Chapter-Two Money Market AND Capital Market: 2.1. Moneymarket

Raya University College of Business & Economics Department of Accounting & Finance
Study material for Financial institutions and markets
CHAPTER-TWO
MONEY MARKET AND CAPITAL MARKET
2.1. MONEYMARKET
Money markets are used to facilitate the transfer of short-term funds from individuals,
corporations, or governments with excess funds to those with deficient funds. Even investors
who focus on long-term securities tend to hold some money market securities. Money
markets enable financial market participants to maintain liquidity.
2.1.1. Money Market Securities
Money market securities are debt securities with a maturity of one year or less. They are
issued in the primary market through a telecommunications network by the Treasury,
corporations, and financial intermediaries that wish to obtain short-term financing. The U.S.
Treasury issues money market securities (Treasury bills) and uses the proceeds to finance the
budget deficit. Corporations issue money market securities and use the proceeds to support
their existing operations or to expand their operations.
Financial institutions issue money market securities and bundle the proceeds to make loans to
households or corporations. Thus, the funds are channelled to support household purchases,
such as cars and homes, and to support corporate investment in buildings and machinery. The
Treasury and some corporations commonly pay off their debt from maturing money market
securities with the proceeds from issuing new money market securities. In this way, they are
able to finance expenditures for long periods of time even though money market securities
have short-term maturities. Overall, money markets allow households, corporations, and the
U.S. government to increase their expenditures; thus the markets finance economic growth.
Money market securities are commonly purchased by households, corporation (including

financial institutions), and government agencies that have funds available for a short-term
period. Because money market securities have a short-term maturity and can typically be sold
in the secondary market, they provide liquidity to investors. Most firms and financial
institutions maintain some holdings of money market securities for this reason.
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The more popular money market securities are:
Each of these instruments is described in turn.
1. Treasury Bills: When the U.S. government needs to borrow funds, the U.S. Treasury
frequently issues short-term securities known as Treasury bills. The Treasury issues T-
bills with 4-week,13-week, and 26-week maturities on a weekly basis. It periodically
issues T-bills with terms shorter than four weeks, which are called cash management
bills. It also issues T-bills with a one-year maturity on a monthly basis. Treasury bills
were formerly issued in paper form but are now maintained electronically.
Investors in Treasury Bills Depository institutions commonly invest in T-bills so that they
can retain a portion of their funds in assets that can easily be liquidated if they suddenly need
to accommodate deposit withdrawals. Other financial institutions also invest in T-bills in the
event that they need cash because cash outflows exceed cash inflows. Individuals with
substantial savings invest in T-bills for liquidity purposes. Many individuals invest in T-bills
indirectly by investing in money market funds, which in turn purchase large amounts of T-
bills. Corporations invest in T-bills so that they have easy access to funding if they suddenly
incur unanticipated expenses.

Credit Risk Treasury bills are attractive to investors because they are backed by the federal
government and are therefore virtually free of credit (default) risk. This is a very
Desirable feature, because investors do not have to use their time to assess the risk of the
issuer, as they do with other issuers of debt securities.
Liquidity Another attractive feature of T-bills is their liquidity, which is due to their short
maturity and strong secondary market. At any given time, many institutional investors are
participating in the secondary market by purchasing or selling existing T-bills. Thus,
investors can easily obtain cash by selling their T-bills in the secondary market. Government
securities dealers serve as intermediaries in the secondary market by buying existing T-bills
from investors who want to sell them, or selling them to investors who want to buy them.
These dealers profit by purchasing the bills at a slightly lower price than the price at which
they sell them.
2. Commercial Paper: Commercial paper is a short-term debt instrument issued only by

well-known, credit worthy firms that is typically unsecured. It is normally issued to
provide liquidity or to finance a firm’s investment in inventory and accounts receivable.
The issuance of commercial paper is an alternative to short-term bank loans. Some large
firms prefer to issue commercial paper rather than borrow from a bank because it is
usually a cheaper source of funds. Nevertheless, even the large creditworthy firms that are
able to issue commercial paper normally obtain some short-term loans from commercial
banks in order to maintain a business relationship with them. Financial institutions such
as finance companies and bank holding companies are major issuers of commercial paper.
Denomination: The minimum denomination of commercial paper is usually $100,000, and

typical denominations are in multiples of $1 million. Maturities are normally between 20 and
45 days but can be as short as 1 day or as long as 270 days. The270-day maximum is due to a
Securities and Exchange Commission ruling that paper with a maturity exceeding 270 days
must be registered. Because of the high minimum denomination, individual investors rarely
purchase commercial paper directly, although they may invest in it indirectly by investing in
money market funds that have pooled the funds of many individuals. Money market funds are

major investors in commercial paper. Although the secondary market for commercial paper is
very limited, it is sometimes possible to sell the paper back to the dealer who initially helped
to place it. However, in most cases, investors hold commercial paper until maturity.
Credit Risk Because commercial paper is issued by corporations that are susceptible to
business failure, commercial paper is subject to credit risk. The risk of default is affected by
the issuer’s financial condition and cash flow. Investors can attempt to assess the probability
that commercial paper will default by monitoring the issuer’s financial condition. The focus
is on the issuer’s ability to repay its debt over the short term because the payments must be
completed within a short-term period. Although issuers of commercial paper are subject to
possible default, historically the percentage of issues that have defaulted is very low, as most
issuers of commercial paper are very strong financially. In addition, the short time period of
the credit reduces the chance that an issuer will suffer financial problems before repaying the
funds borrowed.
3. Negotiable Certificates of Deposit: Negotiable certificates of deposit (NCDs) are

certificates issued by large commercial banks and other depository institutions as a short-
term source of funds. The minimum denomination is $100,000, although a $1 million
denomination is more common. Nonfinancial corporations often purchase NCDs.
Although NCD denominations are typically too large for individual investors, they are
sometimes purchased by money market funds that have pooled individual investors’
funds. Thus, money market funds allow individuals to be indirect investors in NCDs,
creating a more active NCD market. Maturities on NCDs normally range from two weeks
to one year. A secondary market for NCDs exists, providing investors with some
liquidity. However, institutions prefer ot to have their newly issued NCDs compete with
their previously issued NCDs being resold in the secondary market. An oversupply of
NCDs for sale could force institutions to sell their newly issued NCDs at a lower price.
Placement Some issuers place their NCDs directly; others use a correspondent institution that
specializes in placing NCDs. Another alternative is to sell NCDs to securities dealers who in
turn resell them. A portion of unusually large issues is commonly sold to NCD dealers.
Normally, however, NCDs can be sold to investors directly at a higher.

