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Copyright©2010PearsonAddison-Wesley.Allrightsreserved.Chapter2AnOverviewoftheFinancialSystemCopyright©2010PearsonAddison-Wesley.Allrightsreserved.2-22.1FunctionofFinancialMarkets•Performtheessentialfunctionofchannelingfundsfromeconomicplayersthathavesavedsurplusfundstothosethathaveashortageoffunds•Directfinance:borrowersborrowfundsdirectlyfromlendersinfinancialmarketsbysellingthemsecurities.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-3FIGURE1FlowsofFundsThroughtheFinancialSystemCopyright©2010PearsonAddison-Wesley.Allrightsreserved.2-4FunctionofFinancialMarkets•Promoteseconomicefficiencybyproducinganefficientallocationofcapital,whichincreasesproduction•Directlyimprovethewell-beingofconsumersbyallowingthemtotimepurchasesbetterCopyright©2010PearsonAddison-Wesley.Allrightsreserved.2-52.2StructureofFinancialMarkets•2.2.1DebtandEquityMarkets–DebtinstrumentsAbondoramortgage,whichisacontractualagreementbytheborrowertopaytheholderoftheinstrumentfixeddollaramountsatregularintervalsuntilaspecifieddate(maturitydate).Maturity:numberofyears(term)untilthatinstrument’sexpirationdate.short-term:lessthanayear.long-term:tenyearsoflongerintermediate-term:betweenoneandtenyearsCopyright©2010PearsonAddison-Wesley.Allrightsreserved.2-6–Equities–Claimstoshareinthenetincomeandtheassetsofabusiness.•Equitiesoftenmakeperiodicpayments(dividends)totheirholdersandhavenomaturitydate.•Owingstockmeansyouownaportionofthefirmandthushavetherighttovoteonissuesimportanttothefirmandtoelectitsdirectors.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-7•Themaindisadvantageofowningacorporation’sequitiesratherthanitsdebtisthatanequityholderisaresidualclaimant;thatis,thecorporationmustpayallitsdebtholdersbeforeitpaysitsequityholders•Theadvantageofholdingequitiesisthatequityholdersbenefitdirectlyfromanyincreasesinthecorporation’sprofitabilityorassetvalue.•InUS,thesizeofthedebtmarketisoftenlargerthanthesizeoftheequitiesmarket.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-8•2.2.2PrimaryandSecondaryMarkets•Aprimarymarketisafinancialmarketinwhichnewissuesofasecurityaresoldtoinitialbuyersbythecorporationorgovernmentagencyborrowingthefunds.•Asecondarymarketisafinancialmarketinwhichsecuritiesthathavebeenpreviouslyissuedcanberesold.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-9–InvestmentBanksunderwritesecuritiesinprimarymarket.Itguaranteesanpriceforacorporation’ssecuritiesandthensellsthemtothepublic.–Brokersanddealersworkinsecondarymarketsfunds.TheNewYorkandAmericanstockexchangesandNASDAQarethebest-knownexamplesofsecondarymarkets.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-10•Twoimportantfunctionsofsecondarymarkets:•Theymakethefinancialinstrumentsmoreliquid.•Theydeterminethepriceofthesecuritythatissuingfirmsellsintheprimarymarket.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-11•2.2.3ExchangesandOver-the-Counter(OTC)Markets–Exchanges:buyersandsellersofsecuritiesmeetinonecentralllocationtoconducttrades.NYSE,ChicagoBoardofTrade–OTCMarkets:dealersatdifferentlocationswhohaveaninventoryofsecuritiesstandreadytobuyandsellsecurities“overthecounter”toanyonewhocomestothemandiswillingtoaccepttheirprices.Foreignexchange,Federalfunds.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-12•2.2.4MoneyandCapitalMarkets–Moneymarketsdealinshort-termdebtinstruments–Capitalmarketsdealinlonger-termdebtandequityinstruments.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-132.3FinancialMarketInstruments•2.3.1MoneyMarketInstruments•Leastpricefluctuationsandtheleastrisky.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-14Table1PrincipalMoneyMarketInstrumentsCopyright©2010PearsonAddison-Wesley.Allrightsreserved.2-15•(1)USTreasuryBills•Short-termdebtinstrumentsoftheU.S.government•One-,three-,andsix-monthmaturities.•Havenointerestpaymentsandaresoldatadiscount.•Themostliquidandthesafest.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-16•(2)NegotiableBankCertificatesofDeposit•CDisadebtinstrumentsoldbyabanktodepositorsthatpaysannualinterestofagivenamountandatmaturitypaysbacktheoriginalpurchaseprice.•NegotiableCDsareCDssoldinescondarymarkets.•Anextremelyimportantsourceoffundsforcommercialbanks.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-17•(3)CommercialPaper•Ashort-termdebtinstrumentissuedbylargebanksandwell-knowncorporations.•Growthissubstantial.•(4)Banker’sAcceptances•Abankdraftissuedbyafirm,payableatsomefuturedate,andguaranteedforafeebythebankthatstampsit“accepted”.•Oftenresoldinasecondarymarketatadiscountandtheamountoutstandingdeclined.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-18•(5)RepurchaseAgreements•Reposareeffectivelyshort-termloansforwhichTreasurybillsserveascollateral.•Animportantsourceofbankfundsandthemostimportantlendersinthismarketarelargecorporations.Copyright©2010PearsonAddison-Wesley.Allrightsreserved.2-19•(6)Federalfunds•OvernightloansbetweenbanksoftheirdepositsattheFederalReserve.•TheseloansarenotmadebytheFederalReservebutratherbybankstootherbanks•Theinterestrate