FINANC 3000 1st EditionExam # 2 Study Guide Lectures: 8 - 15Lecture 8 (September 23)Understanding Financial Markets and Institutions Pt. 1- Financial Marketso Help manage flow of funds from: Investors to borrowers Investor to investoro Two major market dimensions Primary versus secondary markets Money versus capital markets- Primary Marketso Markets in which corporations and governments raise funds through new issues of securitieso Investment banks arrange most primary market transactions Morgan Stanley, Goldman Sachs or Merrill Lynch Intermediaries between issuing parties and investors Provide advice (regarding price and number of securities to offer) Attract initial purchaserso Initial offering can occur either through public offering or private offering Private – accredited investors only Public – register with SEC and available to the publico Private offerings are mostly illiquid Lack of information and illiquidity raise interest paid on those securitieso Public offering can be: Initial Public Offering (IPO) of stocks or additional sales of shares of public company Public bond issuanceo Primary market transfer of funds- Secondary Marketso Benefit investors and issuers Securities traded after initial issuance Provide liquidity and diversification benefits for investors Security valuation information for issuerso Secondary market buyers often use brokers such as Charles Schwab or Fidelity to act as intermediarieso Original issuers are NOT involved in secondary marketo Physical exchanges vs. over the counter exchanges (OTC) New York Stock Exchange, Chicago Stock Exchange Used to be owned by members, now are traded on exchanges as for profit companies Less formal, network of dealers around the country, includes NASDAQ No physical locationo Clearing houses – stands between two clearing firms and reduces the risk of default- Secondary Market Transfer of Funds- Money Markets vs. Capital Marketso Money markets trade debt securities or instruments with maturities with one year orless Short period of time – almost no fluctuation in price Low volatility – less risky than long term financial instruments Traded in the OTC marketo Capital markets trade stocks and long-term debt with maturities greater than one year Wider price fluctuations- Money Market vs. Capital Market Maturities- Money Market Instrumentso Treasury bills Short-term U.S. government obligationso Federal Funds Funds deposited at regional Federal Reserve Banks to meet daily reserve requirements, available for short term loan to other bankso Repurchase agreements (repos) 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 priceo Commercial paper Short-term unsecured promissory notes that companies use to raise short term casho Negotiable certificates of deposit Bank-issued time deposits that specify and interest rate and maturity date and are negotiable (trade on an exchange). Face value of at least $100,000o Banker acceptances Bank guaranteed time drafts payable to a vendor of goods- Capital marketso U.S. Treasury notes and bonds U.S. Treasury long term obligations issued to finance the national debt and pay for other federal government expenditureso State and local government bonds Debt securities issued by state and local governments, usually to cover capitalimprovementso U.S. government agency bonds Bonds issued by governmental agencies such as Fannie Mae, Freddie Mac, and the Federal Home Loan Bankso Corporate Stockso Mortgages Long term loans issued to individuals or businesses to purchase real estateo Mortgage-Backed Securities 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 flowso Corporate bonds Long term debt securities issued by corporationso Corporate stocks Long term equity securities- Other Marketso Foreign exchange markets Trade currency for immediate delivery (spot) or for some future deliveryo Foreign exchange risk Risk arising from the unknown value at which foreign currency cash flows canbe converted into U.S. dollarso Foreign currency exchange rates are variable Vary with demand and supply of foreign currency and dollaro Derivatives Security Marketso Derivative Security 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 future Linked to underlying security such as stock or currency High degree of leverage – higher risk Yahoo Options Used for hedging and speculating- Financial Institutionso Commercial banks Depository institutions whose major assets are loans and whose major liabilities are depositso Thrifts Depository institutions including savings associations, savings banks, and credit uniono Insurance Companies Protect individual and corporations from financially adverse eventso Securities Firms and Investment Banks Underwrite securities and engage in related activities such as securities brokerage, securities trading, and making markets in which securities tradeo Finance Companies 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 fundingo Mutual Funds Pool many individuals’ and companies’ financial resources and invest those resources in diversified asset portfolioo Pension Funds Offer savings plans through which participants accumulate savings during their working yearso Financial Institutions perform economic functions Monitor costs Make sure funds are not stolen or misused or used on projects with low returns Provide liquidity Fund suppliers might need cash earlier than creditors can repay (need liquidity) Price risk Fund suppliers may not get their funds back, let alone any return- Functions Performed by Financial Institutionso Fund suppliers pool their money i.e. deposit money at the savings accounto funnel those money to corporations or government agencieso receive interest from payments pay less interest than received to depositors (keep the difference)o have the ability to reduce