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Financial Markets and Interest Rates

Financial Markets and Interest Rates. Financial Management. Outline. Meaning of Financial Markets Significance of Financial Markets Types of Financial Markets Money versus Capital Markets Spot versus Futures Market Primary versus Secondary Markets Interest Rate Determination.

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Financial Markets and Interest Rates

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  1. Financial Markets and Interest Rates Financial Management

  2. Outline • Meaning of Financial Markets • Significance of Financial Markets • Types of Financial Markets • Money versus Capital Markets • Spot versus Futures Market • Primary versus Secondary Markets • Interest Rate Determination

  3. Meaning of Financial Markets • A place where borrowers and lenders are brought in contact • A place where people and organizations in need of money are brought in contact with those that have excess funds and are willing to lend

  4. Significance of Financial Markets • Help in collecting the savings of the economy and • Make them available for investment • Helps in capital formation • Helps in resource allocation in the economy • Helps in growth of the economy by transferring funds from the household sector to investment sector

  5. Funds are transferred in three ways: • Direct transfer • Indirect transfer through investment banks • Indirect transfer through financial intermediaries

  6. Types of Financial Markets • Money Markets versus Capital Markets • Money market is for short-term funds up to one year • Treasury bills • Commercial paper • Banker’s acceptances • Capital market is for long-term funds beyond one year • Corporate Bonds • Treasury Bonds • Treasury Notes • Stocks

  7. Spot versus Futures Market • Spot market deals with cash transactions or transactions that will be settled within two business days • Futures market deals with transactions that will be settled beyond two business days

  8. Primary versus Secondary Markets • Primary Markets • A market for issuing of new securities • A market where securities are being issued for the first time by new or existing companies • Contributes directly towards capital formation • Secondary Market • A market that deals with buying and selling of existing securities • Contributed to capital formation indirectly

  9. Secondary Markets • Auction Markets: Stock Exchanges • Have a physical location • Have governing bodies • Trading takes place on the trading floor known as trading pits • Only members are allowed to enter trading floor • Deal in listed securities only

  10. Negotiated Markets: Over-the-Counter Market (OTC) • A network of dealers and brokers connected through • Telephones • Computers networks all over the world • Deals in unlisted securities

  11. Interest Rates • Represent cost of money • Helps in allocation of capital • Nominal interest rate is composed of real risk free rate of interest plus inflation premium and liquidity risk premium

  12. K = K* + IRP + DRP + MP + LP • K = nominal interest rate • K* = real risk free interest rate • IRP = inflation risk premium • DRP = default risk premium • MP = maturity premium • LP = liquidity premium

  13. Factors Impacting Level of Interest Rates • Federal Reserve Policy • Federal Deficits • Business Activity • Interest rates and stock markets Shapes of Yield Curve: • Upward sloping • inverse/downward sloping • flat shaped • hump shaped

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