FINANCIAL MARKETS
CHAPTER 1- FINANCIAL MARKETS
-performs the essential function of transferring funds from
economic players that have saved surplus to those who
have a shortage of funds.
LENDER- person/financial institution providing monetary
credit to the debtor.
BORROWER- person/entity that seeks funds from the
lender.
DIRECT FINANCE- lenders lend their savings directly to
borrowers.
INDIRECT FINANCE- bank lends out depositors’ money to
borrowers at a profit.
FINANCIAL INSTITUTION-intermediaries/ physical location.
an establishment that completes and facilitates monetary
transactions, such as loans, mortgages, and deposits.
FINANCIAL MARKETS- any place or system that provides
buyers and sellers the means to trade financial
instruments, including bonds, equities, the various
international currencies, and derivatives.
FINANCIAL INSTRUMENTS- assets that can easily be
converted into cash, which individuals can acquire. Ex.
bonds
CHAPTER 2- FINANCIAL SYSTEM (set of institutions)
FEATURES OF AN EFFECTIVE EFFECTIVE FINANCIAL
SYSTEM
FIDUCIARY SYSTEM- trust. Person with fiduciary duty has a
legal obligation to maintain that trust.
STRONG LEGAL INFRASTRUCTURE- set of transparent laws
that both parties to a financial institution regard as fair and
protective of their interest.
SAFE, RELIABLE AND EFFICIENT PAYMENT SYSTEM-
participants can make contractual payments; assured that
the funds get transferred to the right place on time at a
relative cost.
DIRECT METHODS OF FINANCE
DIRECT FINANCE- surplus are directly transferred to deficit
unit without intermediaries
INDIRECT-with intermediaries
INVESTMENT BANK
-corporate & municipal bonds, corporate stocks,
commercial paper. (placed with the investors with the
assistance of Investment Bank)
-has good connections: potential investors & knowledge
of how to market securities.
DEBT VS. EQUITY
DEBT INSTRUMENTS- commitment on the part of issuer
to pay specific stream of cash flows to investor over a
period until maturity, when the obligation ius discharged.
EQUITY- claims to share the net income and assets of
business. Owner of equity receives dividends at specified
periods + receiving part of the business assets if goes
bankruptcy. Investor= entitled to receive the leftover
after all other obligations have been paid.
MONEY MARKET-market for short term payments (year
or less to mature). Exist for temporary investments-idle
fund. EX. Treasury Bills, Commercial Papers
CAPITAL MARKET- market for long term financial
instruments. Included in the capital market-issuances of
securities and long term obligation by business and
government agencies.
EX. Goverments Bonds, Corporate Bonds and Stocks
ASSYMETRIC INFORMATION- imbalance between two
negotiating parties in their knowledge of relevant factors
and details. (side with more information enjoys a
competitive advantage over the other party)
ADVERSE SELECTION- problem created by assymetric
information, occurs before the transaction takes place,
leads to undesirable outcome.
MORAL HAZARD- problem created by assymetric
information, occurs after the transaction.
INDIRECT METHOD OF FINANCE- intermediaries standing
between the surplus unit and deficit unit.
DEPOSITORY INSTITUTIONS- receive funds (mostly in the
form of deposits) used to make loans.
EX. Commercial Banks
FINANCE COMPANIES- acquires fund by selling
commercial papers and issuing stocks and bonds-lend
them to consumers and small businesses.
 trading platform/s where the instrument is traded
CONTRACTUAL SAVINGS INSTITUTION- pension funds & and for getting the best terms for the customer.
life insurance companies.

COLLECTION OF INVESTMENT SCHEMES CHAPTER 3- THE SPECIAL ROLE OF COMMERCIAL BANKS

MUTUAL FUNDS- build portfolios or marketable assets.
Funds-offered and managed by large complexes that COMMERCIAL BANKS- bank that offers services to the general
provide a variety of funds and allow easy conversion from public.
one to another. ASSETS= LIABILITIES + NET WORTH (EQUITY
PRIVATE EQUITY FUNDS- Look for established corporations ASSETS:
that are not performing up to their best, acquire them, and • Cash
makes them private. (acquire existingly publicly traded • Securities
shares in target firm and converts to private ownership. • Core Loans (Business, Consumer, and Real Estate
HEDGE FUNDS- offer investment in professionally Loan)
managed portfolios and focus largely on marketable • Other Assets (Other Kinds of Loans, Bank Premises
instruments. and Bank Equipment, Real Estate Owned, and Misc.
VENTURE CAPITAL FUNDS- focused on investing in and other assets.
assisting firms in the early stage of development. LIABILITIES:
(commonly in the high-tech and biotech sectors of the • Deposits
company. • Transaction Deposits
• Other Retail Deposits
• Wholesale Deposits (Managed Liabilities)
NET WORTH:
• A.K.A. Bank Capital
• Acts as cushion against losses in asset values
• Government Policies places the government as a
potential creditor of the bank.

