Financial Markets and Interest Rates Financial Management

Outline Meaning of Financial Markets Significance of Financial Markets Types of Financial Markets Money versus Capital Markets Spot versus Futures Market Primary versus Secondary Markets Interest Rate Determination

Meaning of Financial Markets A place where borrowers and lenders are brought in contact A place where people and organizations in need of money are brought in contact with those that have excess funds and are willing to lend

Significance of Financial Markets Help in collecting the savings of the economy and Make them available for investment Helps in capital formation Helps in resource allocation in the economy Helps in growth of the economy by transferring funds from the household sector to investment sector

Funds are transferred in three ways: Direct transfer Indirect transfer through investment banks Indirect transfer through financial intermediaries

Types of Financial Markets Money Markets versus Capital Markets Money market is for short-term funds up to one year Treasury bills Commercial paper Banker’s acceptances Capital market is for long-term funds beyond one year Corporate Bonds Treasury Bonds Treasury Notes Stocks

Spot versus Futures Market Spot market deals with cash transactions or transactions that will be settled within two business days Futures market deals with transactions that will be settled beyond two business days

Primary versus Secondary Markets Primary Markets A market for issuing of new securities A market where securities are being issued for the first time by new or existing companies Contributes directly towards capital formation Secondary Market A market that deals with buying and selling of existing securities Contributed to capital formation indirectly

Secondary Markets Auction Markets: Stock Exchanges Have a physical location Have governing bodies Trading takes place on the trading floor known as trading pits Only members are allowed to enter trading floor Deal in listed securities only

Negotiated Markets: Over-the-Counter Market (OTC) A network of dealers and brokers connected through Telephones Computers networks all over the world Deals in unlisted securities

Interest Rates Represent cost of money Helps in allocation of capital Nominal interest rate is composed of real risk free rate of interest plus inflation premium and liquidity risk premium

K = K* + IRP + DRP + MP + LP K = nominal interest rate K* = real risk free interest rate IRP = inflation risk premium DRP = default risk premium MP = maturity premium LP = liquidity premium

Factors Impacting Level of Interest Rates Federal Reserve Policy Federal Deficits Business Activity Interest rates and stock markets Shapes of Yield Curve: Upward sloping inverse/downward sloping flat shaped hump shaped