The Financial Environment: Markets & Institutions

1. The Financial Environment: Markets & Institutions

2. Financial markets • Businesses, individuals, and governments often need to raise capital. For example, • suppose Carolina Power & Light (CP&L) forecasts an increase in the demand for electricity in North Carolina, and the company decides to build a new power plant. • Because CP&L almost certainly will not have the $1 billion or so necessary to pay for the plant, the company will have to raise this capital in the financial markets. Or suppose Mr. Fong, the proprietor of a San Francisco hardware store, decides to expand into appliances. • Where will he get the money to buy the initial inventory of TV sets, washers, and freezers? Similarly, if the Johnson family wants to buy a home that costs $100,000, but they have only $20,000 in savings, how can they raise the additional $80,000? If the city of New York wants to borrow $200 million to finance a new sewer plant, or the federal government needs money to meet its needs, they too need access to the capital markets

3. Financial markets • On the other hand, some individuals and firms have incomes that are greater • than their current expenditures, so they have funds available to invest. • For example, • Carol Hawk has an income of $36,000, but her expenses are only $30,000, and in 2000 Ford Motor Company had accumulated roughly $21 billion of cash and marketable securities, which it has available for future investments.

4. Financial Intermediation • A Financial intermediary is a party bringing together providers and users of finance, either as broker or as principal. • A financial intermediary is an institution which links lenders with borrowers, by obtaining deposits from lenders and then re-lending them to borrowers.

5. Financial Intermediation • Not all intermediation takes place between savers and investors. • Some institutions act mainly as intermediaries between other institutions. Financial intermediaries may also lend abroad or borrow from abroad. • Examples of financial intermediaries. • Commercial banks • Finance houses • Building societies • Government's National Savings department • Institutional investors e.g. pension funds and investment trusts

6. Functions Of Financial Markets • Financial markets provide the following three major economic functions: • Price discovery • Liquidity • Reduced transaction costs.

7. Price discovery • Price discovery means that the interactions of buyers and sellers in a financial market determine the price of the traded asset. • Equivalently, they determine the required return that participants in a financial market demand in order to buy a financial instrument. • Because the motivation for those seeking funds depends on the required return that investors demand, it is this function of financial markets that signals how the funds available from those who want to lend or invest funds will be allocated among those needing funds and raise those funds by issuing financial instruments.

8. Liquidity • Financial markets provide a forum for investors to sell a financial instrument and is said to offer investors “liquidity.” • This is an appealing feature when circumstances arise that either force or motivate an investor to sell a financial instrument. • Without liquidity, an investor would be compelled to hold onto a financial instrument until either conditions arise that allow for the disposal of the financial instrument or the issuer is contractually obligated to pay it off. • For a debt instrument, that is when it matures, whereas for an equity instrument that is until the company is either voluntarily or involuntarily liquidated. • All financial markets provide some form of liquidity. However, the degree of liquidity is one of the factors that characterize different financial markets.

9. Reduced Transaction Costs • The third economic function of a financial market is that it reduces the cost of transacting when parties want to trade a financial instrument In general, • one can classify the costs associated with transacting into two types search costs and information costs. • Search costs in turn fall into categories: explicit costs and implicit costs. • Explicit costs include expenses that may be needed to advertise one’s intention to sell or purchase a financial instrument; • Implicit Costs include the value of time spent in locating a counterparty to the transaction.

10. Reduced Transaction Costs • The presence of some form of organized financial market reduces search costs. • Information costs are costs associated with assessing a financial instrument’s investment attributes. • In a price efficient market, prices reflect the aggregate information collected by all market participants.

11. Classification Of Financial Markets • Classification of a Country’s Financial Markets • From the perspective of a given country, its financial market can be broken down into an internal market and an external market. • Theinternal market, which is also referred to as the national market, is made up of two parts: the domestic market and the foreign market. • The domestic market is where issuers domiciled in the country issue securities and where those securities are subsequently traded. • For example, from the perspective of the United States, securities issued by General Motors, a U.S. corporation, trade in the domestic market. • The foreign market is where securities of issuers not domiciled in the country are sold and traded.

