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1. Overview of Financial Markets

A financial market is a market in which financial assets
(securities) can be purchased or sold
Financial markets facilitate financing and investing by
households, firms, and government agencies
Participants that provide funds are called surplus units
e.g., households

Chapter 5: Financial Markets Participants that enter markets to obtain funds are
deficit units
e.g., the government

Role of Financial Markets 2. Types of Financial Markets

1. Liquidity: 1. Classified according to the characteristics of participants

Ensure owners can buy and sell financial instruments cheaply. and securities involved: primary or secondary markets.
Keeps transactions costs low.
2. Categorize by the way they trade: centralized exchange
2. Information: or not.
Pool and communication information about issuers of financial
instruments. 3. Group based on the characteristics of instrument they
trade: debt market, equity market and derivative market
3. Risk sharing:
Provide individuals a place to buy and sell risk 4. Group based on term of instruments: money market and
capital market
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Primary Market vs Secondary Market Primary Market

A primary market is a market in which securities are bought and

sold for the first time. In this market, the firm selling securities Funds
actually receives the money raised

A secondary market is a market where people can buy and sell Primary
existing securities. In this market, the issuing firm does not
receive any new financing. The securities are simply transferred Market
from one investor to another
Securities

Secondary Market Centralized Exchange vs OTC

Centralized exchanges - buyers and sellers meet in a

Funds
central, physical location.

Over-the-counter markets (OTC) - decentralized markets

Secondary of securities not listed on an exchange where market
Market participants trade over the telephone, facsimile or
electronic network instead of a physical trading floor
Securities

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Debt and Equity Markets vs Derivative Markets

Money Market vs Capital Market

Money Market
Trade short term (1 year or less) debt instruments (e.g.
T-Bills, Commercial Paper)
Major money centers in Tokyo, London and New York
In debt and equity markets, actual claims are bought and
sold for immediate cash payments.
In derivative markets, investors make agreements that are
settled later.

Capital Market
Trades long term securities (Bonds, Stocks)
NYSE, ASE, over-the-counter (Nasdaq and other OTC)

3. Money Market Securities Money Market Securities

Money market securities are debt securities with a a. Treasury Bills (T-Bills)
maturity of one year or less
b. Negotiable Certificate of Deposits (NCDs)
Characteristics:
Liquid c. Commercial Papers
Low expected return
Low degree of risk d. Banker’s Acceptance

e. Repurchase Agreement

f. Eurodollars
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a. Treasury Bills T-Bills

Issued by the Federal Government, to finance national debt Pricing Treasury bills
and new deficits The price is dependent on the investor’s required rate of return:

Are sold through an auction Pm  Par /(1  i ) n

Generally viewed as having zero default risk -> risk-free asset
Treasury bills do not pay interest
After initial sale, they have an active secondary market.
To price a T-bill with a maturity less than one year, the
annualized return can be reduced by the fraction of the year in
which funds would be invested

Examples T-Bills

1. A one-year Treasury bill has a par value of $10,000. Estimating the yield
Investors require a return of 7 percent on the T-bill. What is
the price investors would be willing to pay for this T-bill? T-bills are sold at a discount from par value

The yield is influenced by the difference between the selling

2. A 6-month Treasury bill has a par value of $10,000.
Investors require a return of 8 percent on the T-bill. What is
the price investors would be willing to pay for this T-bill?
price and the purchase price
If a newly-issued T-bill is purchased and held until maturity,
the yield is based on the difference between par value and
the purchase price
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T-Bills Examples

The annualized yield is: 1. An investor buys a 3-month (91-day), $100,000 par value
Treasury bill for $98,500. What is the annualized yield for this
SP  PP 365 investor? What is the quoted discount for the T-bill?
YT  
PP n

Estimating the T-bill discount

The discount represents the percent discount of the purchase 2. Suppose the investor plans to sell the bill in one month (30
price from par value for newly-issued T-bills: days) at a price of $99,250. What is the expected annual yield
for this investor?
Par  PP 360
T - bill discount  
Par n

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b. NCDs c. Commercial Papers

