financial markets zfacilitate transactions between borrowers and lenders zlenders -- earn return on...
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Financial Markets
Facilitate transactions between borrowers and lenders
Lenders -- earn return on fundsBorrowers -- 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 -- Mutual Funds, Banks
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 to Lender for Inconvenience
Inconvenience Interest RateSources of Inconvenience
Liquidity -- ability to convert instrument into a medium of exchange
Default (Credit) Risk -- likelihood that borrower will not meet promised payments
Applications to Money Supply Components
Passbook Savings Deposits versus Small 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 interest (or, more broadly, 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
Generally viewed as having zero default risk
Best secondary market within group
Commonly 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 and above (Large Time Deposits)
Issued by banks to raise money for loans.Represents cost of funds for banks --
changes in iCD induce changes in bank loan rates.
Low Default Risk -- deposit insuranceGood 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” iFF
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, iDISC = 0.5% + Target iFF
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
Generally viewed as having zero default riskBest secondary market of bonds within
groupFinancial 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 Treasury 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 marketTypical maturity -- 20 yearsDifference 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 marketTends to have lowest interest rate within this
group Interest is exempt from taxes (Federal taxes
and within the state where they’re issued)
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: iCORP = 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 with falling house prices), 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 riskTend to be shorter-term relative to
consumer mortgages.
(3) US Savings Bonds
Issued by Federal Government to finance debt.
Low denominations, available to the small saver.
Generally viewed as having zero default risk. Interest assigned each year, tax-deferred
until savings bond is redeemed.Tax advantages, particularly for use in
funding college education
What Makes Interest Rates Different?
Secondary Market MaturityDefault RiskTaxability
Above characteristics constitute structural differences that bring about various degrees of inconvenience.
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