12. Classification Of Financial Markets • For example, from a U.S. perspective, the securities issued by Toyota Motor Corporation trade in the foreign market. • The foreign market in the United States is called the “Yankee market.” There are nicknames for the foreign market of other countries • The other sector of a country’s financial market is the External Market. • This is the market where securities with the following two distinguishing features are trading: (1) at issuance they are offered simultaneously to investors in a number of countries; and (2) they are issued outside the jurisdiction of any single country. • The external market is also referred to as the International Market, Offshore Market, and the Euromarket (despite the fact that this market is not limited to Europe).

13. Financial markets Internal External Domestic Foreign

14. Classification Of Financial Markets • Money Market • The money market is the sector of the financial market that includes financialinstruments that have a maturity or redemption date that is one year or less at the time of issuance. • Typically, money market instruments are debt instruments and include Treasury bills, commercial paper, negotiable certificates of deposit, repurchase agreements, and bankers acceptances. • There is one form of equity, preferred stock, that can be viewed under certain conditions as a money market instrument.

15. Classification Of Financial Markets • Treasury bills • popularly referred to as T-bills are short-term securities issued by the U.S. government. • they have original maturities of either four weeks, three months, or six months. • T-bills carry no stated interest rate. • Instead, they are sold on a discounted basis. • This means that the holder of a T-bill realizes a return by buying these securities for less than their maturity value and then receiving the maturity value at maturity.

16. Classification Of Financial Markets • Commercial paper is a promissory note—a written promise to pay issued by a large, creditworthy corporation or a municipality. • This financial instrument has an original maturity that typically ranges from one day to 270 days. • Most commercial paper is backed by bank lines of credit, which means that a bank is standing by ready to pay the obligation if the issuer is unable to. • Commercial paper may be either interest bearing or sold on a discounted basis.

17. Classification Of Financial Markets • Certificates of deposit (CDs) are written promises by a bank to pay a depositor. • Nowadays, they have original maturities from six months to three years. • Negotiable certificates of deposit are CDs issued by large commercial banks that can be bought and sold among investors. • Negotiable CDs typically have original maturities between one month and one year and are sold in denominations of $100,000 or more. • Negotiable CDs are sold to investors at their face value and carry a fixed interest rate. • On the maturity date, the investor is repaid the principal plus interest

18. Classification Of Financial Markets • A Eurodollar CD is a negotiable CD for a U.S. dollar deposit at a bank located outside the United States or in U.S. International Banking Facilities. • The interest rate on Eurodollar CDs is the London Interbank Offered Rate (LIBOR), • LIBOR is the rate at which major international banks are willing to offer term Eurodollar deposits to each other.

19. Classification Of Financial Markets • Repurchase Agreement • The lender will loan a certain amount of funds to an entity in need of funds using the bonds as collateral. • This common lending agreement is referred to as a repurchase agreement or repo because it specifies that the (1) the borrower sell the bonds to the lender in exchange for proceeds; and (2) a some specified future date, the borrower repurchases the bonds from the lender at a specified price. • The specified price, called the repurchase price, is higher than the price at which the bonds are sold because it embodies the interest cost that the lender is charging the borrower. • The interest rate in a repo is called the repo rate. • Thus, a repo is nothing more than a collateralized loan. • It is classified as a money market instrument because the term of a repo is typically less than one year.

20. Classification Of Financial Markets • Bankers’ acceptances are short-term loans, usually to importers and exporters, made by banks to finance specific transactions. • An acceptance is created when a draft (a promise to pay) is written by a bank’s customer and the bank “accepts” it, promising to pay. • The bank’s acceptance of the draft is a promise to pay the face amount of the draft to whomever presents it for payment. • The bank’s customer then uses the draft to finance a transaction, giving this draft to her supplier in exchange for goods. • Since acceptances arise from specific transactions, they are available in a wide variety of principal amounts. • Typically, bankers’ acceptances have maturities of less than 180 days. Bankers’ acceptances are sold at a discount from their face value, and the face value is paid at maturity. • Since acceptances are backed by both the issuing bank and the purchaser of goods, the likelihood of default is very small.