NCDs are interest-bearing securities issued by banks to raise
money for loans
Denominations: $100,000 and above (Large Time Deposits)
They have maturities of one year or less.
NCDs offer a premium above the T-bill yield to compensate for
less liquidity and safety. Premiums are generally higher during
recessionary periods
Are unsecured debt issued by corporations with good credit
ratings to finance short-term debt (e.g. inventories)
Most buyers are large institutions.
Are typically established for a maturity range from 0 to 90
days

NCDs have a secondary market

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Sequence of Steps in the Creation of A Banker’s Acceptance

d. Banker’s Acceptance
A bankers' acceptance (BA) is a short-term credit investment Purchase Order
created by a non-financial firm and guaranteed by a bank to 1
make payment. Importer Exporter
5 Shipment of Goods
Are commonly used for international trade transactions
4 L/C Notification
Exporters frequently sell an acceptance before the payment 2 L/C Application
date 6 Shipping Documents & Time Draft
Have an active secondary market facilitated by dealers.
Acceptances are traded at discounts from face value in the
3 L/C
American Bank Japanese Bank
secondary market. Shipping Documents (Exporter’s Bank)
(Importer’s Bank)
7 & Time Draft Accepted

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e. Repurchase Agreement f. Eurodollars

One party sells securities to another with an agreement to
repurchase them at a specified date and price
Transactions amounts are usually for $10 million or more
Common maturities are from 1 day to 15 days and for one,
three, and six months
- Eurodollars are U.S.-dollar denominated deposits at banks
outside of the United States. This market evolved in Europe
(specifically London), hence the name, but eurodollars can be
held anywhere outside the United States.
- Buyers and sellers are large institutions.

There is no secondary market for repos

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4. Capital Market Securities a. Bonds

Capital market instruments are those with a maturity of more Are “IOUs” issued by the borrower and sold to investors.
than one year
The issuer promises to repay the face amount on the
Bonds and mortgages maturity date and to pay interest each year in the amount of
the coupon rate times the face value.
Stocks

Capital market instruments have a higher expected return

and more risk than money market securities

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Bonds Callable bond vs Convertible bond

Treasury Bonds: are issued by the federal government. - A callable bond: is a bond that can be redeemed by the issuer
prior to its maturity

- A convertible bond: is a type of debt security that can be

Municipal Bonds: are issued by state and local governments. converted into a predetermined amount of the underlying
company's equity at certain times during the bond's life

Corporate Bonds: are issued by corporations.


b. Stocks
Companies can also raise funds by selling shares of stock
- Common stocks
- Preferred stocks
Preferred Stocks
Preferred stock is an equity security. However, preferred
stockholders have preference with regard to:
Dividends: They are paid before the common stockholders.
Claim on assets: They are paid before common stockholders if
the firm goes bankrupt and sells or liquidates its assets.
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Common stocks
Common stock is a security that represents equity ownership in
a corporation, provides voting rights, and entitles the holder to
a share of the company’s success in the form of dividends and
any capital appreciation in the value of the security.
Common stockholders are residual owners of the firm. They earn a
return only after all other security holder claims (debt and
preferred equity) have been satisfied in full.
Dividend on common stock are neither fixed nor guaranteed.
Thus, a company can choose to reinvest all of the profits in a new
project and pay no dividends.
Preferred Stocks
Preferred stock is also referred to as a hybrid security as it has
features of both common stock and bonds.
Preferred stock is similar to common stocks in that:
It has no fixed maturity date,
The nonpayment of dividends does not result in bankruptcy of the
firm, and
The dividends are not deductible for tax purposes.
Preferred stock is similar to corporate bonds in that:
The dividends are typically a fixed amount, and
There are no voting rights.
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5. Derivative securities Derivative securities

Derivative securities are financial contracts whose values are 1. Forward Contracts
derived from the values of underlying assets
2. Future Contracts
Speculating with derivatives allow investors to benefit from
increases or decreases in the underlying asset 3. Options

Risk management with derivatives generates gains if the value 4. Swaps

of the underlying security declines