may prepay –Refinance a fixed mortgage if interest rates decline

10 Mortgages SecuritizationIndividual mortgages may be pooled and sold as a unit to reduce uncertainty. Mortgages may be insured by government agencies –Federal Housing Authority (FHA) –Veterans Administration (VA)

11 Options and Futures Contracts Contractual agreement between two parties to exchange an asset in the future at a stated price Derivative financial instruments –Derive value from underlying assets Long –Buyer of the contract, receive commodity in the future Short –Seller of the contract, provide commodity in the future Speculators –Gamble on price fluctuations and hope to profit Hedgers –Eliminate the risk of price fluctuations

12 The Capital Market Exchange of long-term securitiesin excess of one year Generally used to secure long-term financing for capital investment –Stock marketLargest part of capital market and held by private and institutional investors –Corporate bond marketHeld by insurance companies, pension and retirement funds –Local and state government bondsPrimarily held for tax-exempt feature –Government securitiesHeld by commercial banks, the Fed, individual Americans/foreigners, and dealers

13 The Money Market Exchange of short-term instrumentsless than one year Highly liquid, minimal risk Use of a temporary surplus of funds by banks or businesses –U.S. Treasury billsshort-term debts of US government –Bank Certificates of Depositsliabilities of issuing bank, interest bearing to corporations that hold them –Commercial papershort-term liabilities of prime business firms and finance companies –Federal FundsExchange of excess/deficient reserves between banks on an overnight basis.

14 Role of Financial Intermediaries Act as agents in transferring funds from savers- lenders to borrowers-spenders. Acquire funds by issuing their liabilities to public and use money to purchase financial assets –Earn profits on difference between interest paid and earned –Diversify portfolios and minimize risk –Lower transaction costs –Competition lowers interest ratesbeneficial to economic growth

15 Economic Functions of Financial Markets Interactions of buyers and sellers determines price. –Price discovery process. Provides a mechanism to sell. –Liquidity. Reduces transactions costs. –Search costs. –Information costs.

16 Commercial Banks Most prominent financial institution Range in size from huge (BankAmerica) to small (local banks) Major sources of funds –used to be demand deposits of public –now rely more on other liabilities –also accept savings and time deposits Uses of funds –short-term government securities –long-term business loans –home mortgages

17 Life Insurance Companies Insure against death Receive funds in form of premiums Use of funds is based on mortality statisticspredict when funds will be needed Invest in long-term securitieshigh yield –Long-term corporate bonds –Long-term commercial mortgages

18 Pension and Retirement Funds Concerned with long run Receive funds from working individuals building nest-egg Accurate prediction of future use of funds Invest mainly in long-term corporate bonds and high-grade stock

19 Mutual Funds Stock or bond market related institutions Pool funds from many people Invest in wide variety of securities minimize risk

20 Money Market Mutual Funds Individuals purchase shares in the fund Fund invests in highly liquid short-term money market instruments –Large-size negotiable CDs –Treasury bills –High-grade commercial paper

21 Savings and Loan Associations (S&Ls) Traditionally acquired funds through savings deposits Used funds to make home mortgage loans Now perform same functions as commercial banks –issue checking accounts –make consumer and business loans

22 Commercial and Consumer Finance Companies Acquire funds primarily by selling short term loans (commercial paper) Lend money for consumer purchases or business firms to finance inventories

23 Property and Casualty Insurance Companies Insure homeowners and businesses against losses Receive premiums Need to be fairly liquid due to uncertainty of claims Purchase a variety of securities –high-grade stocks and bonds –short-term money market instruments for liquidity

24 Credit Unions Organized as cooperatives for people with common interest Members buy shares [deposits] and can borrow Changes in the law in 1980 broadened their powers –checking [share] accounts –make long-term mortgage loans

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