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Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
Role of Financial mark
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Role of Financial mark

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Financial Market is the market where financial securities like stocks and bonds and commodities like valuable metals are exchanged at efficient market prices. Here, by efficient market prices we mean …

Financial Market is the market where financial securities like stocks and bonds and commodities like valuable metals are exchanged at efficient market prices. Here, by efficient market prices we mean the unbiased price that reflects belief at collective speculation of all investors about the future prospect. The trading of stocks and bonds in the Financial Market can take place directly between buyers and sellers or by the medium of Stock Exchange. Financial Markets can be domestic or international.

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  • 1. Financial InstitutionsAssignment Topic :Role and Functions of FinancialMarketSubmitted To:WaqarAhsanSubmitted By:Muhammad AsjadkhuramRegistration No:1652-411036
  • 2. Financial Market:Financial Market is the market where financial securities like stocks and bonds andcommodities like valuable metals are exchanged at efficient market prices. Here, by efficientmarket prices we mean the unbiased price that reflects belief at collective speculation of allinvestors about the future prospect. The trading of stocks and bonds in the Financial Market cantake place directly between buyers and sellers or by the medium of Stock Exchange. FinancialMarkets can be domestic or international.Different Types of Financial MarketsCapital Market:Capital Market consists of primary market and secondary market. In primary market newlyissued bonds and stocks are exchanged and in secondary market buying and selling of alreadyexisting bonds and stocks take place. So, the Capital Market can be divided into Bond marketand Stock market. Bond market provides financing by bond issuance and bond trading. Stockmarket provides financing by shares or stock issuance and by share trading . As a whole capitalmarket facilitates raising of CapitalMoney MarketMoney Market facilitates short term debt financing capital.Derivatives MarketDerivatives Market provides instruments which help in controlling financial risk.Foreign Exchange MarketForeign Exchange Market facilitates the foreign exchange trading.Insurance MarketInsurance Market helps in relocation of various risks.Commodity MarketCommodity Market organizes trading of commoditiesContribution of Financial MarketsFinancial Markets are essential for fund raising. Through Financial Market borrowers canfind suitable lenders. Banks also help in the process of financing by working asintermediaries. They use the money , which is saved and deposited by a group of people;for giving loans to another group of people who need it . Generally, banks providefinancing in the form of loans and mortgages except banks othe intermediaries in thefinancial market can be insurance companies and mutual funds. But more complicatedtransactions of Financial Market take place in stock exchange. In stock exchange, a
  • 3. company can buy others companys shares or can sell own shares to raise funds or theycan buy their own shares existing in the market.Basis of financial MarketBasis of financial markets are the borrowers and lenders.Borrowers of the financial market can be individual persons, private companies, publiccorporations, government and othe local authorities like municipalities. Individual personsgenerally take short term or long term mortgage loans from banks to buy any property. PrivateCompanies take short term or long term mortgage loans from banks to buy any property. Privatecompanies take short or long term loans for expansion of business or for improvement of thebusiness infrastructure.Lendersin the Financial Market are actually the investors. Their invested money is used to finance therequirements of borrowers. So, there are various types of investments which generate lendingactivities. Some of these types of investments are depositing money in savings bank account,paying premiums to Insurance Companies, investing in shares of different companies, investingin govt. bonds and investing in pension funds and mutual funds.Financial Market is nothing but a tool which is used to raise capital. Just like any other tool, itcan be beneficial and can be harmful too. So, the ultimate outcome solely lies in the hands of thepeople who use it to serve their purpose
  • 4. An asset is anything of durable value, that is, anything that acts as a means to storevalue over time. Real assets are assets in physical form (e.g., land, equipment,houses,...), including "human capital" assets embodied in people (natural abilities,learned skills, knowledge,..). Financial assets are claims against real assets, eitherdirectly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claimsto future income streams that originate ultimately from real assets). Securities arefinancial assets exchanged in auction and over-the-counter markets (see below)whose distribution is subject to legal requirements and restrictions (e.g., informationdisclosure requirements).Lenders are people who have available funds in excess of their desired expendituresthat they are attempting to loan out, and borrowers are people who have a shortage offunds relative to their desired expenditures who are seeking to obtain loans.Borrowers attempt to obtain funds from lenders by selling to lenders newly issuedclaims against the borrowers real assets, i.e., by selling the lenders newly issuedfinancial assets.A financial market is a market in which financial assets are traded. In addition toenabling exchange of previously issued financial assets, financial markets facilitateborrowing and lending by facilitating the sale by newly issued financial assets.Examples of financial markets include the New York Stock Exchange (resale ofpreviously issued stock shares), the U.S. government bond market (resale ofpreviously issued bonds), and the U.S. Treasury bills auction (sales of newly issued T-bills). A financial institution is an institution whose primary source of profits isthrough financial asset transactions. Examples of such financial institutions includediscount brokers (e.g., Charles Schwab and Associates), banks, insurance companies,and complex multi-function financial institutions such as Merrill Lynch.Introduction to Financial Markets and Institutions:Financial markets serve six basic functions. These functions are briefly listed below:Borrowing and Lending: Financial markets permit the transfer of funds(purchasing power) from one agent to another for either investment orconsumption purposes.
