The Role of

Financial Markets
and Financial
Intermediaries
 Financial Markets
•Financial markets are
structures through which
the funds flow.
 Two Dimensions of Financial
Markets:
•Primary Markets vs
Secondary Markets
•Money Markets vs Capital
Markets
 Primary Markets
• Are markets in which users of
funds (e.g. corporation) raise
funds through new issues of
financial instruments such as
stocks and bonds.
 Secondary Markets
• Are markets that trades financial
instruments once they are issued.
• Provide a centralized marketplace
where economic agents know they can
transact quickly and efficiently
• Derivative securities are financial securities
whose payoffs are linked to other, previously
issued (or underlying) primary securities.
• Price information allows users to evaluate how
well they are using the funds generated from
the financial instruments they have already
issued and provides information on how well
any subsequent offerings of debt or equity
might do in terms of raising additional money
(and at what cost).
 Money Markets
•Markets that trade debt
securities or instruments
with maturities of one year
or less.
 Examples of Money Market
Instruments
• Treasury bills
• Federal funds
• Repurchase agreements
• Commercial paper
• Negotiable certificates of deposit
• Banker’s acceptance
 Over-the-counter Markets
• Markets that do not operate in a
specific fixed location—rather
transactions occur via telephones,
wire transfers and computer
trading.
 Capital Markets
• Markets that trade debt (bonds)
and equity (stocks) instruments
with maturities of more than
one year.
Examples of Capital Market
Instruments
•Corporate stocks
•Securitized mortgages
•Corporate bonds
MONEY MARKETS
• The need for money markets
arises because immediate cash
needs of individuals, corporations
and governments do not
necessarily coincide with their
receipts of cash.
 3 Basic Characteristics of
Money Market and Money
Market Securities/Instruments
• Money market instruments are
generally sold in large denominations.
• Money market instruments have low
default risk.
• Money market instruments must have
an original maturity of one year or
less.
• Default risk is the risk of
late or nonpayment of
principal or interest is
generally small.
 Money Market Instruments
• Treasury Bills
• Federal Funds
• Repurchase Agreements
• Commercial Paper
• Negotiable Certificates of
Deposit
• Banker Acceptances
 Treasury bills

•These are short-term

obligations issued by
the U.S. government
 Federal Funds
• These are short-term funds
transferred between financial
institutions usually for no more
than one day.
 Repurchase Agreements
• These are agreements involving
the sale of securities by one party
to another with a promise to
repurchase the securities at a
specified date and price.
 Commercial Paper
• These are short-term unsecured
promissory notes issued by a
company to raise short-term
cash.
Negotiable Certificates of Deposits
• These are bank-issued time
deposit that specifies an
interest rate and maturity date
and is negotiable (saleable on
secondary market).
 Banker Acceptance
• time drafts payable to a
seller of goods, with
payment guaranteed by a
bank
BOND MARKETS
 Bonds
• These are long-term debt
obligations issued by corporations
and government units.
• Proceeds from a bond issue are
used to raise funds to support
long-term operations of the issuer.
 Bond Markets
• These are the markets in which bonds
are issued and traded.
• They are used to assist inn the transfer
of funds from individuals,
corporations, and government units
with excess funds to corporations and
government units in need of long-term
debt funding.
 3 Types of Bond Markets

• Treasury Notes and Bonds

• Municipal Bonds
• Corporate Bonds
Treasury Notes and Bonds
• These are long-term bods issued
by the U.S. Treasury to finance the
national debt and other federal
government expenditures.
 Municipal Bonds
• These are securities issued by state and
local (e.g. county, city or school)
governments either to fund temporary
imbalances between operating
expenditures and receipts or to finance
long-term capital outlays for activities
such as school construction, public
utility construction or transportation
systems.
 Corporate Bonds
•These are long-term
bonds issued by
corporations.
 Types of Bonds
• Bearer Bonds
• Registered Bonds
• Term Bonds
• Serial Bonds
• Mortgage Bonds
• Equipment Trust Certificates
• Debentures
• Subordinated Debentures
• Convertible Bonds
• Stock Warrants
• Callable Bonds
• Sinking Fund Provisions
 Bearer Bonds
• Bonds on which coupons are
attached. The bond holder
presents the coupons to the
issuer for payments of interest
when they come due
 Registered Bonds
• With a registered bond, the
owner's identification
information is recorded by the
issuer and coupon payments
are mailed to the registered
owner.
 Term Bonds

•Bonds in which the

entire issue matures on
a single date.
 Serial Bonds
• Bonds that mature on a
series of dates, with the
portion of the issue paid off
on each.
 Mortgage Bonds
• Bonds that are issued to
finance specific projects that
are pledged as collateral for
the bond issue.
Equipment Trust Certificates

