Financial Markets Midterm Reviewer

LESSON 1: INTRODUCTION AND OVERVIEW OF  Federal funds- short-term funds

FINANCIAL MARKETS transferred between financial
institutions usually for no more than
Financial system - creates a more efficient transfer of one day.
funds by mitigating the information asymmetry problem  Repurchase agreements- agreements
between those with funds to invest and those needing involving the sale of securities by one
funds party to another with a promise by the
Three Components of Financial System seller to repurchase the same securities
from the buyer at a specified date and
(1) Financial markets – it is where transactions takes price.
place  Commercial paper- short-term
unsecured promissory notes issued by a
(2) Financial intermediaries - they facilitate the
company to raise short-term cash.
transactions; and
 Negotiable certificate of deposit- bank-
(3) Regulators of financial activities- they try to make issued time deposit that specifies an
sure that everyone is playing fair interest rate and maturity date and is
negotiable, (i.e., can be sold by the
Financial Asset (Financial Instrument) – assets where holder to another party)
future benefits come in the form of a claim to future  Banker's acceptance-time - draft
cash flows payable to a seller of goods, with
payment guaranteed by a bank.
Financial assets serve two principal functions:
b) Capital Market- instruments with maturity
1. They allow the transference of funds from those of more than one year
entities that have surplus funds to invest to those who  Corporate stock- the fundamental
need funds to invest in tangible assets. ownership claim in a public
corporation.
2. They permit the transference of funds in such a way  Mortgages – loans to individuals or
as to redistribute the unavoidable risk associated with businesses to purchase a home,
the tangible assets cash flow among those seeking and land, or other real property.
those providing the funds.  Corporate bonds - long-term bonds
issued by corporations
Financial Market – market where investors
 Treasury bonds- long-term bonds
exchange/trade financial instruments; are structures
issued by the government treasury.
through which funds flow
 Bank and consumer loans- loans to
Classification of Financial Market commercial banks and individuals
3. Time of Delivery
1. Nature of Claim a) Cash Market – buys stocks and redeems as
a) Debt Market- issues bonds cash
b) Equity Market- issues shares of stock b) Future Market – cash is to be receive in the
2. Maturity of Claim future even if you invest today
a) Money Market- maturity of less than one 4. Organizational Structure
year a) Exchange Traded Market – stocks in bought
 Treasury bills- short-term obligations from exchange market e.g. Philippine Stock
issued by the government. Exchange

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 b) Over the counter market – stocks is bought (suppliers of funds) to those with shortages of funds
on banks (users of funds)

Types of Financial Markets Examples: commercial and savings banks, credit unions,
insurance companies, mutual funds
 Primary Markets - markets in which
corporations raise funds through new issues of Types of Financial Institutions
securities.
 Commercial banks —depository institutions
 Secondary Markets - markets that trade
whose major assets are loans and whose major
financial instruments once they are issued.
liabilities are deposits
 Money Markets - markets that trade debt
 Thrifts — generally perform services similar to
securities and instruments with maturities of
commercial banks, but they tend to concentrate
less than one year.
their loans in one segment, such as real estate
 Capital Markets – markets that trade debt and
loans or consumer loans
equity instruments with maturities more than
 Insurance companies —financial institutions
one year.
that protect individuals and corporations
 Foreign Exchange Markets – markets in which
(policyholders) from adverse events
cash flows from sale of products or assets
 Securities firms and investment banks —
denomination in a foreign currency are
financial institutions that help firms issue
transacted.
securities and engage in related activities such
 Derivative Markets – markets in which
as securities brokerage and securities trading
derivative securities trade.
 Finance companies —financial intermediaries
Functions of Financial Market that make loans to both individuals and
businesses
 Price Determination  Mutual funds —financial institutions that pool
 Provides Liquidity financial resources of individuals and companies
 Reduction of Transaction Cost and invest those resources in diversified
 Capital Formation portfolios of assets
 Reflects economic and business
 Hedge funds —financial institutions that pool
condition
funds from a limited number of wealthy
 Fund Mobilization
individuals) and invest these funds on their
Financial intermediaries include depository institutions, behalf
non- deposit finance companies regulated investment  Pension funds —financial institutions that offer
companies, investment banks, and insurance companies savings plans through which fund participants
accumulate savings during their working years
Role: To create more favorable transactions terms than before withdrawing them during their
could be realized by lenders/investors and borrowers retirement years
dealing directly with each other in the financial market
Unique Economic Functions Performed by Financial
Examples: Institutions