  • 5. Price Determination: Financial markets provide vehicles by which prices are setboth for newly issued financial assets and for the existing stock of financialassets.Information Aggregation and Coordination: Financial markets act as collectorsand aggregators of information about financial asset values and the flow offunds from lenders to borrowers.Risk Sharing: Financial markets allow a transfer of risk from those whoundertake investments to those who provide funds for those investments.Liquidity: Financial markets provide the holders of financial assets with achance to resell or liquidate these assets.Efficiency: Financial markets reduce transaction costs and information costs.In attempting to characterize the way financial markets operate, one must considerboth the various types of financial institutions that participate in such markets and thevarious ways in which these markets are structured.Who are the Major Players in Financial Markets?By definition, financial institutions are institutions that participate in financialmarkets, i.e., in the creation and/or exchange of financial assets. At present in theUnited States, financial institutions can be roughly classified into the following fourcategories: "brokers;" "dealers;" "investment bankers;" and "financial intermediaries."Brokers:A broker is a commissioned agent of a buyer (or seller) who facilitates trade bylocating a seller (or buyer) to complete the desired transaction. A broker does not takea position in the assets he or she trades -- that is, the broker does not maintaininventories in these assets. The profits of brokers are determined by the commissionsthey charge to the users of their services (either the buyers, the sellers, or both).Examples of brokers include real estate brokers and stock brokers.Diagrammatic Illustration of a Stock Broker:Payment ----------------- Payment------------>| |------------->Stock | | StockBuyer | Stock Broker | Seller<-------------|<----------------|<-------------Stock | (Passed Thru) | StockShares ----------------- Shares
  • 6. Dealers:Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they donot engage in asset transformation. Unlike brokers, however, a dealer can and does"take positions" (i.e., maintain inventories) in the assets he or she trades that permitthe dealer to sell out of inventory rather than always having to locate sellers to matchevery offer to buy. Also, unlike brokers, dealers do not receive sales commissions.Rather, dealers make profits by buying assets at relatively low prices and resellingthem at relatively high prices (buy low - sell high). The price at which a dealer offersto sell an asset (the "asked price") minus the price at which a dealer offers to buy anasset (the "bid price") is called the bid-ask spread and represents the dealers profitmargin on the asset exchange. Real-world examples of dealers include car dealers,dealers in U.S. government bonds, and Nasdaq stock dealers.Diagrammatic Illustration of a Bond Dealer:Payment ----------------- Payment------------>| |------------->Bond | Dealer | BondBuyer | | Seller<-------------| Bond Inventory |<-------------Bonds | | Bonds-----------------Investment Banks:An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs =Initial Public Offerings) by engaging in a number of different activities:Advice: Advising corporations on whether they should issue bonds or stock,and, for bond issues, on the particular types of payment schedules thesesecurities should offer;Underwriting: Guaranteeing corporations a price on the securities they offer,either individually or by having several different investment banks form asyndicate to underwrite the issue jointly;Sales Assistance: Assisting in the sale of these securities to the public.Some of the best-known U.S. investment banking firms are Morgan Stanley, MerrillLynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs.Financial Intermediaries:
