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Chapter 6Chapter 6Financial Markets, Financial Markets, Instruments, and Instruments, and

ParticipantsParticipants

©2000 South-Western College Publishing

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MoneyMoney MarketMarket

The market for financial assets with an original maturity of less than one year

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CapitalCapital MarketMarket

The market for financial assets with an original maturity of greater than one year

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Term toTerm to MaturityMaturity

The length of time from when a financial security is initially issued until it matures

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Primary MarketPrimary Market

The market in which a security is initially sold for the first time

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SecondarySecondary MarketMarket

The market in which previously issued financial securities are sold

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Spot MarketSpot Market

Market in which the trading of financial securities takes place instantaneously

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Financial Futures MarketsFinancial Futures Markets

Organized markets that trade financial futures agreements

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SpeculationSpeculation

The buying or selling of financial securities in the hopes of profiting from future price changes

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U.S. TreasuryU.S. Treasury bills (T-bills)bills (T-bills)

Short-term debt instruments of the U.S. government with typical maturities of 3-12 months

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The Principal Money Market Instruments Amount Outstanding, End of Year Billions of Dollars

Type of Instrument

Treasury Bills

Negotiable CDs

Commercial Paper

Banker’s Acceptances

Repurchase Agreements and Fed Funds

Eurodollars

1960

$37

0

5

1

1

1

Exhibit 6-1

1970

$76

45

35

4

22

20

1980

$200

260

99

32

102

68

1990

$482

N.A.

558

52

324

N.A.

1997

$430

N.A

979

12

653

145

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The Money Market

Instrument

•Treasury Bills

•Negotiable CDs

•Commercial Paper

•Banker’s Acceptances

•Repurchase Agreements and Fed Funds

•Fed Funds

•Eurodollars

Typical Maturities

3 to 12 months

1 to 6 months

1 to 270 days

90 days

1 day, and 2 day to 3 months typical; 6 months less typical

Chiefly 1 business day

Overnight, 1 week, 1 to 6 months and longer

Exhibit 6-2a

13Exhibit 6-2b

The Money Market

Instrument

•Treasury Bills

•Negotiable CDs

•Commercial Paper

•Banker’s Acceptances

•Repurchase Agreements and Fed Funds

•Fed Funds

•Eurodollars

Principal Borrowers

U.S. Government

Depository Institutions

Financial & Business Firms

Financial & Business Firms

Banks, Securities, nonfinancial firms, governmentsDepository Institutions

Banks

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The Money MarketInstrument

•Treasury Bills

•Negotiable CDs

•Commercial Paper

•Banker’s Acceptances

•Repurchase Agreements and Fed Funds

•Fed Funds

•Eurodollars

Exhibit 6-2c

Secondary Market

Very Active

Modest Activity

Moderately Active

Limited

None, but very active primary market for short maturities

Active broker’s market

None

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Treasury Bills

MaturitySept 24 ‘98Oct 01 ‘98Oct 08 ‘98Oct 15 ‘98Oct 22 ‘98Oct 29 ‘98Oct 29 ‘98Nov 5 ‘98

Nov 12 ‘98

Daysto

Maturity62697683909797

104111

Asked4.844.894.894.944.944.814.924.984.99

Chg+0.01+0.01+0.01+0.01+0.01+0.01+0.03+0.01+0.01

AskYld4.955.005.015.075.074.945.065.125.14

Bid4.864.914.914.964.954.834.935.005.01

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Negotiable Certificates of Negotiable Certificates of DepositDeposit (CDs)(CDs)

• Certificates of deposit with a minimum maturity of $100,000 that can be traded in a secondary market• First introduced by Citibank in 1961

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Commercial PaperCommercial Paper

Short-term debt instruments issued by corporations

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Banker’sBanker’s AcceptancesAcceptances

Money market instruments created in the course of international trade to guarantee bank drafts due on a future date

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Importer

Exporter

Importer

Exporter

bank

Exhibit 6.3

Goods Now

Cash Later

Investor

No Bankers’ Acceptance

Cash Now

Discounts

Now

Accepted

Tim

e

Draft

NowCash Later

Cash Later

Cas

h L

ater

Acc

epta

nce

Now

Transaction occurs with a

bankers’ acceptance

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Repurchase AgreementsRepurchase Agreements

Short-term agreements in which the seller sells a government security to a buyer with the simultaneous agreement to buy it back on a later date at a higher price

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Federal (Fed)Federal (Fed) FundsFunds

Loans of reserves (deposits at the Fed) between depository institutions typically overnight

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EurodollarsEurodollars

Dollar-denominated deposits held abroad

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The Capital MarketExhibit 6-5

U.S. Govt. Agency Securities

U.S. Government Agency

Some activity

Instrument Typical Principal SecondaryMaturities Borrowers Market

Corporate Stock

____ Corporations

Mortgages 15 to 30 years

Homeowners and other investors

Moderately active

Corporate Bonds

2 to 30 years Corporations

U.S. Govt. Notes

Bonds 2 to 10 yrs. U.S. Government

U.S. Government

Very active

Very active

Municipals 2 to 30 years State & Local Governments

30 years

Up to 30 years

Active

Very active for large corporations

Active

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Stocks Stocks are...are...

