1 Chapter 06 Understanding Financial Markets and Institutions McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Markets Overview of markets and Payroll taxes Manage flow of funds – Two major market dimensions Primary versus secondary markets Money versus capital markets 6-2

Primary Markets Used by corporations and governments Used to issue new financial instruments –Stocks –Bonds 6-3

Primary Market Transfer of Funds 6-4

Secondary Markets Benefit investors and issuers –Securities traded after issue –Provide liquidity and diversification benefits for investors –Security valuation information for issuers 6-5

Secondary Market Transfer of Funds 6-6

Money Markets vs. Capital Markets Money markets trade debt securities or instruments with maturities of one year or less Capital markets trade stocks and long- term debt with maturities greater than one year 6-7

Money Market vs. Capital Market Maturities 6-8

Other Markets Foreign Exchange Markets –Trade currency for immediate delivery (spot) or for some future delivery –Subject to foreign exchange risk due to currency fluctuations 6-9

Other Markets Derivatives –Highly leveraged financial securities linked to underlying security –Potentially high-risk –Used for hedging and speculating 6-10

Financial Institutions Banks Thrifts Insurance companies Mutual funds 6-11

Financial Institutions Perform economic functions ‒ Monitor costs ‒ Provide liquidity ‒ Price risk 6-12

Funds Flow with Financial Institutions 6-13

Interest Rates Affected by economic conditions Nominal rate quoted most often 6-14

Nominal Interest Factors that affect rate –Inflation –Real interest rate –Default and liquidity risk –Provisions of security issuer –Term to maturity 6-15

Inflation Percentage increase in cost of goods or services over given period of time Actual or Expected inflation rate –Interest rates increase in response to inflation 6-16

Inflation Annual inflation calculation using Consumer Price Index (CPI) 6-17

Nominal Rates vs. Inflation 6-18

Default or Credit Risk Risk that issuer fails to pay promised interest and principal Investors demand higher interest with higher default risk U.S. Treasury securities are generally considered to be free of default risk 6-19

Default Risk Premium Calculation DRP j = i jt - i Tt 6-20

Corporate Bond Default Risk Premiums 6-21

Three Yield-Curve Theories Unbiased Expectations Liquidity Premium Market Segmentation 6-22

Yield Curve Shapes 6-23

Forecasting Interest Rates As interest rates rise, investment portfolios values fall Forecasts important to corporate and individual financial wealth 6-24