PAYMENT SYSTEM AND MONEY

COMMERCIAL BANKS AND THE PAYMENT SYSTEM
BANK NOTES- transaction mediums
DEPOSITS- money held in a bank account
*Commercial Banks – provided the public with transaction
PRIMARY MARET- financial market which new issues of a
deposits that serve as payment media, augmenting coins,
security are sold to initial buyers.
and notes issues by governments and central banks.
SECONDARY MARKET- occurs when security that have
previously been issued are resold.
I. PAYMENT SYSTEM INFRASTRUCTURE
COMMERCIAL BANKS role- facilitate transactions that
TRADING PLATFORM
support the economy.
-Over the counter
FUND TRANSFER SYSTEMS:
-specialist system
A. CLEARING HOUSE- bankers’ establishment where
-electronic communications network.
checks & bills from member banks are exchanged, so
that net balances need be paid in cash.
BROKERS- serve the customer by executing trade
B. AUTOMATED CLEARING HOUSE
for the customer-customer submits an order to
ORIGINAL DIRECTORY FINANCIAL INSTITUTION
broker and the broker is responsible for finding the
➡ CLEARING HOUSE (Regulated by NACHA-National
Automated Clearing House Association) verifies and validates
 ➡ RECEIVING DEPOSITORY FINANCIAL INSTITUTION
ODFI- gathers ACH related orders
RDFI-reconcile bank accounts related to ACH
transaction.
II. CREDIT AND STORED VALUE CARDS
CREDIT CARD- bank advancing credit to buyer to
complete transaction instead of transferring funds
from the buyer’s transaction account.
STORED VALUE CARDS- entitles the holder to make
purchases. These involve a certain maximum amount
that a holder can spend.
Credit Card Bill- must be made using a transfer from
the buyer's transaction account.
III. PAYMENT MEDIA IN THE MONEY STOCK
MEASUREMENT OF MONEY STOCK
Money Stock- available money in a specific place at a
specific time.
A. M1- currency + transaction accounts
B. M2- M1 + other components
-cash, checking deposits, non-cash assets that cam
easily be converted into cash.
M1 is roughly one-sixth the size of (nominal) gross domestic
product (GDP) M2 is approximately two-thirds the size of GDP.
IV. VELOCITY (Turnover of Money)
-It represents the number of times the money stock
turns over each year for purchases of all final goods
and services (GDP).
-If the velocity of money is stable - the public wishes to
hold money in proportion to its spending and income -
then a change in the money stock will translate into a
proportionate change in GDP.
V. LIQUIDITY PROVISION
LIQUIDITY - denotes providing readily available funds.
These funds can be used to make a purchase or to
discharge an obligation.
VI. DEALING WITH ASYMMETRIC INFORMATION
-Few businesses and almost no individuals have access to
direct forms of finance because they are characterized by
substantial informational symmetries.
Maturity Transformation - occurs when a bank
receives funds in the form of deposits having one
maturity and uses these funds to make loans or
acquire investments having another maturity.
VII. THE SAFETY NET AND REGULATORY POLICY
-Commercial banks and other depository institutions are
among the most heavily regulated businesses in our
economy.
-It has long been recognized that difficulties faced by one
bank can disrupt the payment system and in other ways spill
over to other banks, and even disrupt the entire economy --
we call this today, systemic risk.
-To limit the scope of disruption, public policy over time has
developed a so-called safety net for commercial banks.
-Central banks require such loans to be adequately
collateralized, to limit their loss exposure.
SHADOW BANKING SYSTEM
SHADOW BANKING - generally been used to denote
arrangements for intermediating credit outside traditional
deposits and loans at commercial banks. EX. Investment
Banks
CHAPTER 4- PRICING OF FINANCIAL ASSETS
VALUE OF SINGLE FUTURE PAYMENTS
-Some financial assets provide their owner with a single cash
payment at some specific date in the future.
CASH PAYMENT - bills or coins paid by the recipient of goods
or services to the provider.
𝐶𝐹 𝑛
𝑃𝑉 =
(1 + 𝑖)𝑛
VALUE OF A COUPON SECURITY
COUPON BOND OR SECURITY- a type of bond that includes
attached coupons and pays periodic interest payments
during its lifetime and its par value at maturity. These bonds
come with a coupon rate, which refers to the bond's interest
per year.
YIELD RATE- the anticipated return on an investment,
expressed as an annual percentage.
COUPON RATE- represents the actual amount of interest
earned by the bondholder annually.
PAR / FACE VALUE- they represent how much a bond will
be worth at the time of the bond's maturity.
COUPON BOND RATE- the present discounted value of
future cash stream generated by a bond.
SOLVING FOR YIELDS TO MATURITY
Yield to Maturity (YTM) -refers to the rate of return the
investor will earn if the bond is held to maturity.
a. Price of the bond
b. Time left to maturity
c. Par Value
d. Annual interest payments
DISCOUNT
-Acquisition cost is less than Face amount
-Yield rate is higher than Coupon rate
PREMIUM
-Acquisition cost is more than Face amount
-Yield rate is lower than Coupon rate
FORMULA Y- YIELDS TO MATURITY
MATURITY - the date on which the principal associated with
a debt or bonds becomes due.
if M represents Maturity and H the Holding period:
M > H = Price (interest rate) risk
M < H = Rollover (reinvestment) risk
RETURN VS YIELD
RETURN- financial gain or loss on an investment and is
typically expressed as the change in the dollar value of an
investment over time.
-also referred to as total return and expresses what an
investor earned from an investment during a certain period.
YIELD- income returned on an investment, such as the
interest received from holding a security.
-usually expressed as an annual percentage rate based on
the investment's cost, current market value, or face value.
- includes investor earnings, such as interest and dividends
received by holding particular investments.

𝐹𝑉 − 𝑝𝑟𝑖𝑐𝑒
𝐶𝑜𝑢𝑝𝑜𝑛 + 𝑛
𝑌𝑇𝑀 =
𝐹𝑉 + 𝑝𝑟𝑖𝑐𝑒
2
FIXED-RATE PAYMENT
FIXED-RATE PAYMENT - an installment loan with an
interest rate that cannot be changed during the life of the
loan.
Sample Solution:

MATURITY AND PRICE SENSITIVITY

-The longer the maturity of a bond, the more sensitive is its
price to change in interest rate.
-The price sensitivity of any bond INCREASES occurs at a
DECREASING RATE
YR < CR = BOND PRICE > FACE AMOUNT

HOLDING PERIODS VS MATURITIES

HOLDING PERIOD- the period of time the bond is owned
by an investor.