•Bonds collaterized
with tangible non-real
estate property.
 Debentures
• Bonds backed solely by
the general credit of the
issuing firm and
unsecured by specific
asset or collateral.
 Subordinate Debentures
• Unsecured debentures
that are junior in their
rights to mortgage bonds
and regular debentures.
 Convertible Bonds
• Bonds that may be
exchanged for another
security of the issuing firm
at the discretion of the bond
hoder.
 Stock Warrants
• Bonds that give the bond
holder an opportunity to
purchase common stock at a
specified price up to a
specified date.
 Callable Bonds
• Bonds that allow the issuer
to force the bond holder to
sell the bond back to the
issuer at price above the par
value.
 Sinking Funds Provision
• Bonds that include a
requirement that the
issuer retire a certain
amount of the bond issue
each year.
STOCK MARKETS
 Stock Market Securities

•Common Stock
•Preferred Stock
 Common Stock
• Is fundamental ownership claim in a public
corporation.
• Residual Claim – common stockholders have the
lowest priority.
• Limited Liability – losses are limited to the original
amount of their investment.
• Voting Rights – fundamental privilege assigned to
common stockholder.
 Preferred Stock
• A hybrid security that has characteristics
of both bonds and common stock.
• Nonparticipating – dividend payments is
fixed regardless of any increase or
decrease in the issuing firm’s profits.
• Cumulative – missed dividends payments go
into arrears and must be made up before any
common stock dividends can be paid.
• Participating – actual dividends paid in any
year may be greater than the promised
dividends.
• Noncumulative – dividend payments do not go
into arrears and are never paid.
 PRIMARY AND
SEOCNDARY STOCK
MARKETS
 Primary Markets
• Underwriter’s spread-
Markets in which corporations
difference between the
raise funds through new
gross proceeds and net
issues of securities.
proceeds.
• Syndicate-the process if
• Net proceeds-the guaranteed distributing securities
price at which the through a group of banks.
investment bank purchases
• Originating house-lead
the stock from issuer.
bank in the syndicate,
• Gross proceeds-the price at
which negotiates with the
which the bank resells the issuing company on behalf
stock to investors. of the syndicate.
Secondary Stock Markets

• The markets in which stocks,

once issued, are traded –
rebought and resold.
 Stock Exchange
Is an exchange or stock market where stock
brokers and traders can buy or sell stocks,
bonds, and other securities.

• The New York Stock Exchange- the most well

known of all the organized exchanges in the
US.
TRADING PROCESS
• Trading post-A specific
place on the floor of the
exchange where
transactions occur
• Specialists- Exchange
members who have an
obligation to keep the
market going, maintaining
liquidity in their assigned
stock at all times.
• Market Order-an order to
transact at the best price
available when the order
reaches the post.
• Limit Order- An order to
transact at a specified
price.
 DERIVATIVE
SECURITIES MARKETS
 Derivative securities
Derivative security markets
• An agreement • The Markets in
between two
which
parties to exchange
a standard derivatives
quantity of an asset securities trade.
at a predetermined
price at a specified
date in future.
FORWARDS AND
FUTURES
 • Forward contract- An
agreement to transact
involving the future
• Spot contract- An exchange of a set
agreement to transact amount of assets at a
involving the set price.
immediate exchange • Futures contract- An
of assets and funds. agreement to transact
involving the future
exchange of a set
amount of assets for a
price that is settled
daily.
 OPTIONS
• A contract that gives the holder the right,
but not the obligation, to buy or sell the
underlying asset at a specified price
within a specified period of time.
• American option • European
- an option that option - an
can be exercised option that can
at any time be exercised
before and on the only on the
expiration date. expiration date.
• Call option- an option • Put option- an option
that gives a purchaser that gives a purchaser
the right, but not the the right, but not the
obligation, to buy the obligation, to buy the
underlying security underlying security
from the writer of the from the writer of the
option at a option at a
prespecified exercise prespecified exercise
price on a price on a
prespecified date. prespecified date.
MORTGAGE MARKETS
Mortgages – loans to individuals or businesses to
purchase a home, land or other real property

• Mortgages are backed by a specific piece of real

property.
• There is no set size or denomination for primary
mortgages.
• Primary mortgages generally involve a single investor.
• Information on these borrowers is less extensive.
Securitization allows financial institutions’ asset
portfolios to become:

-more liquid
-reduces interest rate risk and credit risk
-provides FIs w/ a source of fee income
-helps reduce the effects of regulatory constraints
-reserve requirements
-deposit insurance premiums on FI profits
Primary Mortgage Market
Four basic categories of mortgages:

*home
*multifamily-dwelling
*commercial
*farm
• Lien – a public record attached to the title of
the property that gives the financial institutions
the right to sell the property if the mortgage
borrower defaults

