LECTURE 3

•Practice Questions Chapter 1•Chapter 2

CHAPTER 2The Financial Environment: Markets, Institutions, and Interest Rates and Taxes

Financial markets Types of financial

institutions Determinants of interest

rates Yield curves

1-3

What is a market? A market is a venue where goods

and services are exchanged. A financial market is a place where

individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

1-4

Types of financial markets Physical assets vs. Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Futures Mortgage vs. Consumer credit

1-5

Physical assets vs. Financial assets Physical assets: wheat, autos, real

estate, machinery Financial assets: Stocks, bonds

1-6

Money vs. Capital Money mkt: for debt securities with

maturity of less than 1 year Capital mkt: for long-term debt

AND common stock

1-7

Primary vs. Secondary Primary mkts: in which

corporations & governments raise new capital

Secondary mkts: in which existing, previously issued (already OUTSTANDING) securities are traded

1-8

Spot vs. Futures Spot markets: where assets are

bought or sold for “on the spot” delivery (immediately or within a few days)

Futures markets: where assets are bought or sold for delivery at a later date (e.g. six months or a year into the future)

1-9

Mortgage vs. Consumer credit Mortgage mkts: loans on

commercial, residential, industrial real estate & farmland

Consumer credit markets: loans for autos, appliances, education etc.

1-10

How is capital transferred between savers and borrowers?

1. Direct transfers2. Investment

banking house3. Financial

intermediaries

1-11

Capital transfer…

Business sells stocks or bonds to savers w/o going through any financial institution

1-12

Capital transfer…

Intermediary obtains funds from investors, issuing its own securities

The intermediary might lend to business

Intermediaries create new forms of capital (e.g. certificates of deposit)

Efficiency of financial mkts increases

1-13

Capital transfer…

Investment bank deals with the issuance of securities not loans and deposits

Investment bank buys & holds securities for a period of time—so it is taking a chance

1-14

Types of financial intermediaries

Commercial banks Pension funds Life insurance companies Mutual funds

1-15

Physical location stock exchanges vs. Electronic dealer-based markets

New York Stock Exchange (NYSE)

National Association of Securities Dealers Automated Quotations (NASDAQ)

1-16

NYSE (New York Stock Exchange) All trades occur in a physical place, on the

trading floor of the NYSE An auction market, wherein individuals are

typically buying and selling between one another and there is an auction occurring

Highest buying (bidding) price will be matched with the lowest selling (asking) price

Stocks of well established (Blue chip) companies

1-17

NASDAQ (National Association of Securities Dealers’ Automated Quotations) Located on a telecommunications

network. Dealer's market, wherein market

participants are not buying from and selling to one another but to and from a dealer

The dealer is the market maker Stocks of firms dealing with the Internet

or electronics. Stocks are more volatile

1-18

Differences have narrowed NASDAQ exchange was listed as a

publicly-traded corporation, while the NYSE was private corporation.

In March 2006 the NYSE went public after being a not-for-profit exchange for nearly 214 years.

The shares of these exchanges, like those of any public company, can be bought and sold by investors on an exchange.

1-19

Organized exchange vs. OTC market Organized exchange: Physical

place Over-the-Counter market: Brokers

and Dealers connected over an electronic network

Although, it started out as an OTC market, today NASDAQ is considered a sophisticated market separate from the OTC market

1-20

Video Clip: Key Takeaways Most people think of the stock

market when we talk of financial markets but there are many different markets

Primary and Secondary markets Public financial markets

Where govts borrow money Corporate financial markets

Where corporations borrow money Organized security exchanges vs.

virtual networks

1-21

Cost of money The price, or cost, of debt capital

is the interest rate. The price, or cost, of equity

capital is the required return. The required return investors expect

is composed of compensation in the form of dividends and capital gains.

Role Play

1-23

What four factors affect the cost of money?

1. Production opportunities The returns available within an

economy from investment in productive (cash-generating) assets

The higher the production opportunities, the more the borrower (producer) can offer

1-24

Factors affecting cost of money…

2. Time preferences for consumption Preferences of consumers for current

consumption as opposed to saving for future consumption

The higher the time preference the more the lender will demand

1-25

Factors affecting cost of money…3. Risk

The chance that the financial asset will not earn the return promised

The higher the risk, the more the lender demands

4. Expected inflation The tendency of prices to increase

over time The higher the expected inflation, the

more the lender will demand