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Chapter 2 An Overview of Financial System

Function of Financial Markets:

Channeling funds, economic efficiency, time purchases.

Structure of Financial Markets

Categorizations based on the way to obtain funds Debt Markets Equity Markets By issuing a debt instrument, such as a By issuing equities, such as common bond or a mortgage stock Claims to share in the net income after Reduce default risk expenses and taxes and the assets of a business. The borrower should pay the holder of Equities make periodic payments the instrument fixed dollar amounts (dividends) to holders. (before taxes) at regular intervals Benefit from any increases in the (interest and principal payments) until corporation’s profitability or asset a specified date. value. Maturity: short-term, intermediate-term, No maturity date. long term Residual claimant: all debt holders Equity holders get paid after debt must be paid first holders No ownership rights; often being Equities confer ownership rights on accompanied by redemption provisions equity holders. or convertibility Categorizations based on issues and liquidity of securities Primary Markets Secondary markets New issues of a security are sold by Previously issued securities can be corporation or government agency resold. borrowing funds to initial buyers NASDAQ Investment banks underwrite securities. Securities brokers – agents of investors A corporation acquires new fund only who match buyers with sellers of when its securities are first sold in securities; primary markets. Securities dealers – link sellers by buying and selling securities at stated prices. Two important functions: 1.To make the financial instruments more liquid, then make them more desirable and thus easier for the issuing firm to sell in the primary market; 2. To determine the price of the security that the issuing firm sells in primary markets. Categorizations based on organization modes in secondary markets Exchanges Over-the Counter Markets Meet in one central location to conduct Dealers at different locations who have trades an inventory of securities stand ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices. Categorizations based on the maturity of the securities Money Markets Capital Markets Short-term debt instruments Long-term debt and equity instruments Money market securities are more widely traded and more liquid. Have smaller fluctuations in prices; safer investment Being used to earn interest on surplus Often held by financial intermediaries funds that they expect to have only such as insurance companies and temporarily. pension funds; little uncertainty. Money Markets Instruments United States Treasury Bills:

At a discount; no interest payment (maturity: one-, three-, six-month)

Safest; no possibility of default (The federal government is always able to meet its debt obligations by raising taxes or issuing currency) Most liquid of all the money market instruments Mainly held by banks

Negotiable Bank Certificates of Deposit: 可转让银行存单

Sold by a bank to depositors that pays annual interest of a given amount and pays back the original purchase price.

Extremely important source of funds for commercial banks

Commercial Paper: 商业票据

At a discount; issued by large banks and well-known corporations

Banker’s Acceptance: 银行承兑汇票

A bank draft issued by a firm, guaranteed for a fee by the bank that stamps it “accepted”. Held by many of the same parties that hold Treasury bills (often resold in a secondary market at a discount )

Repurchase Agreements （Repos)： T-bills serve as collateral

The most important lenders are large corporations; repos are now an important source of bank funds (over $500 billion).

Federal Funds:

When a bank find it does not have enough deposits at the Fed to meet the amount required by regulators

Federal funds rate—closely watched barometer of the tightness of credit market conditions in the banking system and the stance of monetary policy (High——strapped for funds; Low——banks’ credit needs are low)

Typically overnight loans between banks of their deposits at the Federal Reserve

Capital Market Instruments Stocks:

Equity claims on the net income and assets of a corporation

Individuals hold around half of the value of stocks; the rest are held by pension funds, mutual funds, and insurance companies.

Mortgages:

Loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for loans.

Savings and loan associations and mutual savings bank —— primary lenders in residential mortgage market (commercial banks have started to enter it more aggressively);

Commercial banks and life insurance companies —— commercial and farm mortgages. The federal government plays an active role (provide funds to the mortgage market by selling bonds and using proceeds to buy mortgages).

Corporate Bonds:

Issued by corporations with very strong credit ratings.

Typically sends the holder an interest payment twice a year and pays off the face value when the bond matures.

Convertible bonds allow the corporation to reduce its interest payments because these bonds can increase in value if the price of the stock appreciates sufficiently. The amount of corporate bonds outstanding less than one-fifth of stocks, but the volume of new corporate bonds issued each year is substantially greater. Thus the behavior of the corporate bond market is probably far more important to a firm’s financing decisions than the behavior of the stock market.

The principal buyers—— life insurance companies; other large holders—— pension funds and households.

U.S. Government Securities:

Issued by the U.S. Treasury to finance the deficits of the federal government