  • 7. Unlike brokers, dealers, and investment banks, financial intermediaries are financialinstitutions that engage in financial asset transformation. That is, financialintermediaries purchase one kind of financial asset from borrowers -- generally somekind of long-term loan contract whose terms are adapted to the specific circumstancesof the borrower (e.g., a mortgage) -- and sell a different kind of financial asset tosavers, generally some kind of relatively liquid claim against the financialintermediary (e.g., a deposit account). In addition, unlike brokers and dealers,financial intermediaries typically hold financial assets as part of an investmentportfolio rather than as an inventory for resale. In addition to making profits on theirinvestment portfolios, financial intermediaries make profits by charging relativelyhigh interest rates to borrowers and paying relatively low interest rates to savers.Types of financial intermediaries include: Depository Institutions (commercial banks,savings and loan associations, mutual savings banks, credit unions); ContractualSavings Institutions (life insurance companies, fire and casualty insurance companies,pension funds, government retirement funds); and Investment Intermediaries (financecompanies, stock and bond mutual funds, money market mutual funds).Diagrammatic Example of a Financial Intermediary: A Commercial BankLending by B Borrowing by Bdeposited------- funds ------- funds -------| |<............. | | <............. | || F |.............> | B | ..............> | H |------- loan ------- deposit -------contracts accountsLoan contracts Deposit accountsissued by F to B issued by B to Hare liabilities of F are liabilities of Band assets of B and assets of HNOTE: F=Firms, B=Commercial Bank, and H=HouseholdsImportant Caution: These four types of financial institutions are simplifiedidealized classifications, and many actual financial institutions in the fast-changing financial landscape today engage in activities that overlap two ormore of these classifications, or even to some extent fall outside theseclassifications. A prime example is Merrill Lynch, which simultaneously acts asa broker, a dealer (taking positions in certain stocks and bonds it sells), afinancial intermediary (e.g., through its provision of mutual funds and CMAcheckable deposit accounts), and an investment banker.
  • 8. What Types of Financial Market Structures Exist?The costs of collecting and aggregating information determine, to a largeextent, the types of financial market structures that emerge. These structurestake four basic forms:Auction markets conducted through brokers;Over-the-counter (OTC) markets conducted through dealers;Organized Exchanges, such as the New York Stock Exchange, whichcombine auction and OTC market features. Specifically, organizedexchanges permit buyers and sellers to trade with each other in acentralized location, like an auction. However, securities are traded onthe floor of the exchange with the help of specialist traders whocombine broker and dealer functions. The specialists broker trades butalso stand ready to buy and sell stocks from personal inventories if buyand sell orders do not match up.Intermediation financial markets conducted through financialintermediaries;Financial markets taking the first three forms are generally referred toas securities markets. Some financial markets combine features from morethan one of these categories, so the categories constitute only roughguidelines.Auction Markets:An auction market is some form of centralized facility (or clearing house) bywhich buyers and sellers, through their commissioned agents (brokers), executetrades in an open and competitive bidding process. The "centralized facility" isnot necessarily a place where buyers and sellers physically meet. Rather, it isany institution that provides buyers and sellers with a centralized access to thebidding process. All of the needed information about offers to buy (bid prices)and offers to sell (asked prices) is centralized in one location which is readilyaccessible to all would-be buyers and sellers, e.g., through a computer network.No private exchanges between individual buyers and sellers are made outsideof the centralized facility.An auction market is typically a public market in the sense that it open to allagents who wish to participate. Auction markets can either be call markets --such as art auctions -- for which bid and asked prices are all posted at one time,
