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Chapter 06Chapter 06 Understanding Financial Markets and Institutions
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Markets
Overview of markets and Payroll taxeshttp://money.cnn.com/?hpt=sitenav
Manage flow of funds– Two major market dimensions
• Primary versus secondary markets• Money versus capital markets
6-2
Primary Markets• Used by corporations and governments
• Used to issue new financial instruments– Stocks– Bonds
6-3
Primary Market Transfer of Funds
6-4
Secondary Markets
• Benefit investors and issuers– Securities traded after issue– Provide liquidity and diversification
benefits for investors– Security valuation information for issuers
6-5
Secondary Market Transfer of Funds
6-6
Money Markets vs. Capital Markets
• Money markets trade debt securities or instruments with maturities of one year or less
• Capital markets trade stocks and long- term debt with maturities greater than one year
6-7
Money Market vs. Capital Market Maturities
6-8
Other Markets
• Foreign Exchange Markets– Trade currency for immediate delivery
(spot) or for some future delivery– Subject to foreign exchange risk due to
currency fluctuations
6-9
Other Markets
• Derivatives– Highly leveraged financial securities
linked to underlying security – Potentially high-risk– Used for hedging and speculating
6-10
Financial Institutions
• Banks
• Thrifts
• Insurance companies
• Mutual funds
6-11
Financial Institutions
• Perform economic functions‒ Monitor costs
‒ Provide liquidity
‒ Price risk
6-12
Funds Flow with Financial Institutions
6-13
Interest Rates
• Affected by economic conditions
• Nominal rate quoted most often
6-14
Nominal Interest• Factors that affect rate
– Inflation– Real interest rate– Default and liquidity risk– Provisions of security issuer– Term to maturity
6-15
Inflation • Percentage increase in cost of goods or
services over given period of time
• Actual or Expected inflation rate– Interest rates increase in response to inflation
6-16
Inflation
• Annual inflation calculation using Consumer Price Index (CPI)
6-17
Nominal Rates vs. Inflation
6-18
Default or Credit Risk• Risk that issuer fails to pay promised interest
and principal
• Investors demand higher interest with higher default risk
• U.S. Treasury securities are generally considered to be free of default risk
6-19
Default Risk Premium Calculation
DRPj = ijt - iTt
6-20
Corporate Bond Default Risk Premiums
6-21
Three Yield-Curve Theories
• Unbiased Expectations • Liquidity Premium • Market Segmentation
6-22
Yield Curve Shapes
6-23
Forecasting Interest Rates • As interest rates rise, investment portfolios
values fall• Forecasts important to corporate and
individual financial wealth
6-24