3-1 CHAPTER 3 FUNDAMENTALS OF FINANCIAL MARKETS

3-2 Examples of Capital Market Claims l Corporate Stock l Bonds l Mortgages

3-3 Net Financial Position of Major Sectors of the Economy Year-End 1998 (In $Billions) Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, March 12, 1999.

3-4 Capital Market Dept and Equity Outstanding (In $Billions) Source: Board of Governors, Federal Reserve System, Flow of Funds Accounts, Federal Reserve Bulletin.

3-5 Capital Market Efficiency l Allocational efficiency relates to whether or not funds are being channeled to their most productive (highest-valued) use. –Are businesses with risky, but potentially productive technology, able to find financing? –Allocational efficiency depends upon high informational and operational efficiency.

3-6 Capital Market Efficiency (continued) l When market participants are able to obtain sufficient,timely, and accurate information about the relative values of securities, the market is said to have high informational efficiency. –Timely, accurate information assists market participants in allocating funds to the most productive use (allocational efficiency).

3-7 Capital Market Efficiency (concluded) –The various levels of market efficiency discussed in finance relate to informational efficiency. –In a market with high informational efficiency, prices embody all relevant information about securities.

3-8 Capital Market Efficiency (concluded) l A market is operationally efficient if the costs of conducting transactions are as low as possible. –If broker/dealers are earning normal profit returns (adequate based on risk assumed), the market is operationally efficient. –Operational efficiency is dependent upon the competitiveness (ease of entry/exit) of broker/dealers. –Allocational efficiency is directly related to the level of operational efficiency in any market.

3-9 Overview of the Money Market l Short-term debt market -- most under 120 days l A few high quality borrowers l Many diverse investors l Informal market centered in New York City l Standardized securities -- one security is a close substitute for another

3- 10 Overview of the Money Market (concluded) l Good marketability -- secondary market l Large, wholesale open-market transactions l Many brokers and dealers are competitively involved in the money market. l Payment in Federal Funds -- immediately available funds. l Physical possession of securities seldom made -- centralized safekeeping.

3-11 Economic Role of Money Market (MM) l The money market is a market for liquidity –Liquidity is stored in MM by investing in MM securities. –Liquidity is bought in MM by issuing securities (borrowing). l There are few high-quality borrowers and many diverse MM investors.

3- 12 Characteristics of Money Market Instruments l Low default risk l Short maturity l High marketability

3- 13 Selected Money Market Instruments Outstanding (December 31, 1998) Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, March 12, 1999 and The Bureau of Public Debt, Monthly Statement of Public Debt, January 31, 1999.

3- 14 Characteristics of Money Market Instruments

3- 15 Money Market Balance Sheet Position of Major Participants

3- 16 Types of Financial Markets l Markets may be differentiated by when a security is sold. –The initial financing of the DSU is the primary market; subsequent resale of the financial claims of the DSU are traded in the secondary markets. –Primary markets are important from a real saving/investment perspective; secondary markets provide liquidity and portfolio rebalancing capacity for the investor.

3- 17 Types of Financial Markets (continued) l Markets may be differentiated by how or where they are traded. –Organized exchanges provide a physical meeting place and communication facilities. –Securities may trade off the exchange in the over- the-counter (OTC) market. OTC markets have no central location.

3- 18 Types of Financial Markets (continued) l Markets may be differentiated by maturity. –High quality short-term (less than one-year) debt securities are issued and traded in the money market. –Long-term (greater than one-year) securities are issued and traded in the capital market.

3- 19 Types of Financial Markets (continued) l Spot and futures markets--variation in timing of delivery and payment. –Items traded in the market for immediate delivery and payment are traded in the spot market. –When delivery at a specific price(payment) is not "spot," a "futures” or “forward” market transaction has occurred. »Futures contracts are traded on organized exchanges. »Forward contracts are traded over the counter.

3- 20 Types of Financial Markets (continued) l Option markets trade contracts specifying price and conditional delivery of a quantity of asset for a specific period of time. –A call option is an option to buy; a put is an option to sell. –Options are traded on major security and commodity exchanges as well as in various over- the-counter markets.

3- 21 Types of Financial Markets (concluded) l Foreign exchange markets. –Foreign exchange, the value of one currency relative to another, is traded in the foreign exchange market. –Foreign exchange is traded in the spot, forward, futures, and option markets.