4. Repurchase Agreements: With a repurchase agreement (or repo), one party sells
securities to another with an agreement to repurchase the securities at a specified date and
price. In essence, the repo transaction represents a loan backed by the securities. If the
borrower defaults on the loan, the lender has claim to the securities. Most repo
transactions use government securities, although some involve other securities such as
commercial paper or NCDs. A reverse repo refers to the purchase of securities by one
party from another with an agreement to sell them. Thus, a repo and a reverse repo refer
to the same transaction but from different perspectives. These two terms are sometimes
used interchangeably, so a transaction described as a repo may actually be a reverse repo.
Financial institutions such as banks, savings and loan associations, and money market
funds often participate in repurchase agreements. Many nonfinancial institutions are also
active participants. The size of the repo market is about $4.5 trillion, and transaction
amounts are usually for $10 million or more. The most common maturities are from1 to
15 days and for one, three, and six months. A secondary market for repos does not exist.
Some firms in need of funds will set the maturity on a repo to be the minimum time
period for which they need temporary financing. If they still need funds when the repo is
about to mature, they will borrow additional funds through new repos and use these funds
to fulfil their obligation on maturing repos.
Placement Repo transactions are negotiated through a telecommunications network. Dealers

and repo brokers act as financial intermediaries to create repos for firms with Deficit or
excess funds, receiving a commission for their services. When the borrowing firm can find
counterparty to the repo transaction, it avoids the transaction fee involved in having a
government securities dealer find the counterparty. Some companies that commonly engage
in repo transactions have an in-house department for finding counterparties and executing the
transactions. A company that borrows through repos may, from time to time, serve as the
lender. That is, it may purchase the government securities and agree to sell them back in the
near future. Because the cash flow of any large company changes on a daily basis, it is not
unusual for a firm to act as an investor one day (when it has excess funds) and a borrower the
next (when it has a cash shortage).
5. Federal Funds: The federal funds market enables depository institutions to lend or
borrow short-term funds from each other at the so-called federal funds rate. This rate is

charged on federal funds transactions, and it is influenced by the supply of and demand
for funds in the federal funds market. The Federal Reserve adjusts the amount of funds in
depository institutions in order to influence the federal funds rate and several other short-
term interest rates. All types of firms closely monitor the federal funds rate because the
Federal Reserve manipulates it to affect general economic conditions. For this reason,
many market participants view changes in the federal funds rate as an indicator of
potential changes in other money market rates.
The federal funds rate is normally slightly higher than the T-bill rate at any given time. A
lender in the federal funds market is subject to credit risk, since it is possible that the financial
institution borrowing the funds could default on the loan. Once loan transaction is agreed
upon, the lending institution can instruct its Federal Reserve district bank to debit its reserve
account and to credit the borrowing institution’s reserve account by the amount of the loan. If
the loan is for just one day, it will likely be based on an oral agreement between the parties,
especially if the institutions commonly do business with each other.
Commercial banks are the most active participants in the federal funds market. Federal funds
brokers serve as financial intermediaries in the market, matching up institutions that wish to
sell (lend) funds with those that wish to purchase (borrow) them. The brokers receive a
commission for their service. The transactions are negotiated through a telecommunications
network that links federal funds brokers with participating institutions. Most loan transactions
are for $5 million or more and usually have a maturity of one to seven days (although the
loans may often be extended by the lender if the borrower requests more time).
6. Banker’s Acceptances: A banker’s acceptance indicates that a bank accepts

responsibility for a future payment. Banker’s acceptances are commonly used for
international trade transactions. An exporter that is sending goods to an importer whose
credit rating is not known will often prefer that a bank act as a guarantor. The bank
therefore facilitates the transaction by stamping ACCEPTED on a draft, which obligates
payment at a specified point in time. In turn, the importer will pay the bank what is owed
to the exporter along with a fee to the bank for guaranteeing the payment. Exporters can
hold a banker’s acceptance until the date at which payment is to be made, but they
frequently sell the acceptance before then at a discount to obtain cash immediately. The

investor who purchases the acceptance then receives the payment guaranteed by the bank
in the future. The investor’s return on a banker’s acceptance, like that on commercial
paper, is derived from the difference between the discounted price paid for the acceptance
and the amount to be received in the future. Maturities on banker’s acceptances typically
range from 30 to 270 days. Because there is a possibility that a bank will default on
payment, investors are exposed to a slight degree of credit risk. Thus, they deserve a
return above the T-bill yield in compensation. Because acceptances are often discounted
and sold by the exporting firm prior to maturity, an active secondary market exists.
Dealers match up companies that wish to sell acceptances with other companies that wish
to purchase them. A dealer’s bid price is less than its asking price, and this creates the
spread (or the dealer’s reward for doing business). The spread is normally between one-
eighth and seven-eighths of 1 present.
Globalization of Money Markets
As international trade and financing have grown, money markets have developed in Europe,
Asia, and South America. Corporations commonly accept foreign currencies as revenue if
they will need those currencies to pay for imports in the future. Since a corporation may not
need to use funds at the time it receives them, it deposits the funds to earn interest until they
are needed. Meanwhile, other corporations may need funds denominated in foreign
currencies and therefore may wish to borrow those funds from a bank. International banks
facilitate the international money markets by accepting deposits and providing loans in a
wide variety of currencies. The flow of funds between countries has increased as a result of
tax differences among countries, speculation on exchange rate movements, and a reduction in
government barriers that were previously imposed on foreign investment in securities.
Consequently, international markets are integrated.
The money market interest rates in each country are influenced by the demand for short-term
funds by borrowers, relative to the supply of available short-term funds that are provided by
savers. If the demand for short-term funds denominated in a particular currency is high
relative to the short-term funds that are available in that currency, the money market interest
rates will be relatively high in that country. Conversely, if the demand for short-term funds in
that currency is low relative to the supply of short-term funds available, the money market

interest rates in that country will be relatively low. The money market interest rate paid by
corporations who borrow short-term funds in a particular country is slightly higher than the
rate paid by the federal government in the same country, which reflects the premium to
compensate for credit risk of corporate borrowers. There may also be an additional premium
to compensate for less liquidity of short-term securities issued by corporations.
2.2. CAPITAL MARKET
The capital market aids rising of capital on a long-term basis, generally over 1 year. It
consists of a primary and a secondary market and can be divided into two main subgroups –
Bond market and Stock market.
 The Bond market provides financing by accumulating debt through bond issuance and bond
trading
 The Stock market provides financing by sharing the ownership of a company through stocks
issuing and trading
A primary market, or the so-called “new issue market”, is where securities such as shares and
bonds are being created and traded for the first time without using any intermediary such as
an exchange in the process. When a private company decides to become a publicly-traded
entity, it issues and sells its stocks at a so-called Initial Public Offering. IPOs are a strictly
regulated process which is facilitated by investment banks or finance syndicates of securities
dealers that set a starting price range and then oversee its sale directly to the investors.
A secondary market or the so-called “aftermarket” is the place where investors purchase
previously issued securities such as stocks, bonds, futures and options from other investors,
rather from issuing companies themselves. The secondary market is where the bulk of

