Financial Markets

Facilitate transactions between

borrowers and lenders
Lenders -- earn return on
funds
Borrowers -- permits increased
flexibility for expenditure
Motivations for Borrowing
Consumers -- allows for non-
synchronous patterns of desired
consumption and income
Business -- financing short-term needs
(e.g. inventories) and long-term
investment projects
Government (Federal as well as State
and Local)-- financing existing debt
and new deficits
Types of Borrowing
Debt -- A contract to pay specified
amounts over a predetermined
time interval (e.g. bonds, bank
loans)
Equity -- Purchases of shares of
ownership (e.g. stock)
Direct Vs Indirect Finance
Direct Finance -- Borrower
borrows directly from lender.
Examples -- Personal transactions,
Bonds
Indirect Finance -- Lender loans to
Financial Intermediary, who then
loans to borrowers.
Examples -- Banks, Mutual Funds
Exchanges Versus Over
the Counter Markets
Exchange -- Buyers and sellers
meet in one central location
Over the Counter -- Trades made
from home or office, via
computers.
Primary Versus
Secondary Markets
Primary Markets -- Markets for
new issues.
Secondary Markets -- Markets for
issues sold before maturity
Money Vs Capital Markets
Money Market -- Market for bonds
with maturity one year or less
high denominations
excellent secondary markets
Capital Market -- Market for long-
term bonds and equity
lower denominations
lower volume -- relatively narrow
secondary markets
Interest: Compensation for
Inconvenience
Inconvenience Interest Rate
Sources of Inconvenience
Liquidity -- ability to convert
instrument into a medium of
exchange
Default Risk -- likelihood that
borrower will not meet promised
payments
Applications to
Money Supply Components
Savings Deposits versus
Time Deposits
Relative liquidity

Money Market Deposit Accounts
(MMDA) versus Money Market Mutual
Funds (MMMF)
MMDA -- deposit insurance
MMMF -- none, more default risk
Money Market Instruments

Group #1 --
Short-Term Bonds
Buyers (Lenders): Looking for a
return, willing to tolerate various
degrees of inconvenience.
Sellers (Borrowers): Issued by
different entities for different
reasons.
(1) Treasury Bills
Issued by the Federal
Government, to finance national
debt and new deficits
3 month, 6 month, and 1 year
maturities
Zero default risk
Best secondary market within
group

Used by the Federal Reserve to
perform Open Market Operations
Generally lowest interest rate of
group
(2) Negotiable
Certificates of Deposit (CDs)
Denominations: $100,000+
Issued by banks to raise money for
loans.
Represents cost of funds for banks --
changes in i
CD
induce changes in bank
loan rates.
Low Default Risk -- deposit insurance
Good secondary market
(3) Commercial Paper (CP)
Issued by firms to finance short-
term debt (e.g. inventories)
Flexible maturities.
Rated according to default risk of
issuing company.
Good secondary market.

(4) Bankers Acceptances
Issued by banks to carry out
international transactions.
Characteristics similar to
Negotiable CDs.
Overall -- Group #1
Close -- but not perfect --
substitutes
Interest rates --different due to
non-price differences
Liquidity (secondary market)
Default Risk
Group #2 -- Banks Seeking
Very Short-Term Funds
Eurodollars -- dollar denominated
deposits in foreign banks (banks
can borrow from these),
Repurchase Agreements (RP) --
banks selling one of their bonds to
a deposit holding customer, with
the promise to buy it back at a
specific date and price.
Another Option
Federal Funds (FF) -- one bank
borrowing from another bank, usually
overnight.
Key rate in monetary policy, Federal
Reserve targets i
FF

Cost of obtaining bank reserves in
the market
Major increase in volume over the
years
Still Another Option
Discount Window -- banks borrowing
from the Federal Reserve, paying the
discount rate.
only non-market determined rate,
preset by Federal Reserve
small usage as borrowing source for
short-term reserve adjustment, due
to expensiveness and attraction of
alternatives
Typically, i
DISC
= 0.5% + Target i
FF

Capital Market Instruments
Stocks -- equity, returns compete
with bonds
Group #1 --
Long-Term Bonds

(1) Treasury Bonds
Issued by the Federal Government to
finance debt
Zero default risk
Best secondary market of bonds within
group
Financial analysts track rates of
various maturities on a given date, a
plot of which is called the yield curve
(2) US Government
Agency Securities
Issued by the US government
agencies to finance their
operations (e.g. EPA)
Characteristics very similar to T-
Bonds
(3) Corporate Bonds
Issued by corporations to finance
investment projects
Rated according to default risk
AAA -- least risky
AA -- next grade
A -- next grade
BAA -- more risky
Junk Bonds -- bonds rated below B
Corporate Bonds, continued
Narrow secondary market
Typical maturity -- 20 years
Difference between BAA rate and
AAA rate called risk premium,
economic interpretation: difference
in compensation required to take on
increased default risk
tends to increase during economic
slowdowns and recessions
(4) Municipal Bonds
Issued by State and Local
Governments to finance projects in
capital budget.
Positive default risk
Narrow secondary market
Tends to have lowest interest rate
within this group
Interest is exempt from taxes
The After-Tax Interest Rate
After-tax rate = (i)(1 - ), where is the
marginal tax rate.
For Municipal Bonds, after-tax rate =
pre-tax rate (since = 0)
Example: i
CORP
= 8.00%, = 0.28,
After-tax rate = 8.00(1 - 0.28) = 5.76%
Compare with Municipal Bond rate.
Group #2 -- Bank Loans
Issued by various borrowers, held
by banks.
Secured versus unsecured loans
Secured Loans -- Has collateral (e.g.
consumer and commercial
mortgages)
Unsecured Loans -- No collateral
(e.g. credit cards)
(1) Mortgages
Loans to individuals or business to
purchases housing, land, or building
structure
Some default risk (e.g. sub-prime
mortgages), but risky in other ways as
well
Availability highly valued in American
culture (tax system)
Secondary Markets --
Consumer Mortgages
Government National Mortgage
Association (GNMA)
Federal National Mortgage Association
(FNMA)
Federal Home Loan Mortgage
Corporation (FHLMC)
Securitized Mortgages bundling
mortgages into a bond, then selling in
the capital market
(2) Other Types
of Bank Loans
Commercial Loans: Prime Rate --
interest rate given to firms with the
lowest perceived default risk
Consumer Loans (e.g. auto loans)
Credit Card Balances -- unsecured
high default risk
Shorter-term relative to mortgages,
tends to have no secondary market.
(3) US Savings Bonds
Issued by Federal Government to
finance debt.
Low denominations, available to the
small saver.
Zero default risk.
Zero Coupon bond, double purchase
price payment at maturity
Tax advantages, particularly for use in
funding college education
What Makes
Interest Rates Different?
Secondary Market
Maturity
Default Risk
Taxability
Above characteristics constitute
structural differences that bring about
various degrees of inconvenience.