Chapter 6: Understanding Financial Markets and Institutions

Financial Institutions

Examples: Banks, Thrifts, Insurance companies, Mutual funds

Other markets

Foreign exchange markets, Trade currency for immediate delivery (spot) or for some future delivery, subject to foreign exchange rick due to currency fluctuations

Financial Markets

Manage flow of funds: Two major market dimensions, Primary verses secondary markets, money versus capital markets

Money Markets vs Capital Markets

Money markets trade debt securities or instruments with maturities of one year or less, Capital markets trade stocks and long term debt with maturities greater than one year

Inflation.....

Percentage increases in cost of goods or services over given period of time, actual or expected inflation rate)interest rates increases in response to inflation)

Default or Credit Risk.....

Risk that issuer fails to pay promised interest and principal, investors demand higher interest with higher default risk, US Treasury securities are generally considered to be free of default risk

Which of these statements is true?

The higher the default risk, the higher the interest rate that security buyers will demand

Which of the following is not a capital market instrument?

US treasurer bills

Three yield curve theories.....

Unbiased expectations, liquidity premium, market segmentation

This is the risk that a security issuer will miss an interest or principal payment or continue to miss such payments?

default risk

This is a security formalizing an agreement between two parties to exchange a standard quality of an asset at a predetermined price on a specified date in the future?

derivative security

These money market instruments are short term funds transferred between financial institutions, usually for no more than one day?

federal funds......

These markets trade currencies for immediate or for some future stated delivery?

foreign exchange markets

This is the continual increase in the price level of a basket of goods and services?

inflation

Primary market financial instruments include stock issues from firms allowing their equity shares to be publicly traded on stock market for the first time. We usually refer to these first time issues as which of the following?

initial public offerings

In the US these financial institutions arrange most primary market transactions for businesses.

investment banks

These feature debt securities of instruments with maturities of one year or less.

money markets

This is the interest rate that is actually observed in financial markets?

nominal interest rates

Continuation.......

perform economic functions, monitor costs, provide liquidity, price risk

This is the risk that an assets' sale price will be lower than its purchase price?

price risk.....

These provide a forum in which demanders of funds raise funds by issuing new financial instruments, such as stocks and bonds.

primary markets

This is the interest rate that would exist on a default free security if no inflation were expected?

real interest rate....

Once firms issue financial instruments in primary markets, these same stocks and bonds are then traded in which of these?

secondary markets

Primary Markets

used by corporations and governments, used to issue new financial instruments: Stocks, Bonds

Primary Market Transfer of Funds

where new issues of financial instruments are offered for sale

Interest Rates.....

Affected by economic conditions, nominal rate quoted most often

Default Risk Premium Calculation

DRP j = I jt - I Tt

Continuation........

Derivatives: Highly leveraged financial securities linked to underlying security, potential high risk, used for hedging and speculating

Continuous......

annual inflation calculation using Consumer Price Index(CPI) IP = (CPi t+1 - CPIt)/ CPIt * 100

Forecasting Interest Rates.....

as interest rates rise, investment portfolios values fall, forecasts important to corporate and individual financial wealth

This is the ease with which an asset can be converted into cash?

liquidity

Nominal Interest....

..Factors that affect rate (inflation, real interest rate, default and liquidity risk, provisions of security issuer, term to maturity

Secondary Markets

Benefits investors and issuers: securities traded after issue, provide liquidity and diversification benefits for investors, security valuation information for issues

Which of the following is not a money market instrument?

Corporate bonds