Financial Instruments, Markets and Institutions

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Financial Instruments, Markets and Institutions
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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

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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

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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.

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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.

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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

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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

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• 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

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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

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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)

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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

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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

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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.

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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

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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.

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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

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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

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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

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Mutual Funds

• Stock or bond market related institutions
• Pool funds from many people
• Invest in wide variety of securitiesminimize
  risk

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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

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Savings and Loan Associations (SLs)

• 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

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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

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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

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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