Financial Markets, Instruments, and Market Makers Chapter 3 © 2003 South-Western/Thomson Learning

Slide 2 Learning Objectives  Classifying financial markets  Primary & secondary  Money and capital  Spot and futures  Definitions & characteristics of financial market instruments  Functions of market makers  Connection of various sectors of financial markets

Slide 3 Introducing Financial Markets A market for financial claims (instruments) can be viewed as the process or mechanism that connects the buyers and sellers of claims.

Slide 4 Introducing Financial Markets  Money market includes  Markets where securities with original maturities of one year or less are traded  Capital market includes  Markets where securities with original maturities of more than one year are traded

Slide 5 Introducing Financial Markets  Primary market  Security is initially sold for the first time  Secondary market  Further trading Conceptual distinction: Selling of new securities in primary market and trading of older securities in secondary market occur simultaneously. Conceptual distinction: Selling of new securities in primary market and trading of older securities in secondary market occur simultaneously.

Slide 6 Financial Markets  Financial futures  Financial forward markets These fulfill two basic functions:  Reduce risk associated with future price changes  Facilitates speculation - the buying or selling of securities in hopes of profiting from future price changes

Slide 7 Money Market Instruments  U.S. Treasury Bills (T-bills)  Short term government debt instruments  Typical maturities of 3-12 months  Negotiable Certificates of Deposit (CDs)  Debt instrument sold by depository institution  Pays annual interest payments equal to fixed % of original purchase price  Can be resold in secondary market  Minimum denomination of $100,000 (in practice, to trade in secondary market the minimum is $2,000,000)

Slide 8 Money Market Instruments  Commercial paper  Short-term debt instrument issued by corporations  Supported by backup line of bank credit  Bankers’ Acceptances  Instruments created in course of financing international trade

Slide 9 Money Market Instruments  Repurchase Agreements  Short-term agreements in which seller  Sells government security to buyer  Agrees to buy government security back on later date at higher price  Federal Funds  Overnight loans between depository institutions of their deposits at the Fed  Eurodollars  Dollar-denominated deposits held in banks outside the United States

Slide 10 Exhibit 3–2 The Money Market

Slide 11 Exhibit 3–3 Bankers’ Acceptances Source: Adapted from Ann-Marie Meulendyke, U.S. Monetary Policy and Financial Markets (New York: Federal Reserve Bank of New York, 1989), p. 80.

Slide 12 Capital Market Instruments The capital market raises the funds needed by DSUs to carry out their spending and investment plans.

Slide 13 Exhibit 3–4 The Principal Capital Market Instruments: Amount Outstanding, End of the Year (in Billions of Dollars) a Excludes federally sponsored mortgage pools. b As of June 30, Source: Federal Reserve Flow of Funds Accounts, Z1, 2nd Quarter 2001, September 18, 2001; Federal Reserve Bulletin, various issues; Banking and Monetary Statistics 1941–1970.

Slide 14 Exhibit 3–5 The Capital Market

Slide 15 Capital Market Instruments  Stocks  Equity claims  Represent ownership of net income and assets of corporation  Preferred stock  Pays fixed dividend; in event of bankruptcy, preferred stock owners entitled to be paid first  Common stock  Pays variable dividend depending on profits left over after  preferred stockholders have been paid  retained earnings set aside

Slide 16 Capital Market Instruments  Mortgages  Loans to purchase  Single-multiple family residential housing  Land  Other real structures … land or structures serve as collateral for loan  Corporate Bonds  Long-term bonds  Issued by corporations  Usually have excellent credit ratings  Maturities range from 2 – 30 years  Not as liquid as other securities

Slide 17 Capital Market Instruments  U.S. Government Securities  Long-term debt instruments  Maturities of 2 – 30 years  Issued by U.S. Treasury to finance deficits of federal government  U.S. Government Agency Securities  Long-term bonds issued by various government agencies that support  Commercial, residential, & agricultural real estate lending  Student loans

Slide 18 Capital Market Instruments  State and local government bonds (municipals) Long-term instruments issued by state and local governments to finance expenditures on schools, roads, college dorms and the like.  Revenue bonds - finance specific projects  General obligation bonds - backed by full faith and credit of issuer

Slide 19 Role of Market Makers  Function as coordinators who link buyers and sellers of financial instruments.  Help maintain a smoothly functioning, orderly financial market.  Receive, process, interpret and disseminate information to potential buyers and sellers.

Slide 20 Exhibit 3– 6 Market Makers

Slide 21 Market Makers  Broker arranges trades between  Buyers  Sellers  Dealer  Arranges trades between buyers and sellers  Is the principal in transactions  Purchases and holds securities sold by investors

Slide 22 Why Market Makers Make Markets  Expected profits  Mainly from revenue generated by price it charges for conducting a transaction  Number of transactions engaged in  Capital gains or losses associated with inventory of securities  Fee for  Brokerage fee or commission charge for each transaction  Function of spread between Bid Price (buy securities) and Asked Price (sell securities) and number of transactions

Slide 23 Market Making and Liquidity Transactions costs and liquidity affect portfolio decisions

Slide 24 Exhibit 3–7 The Marketing and Subsequent Trading of a Corporate Bond