exchange trading occurs and it is what people are talking about when they refer to the “stock
market”. It includes the NYSE, Nasdaq and all other major exchanges.
Some previously issued stocks however are not listed on an exchange, rather traded directly
between dealers over the telephone or by computer. These are the so-called over-the-counter
traded stocks, or “unlisted stocks”. In general, companies which are traded this way usually
don’t meet the requirements for listing on an exchange. Such shares are traded on the Over
the Counter Bulletin Board or on the pink sheets and are either offered by companies with a
poor credit rating or are penny stocks.
2.2.1. STOCK MARKET
Stock markets facilitate equity investment into firms and the transfer of equity investments
between investors.
Private Equity: When a firm is created, its founders typically invest their own money in the
business. The founders may also invite some family or friends to invest equity in the
business. This is referred to as private equity because the business is privately held and the
owners cannot sell their shares to the public. Young businesses use debt financing from
financial institutions and are better able to obtain loans if they have substantial equity
invested. Over time, businesses commonly retain a large portion of their earnings and
reinvest it to support expansion. This serves as another means of building equity in the firm.
The founders of many firms dream of going public someday so that they can obtain large
amount of financing to support the firm’s growth. They may also hope to “cash out” by
selling their original equity investment to others.
Normally, however, a firm’s owners do not consider going public until they want to sell at
least $50 million in stock. A public offering of stock may be feasible only if the firm will
have a large enough shareholders base to support an active secondary market. With an
inactive secondary market, the shares would be illiquid. Investors who own shares and want
to sell them would be forced to sell at a discount from the fundamental value, almost as if the
firm were not publicly traded. This defeats the purpose of being public. In addition, there are
many fixed costs associated with going public, and these costs would be prohibitive for a firm
that seeks to raise only a small amount of funds.

Public Equity: When a firm goes public, it issues stock in the primary market in exchange
for cash. This changes the firm’s ownership structure by increasing the number of owners. It
changes the firm’s capital structure by increasing the equity investment in the firm, which
allows the firm to pay off some of its debt. It also enables corporations to finance their
growth. A stock is a certificate representing partial ownership in the firm. Like debt
securities, common stock is issued by firms in the primary market to obtain long-term funds.
Yet the purchaser of stock becomes a part owner of the firm, rather than a creditor. This
ownership feature attracts many investors who want to have an equity interest in a firm but do
not necessarily want to manage their own firm. Owners of stock can benefit from the growth
in the value of the firm and therefore have more to gain than creditors. However, they are
also susceptible to large losses, as the values of even the most respected corporations have
declined substantially in some periods. The stock markets are like other financial markets in
that they link the surplus units (that have excess funds) with deficit units (that need funds).
Stock issued by corporations may be purchased directly by households. Alternatively,
households may invest in shares of stock mutual funds; the managers of these funds use the
proceeds to invest in stocks.
Other institutional investors such as pension funds and insurance companies also purchase
stocks. The massive growth in the stock market has enabled many corporations to expand to a
much greater degree and has allowed investors to share in the profitability of corporations. In
addition to the primary market, which facilitates new financing for corporations, there is also
a secondary market that allows investors to sell the stock they previously purchased to other
investors who want to buy it. Thus the secondary market creates liquidity for investors who
invest in stocks. In addition to realizing potential gains when they sell their stock, investors
may also receive dividends on a quarterly basis from the corporations in which they invest.
Some corporations distribute a portion of their earnings to shareholders in the form of
dividends, but others reinvest all of their earnings so that they can achieve greater growth.
Ownership and Voting Rights: The owners of small companies also tend to be the
managers. In publicly traded firms, however, most of the shareholders are not managers.
Thus they must rely on the firm’s managers to serve as agents and to make decisions in the
shareholders’ best interests. The ownership of common stock entitles shareholders to a
number of rights not available to other individuals. Normally only the owners of common
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stock are permitted to vote on certain key matters concerning the firm, such as the election of
the board of directors, authorization to issue new shares of common stock, approval of
amendments to the corporate charter, and adoption of bylaws. Many investors assign their
vote to management through the use of a proxy, and many other shareholders do not bother to
vote. As a result, management normally receives the majority of the votes and can elect its
own candidates as directors.
Preferred Stock: Preferred stock represents an equity interest in a firm that usually does not
allow for significant voting rights. Preferred shareholders technically share the ownership of
the firm with common shareholders and are therefore compensated only when earnings have
been generated. Thus, if the firm does not have sufficient earnings from which to pay the
preferred stock dividends, it may omit the dividend without fear of being forced into
bankruptcy. A cumulative provision on most preferred stock prevents dividends from being
paid on common stock until all preferred stock dividends (both current and those previously
omitted) have been paid. The owners of preferred stock normally do not participate in the
profits of the firm beyond the stated fixed annual dividend. All profits above those needed to
pay dividends on preferred stock belong to the owners of common stock.
Because the dividends on preferred stock can be omitted, a firm assumes less risk when
issuing it than when issuing bonds. However, a firm that omits preferred stock dividends may
be unable to raise new capital until the omitted dividends have been paid, because investors
will be reluctant to make new investments in a firm that is unable to compensate its existing
sources of capital.
From a cost perspective, preferred stock is a less desirable source of capital for a firm than
bonds. Because a firm is not legally required to pay preferred stock dividends, it must entice
investors to assume the risk involved by offering higher dividends. In addition, preferred
stock dividends are technically compensation to owners of the firm. Therefore, the dividends
paid are not a tax-deductible expense to the firm, whereas interest paid on bonds is tax
deductible. Because preferred stock normally has no maturity, it represents a permanent
source of financing.
Participation in Stock Markets

