Understanding Financial Markets and Institutions

1. Understanding Financial Markets and Institutions Chapter 8 Fin 325, Section 04 – Spring 2010 Washington State University

2. Financial Markets • Financial markets exist to manage the flow of funds from investors to borrowers • Financial markets can be distinguished along two dimensions: • Primary versus secondary markets • Money versus capital markets

3. Primary Markets • Provide a forum in which corporations and governments raise funds by issuing new financial instruments (stocks and bonds) • Because many companies and government entities can’t generate enough cash flow from internal sources to fund their needs, they must raise capital from external sources (fund suppliers - households)

4. Primary Market Transactions • Initial Public Offering (IPO) • On April 29, 2004, Google announced a $2.7 billions IPO of its common stocks. • Seasoned Offering (SO) • Investment banks underwrite IPOs and SOs and provide services including • Advising • Pricing • Attracting investors

5. Secondary Markets • Bonds and stocks are traded among investors in the secondary market • NYSE • AMEX • NASDAQ • Secondary markets provide a centralized marketplace where economic agents know they can buy or sell securities quickly and efficiently (provide liquidity)

6. Securities brokers such as Charles Schwab or other brokerage firms act as intermediaries in the secondary market • Note: the firm that originally issued the bond or stock is not involved in secondary transactions • If you buy shares of IBM through your broker, you are buying them from another investor. IBM has nothing to do with the transaction

7. Money Markets • Money markets feature debt securities with maturities of one year or less • Because of the shorter maturity, fluctuations in secondary market prices are usually small • Money market securities are less risky than long-term instruments • Most money market securities trade over-the-counter

8. Capital Markets Stocks and long-term debt (with a maturity of greater than one year) trade in capital markets Capital market instruments are subject to wider price fluctuations than money market instruments

9. Other Markets • Foreign Exchange Markets • Firms that sell goods outside the U.S. receive cash flows that are subject to foreign exchange risk • Derivative Markets • Futures contract • Option contract (calls and puts) • Swap contract

10. Financial Institutions • Financial institutions include: • Commercial Banks • Thrifts • Insurance Companies • Securities Firms and Investment Banks • Finance Companies • Mutual Funds • Pension Funds • These institutions act to channel funds from those with surplus funds to those with a shortage of funds

11. Function of Financial Institutions • Efficiently monitor the users of funds • Provide liquidity to suppliers of funds • Reduce monitoring costs, liquidity costs, and price risk • Without financial institutions, the flow of funds between suppliers of funds (households) and users of funds (corporations) would be low

12. Interest Rates • The rates we actually observe in financial markets are called nominal interest rates, sometimes called the quoted rate • Factors that influence interest rates for individual securities • Inflation • Default risk • Liquidity risk • Special provisions regarding use of funds • Term to maturity

13. Real Interest Rates • The rate that a security would pay if no inflation were expected over its holding period • Fisher Effect • Nominal interest rates must compensate investors for inflation:

14. Real Interest Rate Example • The one-year Treasury bill rates in 2007 averaged 4.93 percent and inflation for the year was 1.80 percent. Calculate the real interest rate for 2007 according to the Fisher Effect. RIR = i – Expected (IP) = 4.93% - 1.80% = 3.13%

15. Have a great Spring Break!