Understanding Financial Markets and Institutions

Finance 3rd Edition Cornett, Adair, and Nofsinger

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Understanding
Financial Markets
and Institutions

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Financial Markets

Manage flow of funds

Two major market dimensions

Primary versus secondary markets

Money versus capital markets

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Primary Markets

Used by corporations and governments

Used to issue new financial instruments

Stocks

Bonds

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Primary Market Transfer of Funds

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Secondary Markets

Benefit investors and issuers

Securities traded after issue

Provide liquidity and diversification benefits for investors

Security valuation information for issuers

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Secondary Market Transfer of Funds

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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

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Money Market vs. Capital Market Maturities

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Other Markets

Foreign Exchange Markets

Trade currency for immediate delivery (spot) or for some future delivery

Subject to foreign exchange risk due to currency fluctuations

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Other Markets

Derivatives

Highly leveraged financial securities linked to underlying security

Potentially high-risk

Used for hedging and speculating

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Financial Institutions

Banks

Thrifts

Insurance companies

Mutual funds

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Financial Institutions

Perform economic functions

Monitor costs

Provide liquidity

Price risk

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Funds Flow with Financial Institutions

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Interest Rates

Affected by economic conditions

Nominal rate quoted most often

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Nominal Interest

Factors that affect rate

Inflation

Real interest rate

Default and liquidity risk

Provisions of security issuer

Time to maturity

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Inflation

Percentage increase in cost of goods or services over given period of time

Actual or Expected inflation rate

Interest rates increase in response to inflation

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Inflation

Annual inflation calculation using Consumer Price Index (CPI)

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Nominal Rates vs. Inflation

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Default or Credit Risk

Risk that issuer fails to pay promised interest and principal

Investors demand higher interest with higher default risk

U.S. Treasury securities are generally considered to be free of default risk

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Default Risk Premium Calculation

DRPj = ijt – iTt

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Corporate Bond Default Risk Premiums

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Three Yield-Curve Theories

Unbiased Expectations

Liquidity Premium

Market Segmentation

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Unbiased Expectation Yield Curves

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Forecasting Interest Rates

As interest rates rise, investment portfolios values fall

Forecasts important to corporate and individual financial wealth