• Down payment – decrease the probability that

the borrower will default on the mortgage
 Mortgage Securities
• A mortgage has an original maturity of 15 to
30 years.
• A mortgage is amortized when the fixed
principal and interest payments fully pay off
the mortgage by its maturity date.
• Balloon payment mortgages
Secondary Mortgage Markets
• created by the federal government
to help boost U.S. economic
activity during the Great
Depression
 Mortgage-Backed Securities
Three major types:
1. pass-through security
2. Collateralized mortgage obligation
3. Mortgage-backed bond
Foreign Exchange
Markets
Foreign Exchange Markets
• are markets in which trades of
foreign currencies transact
most efficiently and at the
lowest cost
- facilitate foreign trade
- facilitate raising capital in foreign
markets
- facilitate the transferring of risk between
participants
- facilitate speculation on currency values
• If a foreign currency depreciates relative to the
U.S. dollar over the investment period , the
dollar value of cash flows received will fall.

• If the foreign currency appreciates, or rises in

value, relative to the U.S. dollar, the dollar
value of cash flows received on the foreign
investment will increase.
• The sensitivity of the value of
cash flows on foreign investments
to changes in the foreign
currency’s price in terms of
dollars is referred to as foreign
exchange risk.
 Foreign Exchange Transaction
Spot Foreign Exchange Transactions- involve
immediate exchange of currencies at the
current exchange rate

Forward Foreign Exchange Transactions-

exchange of currencies at a specified exchange
rate at some specified date in the future
 The Role of Money
• Money is anything that is generally
accepted as a means of payment
• Liquidity is the ease of converting an
asset into cash without loss; the depth
of a financial market
Measures of the Supply of Money
• Money supply – total amount of money in
circulation
• M-1 – sum of coins, currency, and
demand deposits
• M-2 – sum of coins, currency, demand
deposits, savings accounts, and small
certificates of deposit
 The Role of Interest Rates
• Money is a medium of exchange; its value
is related to what it will purchase
• Interest – the cost of credit; it is the price
paid for the use of someone else’s money
 The Term Structure of Interest
Rates
• Term structure of interest rates –
relationship between yields and the time
to maturity for debt with a given level of
risk
• Yield curve – graph relating interest rates
and the term to maturity
Financial Markets and the Transfer
of Savings
• Financial markets are the mechanism to
transfer these savings to productive uses.
• The process of transferring savings into
investments is the most important
function of the financial system.
 The Indirect Transfer through
Financial Intermediaries
• New securities are issued
Funds
savers firms
• To obtain the funds, the F.I. create
claims on themselves
 The Indirect Transfer through
Financial
• Investment Banker – facilities an initial sale
• Securities Broker & Secondary Markets –
facilitate subsequent sale

* They are not F.I. but function as middle men who

facilitates the buying a selling of new and existing
securities
 Commercial Banks
•The most depository institution
•Prime source of funds to consumers

Primary Liabilities of C.B.:

•Checking account
•Various types of savings:
time deposit (issued fixed terms 6 mos. to 2 years)
certificate of deposits
 Thrift Institutions

• Are a place for savers,

especially individuals with
modest sums, to deposit funds
 Thrift Institutions
Savings and Loan
Mutual Savings
Associations
• Owned by its depositors • A source of mortgage
but the bank itself is loan
managed by a board of • Self-liquidating, they
trustees could not grow
• Must have sufficient • Simply saved a specific
liquidity to meet need of their members
withdrawals
 Regulation of Commercial
Banks and Thrift Institutions
RESERVE
• Required reserves
• Excess reserves
• Secondary reserves
 Correspondent bank

Deposit Insurance
Life Insurance
Companies
Pension Plans
 Money Market Mutual
Funds and Money Market
Instruments
• Mutual Funds that invests on behalf of
individuals
• Most of these funds are not financial
intermediaries.
• They create claims on themselves.
• Mutual fund could buy newly issued shares
• Most Mutual Funds do not serve as financial
intermediaries.
 Money Market Mutual Funds

•Investment company that

invests solely in short-term
money market instrument
Immediate popularity may be
explained by three factors:
• Safety of Principal
• Liquidity
• Interest Rates that exceed the
rates paid by banks
 U.S. Treasury Bill
•Short-term debt
instrument issued by the
federal government
 Commercial Paper
•Unsecured short-term
promissory note issued by
the most creditworthy
corporations
Repurchase Agreement (REPO)
• Sale of a short-term security in
which the seller agrees to buy
back the security at a specified
price
 Banker’s Acceptances
•Short-term promissory
note guaranteed by a
bank
 Tax Anticipation Note
•Short-term government
security secured by
expected tax revenues