Investors can be classified as individual or institutional. The investment by individuals in a

large corporation commonly exceeds 50 percent of the total equity. Each individual’s
investment is typically small, however, which means that ownership is scattered among
numerous individual shareholders. Because some financial institutions hold large amounts of
stock, their collective sales or purchases of stocks can significantly affect stock market prices.
In addition to participating in stock markets by investing funds, financial institutions

sometimes issue their own stock as a means of raising funds. Many stock market transactions
involve two financial institutions. For example, an insurance company may purchase the
newly issued stock of a commercial bank. If the insurance company someday sells this stock
in the secondary market, the purchaser may be a mutual fund or pension fund.
Initial Public Offerings: A corporation first decides to issue stock to the public in order to
raise funds. It engages in an initial public offering (IPO), which is a first-time offering of
shares by a specific firm to the public. An IPO is commonly used not only to obtain new
funding but also to offer some founders and VC funds a way to cash out their investment. A
typical IPO is for at least $50 million, since this would be the minimum size needed to ensure
adequate liquidity in the secondary market if investors wish to sell their shares.
Process of Going Public: Because firms that engage in an IPO are not well known to
investors, they must provide detailed information about their operations and their financial
condition. A firm planning on going public normally hires a securities firm that serves as the
lead underwriter for the IPO. The lead underwriter is involved in the development of the
prospectus and the pricing and placement of the shares.
Developing a Prospectus: A few months before the IPO, the issuing firm (with the help of
the lead underwriter) develops a prospectus and files it with the Securities and Exchange
Commission (SEC). The prospectus contains detailed information about the firm and includes
financial statements and a discussion of the risks involved. It is intended to provide potential
investors with the information they need to decide whether to invest in the firm. Within about
30 days, the SEC will assess the prospectus and determine whether it contains all the
necessary information. In many cases the SEC, before approving the prospectus, recommends
some changes in order to provide more information about the firm’s financial condition.

Once the SEC approves the prospectus, it is sent to institutional investors who may want to
invest in the IPO. In addition, the firm’s management and the underwriters of the IPO meet
with institutional investors. Often these meetings occur in the form of a road show: the firm’s
managers travel to various cities and put on a presentation for large institutional investors in
each city. The institutional investors are informed of the road show in advance so that they
can attend if they have any interest in purchasing shares of the IPO. Some institutional
investors may even receive separate individual presentations.
Institutional investors are targeted because they may be willing to buy large blocks of shares
at the time of the IPO. For this reason, they typically have priority over individual investors
in purchasing shares during an IPO.A law in 2012 loosened the reporting restrictions for
smaller firms about to go public. However, most of the firms that could have qualified did not
capitalize on the looser requirements, because they wanted to provide investors with as much
financial information as possible. They may have attracted more interest from institutional
investors by providing more complete information.
Pricing: Before a firm goes public, it attempts to gauge the price that will be paid for its
shares. It may rely on the lead underwriter to determine the so-called offer price. The
valuation of a firm should equal the present value of the firm’s future cash flows. Although
the future cash flows are uncertain, the lead underwriter may forecast future cash flows based
on the firm’s recent earnings. The offer price also may be influenced by prevailing market
and industry conditions. If other publicly traded firms in the same industry are priced high
relative to their earnings or sales, then the offer price assigned to shares in the IPO will be
relatively high. During the road show, the lead underwriter solicits indications of interest in
the IPO by institutional investors as to the number of shares that they may demand at various
possible offer prices. This process is referred to as book building.
2.2.2. BOND MARKET
Bonds are long-term debt securities that are issued by government agencies or corporations.
The issuer of a bond is obligated to pay interest (or coupon) payments periodically (such as
annually or semi-annually) and the par value (principal) at maturity. An issuer must be able to
show that its future cash flows will be sufficient to enable it to make its coupon and principal
payments to bondholders. Investors will consider buying bonds for which the repayment is

questionable only if the expected return from investing in the bonds is sufficient to
compensate for the risk.
Bonds are often classified according to the type of issuer. Treasury bonds are issued by the
U.S. Treasury, Federal agency bonds are issued by federal agencies, Municipal bonds are
issued by state and local governments, and corporate bonds are issued by corporations. Most
bonds have maturities of between 10 and 30 years. Bonds are classified by the ownership
structure as either bearer bonds or registered bonds. Bearer bonds require the owner to clip
coupons attached to the bonds and send them to the issuer to receive coupon payments.
Registered bonds require the issuer to maintain records of who owns the bond and
automatically send coupon payments to the owners.
Bonds are issued in the primary market through a telecommunications network. The U.S.
Treasury issues bonds and uses the proceeds to support deficit spending on government
programs. Federal agencies issue bonds and use the proceeds to buy mortgages that are
originated by financial institutions. Thus, they indirectly finance purchases of homes.
Corporations issue bonds and use the proceeds to expand their operations. Overall, by
allowing households, corporations, and the U.S. government to increase their expenditures,
bond markets finance economic growth.
Institutional Participation in Bond Markets: All types of financial institutions participate
in the bond markets. Commercial banks, savings institutions, and finance companies
commonly issue bonds in order to raise capital to support their operations. Commercial
banks, savings institutions, bond mutual funds, insurance companies, and pension funds are
investors in the bond market. Financial institutions dominate the bond market in that they
purchase a large proportion of bonds issued.
Treasury and Federal Agency Bonds: The U.S. government, like many country
governments, commonly wants to use a fiscal policy of spending more money than it receives
from taxes. Under these conditions, it needs to borrow funds to cover the difference between
what it wants to spend versus what it receives. To facilitate its fiscal policy, the U.S. Treasury
issues Treasury notes and Treasury bonds to finance federal government expenditures. The
Treasury pays a yield to investors that reflect the risk-free rate, as it is presumed that the
Treasury will default on its payments. Because the Treasury notes and bonds are free from
credit (default) risk, they enable the Treasury to borrow funds at a relatively low cost.
However, there might be a limit at which any additional borrowing by the U.S. government

could cause investors to worry about the Treasury’s ability to cover its debt payments. Some
other countries (such as Greece, Spain, and Portugal) have already reached that point, and the
governments of those countries have to offer a higher yield on their bonds to compensate
investors for the credit risk. The minimum denomination for Treasury notes and bonds is now
$100. The key difference between a note and a bond is that note maturities are less than 10
years where as bond maturities are 10 years or more. Since 2006, the Treasury has commonly
issued 10-year Treasury bonds and 30-year Treasury bonds to finance the U.S. budget deficit.
An active over-the-counter secondary market allows investors to sell Treasury notes or bonds
prior to maturity. Investors in Treasury notes and bonds receive semi-annual interest
payments from the Treasury. Although the interest is taxed by the federal government as
ordinary income, it is exempt from any state and local taxes. Domestic and foreign firms and
individuals are common investors in Treasury notes and bonds.
Municipal bonds: Like the federal government, state and local governments frequently
spend more than the revenues they receive. To finance the difference, they issue municipal
bonds, most of which can be classified as either general obligation bonds or revenue bonds.
Payments on general obligation bonds are supported by the municipal government’s ability to
tax, whereas payments on revenue bonds must be generated by revenues of the project (toll
way, toll bridge, state college dormitory, etc.) for which the bonds were issued. Revenue
bonds are more common than general obligation bonds. There are more than 44,000 state and
local government agencies that issue municipal bonds in order to finance their spending on
government projects. The market value of these bonds is almost $4 trillion. Revenue bonds
and general obligation bonds typically promise semi-annual interest payments. Common
purchasers of these bonds include financial and nonfinancial institutions as well as
individuals. The minimum denomination of municipal bonds is usually $5,000. A secondary
market exists for them, although it is less active than the one for Treasury bonds.
Most municipal bonds contain a call provision, which allows the issuer to repurchase the
bonds at a specified price before the bonds mature. A municipality may exercise its option to
repurchase the bonds if interest rates decline substantially because it can then
Reissue bonds at the lower interest rate and thus reduce its cost of financing.

