6

Understanding
Financial Markets
and Institutions
Finance 3rd Edition

Cornett, Adair, and Nofsinger

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Financial Markets
Manage flow of funds

Two major market dimensions

Primary versus secondary markets
Money versus capital markets

6-2

Primary Markets
Used by corporations and governments
Used to issue new financial instruments
Stocks
Bonds

6-3

Primary Market Transfer of Funds

6-4

Secondary Markets
Benefit investors and issuers
Securities traded after issue
Provide liquidity and diversification benefits for

investors
Security valuation information for issuers

6-5

Secondary Market Transfer of Funds

6-6

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

6-7

Money Market vs. Capital Market Maturities

6-8

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

6-9

Other Markets
Derivatives
Highly leveraged financial securities linked to

underlying security
Potentially high-risk
Used for hedging and speculating

6-10

Financial Institutions
Banks

Thrifts
Insurance companies
Mutual funds

6-11

Financial Institutions
Perform economic functions
Monitor costs
Provide liquidity
Price risk

6-12

Funds Flow with Financial Institutions

6-13

Interest Rates
Affected by economic conditions

Nominal rate quoted most often

6-14

Nominal Interest
Factors that affect rate
Inflation
Real interest rate
Default and liquidity risk
Provisions of security issuer
Time to maturity

6-15

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

6-16

Inflation
Annual inflation calculation using

Consumer Price Index (CPI)

6-17

Nominal Rates vs. Inflation

6-18

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

6-19

Default Risk Premium Calculation

DRPj = ijt - iTt

6-20

Corporate Bond Default Risk Premiums

6-21

Three Yield-Curve Theories

Unbiased Expectations

Liquidity Premium
Market Segmentation

6-22

Unbiased Expectation Yield Curves

6-23

Forecasting Interest Rates

As interest rates rise, investment portfolios

values fall
Forecasts important to corporate and

individual financial wealth

6-24