  • 9. or continuous markets -- such as stock exchanges and real estate markets -- forwhich bid and asked prices can be posted at any time the market is open andexchanges take place on a continual basis. Experimental economists havedevoted a tremendous amount of attention in recent years to auction markets.Many auction markets trade in relatively homogeneous assets (e.g., Treasurybills, notes, and bonds) to cut down on information costs. Alternatively, someauction markets (e.g., in second-hand jewelry, furniture, paintings etc.) allowwould-be buyers to inspect the goods to be sold prior to the opening of theactual bidding process. This inspection can take the form of a warehouse tour, acatalog issued with pictures and descriptions of items to be sold, or (in televisedauctions) a time during which assets are simply displayed one by one toviewers prior to bidding.Auction markets depend on participation for any one type of asset not being too"thin." The costs of collecting information about any one type of asset are sunkcosts independent of the volume of trading in that asset. Consequently, auctionmarkets depend on volume to spread these costs over a wide number ofparticipants.Over-the-Counter Markets:An over-the-counter market has no centralized mechanism or facility fortrading. Instead, the market is a public market consisting of a number of dealersspread across a region, a country, or indeed the world, whomake the market insome type of asset. That is, the dealers themselves post bid and asked prices forthis asset and then stand ready to buy or sell units of this asset with anyone whochooses to trade at these posted prices. The dealers provide customers moreflexibility in trading than brokers, because dealers can offset imbalances in thedemand and supply of assets by trading out of their own accounts. Many well-known common stocks are traded over-the-counter in the United Statesthrough NASDAQ (National Association of Securies Dealers AutomatedQuotation System).Intermediation Financial Markets:An intermediation financial market is a financial market in which financialintermediaries help transfer funds from savers to borrowers by issuing certaintypes of financial assets to savers and receiving other types of financial assetsfrom borrowers. The financial assets issued to savers are claims against thefinancial intermediaries, hence liabilities of the financial intermediaries,whereas the financial assets received from borrowers are claims against the
  • 10. borrowers, hence assets of the financial intermediaries. (See the diagrammaticillustration of a financial intermediary presented earlier in these notes.)Additional Distinctions Among Securities MarketsPrimary versus Secondary Markets:Primary markets are securities markets in which newly issued securities areoffered for sale to buyers. Secondary markets are securities markets inwhich existing securities that have previously been issued are resold. Theinitial issuer raises funds only through the primary market.Debt Versus Equity Markets:Debt instruments are particular types of securities that require the issuer (theborrower) to pay the holder (the lender) certain fixed dollar amounts atregularly scheduled intervals until a specified time (the maturity date) isreached, regardless of the success or failure of any investment projects forwhich the borrowed funds are used. A debt instrument holder onlyparticipates in the management of the debt instrument issuer if the issuergoes bankrupt. An example of a debt instrument is a 30-year mortgage.In contrast, an equity is a security that confers on the holder an ownershipinterest in the issuer.There are two general categories of equities: "preferred stock" and "commonstock."Common stock shares issued by a corporation are claims to a share of theassets of a corporation as well as to a share of the corporations net income --i.e., the corporations income after subtraction of taxes and other expenses,including the payment of any debt obligations. This implies that the returnthat holders of common stock receive depends on the economic performanceof the issuing corporation.Holders of a corporations common stock typically participate in any upsideperformance of the corporation in two ways: by receiving a share of net
  • 11. income in the form of dividends; and by enjoying an appreciation in the priceof their stock shares. However, the payment of dividends is not a contractualor legal requirement. Even if net earnings are positive, a corporation is notobliged to distribute dividends to shareholders. For example, a corporationmight instead choose to keep its profits as retained earnings to be used fornew capital investment (self-financing of investment rather than debt orequity financing).On the other hand, corporations cannot charge losses to their common stockshareholders. Consequently, these shareholders at most risk losing thepurchase price of their shares, a situation which arises if the market price oftheir shares declines to zero for any reason. An example of a common stockshare is a share of IBM.In contrast, preferred stock shares are usually issued with a par value (e.g.,$100) and pay a fixed dividend expressed