Corporate Bonds: Corporate bonds are long-term debt securities issued by corporations that
promise the owner coupon payments (interest) on a semi-annual basis. The minimum
denomination is $1,000, and their maturity is typically between 10 and 30 years. However,
Boeing, Chevron, and other corporations have issued 50-year bonds, and Disney, AT&T, and
the Coca-Cola Company have even issued 100-year bonds.
The interest paid by the corporation to investors is tax deductible to the corporation, which
reduces the cost of financing with bonds. Equity financing does not offer the same tax
advantage because it does not involve interest payments. This is a major reason why many
corporations rely heavily on bonds to finance their operations. Nevertheless, the amount of
funds a corporation can obtain by issuing bonds is limited by its ability to make the coupon
payments.
The interest income earned on corporate bonds represents ordinary income to the bondholders
and is therefore subject to federal taxes and to state taxes, if any. For this reason, corporate
bonds do not provide the same tax benefits to bondholders as do municipal bonds.
Corporate Bond Offerings: Corporate bonds can be placed with investors through a public
offering or a private placement.
Public Offering: Corporations commonly issue bonds through a public offering. A

corporation that plans to issue bonds hires a securities firm to underwrite the bonds. The
underwriter assesses market conditions and attempts to determine the price at which the
corporation’s bonds can be sold and the appropriate size (dollar amount) of the offering. The
goal is to price the bonds high enough to satisfy the issuer but also low enough so that the
entire bond offering can be placed. If the offering is too large or the price is too high, there
may not be enough investors who are willing to purchase the bonds. In this case, the
underwriter will have to lower the price in order to sell all the bonds. The issuer registers with
the Securities and Exchange Commission (SEC) and submits a prospectus that explains the
planned size of the offering, its updated financial condition (supported by financial
statements), and its planned use of the funds. Meanwhile, the underwriter distributes the
prospectus to other securities firms that it invites to join a syndicate that will help place the
bonds in the market. Once the SEC approves the issue, the underwriting syndicate attempts to

place the bonds. A portion of the bonds that are registered can be shelved for up to two years
if the issuer wants to defer placing the entire offering at once.
Underwriters typically try to place newly issued corporate bonds with institutional investors
(e.g., pension funds, bond mutual funds, and insurance companies) because these investors
are more likely to purchase large pieces of the offering. Many institutional investors may plan
to hold the bonds for a long-term period, but they can be sold to other investors should their
plans change. For some bond offerings, the arrangement between the underwriter and the
issuer is a firm commitment, whereby the underwriter guarantees the issuer that all bonds will
be sold at a specified price. Thus the issuer knows the amount of proceeds that it will receive.
The underwriter is exposed to the risk if it cannot sell the bonds. Normally, the underwriter
will only agree to a firm commitment if it has already received strong
Secondary Market for Corporate Bonds: Corporate bonds have a secondary market, so
investors who purchase them can sell them to other investors if they prefer not to hold them
until maturity. The value of all corporate bonds in the secondary market exceeds $5 trillion.
Corporate bonds are listed on an over-the-counter market or on an exchange such as the
American Stock Exchange (now part of NYSE Euronext). More than a thousand bonds are
listed on the New York Stock Exchange (NYSE). Corporations whose stocks are listed on the
exchange can list their bonds for free.
Dealer Role in Secondary Market The secondary market is served by bond dealers, who can
play a broker role by matching up buyers and sellers. Bond dealers also have an inventory of
bonds, so they can serve as the counterparty in a bond transaction desired by an investor. For
example, if an investor wants to sell bonds that were previously issued by the Coca-Cola
Company, bond dealers may execute the deal either by matching the sellers with investors
who want to buy the bonds or by purchasing the bonds for their own inventories. Dealers
commonly handle large transactions, such as those valued at more than $1 million.
Information about the trades in the over the counter market is provided by the National
Association of Securities Dealers’ Trade Reporting and Compliance Engine, which is referred
to as TRACE.
Liquidity in Secondary Market Bonds issued by large, well-known corporations in large

volume is liquid because they attract a large number of buyers and sellers in the secondary

market. Bonds issued by small corporations in small volume are less liquid because there
may be few buyers (or no buyers) for those bonds in some periods. Thus investors who wish
to sell these bonds in the secondary market may have to accept a discounted price in order to
attract buyers. About 95 percent of the trading volume of corporate bonds in the secondary
market is attributed to institutional investors. Often, a particular company issues many
different bonds with variations in maturity, price, and credit rating. Having many different
bonds allows investors to find a bond issued by a particular company that fits their desired
maturity and other preferences. However, such specialized bonds may exhibit reduced
liquidity because they may appeal to only a small group of investors. The trading of these
bonds will require higher transaction costs, because brokers require more time to execute
transactions for investors.
Electronic Bond Networks Electronic bond networks have recently been established that can
match institutional investors that wish to sell some bond holdings or purchase additional
bonds in the over-the-counter bond market at a lower transaction cost. Trading platforms
have been created by financial institutions such as J.P. Morgan and Goldman Sachs so that
institutional investors can execute bond trades in the secondary market. The institutional
investors that wish to purchase bonds can use the platforms to identify bond holdings that are
for sale by other institutional investors in the secondary market, and can purchase the bonds
electronically, without relying on bond dealers. They pay a small fee (percentage of their
transactions) for the use of the trading platforms. However, the participation by investors in
electronic bond networks is limited,
2.2.3. STOCK EXCHANGES
Any shares of stock that have been issued as a result of an IPO or a secondary offering can be
traded by investors in the secondary market. In the United States, stock trading between
investors occurs on the organized stock exchanges and the over-the-counter(OTC) market.
Organized Exchanges: Each organized exchange has a trading floor where floor traders
execute transactions in the secondary market for their clients. The NYSE was merged with
stock exchanges in Paris, Brussels, and Amsterdam in 2007, resulting in NYSE Euronext. In
December 2012, NYSE Euronext was purchased by Intercontinental Exchange (ICE) Inc.,
(subject to regulatory approval) although it would still use the NYSE Euronext name. The