 Commercial Bank 1) Monitoring Costs - large number of small investors to

 Mutual Fund group their funds together by holding the claims issued
by a financial institution.
LESSON 2: FUNCTIONS OF FINANCIAL INSTITUTIONS
2) Liquidity and Price Risk. FIs are acting as asset
Financial institutions - perform the essential function of
transformers wherein they purchase the financial claims
channeling funds from those with surplus funds

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issued by users of funds and finance these purchases by markets by net suppliers of funds; quantity of
selling financial claims to household investors and other loanable funds supplied increases as interest
fund suppliers in the form of deposits insurance
rates rise
policies, or other secondary securities
 Demand for loanable funds - term used to
Additional Benefits FIs Provide to Suppliers of Funds
describe the total net demand for funds by fund
1) Reduced Transaction Cost - their average cost of users; quantity of loanable funds demanded is
collecting relevant information is lower than for the
higher as interest rates fall
individual investor

2) Maturity Intermediation - ability to reduce risk by 4 Factors That Cause the Supply and Demand Curves for
diversification Loanable Funds to Shift

Economic Functions FIs Provide to the Financial System

1) Wealth - As the total wealth of financial market
as a Whole
participants increases, the absolute dollar value
1) The Transmission of Monetary Policy
available for investment purposes increases
2) Credit Allocation
3) Intergenerational Wealth Transfers or Time 2) Risk of financial security - As the risk of a
Intermediation
4) Payment Services financial security decreases it becomes more
attractive to suppliers of funds
Risks Incurred by Financial Institutions
3) Near-Term Spending Needs - When financial
 FIs hold some assets that are potentially subject
market participants have few near-term
to default or credit risk
spending needs, the absolute dollar value of
 FIs are exposed to interest rate risk
funds available to invest increases
 FIs are further exposed to market risk or asset
price risk 4) Monetary Expansion - altering the availability
 FIs are exposed to some degree of liability of funds; the growth in the money supply, and
withdrawal or liquidity risk thus the rate of economic expansion of the
 All FIs are exposed to technology risk and economy
operational risk
5) Economic Conditions - As the underlying
LESSON 3: DETERMINANTS OF INTEREST RATES economic conditions themselves improve in a
country relative to other countries, the flow of
 Nominal interest rates - interest rates actually
funds to that country increases
observed in financial markets
 Loanable funds theory - views the level of Factors Affecting Nominal Interest Rates
interest rates in financial markets as resulting
 Inflation —continual increase in the price level
from factors that affect the supply
of a basket of goods and services
 Supply of loanable funds - term commonly used
to describe funds provided to the financial

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  Real Interest Rate —nominal interest rate that 4) Single-Payment Yields - some money market
would exist on a security if no inflation were securities pay interest only once during their
expected lives: at maturity
 Default Risk —risk that a security issuer will
Money Market Instruments
default on the security by missing an interest or
principal payment.  Treasury bills — short-term obligations issued
 Liquidity Risk —risk that a security cannot be by the government.
sold at a predictable price with low transaction  Federal funds — short-term funds transferred
costs at short notice. between financial institutions usually for no
 Special Provisions —provisions that impact the more than one day.
security holder beneficially or adversely  Repurchase agreements — agreements

 Term to Maturity —length of time a security has involving the sale of securities by one party to

until maturity. another with a promise to repurchase the

 Inflation - The first factor to affect interest rates securities at a specified date and price.

is the actual or expected inflation rate in the  Commercial paper — short-term unsecured

economy promissory notes issued by a company to raise

short-term cash.
LESSON 4: MONEY MARKETS
 Negotiable certificates of deposit — bank-

