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Financial Markets


Real (Tangible Asset) Market is the market where real assets are traded. These assets include such products as wheat, auto, real estate, computers, and Machinery. ... – PowerPoint PPT presentation

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Title: Financial Markets

Financial Markets
  • John G. Kooti

Financial Markets
  • Real versus Financial Assets Markets
  • The Role of Financial Markets
  • Classification of Financial Markets
  • Primary versus Secondary Markets
  • Spot versus futures markets
  • World, national, regional, and local markets

Real vs. Financial Asset Markets
  • Real (Tangible Asset) Market is the market where
    real assets are traded. These assets include
    such products as wheat, auto, real estate,
    computers, and Machinery.
  • Financial Asset Markets deal with financial
    assets such as stocks, bonds, notes, mortgages,
    and other claims on real assets.

Major Types of Financial Markets
  • Money Markets
  • Capital Markets
  • Mortgage Markets
  • Consumer credit markets

Primary vs. Secondary Markets
  • Primary Markets---are the markets for primary
    securities (new issues of stocks and bonds)
  • Secondary Markets are the markets for existing
    securities. Generally, investors other than the
    issuing firm buy or sell financial instruments
    such as bonds, stocks, options or future.

Financial Markets
  • Money markets the market for short-term
    securities (maturity of one year or less).. The
    New York Commercial Paper and Treasury Bill
    markets are money markets.
  • Capital Market is the market for long-term
    securities, such as notes, bonds, and stocks.

Financial Markets
  • Consumer Credit Markets are loans for purchase of
    goods and services such auto loan, vacation loan,
    personal loan, etc.

The Capital Formation Process
  • Direct Transfer
  • Indirect Transfers through Investment Bankers
  • Indirect Transfers through a Financial

Transfer of Funds
  • Direct when securities are sold directly to
    savers by the issuers.
  • Indirect Transfer through investment banking is
    when the issuer sells the securities to the
    investment bank who in turn sells them to

Transfer of Funds
  • Indirect Transfer through Intermediaries--issuer
    sells the securities the intermediaries who in
    turn issue their own securities to savers.

Investment Banks
  • Act as middlemen between savers and borrowers
    (issuers of securities). Example Merrill
    Lynch, Salomon Brothers, Dean Witter, and Goldman

  • Commercial banks
  • Savings and loan associations
  • Mutual saving banks
  • Credit unions
  • Life Insurance Companies
  • Mutual funds
  • Pension Funds

Stock Markets
  • New York Stock Exchange (NYSE)
  • American Stock Exchange (AMEX)
  • Over-the-counter (OTC) markets
  • Smaller regional markets

Organized Exchanges
  • The organized security exchanges are formal
    organizations having tangible, physical locations
    and trading in designated securities. There are
    exchanges of stocks, bonds, commodities, future,
    and options. Two well known markets are NYSE and
    American Stock Exchange (AMEX)

Trading at the NYSE
  • The NYSE is a continuous, secondary security
    market with a centralized exchange
  • Trading can occurany time when the market is
    open (at this point between 930 a.m. and 400
  • Trading is in shares issued previously by a firm
  • All trading occurs on the NYSE floor

Trading at the NYSE
  • Suppose you wish to sell shares of a NYSE-listed
    firm such as GM. How would you do it?
  • You need to locate a broker to assist you and
    instruct her or him on how you want to execute
    the trade.

Trading at the NYSE
  • The broker will pass your order to a trader
    (market maker) who has a permission to trade at
    the NYSE, such as floor broker, or a competitive
  • The floor broker will either trade directly on
    the floor with another broker (who wishes to buy
    GM shares) or trade with an individual called the
    specialist associated with GM.

Who is the Specialist?
  • Each stock on the NYSE has a specialist
    associated to it who manages its purchases and
    sales and keeps an inventory of the stock.
  • If you wish to sell GM stocks, the specialist is
    obligated to buy all GM stocks. The specialist
    sets the price.
  • Of course, price can not be set arbitrarily.

How does the Specialist Compensated?
  • The specialist supplies liquidity to the market
    by buying when you want to sell and selling when
    you want to buy.
  • As a supplier of liquidity, the specialist seeks
    a compensation.
  • As a demander of liquidity, you must pay for the

The Specialist Compensation
  • The ask is the selling price of the security by
  • The bid is the buying price of the security by
  • Spread is the difference between the ask and the
  • The Specialist receives the spread between the
    bid and the ask

Liquidity Supply and Demand
  • You may demand liquidity by placing a market
  • Immediately sell 100 shares of GM shares at the
    best price you can get.
  • You may supply liquidity by placing a limit order
    to sell GM shares
  • Sell 100 shares of GM at a price of 54 or better
    as soon as possible.