ICE, based in Atlanta, emerged in 2000 to facilitate electronic trades of futures contracts on
commodities such as cotton and oil. It is known for its efficiency in electronic trading of
derivative contracts and went public in 2005. The combination of the ICE and NYSE
Euronext exchanges creates a massive network that can trade stocks, bonds, commodities,
and derivative securities across the world. The firms listed on the NYSE are typically much
larger than those listed on the other exchanges.
For some firms, more than 100 million shares are traded on a daily basis. The NYSE has a
trading floor where trades can be executed. It has two broad types of members: floor brokers
and specialists. Floor brokers are either commission brokers or independent brokers.
Commission brokers are employed by brokerage firms and execute orders for clients on the
floor of the NYSE. Independent brokers trade for their own account and are not employed by
any particular brokerage firm. However, they sometimes handle the overflow for brokerage
firms and handle orders for brokerage firms that do not employ full-time brokers. The fee that
independent brokers receive depends on the size and liquidity of the order they trade.
Specialists can match orders of buyers and sellers. In addition, they can buy or sell stock for
their own account and thereby create more liquidity for the stock. While the NYSE was
always known for its trading floor, much of the trading has been executed by the NYSE
Super Display Book System (SDBK), which is an electronic system for matching trades. At
the time NYSE Euronext was purchased by intercontinental Exchange, only about 20 percent
of the NYSE trades were executed on the trading floor, versus about 40 percent in 2007. The
other trades are executed electronically. The proportion of trades executed electronically will
likely increase to the point in which the trading floor is no longer needed.
Listing Requirements: The NYSE charges an initial fee to firms that wish to have their
stock listed. The fee depends on the size of the firm. Corporations must meet specific
requirements to have their stock listed on the NYSE, such as a minimum number of shares
outstanding and a minimum level of earnings, cash flow, and revenue over a recent period.
Once a stock is listed, the exchange also requires that the share price of the stock be at least
$1 per share. As time passes, new listings are added and some firms are delisted when they
no longer meet the requirements.

The requirement of a minimum number of shares outstanding is intended to ensure adequate

liquidity. For a stock to be liquid there should be many willing buyers and seller sat any time
so that an investor can easily buy or sell the stock at the prevailing market price. In a liquid
market, the bid price that brokers are willing to pay for a stocks should be just slightly less
than the ask price at which they would sell the stock.
Over-the-Counter Market: Stocks not listed on the organized exchanges are traded in the
over-the-counter (OTC)market. Like the organized exchanges, the OTC market also
facilitates secondary market transactions. Unlike the organized exchanges, the OTC market
does not have a trading floor. Instead, the buy and sell orders are completed through a
telecommunications network.
Because there is no trading floor, it is not necessary to buy a seat to trade on this exchange;
however, it is necessary to register with the SEC.NASDAQ Many stocks in the OTC market
are served by the National Association of Securities Dealers Automatic Quotations
(NASDAQ), which is an electronic quotation system that provides immediate price
quotations. Firms that wish to have their price quoted by the NASDAQ must meet specific
requirements on minimum assets, capital, and number of shareholders. More than 3,000
stocks trade on the NASDAQ. Although most stocks listed in this market are issued by
relatively small firms, stocks of some very large firms (e.g., Apple and Intel) are also traded
there.
OTC Bulletin Board: The OTC Bulletin Board lists stocks that have a price below$1 per
share, which are sometimes referred to as penny stocks. More than 3,500 stocks are listed
here. Many of these stocks were once traded in the NASDAQ market but no longer meet that
exchange’s requirements. Penny stocks are less liquid than those traded on exchanges
because there is an extremely limited amount of trading. They are typically traded only by
individual investors. Institutional investors tend to focus on more liquid stocks that can be
easily sold in the secondary market at any time.
Pink Sheets: the OTC market has another segment, known as the “pink sheets,” where even
smaller stocks are traded. Like those on the OTC Bulletin Board, these stocks typically do not
satisfy the NASDAQ’S listing requirements. Financial data on them are very limited, if
available at all. Companies whose stocks are traded on the pink sheets market do not have to

register with the SEC. Some of the stocks have very little trading volume and may not be
traded at all for several weeks.
2.3. Derivative Market
Financial markets are classified in terms of cash market and derivative markets. The cash
market, also referred to as the spot market, is the market for the immediate purchase and sale
of a financial instrument. In contrast, some financial instruments are contracts that specify
that the contract holder has either the obligation or the choice to buy or sell another
something at or by some future date. The “something” that is the subject of the contract is
called the underlying. The underlying is a stock, a bond, a financial index, an interest rate, a
currency, or a commodity. Because the price of such contracts derives their value from the
value of the underlying, these contracts are called derivative instruments and the market
where they are traded is called the derivatives market.
Derivatives instruments, or simply derivatives, include futures, forwards, options, swaps,

caps, and floors. The primary role of derivative instruments is to provide a transactional
efficient vehicle for protecting against various types of risk encountered by investors and
issuers. Derivatives serve an important function of the global financial marketplace,
providing end-users with opportunities to better manage financial risks associated with their
business transactions.
2.3.1. Basics of Derivatives

Derivative instruments play an important role in financial markets as well as commodity
markets by allowing market participants to control their exposure to different types of risk. In
this chapter, we describe the various types of derivative contracts. The two basic derivative
contracts are futures and forward contracts and options contracts. There are other types of
derivative contracts that are economically equivalent to a package of these two basic
contracts: swaps and caps and floors.
2.3.2. Futures and Forward Contracts
Basic Features of Futures Contracts: A futures contract is a legal agreement between a buyer
and a seller in which: The buyer agrees to take delivery of something at a specified price at
the end of a designated period of time. The seller agrees to make delivery of something at a

specified price at the end of a designated period of time. Of course, no one buys or sells
anything when entering into a futures contract. Rather, those who enter into a contract agree
to buy or sell a specific amount of a specific item at a specified future date. When we speak
of the “buyer” or the “seller” of a contract, we are simply adopting the jargon of the futures
market, which refers to parties of the contract in terms of the future obligation they are
committing themselves to.
Let’s look closely at the key elements of this contract. The price at which the parties agree to
transact in the future is called the futures price. The designated date at which the parties must
transact is called the settlement date or delivery date. The “something” that the parties agree
to exchange is called the underlying.
To illustrate, suppose a futures contract is traded on an exchange where the underlying to be

