Types of Financial Market
Capital Market and Money Market
Financial Market
facilitate the flow of funds from Investor-to-borrower as well as from investor-to-investor
Types of Capital Market
Primary and Secondary
Primary Market
provide the mechanism by which those needing capital ("demanders" of funds) can obtain it by issuing NEW financial instruments, such as stocks and bonds
Governments and Corporations in regards to Primary Markets
are the main issuers (sellers) of these financial instruments.
Investment Banks (definition and examples)
arrange ("underwrite") most of the primary market transactions.
ex. Morgan Stanley, Goldman Sachs, Merrill Lynch
Two Kinds of primary market transactions
Public Offering and Private Placement
Secondary Market
provide a Centralized Marketplace where investors can buy or sell publicly traded securities quickly and efficiently, eliminate the "search" costs by matching willing buyers and sellers, Secondary market transactions are typically facilitated by Brokerage
examples of Secondary Market
New York Stock Exchange
NASDAQ
New York Futures Exchange
New York/ Chicago Mercantile Exchange
Capital Market Instruments
trade Equities (stocks) and Debt (bonds) having maturities > 1 year and include -
US Treasury notes and bonds
US government agency bonds
State and local government bonds
Mortgages and mortgage-backed securities
Corporate bonds and stocks
Money Market Instruments
trade only Debt (bonds) only having maturities < 1 year and include -
Treasury bills
Federal funds
Repurchase agreements
Commercial paper
Certificates of deposit
Treasury Notes
U. S. Government issued debt security
Fixed interest rate; Maturity of 1-10 years
Large secondary market adds to their liquidity
Interest paid every 6 months
(Capital Market Instrument)
Treasury Bonds
Like Treasury Note; Maturities > 10 years
Widely accepted as the benchmark "risk-free" rate (Capital Market Instrument)
TIPS (Treasury Inflation Protection Security)
(Capital Market Instrument)
U. S. Government Agency Bonds
Bonds issued by government agency (Fannie Mae, Freddie Mac, FHLB)
Not guaranteed like U. S. government bonds
Generally pays higher interest due to higher risk
(Capital Market Instrument)
State and Local (Municipal) Bonds
Issued by state or local government or municipalities
Proceeds used for local projects (streets, sewers, schools, etc.)
Interest is tax-free (very attractive to high-bracket tax payers)
(Capital Market Instrument)
Mortgages and Mortgage-backed Securities
(Capital Market Instruments)
Corporate Bonds
Issued by corporations
Alternative to equity financing
Interest rate will vary depending on credit (default) risk
Corporate bonds are monitored by rating agencies (S&P, Moody's, Fitch)
Corporate credit risk is measured by ratings (AAA, AA, A, BBB, BB, etc
Treasury Bills
U.S Government I.O.U.
Very low risk
Purchased in denominations of $1,000 - $5,000,000
Does not pay interest; instead, purchased at a discount to par value (e.g., you pay $970 for a $1,000 T-bill that matures in 1 year)
(Money Market Instruments)
Federal (Fed) Funds
Short term funds transferred between financial institutions for usually no more than one day
(Money Market Instruments)
Repurchase Agreements
Short-term borrowings for dealers in government securities
Dealer sells the securities to investors and buys back the security the next day
Allows investors to "sweep" funds overnight and earn interest
(Money Market Instruments)
Commercial Paper
Unsecured short-term debt issued by a corporation
Typically used to cover finance receivables and inventory or cover short-term cash needs
Issued at a discount to par value (like T-bills)
Typically mature < 270 days
(Money Market Instruments)
Certificates of Deposit (CDs)
Savings certificate issued by banks
Fixed maturity date (30, 60, 90 or 180 days) at specified interest rate
Any denomination
FDIC insured up to $250,000
(Money Market Instruments)
The Federal Reserve
1. Conduct nation's monetary policy to promote maximum employment, stable prices and moderate long-term interest rates
2. Promote stability of U.S. financial system
3. Promote the safety and soundness of individual financial institutions
4. Maintain safe
Fed Funds rate
the rates banks charge each other when short-term loans are needed to meet Federal Reserve requirements
Prime commercial loan rate
the interest rate paid by the most credit-worthy commercial loan customers
3-month Treasury bill rate
the interest rate paid by the US Government on 90-day borrowings (presumed to be of highest credit-worthiness)
Home mortgage rate
the going interest rate by credit-worthy home buyers
High-grade corporate bond rate
the interest paid by the most credit-worthy corporate bond issuers
Nominal Rate
rate before inflation. These are the rates observed in the financial markets.
Real Rate
rate after the effects of inflation.
