Financial Markets Channels funds

from lender-savers to borrowersspenders

Financial Markets have the basic

function of.. bringing together people
with funds to lend and people who
want to borrow funds

Which of the following can be

described as involving direct finance
- A corporation buys commercial
paper issued by another corporation
- A pension fund manager buys
commercial paper from the issuing
corporation

Indirect finance - A corporation takes

out loans from a bank
- People buy shares in a mutual fund
- A corporation buys commercial
paper in a secondary market

- A bank buys a U.S. Treasury bill

from one of its depositors

Financial markets improve economic

welfare because - they allow funds to
move from those without productive
investment
- they allow consumers to time their
purchases better

Securities i.e. - A certificate of

deposit
- A share of Texaco common stock
- A Treasury Bill

Characteristics of debt and equity They can both be long-term financial

instruments
- They both involve a claim on the
issuer's income
- They both enable a corporation to
raise funds


Example of a long term financial
instrument A U.S. Treasury bond

Short-term financial Instruments - a

negotiable certificate of deposit
- banker's acceptance

Secondary Markets i.e. - The New

York Stock Exchange
- The U.S. government bond market
- Over-the-counter stock market
- the options markets

a corporation acquires new funds

only when its securities are sold in
the primary market by an investment
bank

Brokers Intermediaries who are

agents of investors and match
buyers with sellers of securities

Dealers Intermediaries who link

buyers and sellers by buying and
selling securities at stated prices are
called

Investment bank an important

financial institution that assets in the
initial sale of securities in the
primary markets

Most common stocks are traded

over-the-counter, although the
largest corps. have their shares
traded at organized stock exchanges
such as the N.Y.S.E. TRUE

A corporation acquires new funds

only when its securities are sold in
the primary market TRUE


Money markets securities are usually
more widely traded than longer-term
securities and so trend to be more
liquid TRUE

A debt instrument is long term if its

maturity is ten years or longer TRUE

A corporation acquires new funds

only when its securities are sold in
the primary market TRUE

Over-the-Counter Market i.e. - the

stock market
- the bond market
- the foreign exchange market
- the Federal funds market

Instruments traded in a money

market - Banker's acceptances

- U.S. Treasury Bills

- Eurodollars
- Commercial paper

Instruments traded in a capital

market - U.S. Government agency
securities
- Corporate Bonds

Bonds that are sold in foreign

country and are denominated in that
country's currency are known as foreign bonds

Bonds that are sold in a foreign

country and denominated in a
currency OTHER THAN that of the
country in which they are sold are
known as Eurobonds

Financial Intermediaries - exist

because there are substantial

information and transaction cost in

the economy
- improve the lot of the small saver
- are involved in the process of
indirect finance

The main sources of financing for

businesses, in order of importance,
are 1. financial Intermediaries
2. Issuing Bonds
3. Issuing Stock

The presence of transaction cost in

financial markets explains, in part
why financial intermediaries and
indirect finance play such an
important role in financial markets

Financial intermediaries can

substantially reduce transaction cost
per dollar of transactions because

their large size allows them to take

advantage of economies of scale

The presence of asymmetric

information in financial markets
leads to.. adverse selection and
moral hazard problems that interfere
with efficient functioning of financial
markets

When the lender and the borrower

have different amounts of
information regarding a transaction..
asymmetric information is said to
exist

When the borrowers who are the

most likely to default are the ones
most actively seeking a loan,
adverse selection is said to exist

When a borrower engages in

activities that make it less likely that

the loan will be repaid moral hazard

is said to exist

The concept of adverse selection

helps to explain - which firms are
more likely to obtain funds from
banks and other financial
intermediaries, rather than from the
security markets
-why indirect finance is more
important than direct finance as a
source of business finance

Adverse selection is a problem

associated with equity and debt
contracts arising from the lender's
relative lack of info about the
borrower's potential returns and risks
of his investment activities

When the least desirable credit risks

are the ones most likely to seek

loans, lenders are subject to the

adverse selection problem

Financial institutions expect that

opportunistic behavior will occur, as
the least desirable credit risks will be
the ones more likely to seek out
loans.

Successful financial intermediaries

have higher earnings on their
investments because they are better
equipped than individuals to screen
out good from bad risks, thereby
reducing losses due to adverse
selection

asymmetric information the

difference in information in financial
markets, are lenders typically have
inferior info about potential returns
and risks associated with any
investment project.


depository institutions i.e. - saving
and loan association
- commercial bank
- credit union

contractual savings institution i.e. life

insurance company

Investment intermediaries i.e.

-finance companies
-mutual funds

The gov. regulates financial markets

for 3 main reasons 1. to ensure
soundness of the financial system
2. to improve control of monetary
policy
3. to increase the information
available to investors

Financial Panic Asymmetric info can

lead to widespread collapse of
financial intermediaries

Every financial market allows loans

to be made FALSE

An example of direct financing is if

your were to lend money to your
neighbor TRUE

The N.Y.S.E. is an example of a

primary market FALSE

Commercial paper(money market) is

not traded in the capital market
TRUE

Eurodollars are traded in money

market TRUE

The process of financial

intermediation is also known as
direct finance FALSE

A mutual fund(investment
intermediaries) is not a depository
institution TRUE

A pension fund is not a contractual

saving institution FALSE

Equity represents an ownership

interest in a firm and entitles the
holder to residual cash flows TRUE

Adverse selection refers to those

most at risk being most aggressive in
their search for funds FALSE

Nominal interest rates the interest

rates actually observed in financial
markets


Loanable funds theory a theory of
interest rate determination that
views equilibrium interest rates in
financial markets as a result of the
supply and demand for loanable
funds

Inflation the continual increase in the

price level of a basket of goods and
services

Real Interest Rate nominal interest

rate that would exist on a security if
no inflation were expected

Default Risk risk that a security

issuer will default on the security by
missing an interest or principal
payment

Liquidity Risk risk that a security

cannot be sold at a predictable price
with low transaction

Special Provisions provisions (e.g.

taxability, convertibility, and
callability) that impact the security
holder beneficially or adversely and
as such are reflected in the interest
rates on securities that contain such
provisions

Term to Maturity length of time a

security has until maturity

Term structure of interest rates a

comparison of market yields on
securities, assuming all
characteristics except maturity are
the same.

forward rate an expected rate

(quoted today) on a security that

originates at some point in the

future.

compound interest interest earned

on an investment is reinvested

simple interest interest earned on an

investment is not reinvested

Lump sum payment a single cash

flow occurs at the beginning and end
of the investment horizon with no
other cash flows exchanged

annuity a series of equal cash flows

received at fixed intervals over the
investment horizon