bought or sold is asset XYZ, and the settlement is three months from now. Assume further
that Bob buys this futures contract, and Sally sells this futures contract, and the price at which
they agree to transact in the future is $100. Then $100 is the futures price. At the settlement
date, Sally will deliver asset XYZ to Bob. Bob will give Sally $100, the futures price.
When an investor takes a position in the market by buying a futures contract (or agreeing to
buy at the future date), the investor is said to be in a long position or to be long futures. If,
instead, the investor’s opening position is the sale of a futures contract (which means the
contractual obligation to sell something in the future), the investor is said to be in a short
position or short futures. The buyer of a futures contract will realize a profit if the futures
price increases; the seller of a futures contract will realize a profit if the futures price
decreases.
For example, suppose that one month after Bob and Sally take their positions in the futures
contract, the futures price of asset XYZ increases to $120. Bob, the buyer of the futures
contract, could then sell the futures contract and realize a profit of $20. Effectively, at the
settlement date, he has agreed to buy asset XYZ for $100 and has agreed to sell asset XYZ
for $120. Sally, the seller of the futures contract, will realize a loss of $20. If the futures price
falls to $40 and Sally buys back the contract at $40, she realizes a profit of $60 because she
agreed to sell asset XYZ for $100 and now can buy it for $40. Bob would realize a loss of

$60. Thus, if the futures price decreases, the buyer of the futures contract realizes a loss while
the seller of the futures contract realizes a profit, as we show in Figure 6.1.
2.4. FOREIGN EXCHANGE MARKETS
As international trade and investing have increased over time, so has the need to exchange
currencies. Foreign exchange markets consist of a global telecommunications network among
the large commercial banks that serve as financial intermediaries for such exchange. These
banks are located in New York, Tokyo, Hong Kong, Singapore, Frankfurt, Zurich, and
London. Foreign exchange transactions at these banks have been increasing over time.
At any given time, the price at which banks will buy a currency (bid price) is slightly lower
than the price at which they will sell it (ask price). Like markets for other commodities and
securities, the market for foreign currencies is more efficient because of financial
intermediaries (commercial banks). Otherwise, individual buyers and sellers of currency
would be unable to identify counterparties to accommodate their needs.
Institutional Use of Foreign Exchange Markets: The degree of international investment by

financial institutions is influenced by potential return, risk, and government regulations.
Commercial banks use international lending as their primary form of international investing.
Mutual funds, pension funds, and insurance companies purchase foreign securities. In recent
years, technology has reduced information costs and other transaction costs associated with
purchasing foreign securities, prompting an increase in institutional purchases of foreign
securities. Consequently, financial institutions are increasing their use of the foreign
exchange markets to exchange currencies. They are also increasing their use of foreign
exchange derivatives to hedge their investments in foreign securities.
Exchange Rate Quotations: The direct exchange rate specifies the value of a currency in
U.S. dollars. For example, the Mexican peso may have a value such as $0.10 while the
British pound is valued at $2.00. The indirect exchange rate specifies the number of units of a
currency equal to a U.S. dollar. For the example values given here, the indirect exchange
rates are 10 pesos per dollar and 0.50 pounds per dollar. The indirect exchange rate is the
reciprocal of the direct exchange rate.

Forward Rate: For widely used currencies, forward rates are available and are commonly
quoted next to the respective spot rates. The forward rates indicate the rate at which a
currency can be exchanged in the future. If the forward rate is above the spot rate, it contains
a premium. If the forward rate is below the spot rate, it contains a negative premium (also
called a discount).
Cross-Exchange Rates: Most exchange rate quotation tables express currencies relative to
the dollar. In some instances, however, the exchange rate between two non-dollar currencies
is needed.
Factors Affecting Exchange Rates: As the value of a currency adjusts to changes in demand
and supply conditions, it moves toward equilibrium. In equilibrium, there is no excess or
deficiency of that currency.
EXAMPLE A large increase in the U.S. demand for European goods and securities will result
in an increased demand for euros. Because the demand for euros will then exceed the supply
of euros for sale, the foreign exchange dealers (commercial banks) will experience a shortage
of euros and will respond by increasing the quoted price of euros. Hence the euro will
appreciate, or increase in value. Conversely, if European corporations begin to purchase more
U.S. goods and European investors purchase more U.S. securities, the opposite forces will
occur. There will be an increased sale of euros in exchange for dollars, causing a surplus of
euros in the market. The value of the euro will therefore decline until it once again achieves
equilibrium.
In reality, both the demand for euros and the supply of euros for sale can change
simultaneously. The adjustment in the exchange rate will depend on the direction and
magnitude of these changes. A currency’s supply and demand are influenced by a variety of
factors, including (1) differential inflation rates, (2) differential interest rates, and (3)
government (central bank) intervention. These factors will be discussed next.
Factors affecting exchange rates
Differential Differential Government

Inflation rates Interest rates Intervention
Differential Inflation Rates: Begin with an equilibrium situation and consider what will
happen to the U.S. demand for euros, and to the supply of euros for sale, if U.S. inflation
suddenly becomes much higher than European inflation. The U.S. demand for European
goods will increase, reflecting an increased U.S. demand for euros. In addition, the supply of
euros to be sold for dollars will decline as the European desire for U.S. goods decreases. Both
forces will place upward pressure on the value of the euro.
Under the reverse situation, where European inflation suddenly becomes much higher than
U.S. inflation, the U.S. demand for euros will decrease while the supply of euros for sale
increases, placing downward pressure on the value of the euro. A well-known theory about
the relationship between inflation and exchange rates, purchasing power parity (PPP)
suggests that the exchange rate will, on average, change by a percentage that reflects the
inflation differential between the two countries of concern.
Differential Interest Rates: Interest rate movements affect exchange rates by influencing the
capital flows between countries. An increase in interest rates may attract foreign investors,
especially if the higher interest rates do not reflect an increase in inflationary expectations
Central Bank Intervention: Central banks commonly consider adjusting a currency’s value
to influence economic conditions. For example, the U.S. central bank may wish to weaken
the dollar to increase demand for U.S. exports, which can stimulate the economy. However, a
weaker dollar can also cause U.S. inflation by reducing foreign competition (because it raises