Money Markets - markets that trade debt securities or issued time deposit that specifies an interest

instruments with maturities of less than one year rate and maturity date and is negotiable
 Banker’s acceptances — time drafts payable to
Opportunity cost - The forgone interest cost from the
a seller of goods, with payment guaranteed by a
holding of cash balances when they are received.
bank; arises from letters of credit

Default risk - The risk of late or nonpayment of principal

Additional Terms:
or interest
 Treasury bill auctions - The formal process by
Yields on Money Market Securities
which the U.S. Treasury sells new issues of

1) Bond Equivalent Yield - rate used to calculate Treasury bills

the present value of an investment  Federal funds rate - interest rate for borrowing

2) Effective Annual Return - quoted nominal or fed funds

stated rate earned on an investment over a  Correspondent banks - bank’s with reciprocal

one-year period accounts and agreements

3) Discount Yields - some money market  Reverse repurchase agreement - an agreement

instruments are bought and sold on a discount involving the purchase of securities by one

basis party from another with the promise to sell

them back

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  Bearer Instrument - an instrument in which the Eurocommercial paper - Eurosecurities issued in Europe
holder at maturity receives the principal and by dealers of commercial paper without involving a
interest bank

LESSON 5: MONEY MARKET PARTICIPANTS LESSON 6: BOND MARKET SECURITIES

The U.S. Treasury - raises significant amounts of funds Bonds are long-term debt obligations issued by
in the money market when it issues T-bills corporations and government units

The Federal Reserve - is a key (arguably the most Bond markets are markets in which bonds are issued
important) participant in the money markets and traded

Commercial Banks - the most diverse group of Coupon Rate – term used for the rate of return of
participants in the money markets bonds

Brokers and Dealers - services are important to the Capital Markets Market’s that trade debt (bonds and
smooth functioning of money markets mortgages) and equity (stocks) instruments with
maturities of more than one year
Corporations - raise large amounts of funds in the
money markets, primarily in the form of commercial BOND MARKET SECURITIES
paper
Treasury notes and bonds - Long-term securities issued
Other Financial Institutions - insurance companies by the U.S. Treasury to finance the national debt and
invest heavily in highly liquid money market securities other federal government expenditures

Individuals - participate in the money markets through STRIP - A Treasury security in which the periodic
direct investments in these securities or through interest payment is separated from the final principal
investments in money market mutual funds payment

Euro Money Markets - U.S. dollar is still the major Accrued interest - That portion of the coupon payment
international medium of exchange accrued between the last coupon payment and the
settlement day
Eurodollar market - The market in which Eurodollars
trade. Treasury Inflation Protection Securities (TIPS) - provide
returns tied to the inflation rate
London Interbank Offered Rate (LIBOR) - The rate paid
on Eurodollars. Municipal bonds - Securities issued by state and local
(e.g., county, city, school) governments
Eurodollar Certificates of Deposits - Dollar-
denominated deposits in non-U.S. banks General obligation (GO) bonds are backed by the full
faith and credit of the issuer

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Revenue bonds are sold to finance a specific revenue- Mortgage Bond - are secured debt issues
generating project
Debentures - Bonds backed solely by the general credit
The Trading Process for Municipal Bonds: either worthiness of the issuing firm, unsecured
through a public offering, using an investment bank
Subordinated debentures - Bonds that are unsecured
serving as a security underwriter or through a private
and are junior in their rights to mortgage bonds and
placement to a small group of investors
regular debentures
Firm commitment underwriting - investment bank
Convertible bonds - Bonds that may be exchanged for
guarantees the issuer a price for newly issued securities
another security of the issuing firm
Best-Efforts offering - investment bank does not
Stock Warrants - Bonds can also be issued with stock
guarantee a price to the issuer and acts more as a
warrants attached
placing or distribution agent
Callable Bonds - allows the issuer to require the bond
Private placement - A security issue placed with one or
holder to sell the bond back to the issuer at a given
a few large institutional buyers
(call) price— usually set above the par value of the bond
Corporate bonds - are long-term bonds issued by
Call provision - a provision on a bond issue that allows
corporations
the issuer to force the bond holder to sell the bond back
Bond indenture -legal contract that specifies the rights to the issuer at a price above the par value (or at the
and obligations of the bond issuer and the bond holders call price)