Over-the-Counter Market
  • Made of hundreds of brokers and dealers around
    the country who are connected electronically by
    telephones and computers.

Bond Markets
  • Over-the-counter (OTC) markets
  • New York Stock Exchange (NYSE)

Sources of Funds
Interest Rates
  • Interest Rate is the price paid for borrowed
  • Fundamental Factors influencing Interest Rates
  • Production Opportunities
  • Time Preference for consumption
  • Risk
  • Expected inflation

Production Opportunities
  • Refers to the returns that are available from
    investment in productive assets.
  • The more productive the asset, the more willing
    to pay acquire the capital needed for investment.

Time Preference of Consumers
  • Consumer preference for current consumption
    versus future consumption also affects interest
    rate. Thrift minded people are willing to accept
    lower rate to invest.

  • Refers to the tendency for prices to rise.
  • The higher the expected rate of inflation, the
    higher the rate of return required.

  • Default Risk - the chance that the issuer will
    default on a loan
  • Maturity Risk is related to the length of the
    term. It reflects the interest rate risk. Longer
    term securities bear higher risk.
  • Liquidity Risk is the risk related to the
    marketability of the security. Higher risk is
    associated with less marketable securities.

Other Factors Influencing Interest Rates
  • Federal Reserve Board Policy
  • Balance of Payments
  • Taxes federal deficit

Components of Interest Rate
  • The real risk-free rate of interest (k)
  • The inflation premium (IP)
  • The nominal risk-free rate (Krf K IP
  • The default risk premium (DRP)
  • The liquidity premium (LP)
  • The maturity risk premium
  • K Krf DRP LP MRP

Risk Free Rate of Return
  • Risk free rate of return is the real risk-free
    rate plus expected rate of inflation. The
    Treasury bill is the closest security to risk
    free security.
  • The T-bill is used as a proxy for long-term risk
    free rate. Long-term bonds have interest rate
    risk, while T-bill does not.

Risk Premium
  • Default risk is the premium based on the
    probability that the issuer will default on the
    loan. It is measured by the difference between
    the interest rate on US Treasury Bonds and a
    corporate bond of equal maturity and

Risk Premium
  • Liquidity Risk Premium is added to the rate of
    return on securities that are not liquid.
  • The maturity Risk Premium (MRP) is a premium
    which reflects interest rate risk. Longer term
    securities have more interest rate risk than do
    shorter term securities.

  • Shorter term treasury securities include only
    inflation premium.
  • Long-term Treasury securities contain inflation
    and MRP
  • The rate of short-term corporate securities is
    equal to the real risk free rate plus inflation
    DRP LP
  • Long-term Corp. Bond has MRP in addition to the

Risk Premium
Term Structure of Interest Rate
  • Is the relationship between interest rates, or
    yields, and the maturities of securities.
  • The Yield Curve is a graph showing the
    relationship between interest rate and the
  • The Yield curve is normally upward.
  • term structure

Theories to Explain the Yield Curve
  • Market Segment Theory
  • Liquidity Preference Theory
  • Expectation Theory

Segmented Theory
  • The Market Segmented Theory--states that each
    borrower and lender has a preferred maturity, and
    that the slope of the yield curve depends on the
    supply and demand for short-term and long-term

The Liquidity Theory
  • States that investors generally prefer short-term
    securities t while borrowers generally prefer to
    borrow long-term.
  • Long-term rate is generally higher than
    short-term rate.

Expectation Theory
  • States that the yield curve depends on investors
    expectations about future interest rates. If
    inflation is expected to rise, the yield curve
    will be upward-sloping
  • Conclusion is that all these theories have merit,
    and each of the above factors influences the
    shape of the curve.

Corporate Income Tax
Deductions from Incomes
  • Depreciation
  • Straight line
  • Accelerated Cost Recovery
  • Interest expenses
  • Dividend income
  • Operating losses

Corporate Income Tax
  • The Tax Schedule
  • The marginal tax rate is that rate paid on the
    next dollar of corporate income.
  • The average tax rate is that rate paid on all
    corporate income.
  • When are both equal to 34?
  • Tax Problems
  • Capital loss
  • Capital gain

Tax Schedule
Calculation of Taxable Income
Tax Liability
  • Tax Liability 3,413 .28(40,900 - 22,750)

Calculation of Marginal Taxes
  • Average Tax Rates Tax Liability / Taxable
  • Marginal Tax Rate Change in Tax
    Liability/Change in Taxable Income

After Tax Yields
  • A single individual in the 28 marginal tax
    bracket has two investment opportunities with
    the following yields
  • 7 state of California municipal bonds
  • 10 IBM corporate bonds
  • Which alternative is the best?
  • After tax yield BTY -Taxes BTY (1-T)