Financial Markets zFacilitate transactions between borrowers and lenders zLenders -- earn return on funds zBorrowers -- permits increased flexibility for expenditure

Motivations for Borrowing zConsumers -- allows for non- synchronous patterns of desired consumption and income zBusiness -- financing short-term needs (e.g. inventories) and long-term investment projects zGovernment (Federal as well as State and Local)-- financing existing debt and new deficits

Types of Borrowing zDebt -- A contract to pay specified amounts over a predetermined time interval (e.g. bonds, bank loans) zEquity -- Purchases of shares of ownership (e.g. stock)

Direct Vs Indirect Finance zDirect Finance -- Borrower borrows directly from lender. yExamples -- Personal transactions, Bonds zIndirect Finance -- Lender loans to Financial Intermediary, who then loans to borrowers. yExamples -- Mutual Funds, Banks

Exchanges Versus Over the Counter Markets zExchange -- Buyers and sellers meet in one central location zOver the Counter -- Trades made from home or office, via computers.

Primary Versus Secondary Markets zPrimary Markets -- Markets for new issues. zSecondary Markets -- Markets for issues sold before maturity

Money Vs Capital Markets zMoney Market -- Market for bonds with maturity one year or less yhigh denominations yexcellent secondary markets zCapital Market -- Market for long- term bonds and equity ylower denominations ylower volume -- relatively narrow secondary markets

Interest: Compensation to Lender for Inconvenience zInconvenience Interest Rate zSources of Inconvenience yLiquidity -- ability to convert instrument into a medium of exchange yDefault (Credit) Risk -- likelihood that borrower will not meet promised payments

Applications to Money Supply Components zPassbook Savings Deposits versus Small Time Deposits yRelative liquidity zMoney Market Deposit Accounts (MMDA) versus Money Market Mutual Funds (MMMF) yMMDA -- deposit insurance yMMMF -- none, more default risk

Money Market Instruments

Group #1 -- Short-Term Bonds zBuyers (Lenders): Looking for interest (or, more broadly, return), willing to tolerate various degrees of inconvenience. zSellers (Borrowers): Issued by different entities for different reasons.

(1) Treasury Bills zIssued by the Federal Government, to finance national debt and new deficits z3 month, 6 month, and 1 year maturities zGenerally viewed as having zero default risk zBest secondary market within group

zCommonly Used by the Federal Reserve to perform Open Market Operations zGenerally lowest interest rate of group

(2) Negotiable Certificates of Deposit (CDs) zDenominations: $100,000 and above (Large Time Deposits) zIssued by banks to raise money for loans. zRepresents cost of funds for banks -- changes in i CD induce changes in bank loan rates. zLow Default Risk -- deposit insurance zGood secondary market

(3) Commercial Paper (CP) zIssued by firms to finance short- term debt (e.g. inventories) zFlexible maturities. zRated according to default risk of issuing company. zGood secondary market.

(4) Bankers Acceptances zIssued by banks to carry out international transactions. zCharacteristics similar to Negotiable CDs.

Overall -- Group #1 zClose -- but not perfect -- substitutes zInterest rates --different due to non-price differences yLiquidity (secondary market) yDefault Risk

Group #2 -- Banks Seeking Very Short-Term Funds zEurodollars -- dollar denominated deposits in foreign banks (banks can borrow from these), zRepurchase 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 zFederal Funds (FF) -- one bank borrowing from another bank, usually overnight. yKey rate in monetary policy, Federal Reserve targets i FF yCost of obtaining bank reserves in the market yMajor increase in volume over the years

Still Another Option zDiscount Window -- banks borrowing from the Federal Reserve, paying the discount rate. yonly non-market determined rate, preset by Federal Reserve ysmall usage as borrowing source for short-term reserve adjustment, due to expensiveness and attraction of alternatives yTypically, i DISC = 0.5% + Target i FF

Capital Market Instruments zStocks -- equity, returns compete with bonds

Group #1 -- Long-Term Bonds

(1) Treasury Bonds zIssued by the Federal Government to finance debt zGenerally viewed as having zero default risk zBest secondary market of bonds within group zFinancial analysts track rates of various maturities on a given date, a plot of which is called the yield curve

(2) US Government Agency Securities zIssued by the US government agencies to finance their operations (e.g. EPA) zCharacteristics very similar to Treasury Bonds

(3) Corporate Bonds zIssued by corporations to finance investment projects zRated according to default risk yAAA -- least risky yAA -- next grade yA -- next grade yBAA -- more risky yJunk Bonds -- bonds rated below B

Corporate Bonds, continued zNarrow secondary market zTypical maturity years zDifference between BAA rate and AAA rate called risk premium, y economic interpretation: difference in compensation required to take on increased default risk ytends to increase during economic slowdowns and recessions

(4) Municipal Bonds zIssued by State and Local Governments to finance projects in capital budget. zPositive default risk zNarrow secondary market zTends to have lowest interest rate within this group zInterest is exempt from taxes (Federal taxes and within the state where theyre issued)

The After-Tax Interest Rate zAfter-tax rate = (i)(1 - ), where is the marginal tax rate. zFor Municipal Bonds, after-tax rate = pre-tax rate (since = 0) zExample: i CORP = 8.00%, = 0.28, After-tax rate = 8.00( ) = 5.76% zCompare with Municipal Bond rate.

Group #2 -- Bank Loans zIssued by various borrowers, held by banks. zSecured versus unsecured loans ySecured Loans -- Has collateral (e.g. consumer and commercial mortgages) yUnsecured Loans -- No collateral (e.g. credit cards)

(1) Mortgages zLoans to individuals or business to purchases housing, land, or building structure zSome default risk (e.g. sub-prime mortgages with falling house prices), but risky in other ways as well zAvailability highly valued in American culture (tax system)

Secondary Markets -- Consumer Mortgages zGovernment National Mortgage Association (GNMA) zFederal National Mortgage Association (FNMA) zFederal Home Loan Mortgage Corporation (FHLMC) zSecuritized Mortgages – bundling mortgages into a bond, then selling in the capital market

(2) Other Types of Bank Loans zCommercial Loans: Prime Rate -- interest rate given to firms with the lowest perceived default risk zConsumer Loans (e.g. auto loans) zCredit Card Balances -- unsecured high default risk zTend to be shorter-term relative to consumer mortgages.

(3) US Savings Bonds zIssued by Federal Government to finance debt. zLow denominations, available to the small saver. zGenerally viewed as having zero default risk. zInterest assigned each year, tax-deferred until savings bond is redeemed. zTax advantages, particularly for use in funding college education

What Makes Interest Rates Different? zSecondary Market zMaturity zDefault Risk zTaxability zAbove characteristics constitute structural differences that bring about various degrees of inconvenience.