as a percentage of par value.Preferred stock is a claim against a corporations cash flow that is prior to theclaims of its common stock holders but is generally subordinate to the claimsof its debt holders. In addition, like debt holders but unlike common stockholders, preferred stock holders generally do not participate in themanagement of issuers through voting or other means unless the issuer is inextreme financial distress (e.g., insolvency). Consequently, preferred stockcombines some of the basic attributes of both debt and common stock and isoften referred to as a hybrid security.Money versus Capital Markets:The money market is the market for shorter-term securities, generally thosewith one year or less remaining to maturity.Examples: U.S. Treasury bills; negotiable bank certificates of deposit (CDs);commercial paper, Federal funds; Eurodollars.Remark: Although the maturity on certificates of deposit (CDs) -- i.e., on largetime deposits at depository institutions -- can run anywhere from 30 days toover 5 years, most CDs have a maturity of less than one year. Those with amaturity of more than one year are referred to as term CDs. A CD that can be
  • 12. resold without penalty in a secondary market prior to maturity is known asa negotiableCD.The capital market is the market for longer-term securities, generally thosewith more than one year to maturity.Examples: Corporate stocks; residential mortgages; U.S. government securities(marketable long-term); state and local government bonds; bank commercialloans; consumer loans; commercial and farm mortgages.Remark: Corporate stocks are conventionally considered to be long-termsecurities because they have no maturity date.Domestic Versus Global Financial Markets:Eurocurrencies are currencies deposited in banks outside the country of issue.For example, eurodollars, a major form of eurocurrency, are U.S. dollarsdeposited in foreign banks outside the U.S. or in foreign branches of U.S.banks. That is, eurodollars are dollar-denominated bank deposits held in banksoutside the U.S.An international bond is a bond available for sale outside the country of itsissuer.Example of an International Bond: a bond issued by a U.S. firm that is availablefor sale both in the U.S. and abroad.A foreign bond is an international bond issued by a country that isdenominated in a foreign currency and that is for sale exclusively in thecountry of that foreign currency.Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated inJapanese yen and that is for sale exclusively in Japan.A Eurobond is an international bond denominated in a currency other thanthat of the country in which it is sold. More precisely, it is issued by aborrower in one country, denominated in the borrowers currency, and soldoutside the borrowers country.
  • 13. Example of a Eurobond: Bonds sold by the U.S. government to Japan that aredenominated in U.S. dollars.Asymmetric Information in Financial MarketsAsymmetric information in a market for goods, services, or assets refers todifferences ("asymmetries") between the information available to buyers andthe information available to sellers. For example, in markets for financialassets, asymmetric information may arise between lenders (buyers of financialassets) and borrowers (sellers of financial assets).Problems arising in markets due to asymmetric information are typicallydivided into two basic types: "adverse selection;" and "moral hazard." Thissection explains these two types of problems, using financial markets forconcrete illustration.1. Adverse SelectionAdverse selection is a problem that arises for a buyer of goods, services, orassets when the buyer has difficulty assessing the quality of these items inadvance of purchase.Consequently, adverse selection is a problem that arises because of different("asymmetric") information between a buyer and a seller before any purchaseagreement takes place.An Illustration of Adverse Selection in Loan Markets:In the context of a loan market, an adverse selection problem arises if thecontractual terms that a lender sets in advance in an attempt to protecthimself against the consequences of inadvertently lending to high riskborrowers have the perverse effect of encouraging high risk borrowers to self-select into the lenders loan applicant pool while at the same timeencouraging low risk borrowers to self-select out of this pool. In this case, thelenders pool of loan applicants is adversely affected in the sense that theaverage quality of borrowers in the pool decreases.