Bond Characteristics - Corporate bonds have many Call premium - the difference between the call price
different characteristics that differentiate one issue and the face value on the bond
from another
Sinking Fund Provision - a requirement that the issuer
Bearer bond - bonds with coupons attached to the retire a certain amount of the bond issue each year
bond. The holder presents the coupons to the issuer for
Trading Process for Corporate Bonds: Either a public
payments of interest when they come due.
sale (issue) or a private placement
Registered bond - bond in which the owner is recorded
Junk bond - Bond rated as speculative or less than
by the issuer and the coupon payments are mailed to
investment grade
the registered owner
LESSON 7: BOND MARKET SECURITIES 2
Term bonds - Bonds in which the entire issue matures
on a single date International Aspects of Bond Markets

Serial bonds - Bonds that mature on a series of dates,

with a portion of the issue paid off on each

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International bond markets - those markets that trade  Farm mortgages are used to finance the
bonds that are underwritten by an international purchase of farms
syndicate
Mortgage Characteristics
Eurobonds - long-term bonds issued and sold outside
Collateral - All mortgage loans are backed by a specific
the country of the currency in which they are
piece of property that serves as collateral to the
denominated
mortgage loan
Foreign Bonds - Foreign bonds are long-term bonds
Lien - is a public record attached to the title of the
issued by firms and governments outside of the issuer’s
property that gives the financial institution the right to
home country and are usually denominated in the
sell the property if the mortgage borrower defaults; title
currency of the country in which they are issued rather
has the word “ENCUMBERED” on it
than in their own domestic currency
Down payment – a portion of the purchase price of the
Sovereign Bonds - are government-issued debt;
property a financial institution requires the mortgage
uncollateralized and their price or value reflects the
borrower to pay up front
credit risk rating of the country issuing the bonds
Private Mortgage Insurance - Insurance contract
LESSON 8: MORTGAGE MARKET
purchased by a mortgage borrower guaranteeing to pay
Mortgages - backed by a specific piece of property that the financial institution the difference between the
allows the lender to take ownership in the event of a value of the property and the balance remaining on the
default mortgage

Securitized - Securities packaged and sold as assets Mortgage Maturities - A mortgage generally has an
backing a publicly traded or privately held debt original maturity of either 15 or 30 years
instrument
Amortized - A mortgage is amortized when the fixed
Primary Mortgage Market principal and interest payments fully pay off the
mortgage by its maturity date
 Home mortgages are used to purchase one-to-
four family dwellings. Balloon payment mortgage - Mortgage that requires a
fixed monthly interest payment for a three- to five-year
 Multifamily dwelling mortgages are used to
period
finance the purchase of apartment complexes,
townhouses, and condominiums. Interest Rates - Possibly the most important
characteristic identified in a mortgage contract
 Commercial mortgages are used to finance the
purchase of real estate for business purposes Fixed-rate mortgage - A mortgage that locks in the
borrower’s interest rate

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Adjustable-rate mortgage - A mortgage in which the
interest rate is tied to some market interest rate

Discount points - Interest payments made when the

loan is issued (at closing)

Other Fees:

 Application fee - Covers the issuer’s initial costs

of processing the mortgage application and
obtaining a credit report.
 Title search - Confirms the borrower’s legal
ownership of the mortgaged property and
ensures there are no outstanding claims against
the property.
 Title insurance - Protects the lender against an
error in the title search.
 Appraisal fee - Covers the cost of an
independent appraisal of the value of the
mortgaged property.
 Loan origination fee - Covers the remaining
costs to the mortgage issuer for processing the
mortgage application and completing the loan.
 Closing agent and review fees - Cover the costs
of the closing agent who actually closes the
mortgage.
 Other costs - Any other fees, such as VA loan
guarantees, or FHA or private mortgage
insurance

Mortgage Refinancing - occurs when a mortgage

borrower takes out a new mortgage and uses the
proceeds obtained to pay off the current mortgage

Mortgage Amortization - the fixed monthly payment

made by a mortgage borrower generally consists partly
of repayment of the principal borrowed and partly of
the interest on the outstanding balance

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