Real Risk-Free Rates
The rate of interest a risk-free security would pay if no inflation were expected
"Risk-Free" generally refers to US Treasuries
The higher the risk-free rate, the higher the interest rate borrowers will pay
Inflation
Defined as the % increase in the price of a standardized basket of goods and services over time
Measured by the Consumer Price Index (CPI)
Higher inflation means higher interest rates
Default or Credit Risk
Default or credit risk is the risk that a bond issuer may fail to make promised interest and principle payments.
The higher the default risk, the higher the interest rate the borrower will pay
Liquidity Risk
The interest rate on a security reflects its relative liquidity
The higher liquidity, the lower the interest rate
Term to Maturity
Generally, the higher the term to maturity, the higher the interest rate
Yield Curve
a line that plots the interest rates at a set point in time of bonds having equal credit quality but differing maturity dates
Bond
are debt securities (like a loan) issued by federal, state and local governments, and corporations as a way to fund various projects or operations.
Also known as "fixed income securities
Par Value
the amount of the loan to be repaid, generally $1000
corporate bonds are quoted in 1/8 increments, while government bonds are quoted in 1/32 increments
Time to Maturity
the number of years left until the maturity date
Call
the opportunity for the issuer to repay the principal before the maturity date
Coupon Rate
the percentage rate used to compute the bond's interest payment, usually paid semi-annually
Bond Price
the bonds market price reported as a percentage of par value
Interest Rates regarding bonds
bond prices decrease as interest rates increase
Bond Coupon Rates
established when the bond is issued and are based on the following factors -
Credit risk, i.e., the amount of uncertainty about whether the issuer will repay the debt
The term...longer term bonds must pay a higher coupon rate in order to entice investors
Common Stock Characteristics
Common stock represents an ownership stake in a corporation; issued in the form of "shares".
Over time, stocks offer the best opportunity to increase financial wealth.
Stock values can be volatile in the short-term, so best to take a long-term view. (See
New York Stock Exchange (NYSE)
World's largest stock exchange
Home to 2,300 U.S. companies (large-cap)
Approx 3 billion shares traded daily
American Stock Exchange (AMEX)
Owned by NYSE
Mostly small-cap stocks, exchange-traded funds and derivatives are traded here
Approx 81 million shares traded daily
Nasdaq
Global electronic marketplace (no physical location)
Leader in securities trading technology (NYSE and AMEX have followed)
Home to 3,000 companies
Benchmark for U.S. Technology stocks
Home to technology giants Apple, Google, Microsoft, Oracle, Amazon, Int
Dow Jones Industrial Average
The Dow"...most popular stock market index, comprised of 30 large-cap, industry leading companies
Represents approximately 30% of U.S. stock market value
Established in 1884 by Charles Dow and comprised mostly railroads; industrial companies added in 190
S&P 500 Index
The S&P"...comprised of the largest 500 large-cap stocks listed on the NYSE or Nasdaq
Represents 80% of all U.S. stock market value
Most common benchmark against which stock analysts and investment managers are measured
Nasdaq Composite
Index of all stocks traded on the Nasdaq
Heavily weighted toward information technology companies
Systematic Risk
Also known as "market" risk or "undiversifiable" risk...systemic risk is the uncertainty inherent to the entire market or entire market segment.
Examples of Systematic risks include interest rates, recessions, wars, headline news events...
Impacts the ent
Unsystematic Risk
Also known as "specific risk", "diversifiable risk" or "residual risk", this type of uncertainty comes with the company or the industry in which you invest.
Examples of unsystematic risk -
Labor problems
Competition (domestic and foreign)
Poor management
Volatility
a statistical measure of the dispersion of returns for a given investment due to systematic risk.
Volatility is typically measured by the standard deviation or variance between an investment's returns over time.
Higher volatility means riskier
Beta
a statistical measure a stock's volatility relative to the market (the "market" typically defined as the S&P 500 index).
A beta of 1 means that the stock price moves with the market
A beta < 1 means that the stock is LESS volatile than the market
A beta >
Risk-Return Tradeoff
The risk-return tradeoff is the principle that higher returns are associated with higher risk.
An appropriate risk-return tradeoff depends on a variety of factors -
Risk tolerance or appetite
Years to retirement
Potential to absorb lost funds
Ability to w
Coefficient of Variation
allows you to determine how much volatility, or risk, you are assuming in comparison to the amount of return you can expect from your investment.
Lower CoV means better risk-return tradeoff.
Correlation
Correlation is a measures of the degree to which two securities move in relation to each other.
Correlations are used in portfolio management. Correlation is computed into what is known as the Correlation Coefficient, which has value that must fall betwee
Call Premium
to compensate the bond holders for getting the bond called the issuer pays...