  • 14. 2. Moral HazardMoral hazard is said to exist in a market if, after the signing of a purchaseagreement between the buyer and seller of a good, service, or asset:the seller changes his or her behavior in such a way that theprobabilites (risk calculations) used by the buyer to determine theterms of the purchase agreement are no longer accurate;the buyer is only imperfectly able to monitor (observe) this change inthe sellers behavior.For example, a moral hazard problem arises if, after a lender purchases a loancontract from a borrower, the borrower increases the risks originally associatedwith the loan contract by investing his borrowed funds in more risky projectsthan he originally reported to the lender.The Concept of Present ValueSuppose someone promises to pay you $100 in some future period T. Thisamount of money actually has two different values: a nominal value of $100,which is simply a measure of the number of dollars that you will receive inperiod T; and a present value (sometimes referred to as a present discountedvalue), roughly defined to be the minimum number of dollars that you wouldhave to give up today in return for receiving $100 in period T.Stated somewhat differently, the present value of the future $100 payment isthe value of this future $100 payment measured in terms of current (or present)dollars.The concept of present value permits financial assets with different associatedpayment streams to be compared with each other by calculating the value ofthese payment streams in terms of a single common unit: namely, currentdollars.A specific procedure for the calculation of present value for future paymentswill now be developed.Present Value of Payments One Period Into the Future:
  • 15. If you save $1 today for a period of one year at an annual interest rate i,the nominal value of your savings after one year will be(1) V(1) = (1+i)*$1 ,where the asterisk "*" denotes multiplication.On the other hand, proceeding in the reverse direction from the future to thepresent, the present value of the future dollar amount V(1) = (1+i)*$1 is equalto $1. That is, the amount you would have to save today in order to receiveback V(1)=(1+i)*$1 in one years time is $1.Notice that this calculation of $1 as the present value of V(1)=(1+i)*$1 satisfiesthe following formula:V(1)(2) Present Value = -------- .of V(1) (1+i)Indeed, given any fixed annual interest rate i, and any payment V(1) to bereceived one year from today, the present value of V(1) is given by formula (2).In effect, then, the payment V(1) to be received one year from now has beendiscounted back to the present using the annual interest rate i, so that the valueof V(1) is now expressed in current dollars.Present Value of Payments Multiple Periods Into the Future:If you save $1 today at a fixed annual interest rate i, what will be the value ofyour savings in one years time? In two years time?In n years time?If you save $1 at a fixed annual interest rate i, the nominal value of yoursavings in one years time will be V(1)=(1+i)*$1. If you then put aside V(1) assavings for an additional year rather than spend it, the nominal value of yoursavings at the end of the second year will be(3)V(2) = (1+i)*V(1) = (1+i)*(1+i)*$1 = (1+i)2*$1 .And so forth for any number of years n.
  • 16. (4) START --------------------------------///-------->YEAR| 1 2 n|Nominal 2 nValue of $1 (1+i)*$1 (1+i) *$1 (1+i) * $1Savings:Now consider the present value of V(n) = (1+i)n*$1 for any year n. Byconstruction, V(n) is the nominal value obtained after n years when a singledollar is saved for n successive years at the fixed annual interest rate i.Consequently, the present value of V(n) is simply equal to $1, regardless of thevalue of n.Notice, however, that the present value of V(n) -- namely, $1 -- can be obtainedfrom the following formula:V(n)(5) Present Value = ------------ .of V(n) n(1+i)Indeed, given any fixed annual interest rate i, and any nominal amount V(n) tobe received n years from today, the present value of V(n) can be calculated byusing formula (5).Present Value of Any Arbitrary Payment Stream:Now suppose you will be receiving a sequence of three payments over the nextthree years. The nominal value of the first payment is $100, to be received atthe end of the first year; the nominal value of the second payment is $150, to bereceived at the end of the second year; and the nominal value of the thirdpayment is $200, to be received at the end of the third year.Given a fixed annual interest rate i, what is the present value of the paymentstream ($100,$150,$200) consisting of the three separate payments $100, $150,and $200 to be received over the next three years?To calculate the present value of the payment stream ($100,$150,$200), use thefollowing two steps:Step 1: Use formula (5) to separately calculate the present value ofeach of the individual payments in the payment stream, taking care to
