3Chapter Outline: Financial markets Types of financial institutions Determinants of interest rates
4What is a Financial market? A market is a venue where goods and services are exchanged.A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.
5Flow of Funds:Funds flow indirectly from ultimate lenders [households] through financial intermediaries [banks or insurance companies] or directly through financial markets [stock exchange/bond markets] to ultimate borrowers [business firms, government, or other households].In order for financial system to function smoothly, must be adequate information about the markets and their operation.
6Flow of Funds:Financial system provides a transmission mechanism between saver-lenders and borrower-spenders.Savers benefit—earn interestInvestors benefit—access to money otherwise not availableEconomy benefits—efficient means of bringing savers and borrowers together
8The Financial Markets: Physical VS. Financial asset marketsSpot VS. future marketsMoney VS. capital marketsPrimary VS. secondary marketsPublic VS. private markets2
9The Financial Markets: Physical Asset Markets:It is a market for such products as wheat, autos, real estate, and machinery.Financial Asset Markets:It deals with stocks, bonds, notes, mortgages, and derivatives.
10The Financial Markets: Spot Markets:It is a market in which assets are bought and sold for on the spot delivery.Futures Markets:It is a market in which participants agree today to buy or sell an asset at some future date.
11The Financial Markets: The Money Market:Exchange of short-term instruments—less than one yearHighly liquid, minimal riskCommercial paper—short-term liabilities of prime business firms and finance companiesBank Certificates of Deposits—liabilities of issuing bank, interest bearing to corporations that hold themU.S. Treasury bills—short-term debts of US government
12The Financial Markets: The Capital Market:Exchange of long-term securities—in excess of one yearGenerally used to secure long-term financing for capital investment.Stock market—Largest part of capital market and held by private and institutional investorsResidential and commercial mortgages—Held by commercial banks and life insurance companiesCorporate bond market—Held by insurance companies, pension and retirement funds
13The Financial Markets: Primary Markets:Market for issuing a new security and distributing to saver-lenders.Initial Public Offering Market (IPO).Investment Banks—Information and marketing specialists for newly issued securities.
14The Financial Markets: Secondary Markets:Market where existing securities can be exchangedNew York Stock ExchangeAmerican Stock ExchangeOver-the-counter (OTC) markets (NASDAQ).
15Financial Institutions: Funds are transferred between those who have funds and those who need funds by three processes:Direct transfers,Investment banking houses, orFinancial intermediaries.
17Role 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 assetsEarn profits on difference between interest paid and earnedDiversify portfolios and minimize riskLower transaction costs
18Commercial Banks: Most prominent Range in size from huge to small Major source of funds used to be demand deposits of public, but now rely more on “other liabilities”Also accept savings and time deposits—interest earning
19Savings and Loan Associations [S&L’s]: Traditionally acquired funds through savings depositsUsed funds to make home mortgage loansNow perform same functions as commercial banksissue checking accountsmake consumer and business loans
20Credit Unions:Organized as cooperatives for people with common interestMembers buy shares [deposits] and can borrowChanges in the law in early 1980’s broadened their powerschecking [share] accountsmake long-term mortgage loans
21Pension and Retirement Funds: Concerned with long runReceive funds from working individuals building “nest-egg”Accurate prediction of future use of fundsInvest mainly in long-term corporate bonds and high-grade stockInvest in wide variety of securities—minimize risk
22Life Insurance Companies: Insure against deathReceive funds in form of premiumsUse of funds is based on mortality statistics—predict when funds will be neededInvest in long-term securities—high yieldLong-term corporate bondsLong-term commercial mortgages
23Mutual Funds: Stock or bond market related institutions Pool funds from many peopleInvest in wide variety of securities—minimize risk
24Physical location stock exchanges vs. Electronic dealer-based markets Auction market vs. Dealer market (Exchanges vs. OTC)NYSE vs. Nasdaq
25The Stock Market: Organized Security Exchanges: NYSE, AMEX, and regionalActual physical locationsOver-the-Counter Markets:Network of brokers and dealersAuction marketOrganized Investment NetworkElectronic Communications Networks4
26The Cost of Money: Four factors that affect the cost of money: Production opportunitiesTime preferences for consumptionRiskExpected inflation5
27The Cost of Money:What do we call the price, or cost, of debt capital?The Interest RateWhat do we call the price, or cost, of equity capital?Return on Equity =Dividends +Capital Gains6
28“Real” versus “Nominal” Rates: = real risk-free rate.T-Bond rate if no inflation;2% to 4%.k*= any nominal rate.k= Rate on T-securities—risk-free.kRF7
29The Determinants of Market Interest Rates: Quoted Interest Rate = k = k* + IP + DRP + LP + MRPk = Quoted or nominal ratek* = Real risk-free rate (“k-star”)IP = Inflation premiumDRP = Default risk premiumLP = Liquidity premiumMRP = Maturity risk premium8
31Other Factors that Influence Interest Rate Levels: Federal Reserve PolicyControls money supplyFederal DeficitsLarger federal deficits mean higher interest ratesForeign Trade BalanceLarger trade deficits mean higher interest ratesBusiness Activity
32Interest Rate Levels and Stock Prices: The higher the rate of interest, the lower a firm’s profitsInterest rates affect the level of economic activity, and economic activity affects corporate profits
33Risks associated with investing overseas: Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates.Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.