Econ 330 - Chapter 2: Financial Markets

Short-term debt instrument

A type of debt instrument that the maturity term is less than a year

Intermediate-term debt instrument

A type of debt instrument that the maturity term is one to ten years.

Long-term debt instrument

A type of debt instrument that the maturity term is ten years or longer.

Investment Intermediaries: Mutual Funds

Acquire funds by selling shares to individuals and then using the proceeds to purchase diversified portfolios of stocks and bonds. Allows shareholders to pool their resource so they can make advantage of lower transaction costs when buying a lot of stocks/bonds.

Advantage of holding an equity

Benefit directly if there is an increase in profit.

Capital Market Instruments: Mortgage-backed securities

Bond-like debt instruments backed by a bundle of individual mortgages, whose interest and payments are collectively paid to the holders of the security.

Equities

Common stock. It shares the net income and the assets of a business. Considered as long-term securities because they have no maturity date.

Debt Instrument

Example: Bond or Mortgage. There is a contractual agreement by the borrower to pay the lender at regular intervals until a specific date when a final payment is made.

Investment Intermediaries: Investment Banks

Helps a corporation issue securities. It advises corporation on which type of securities to issue (stock/bonds) and then it helps sell (underwrite) the securities by purchasing them from a corporation and reselling them in the market.

Contractual Saving Institutions: Life Insurance Companies

Insure people against financial hazards following a death and sell annuities. Acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages.

Contractual Saving Institutions: Fire and Casualty Insurance Companies

Insure their policy holders against loss from theft, fire, and accidents. Acquire funds from the premiums that people pay to keep their policies in force. Largest holding asset: Muni bonds.

Capital Market Instruments: Consumer and Bank Commercial Loans

Loans to consumer and businesses made principally by banks and finance companies.

Capital Market Instruments: Mortgages

Loans to house-hold or firms to purchase land, housing, or other real structures. The structure or the land itself serves as the collateral. Provided by financial institutions.

Capital Market Instruments: Corporate Bonds

Long-term bonds issued by corporations with very strong credit ratings. Sends the holder interest payment twice a year and pays off the face value when the bond matures. Convertible bonds: have additional feature allowing the holder to convert them into a specific number of shared of stock at any time up to the maturity date (more desirable to holder). Not as liquid as other securities.

Capital Market Instruments: U.S. Government Agency Securities

Long-term bonds issued by various agencies such as Ginnie Mae, the Federal Farm Credit Bank to finance mortgages, farm loans, or power generating equipment. Guaranteed by the fed government.

Capital Market Instruments: U.S. Government Securities

Long-term debt instruments issued by U.S. Treasury to finance deficits in the fed govt. Most liquid security traded in the capital market. Held by the fed reserve, banks, households, and foreigners.

Capital Market Instruments: State and Local Government Bonds (Municipal Bonds)

Long-term debt instruments issued by state/local govt to finance expenditures on schools, roads, and other large programs. Interest payment are exempt from tax. Commercial banks are biggest buyer of this bond.

Residual claimant

Main disadvantage of owning a corporation's equities rather than its debt. Corporation must pay all its debt holders before they pay its equity holders.

Depository Institutions: Saving and Loan Allocations (S&L) and Mutual Savings Banks

Obtains funds primarily through saving deposits and time and check-able deposits. Made mostly mortgage loans for residential housing.

Dividens

Periodic payment to equities holders.

Moral Hazard

Problem created by asymmetric information AFTER the transaction occurs. For example: You gave $1000 loan to Uncle Melvin as he needs to buy a new computer. However, after the loan, he gambles with it instead. You don't know what Uncle Melvin is going to do after you give the money (asymmetric information)

Adverse Selection

Problem created by asymmetric information BEFORE the transaction occurs. E.g. You want to lend to A or B. A is a conservative type who only borrows when needed. B is a gambler. Who would you lend the money to? A of course. But you never know if A is a huge spender, likes to purchase unnecessary stuffs, etc. Adverse selection happens when you dont know EVERYTHING information about your borrower.

Contractual Saving Institutions: Pension Funds and Government Retirement Funds

Provide retirement income in the form of annuities to employees who are not covered by a pension plan.

Investment Intermediaries: Finance Companies

Raise funds by selling commercial paper (short-term debt instrument) by issuing stocks and bonds. Lend these funds to consumers, who use them to purchase items like furnitures, automobiles, and home improvements, and small businesses.

Depository Institutions: Commercial Banks

Raise funds primarily by using checkable deposits, savings deposits, and time deposits. Then, they use the money to make commercial, consumer, and mortgage loans and buy U.S. government securities and muni bonds.

Money Market Instrument: U.S. Treasury Bills

Short-term debt instrument of the U.S. government. Issued in 1, 3, 6 months maturities. Most liquid of all money market instruments because they are most actively traded. Safest due to low probability to default (they can always raise taxes or issue currency to pay off their debts). Held mainly by banks.

Money Market Instrument: Repurchase Agreement (repos)

Short-term loans (maturity term less than 2 weeks) for which Treasury bills serve as a collateral (an asset that the lender receives if the borrower does not pay back the loan).

Investment Intermediaries: Money Market Mutual Funds

Similar to mutual funds, but they offer deposit-type accounts. They sell shares to acquire fund that are then used to buy money market instruments that are both safe and very liquid.

Financial Intermediation

The process of indirect financing using financial intermediaries. Primary route for moving funds from lenders to borrowers.

Economics of scale

The reduction in transaction cost per dollar of transaction as the size (scale) of transaction increases. The bigger the firm, the smaller the cost.

Transaction Cost

Time and money spent in carrying out financial transactions.

Risk Sharing

When financial intermediaries makes risky assets into safer assets. People invest into low risk assets -> financial intermediaries purchase higher risk assets using the money -> the risk per investor is smaller since it is shared amongst many.

Brokers

agent of investors who match buyers with sellers of securities

Money Market Instrument: Negotiable Bank Certificates of Deposit (CD)

debt instrument sold by a bank to depositors. Pays annual interest, and pays the original purchase price at maturity date. Sold in secondary market. Important source of funds for commercial banks. Mostly bought by corporations, money market mutual funds, charitable institutions, and government agencies.

Capital Market Instruments: Stocks

equity claims on net income and assets of a corporation.

Primary market

financial market where new issues of security (bond or stocks) are sold to initial buyers by the corporation or government agency borrowing the funds.

Secondary market

financial market where securities have been previously issued can be resold. For example, you bought a stock from company X in the primary market, you sold the stock to someone else in the secondary market.

The capital market

is a financial market in which longer-term debt instruments (generally those with original maturity terms of one year or greater) and equities are traded.

The money market

is a financial market in which only short-term debt instruments (generally those with original maturity terms for less than one year) are traded.

Dealers

link buyers and sellers by buying and selling securities at stated price

Maturity of a debt instrument

number of years (term) until that instrument's expiration date.

Money Market Instrument: Commercial Paper

short-term debt instrument issued by large banks and well-known corporations (e.g. Microsoft and General Motors). The growth of this type of instrument has been substantial.

Depository Institutions: Credit Union

very small cooperative lending institutions organised around a particular group. Acquire fund mostly from deposits called shares and primarily make consumer loans.