Equity claims that represent ownership of the net assets and income of a corporation

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MortgagesMortgages

Loans made to purchase single or multiple family residential housing, land, or other real structures, with the structure or land serving as collateral for the loan

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The Principal Capital Market Instruments Amount Outstanding, End of Year Billions of Dollars

Type of Instrument

Corporate Stock

Mortgages

Corporate & Foreign Bonds

U.S. Government Securities

U.S. Government Agency Securities

Municipal Securities

1960

$451

142

75

178

10

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Exhibit 6-4

1970

$906

297

167

156

51

144

1980

$1,920

965

319

394

170

N.A.

1990

$3,530

3,804

1,704

1,595

426

N.A.

1997

$12,958

5,288

3,421

3,804

995

1,368

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Corporate BondsCorporate Bonds

Long-term debt instruments issued by

corporations

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U.S. Government U.S. Government SecuritiesSecurities

Long-term debt instruments of the U.S.

government with original maturities of 2-30 years

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U.S.U.S. Government AgencyGovernment Agency SecuritiesSecurities

Long-term bonds issued by various government agencies including those that support commercial, residential and farm real estate lending, and student loans

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State and Local Government State and Local Government BondsBonds (Municipals) (Municipals)

Long-term instruments issued by state and local governments to finance expenditures on schools, roads, etc.

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Revenue BondsRevenue Bonds

Bonds used to finance specific projects with proceeds of those projects used to pay off bondholders

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General Obligation BondsGeneral Obligation Bonds

Bonds that are paid out of the general revenues and are backed by the full faith and credit of the issuer

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Money RatesMoney Rates

Prime Rate- The interest rate that serves as a basis for quoting rates to customers; an indicator of the cost of business borrowing from banksFederal Funds Rate- The interest rate charged on overnight loans in the federal funds market; a sensitive indicator of the cost to banks of borrowing fundsTreasury Bill Rate - The interest rate on Treasury bills; an indicator of borrowing moneyDiscount Rate - The rate charged by the Federal Reserve Banks for loaning reserve asset deposits to depository institutions

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Money RatesMoney RatesFederal Home Loan Mortgage Rate (Freddie Mac)- The interest rate on “Fannie Mae” guaranteed mortgages; an indicator of the cost of financing conventional residential housing purchasesFederal National Mortgage Association Rate (Fannie Mae)- The interest rate on “Fannie Mae” mortgages; an indicator of the cost of financing conventional housing purchasesLondon Interbank Offered Rate (Libor)- The interbank rate for dollar-dominated deposits in the London market among international banks; the interest rate that serves as a basis for quoting other international rates

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Market MakerMarket Maker

A dealer who links up buyers and sellers of financial securities and sometimes takes positions in the securities

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BrokerBroker

Person who arranges trades between buyers and sellers

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DealerDealer

•Person who arranges trades between buyers and sellers AND can be a principal in a transaction•A market maker

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Bid PriceBid Price

The price at which a market maker is willing to buy securities

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Asked PriceAsked Price

The price at which a market maker is willing to sell securities

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Assist in raising funds to finance deficits by marketing a borrower’s new securities in the primary market

Market Makers

Stand ready to buy or sell outstanding

securities in the secondary market

Advise potential buyers and sellers of

securities on the course of action

likely to minimize costs and maximize

returns

Market Makers

Exhibit 6.6

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APEI wants to issue bonds to finance investment

Merrill Lynch agrees (for a fee) to design a bond offering and to

market (sell) the bonds

The Marketing and Trading of a Corporate Bond

Exhibit 6.7

Primary Market Activity

SSUs and financial intermediaries buy APEI bonds that will mature in 20 years

One year later SSUs (or financial intermediaries) decide to sell some of their APEI

Secondary Market Activity

Salomon sells “used” APEI bonds to another SSU

Salomon Bros. Makes a market in APEI bonds by buying bonds

from SSUs