FINANC 3000 1st Edition Lecture 8 Outline of Last Lecture I. Compounding FrequencyII. EAR vs. APRIII. Loan AmortizationIV. 6 Months of “Free” FinancingV. Saving For a Down PaymentOutline of Current Lecture I. Financial MarketsII. Money Market InstrumentsIII. Capital MarketsIV. Financial InstitutionsCurrent LectureFinancial Markets- Help manage flow of funds from:o Investors to borrowerso Investor to investor- Two major market dimensionso Primary versus secondary marketso Money versus capital marketsPrimary Markets- Markets in which corporations and governments raise funds through new issues of securitiesThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- Investment banks arrange most primary market transactionso Morgan Stanley, Goldman Sachs or Merrill Lyncho Intermediaries between issuing parties and investorso Provide advice (regarding price and number of securities to offer)o Attract initial purchasers- Initial offering can occur either through public offering or private offeringo Private – accredited investors onlyo Public – register with SEC and available to the public- Private offerings are mostly illiquido Lack of information and illiquidity raise interest paid on those securities- Public offering can be:o Initial Public Offering (IPO) of stocks or additional sales of shares of public companyo Public bond issuancePrimary market transfer of fundsSecondary Markets- Benefit investors and issuerso Securities traded after initial issuanceo Provide liquidity and diversification benefits for investorso Security valuation information for issuers- Secondary market buyers often use brokers such as Charles Schwab or Fidelity to act as intermediaries- Original issuers are NOT involved in secondary market- Physical exchanges vs. over the counter exchanges (OTC)o New York Stock Exchange, Chicago Stock Exchange Used to be owned by members, now are traded on exchanges as for profit companieso Less formal, network of dealers around the country, includes NASDAQ No physical location- Clearing houses – stands between two clearing firms and reduces the risk of defaultSecondary Market Transfer of FundsMoney Markets vs. Capital Markets- Money markets trade debt securities or instruments with maturities with one year or lesso Short period of time – almost no fluctuation in priceo Low volatility – less risky than long term financial instrumentso Traded in the OTC market- Capital markets trade stocks and long-term debt with maturities greater than one yearo Wider price fluctuationsMoney Market vs. Capital Market MaturitiesMoney Market Instruments- Treasury billso Short-term U.S. government obligations- Federal Fundso Funds deposited at regional Federal Reserve Banks to meet daily reserve requirements, available for short term loan to other banks- Repurchase agreements (repos)o Agreements involving security sales by one party to another, with the promise to reverse the transaction at a specified date and price, usually at discount price- Commercial papero Short-term unsecured promissory notes that companies use to raise short term cash- Negotiable certificates of deposito Bank-issued time deposits that specify and interest rate and maturity date and are negotiable (trade on an exchange). Face value of at least $100,000- Banker acceptanceso Bank guaranteed time drafts payable to a vendor of goodsCapital markets- U.S. Treasury notes and bondso U.S. Treasury long term obligations issued to finance the national debt and pay for other federal government expenditures- State and local government bondso Debt securities issued by state and local governments, usually to cover capital improvements- U.S. government agency bondso Bonds issued by governmental agencies such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks- Corporate Stocks- Mortgageso Long term loans issued to individuals or businesses to purchase real estate- Mortgage-Backed Securitieso Long term debt securities that offer expected principal and interest as collateral. These securities, made up of many mortgages, are gathered into a pool and are thus “backed” by promised principal and interest cash flows- Corporate bondso Long term debt securities issued by corporations- Corporate stockso Long term equity securitiesOther Markets- Foreign exchange marketso Trade currency for immediate delivery (spot) or for some future delivery- Foreign exchange risko Risk arising from the unknown value at which foreign currency cash flows can be converted into U.S. dollars- Foreign currency exchange rates are variableo Vary with demand and supply of foreign currency and dollar- Derivatives Security Markets- Derivative Securityo A security formalizing an agreement between two parties to exchange and standard quantity of an asset at a predetermined price at a specified date in the futureo Linked to underlying security such as stock or currencyo High degree of leverage – higher risko Yahoo Optionso Used for hedging and speculatingFinancial Institutions- Commercial bankso Depository institutions whose major assets are loans and whose major liabilities are deposits- Thriftso Depository institutions including savings associations, savings banks, and credit union- Insurance Companieso Protect individual and corporations from financially adverse events- Securities Firms and Investment Bankso Underwrite securities and engage in related activities such as securities brokerage, securities trading, and making markets in which securities trade- Finance Companieso Make loans to both individuals and businesses. Unlike depository institutions, finance companies do not accept deposits, but instead rely on short and long term debt for funding- Mutual Fundso Pool many individuals’ and companies’ financial resources and invest those resources in diversified asset portfolio- Pension Fundso Offer savings plans through which participants accumulate savings during their working years- Financial Institutions perform economic functionso Monitor costs Make sure funds are not stolen or misused or used on projects with low returnso Provide liquidity Fund suppliers might need cash earlier than creditors can repay (need liquidity)o Price risk Fund suppliers may not get their funds back, let alone any returnFunctions Performed by Financial