the price of foreign goods to U.S. consumers). Alternatively, the U.S. central bank may prefer
to strengthen the dollar to intensify foreign competition, which can reduce U.S. inflation.
Direct Intervention: A country’s government can intervene in the foreign exchange market
to affect a currency’s value. Direct intervention occurs when a country’s central bank (such
as the Federal Reserve Bank for the United States or the European Central Bank for the
Eurozone countries) sells some of its currency reserves for a different currency.
Indirect Intervention: The Fed can affect the dollar’s value indirectly by influencing the
factors that determine its value. For example, the Fed can attempt to lower interest rates by
increasing the U.S. money supply (assuming that inflationary expectations are not affected).
Lower U.S. interest rates tend to discourage foreign investors from investing in U.S.
securities, thereby putting downward pressure on the value of the dollar. Or, to boost the
dollar’s value, the Fed can attempt to increase interest rates by reducing the U.S. money
supply. Indirect intervention can be an effective means of influencing a currency’s value.
When countries experience substantial net outflows of funds (which put severe downward
pressure on their currency), they commonly use indirect intervention by raising interest rates
to discourage excessive outflows and thus limit the downward pressure on their currency’s
value. However, this action adversely affects local borrowers (government agencies,
corporations, and consumers) and may weaken the economy.
Foreign Exchange Derivatives
Foreign exchange derivatives can be used to speculate on future exchange rate movements or
to hedge anticipated cash inflows or outflows in a given foreign currency. As foreign
securities markets have become more accessible, institutional investors have increased their
international investment, which in turn has increased their exposure to exchange rate risk.
Some institutional investors use foreign exchange derivatives to hedge their exposure. The
most popular foreign exchange derivatives are forward contracts, currency futures contracts,
currency swaps, and currency options contracts.
Forward Contracts

Forward contracts are contracts, typically negotiated with a commercial bank, that allow the
purchase or sale of a specified amount of a particular foreign currency at a specified
exchange rate (the forward rate) on a specified future date. A forward market facilitates the
trading of forward contracts. This market is not in one physical place; it is a
telecommunications network through which large commercial banks match participants who
wish to buy a currency forward with other participants who wish to sell a currency forward.
Many of the commercial banks that offer foreign exchange on a spot basis also offer forward
transactions for widely traded currencies. By enabling a firm to lock in the price to be paid
for a foreign currency, forward purchases or sales can hedge the firm’s risk that the
currency’s value may change over time.
Currency Futures Contracts
An alternative to the forward contract is a currency futures contract, which is a standardized

contract that specifies an amount of a particular currency to be exchanged on a specified date
and at a specified exchange rate. A firm can purchase a futures contract to hedge payables in
a foreign currency by locking in the price at which it could purchase that specific currency at
a particular point in time. To hedge receivables denominated in a foreign currency, it could
sell futures and thereby lock in the price at which it could sell that currency. A futures
contract represents a standard number of units. Currency futures contracts also have specific
maturity (or “settlement”) dates from which the firm must choose.
Futures contracts are standardized, whereas forward contracts can specify whatever amount
and maturity date the firm desires. Forward contracts have this flexibility because they are
negotiated with commercial banks rather than on a trading floor.
Currency Swaps
A currency swap is an agreement that allows one currency to be periodically swapped for
another at specified exchange rates. It essentially represents a series of forward contracts.
Commercial banks facilitate currency swaps by serving as the intermediary that links two
parties with opposite needs. Alternatively, commercial banks may be willing to take the
position counter to that desired by a particular party. In such a case, they expose themselves
to exchange rate risk unless the position they have assumed will offset existing exposure.

Currency Options Contracts
Another foreign exchange derivative used for hedging is the currency option. Its primary
advantage over forward and futures contracts is in stipulating that the parties have the right
but not the obligation to purchase or sell a particular currency at a specified price within a
given period.
A currency call option provides the right to purchase a particular currency at a specified price
(called the exercise price) within a specified period. This type of option can be used to hedge
future cash payments denominated in a foreign currency. If the spot rate remains below the
exercise price, the option will not be exercised because the firm could purchase the foreign
currency at a lower cost in the spot market. However, a fee (or a premium) must be paid for
options, so there is a cost to hedging with options even if the options are not exercised.
A put option provides the right to sell a particular currency at a specified price (the exercise
price) within a specified period. If the spot rate remains above that price, the option will not
be exercised because the firm could sell the foreign currency at a higher price in the spot
market. But if the spot rate is below the exercise price at the time the foreign currency is
received, the firm will exercise its put option.
International Arbitrage
Exchange rates and exchange rate derivatives are market determined. If they become
misaligned, various forms of arbitrage can occur, forcing realignment. Common types of
international arbitrage are explained next.
Locational Arbitrage
Locational arbitrage is the act of capitalizing on a discrepancy between the spot exchange rate
at two different locations by purchasing the currency where it is priced low and selling it
where it is priced high.
Triangular Arbitrage
If the quoted cross-exchange rate between two foreign currencies is not aligned with the two
corresponding exchange rates, there is a discrepancy in the exchange rate quotations. Under

this condition, investors can engage in triangular arbitrage, which involves buying or selling
the currency that is subject to a mispriced cross-exchange rate.
Covered Interest Arbitrage
The coexistence of international money markets and forward markets forces a special
relationship, between a forward rate premium and the interest rate differential of two
countries that is known as interest rate parity. This relationship also has implications for
currency futures contracts, since they are normally priced like forward contracts.

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Raya University College of Business & Economics Department of Accounting & Finance

Study material for Financial institutions and markets

2.1.1. Money Market Securities

Money market securities are commonly purchased by households, corporation (including

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The more popular money market securities are:

Each of these instruments is described in turn.

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2. Commercial Paper: Commercial paper is a short-term debt instrument issued only by

Denomination: The minimum denomination of commercial paper is usually $100,000, and

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3. Negotiable Certificates of Deposit: Negotiable certificates of deposit (NCDs) are

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Placement Repo transactions are negotiated through a telecommunications network. Dealers

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6. Banker’s Acceptances: A banker’s acceptance indicates that a bank accepts

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Globalization of Money Markets

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2.2. CAPITAL MARKET

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2.2.1. STOCK MARKET

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Participation in Stock Markets

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Investors can be classified as individual or institutional. The investment by individuals in a

In addition to participating in stock markets by investing funds, financial institutions

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2.2.2. BOND MARKET

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Public Offering: Corporations commonly issue bonds through a public offering. A

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Liquidity in Secondary Market Bonds issued by large, well-known corporations in large

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2.2.3. STOCK EXCHANGES

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The requirement of a minimum number of shares outstanding is intended to ensure adequate

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2.3. Derivative Market

Derivatives instruments, or simply derivatives, include futures, forwards, options, swaps,

2.3.1. Basics of Derivatives

2.3.2. Futures and Forward Contracts

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To illustrate, suppose a futures contract is traded on an exchange where the underlying to be

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2.4. FOREIGN EXCHANGE MARKETS

Institutional Use of Foreign Exchange Markets: The degree of international investment by

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Factors affecting exchange rates

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Differential Differential Government

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Foreign Exchange Derivatives

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Currency Futures Contracts