Appendix to Chapter 3 Financial Instruments

1
Appendix toChapter 3Financial Instruments
2
1. Money-Market Instruments

• Treasury Bills
• Term to maturity Anything from 1 day to 182 days
• No risk of default
• Most liquid of all money-market instruments
• Commercial paper
• 1 to 12 months though typically ? 3 months
• Issued by large corporations, little default risk
• Less liquid than T bills
• Very important and increasingly important source
  of funds for corporations in recent years

3
2. Money-Market Instruments

• Bankers acceptance
• Facilitate international trade
• Liability of large banks, little default risk
• Once important but not much anymore
• Repurchase agreements (RPs)
• A promise to buy back a Treasury bill or bond at
  a future date at a specified price
• Collateralized by the Treasury securities hence,
  no default risk
• Any term but typically very short (often
  overnight)
• Very liquid, perhaps even more so than Tbills

4
3. Money-Market Instruments

• Federal (Fed) funds
• Overnight loans of bank reserves between banks
• Essentially no risk of default
• Highly liquid
• The interest rate on Federal funds is called the
  federal funds rate (fed funds, funds rate for
  short)
• The federal funds rate is used by Federal Reserve
  to conduct monetary policy

5
4. Money-Market Instruments

• Eurodollars
• -denominated deposits in foreign banks
• Any term ? one year
• Little risk of default, highly liquid

6
5. Money-Market Instruments

• Negotiable bank certificates of deposit (CDs)
• There is a secondary market in large CDs, all
  gt 100,000 but typically gtgt 1 million
• An important source of funds for banks
• Many held by money-market mutual funds
• Terms can be anything up to one year
• Little risk of default
• Fairly liquid

7
1. Capital-Market Instruments

• Tbonds
• Terms up to 30 years
• Some of the bonds are real i.e., principal and
  interest rise with the CPI
• Most are nominal i.e., pay
• Most liquid of capital-market instruments
• Federal Agency Debt
• Some federal agencies issue their own debt
• Often it is backed by assets held by the agency
  e.g., mortgages, student loans, farm loans

8
2. Capital-Market Instruments

• State and local government bonds
• Usually termed municipal bonds
• Fund SL investment
• Special tax treatmentmore on this later
• Some risk of default, not very liquid
• Corporate bonds
• Funds private investment
• Some risk of default, not very liquid

9
3. Capital-Market Instruments

• Mortgages
• Loans to households or businesses to fund
  purchase of land or buildings
• Three government-sponsored agencies securitize
  mortgages, issuing bonds backed by mortgages
• Federal National Mortgage Association (FNMA)
• Government National Mortgage Association (GNMA)
• Federal Home Loan Mortgage Corporation (FHLMC)
• Some secondary markets in commercial bank loans,
  but much less than for mortgages

10
4. Capital-Market Instruments

• Stocks
• Stocks account for roughly 2/3 of the value of
  all corporate assets
• About 2/3 to 3/4 of new investment is financed by
  undistributed corporate profits
• Economically, this is equivalent to issuing new
  equity
• But little new equity is actually sold in primary
  markets largely because of the tax system

11
1. Importance in 2006 (billions)

• Treasury bills 959
• Commercial paper 1837
• Negotiable CDs 1168

12
2. Importance in 2006 (billions)

• Treasury bonds 4834
• Federal agency bonds 6387
• SL government bonds 2256
• Corporate bonds 22,092
• Mortgages 14,388
• Commercial Loans 1548
• Consumer Loans 2149