  • 17. note how many years into the future each payment is going to bereceived.Step 2: Sum the separate present value calculations obtained in Step 1to obtain the present value of the payment stream as a whole.Carrying out Step 1, it follows from formula (5) that the present value of the$100 payment to be received at the end of the first year is $100/(1+i). Similarly,it follows from formula (5) that the present value of the $150 payment to bereceived at the end of the second year is$150(6) ----------2(1+i)Finally, it follows from formula (3) that the present value of the $200 paymentto be received at the end of the third year is$200----------(7) 3(1+i)Consequently, adding together these three separate present value calculations inaccordance with Step 2, the present value PV(i) of the payment stream($100,$150,$200) is given by(8)PV(i) = $100 + $150 + $200(1 + i)1(1 + i)2(1 + i)3More generally, given any fixed annual interest rate i, and given any paymentstream (V1,V2,V3,...,VN) consisting of individual payments to be receivedover the next N years, the present value of this payment stream can be found byfollowing the two steps outlined above.In particular, then, given any fixed annual interest rate, and given any paymentstream paid out on a yearly basis to the owner of some financial asset, thepresent (current dollar) value of this payment stream can be found by followingSteps 1 and 2 outlined above. Consequently, regardless how different the
  • 18. payment streams associated with different financial assets might be, one cancalculate the present values for these payment streams in current dollar termsand hence have a way to compare them.Measuring Interest Rates by Yield to MaturityBy definition, the current annual yield to maturity for a financial asset is theparticular fixed annual interest rate i which, when used to calculate the presentvalue of the financial assets future stream of payments to the financial assetsowner, yields a present value equal to the current market value of the financialasset.Below we illustrate this calculation for coupon bonds.Yield to Maturity for Coupon Bonds:The basic contractual terms of a coupon bond are as follows:Seller PurchaseReceives: Price Pb| MATURITYSTART |_______________________ /// _____ DATE| | || | |Coupon Coupon ... CouponBuyer Payment C Payment C Payment CReceives: + Face Value FConsider a coupon bond whose purchase price is Pb=$94, whose face value isF = $100, whose annual coupon payment is C = $10, and whose maturity is 10years.The payment stream to the buyer (new owner) generated by this coupon bond isgiven by(9)( $10, $10, $10, $10, $10, $10, $10, $10, $10, [$10 + $100] ).
  • 19. For any given fixed annual interest rate i, the present value PV(i) of thepayment stream (9) is given by the sum of the separate present valuecalculations for each of the annual payments in this payment stream asdetermined by formula (5). That is,(10)PV(i) = $10/(1+i) + $10/(1+i)2+ ... + $10/(1+i)10+ $100/(1+i)10.The current value of the coupon bond is its current purchase price Pb = $94. Itthen follows by definition that the yield to maturity for this coupon bond isfound by solving the following equation for i:(11)Pb = PV(i) .The calculation of the yield to maturity i from formula (11) can be difficult, buttables have been published that permit one to read off the yield to maturity i fora coupon bond once the purchase price, the face value, the coupon rate, and thematurity are known.More generally, given any coupon bond with purchase price Pb, face value F,coupon payment C, and maturity N, the yield to maturity i is found by means ofthe following formula:(12a)Pb = PV(i) ,where the present value PV(i) of the coupon bond is given by(12b)PV(i) = C/(1+i) + C/(1+i)2+ ... + C/(1+i)N+ F/(1+i)N.Interest Rates vs. Return Rates
  • 20. Given any asset A held over any given time period T, the return to A over theholding period T is, by definition:the sum of all payments (rents, coupon payments, dividends, etc.)generated by A during period T, assumed paid out at the end of theperiod,PLUS the capital gain (+) or loss (-) in the market value of A over periodT, measured as the market value of A at the end of period T minus themarket value of A at the beginning of period T.The return rate on asset A over the holding period T is then defined to be thereturn on A over period T divided by the market value of A at the beginning ofperiod T.More precisely, suppose that an asset A is held over a time period that starts atsome time t and ends at time t+1. Let the market value of A at time t be denotedby P(t) and the market value of A at time t+1 be denoted by P(t+1). Finally, letV(t,t+1) denote the sum of all payments accruing to the holder of asset A from tto t+1, assumed to be paid out at time t+1.Then, by definition, the return rate on asset A from t to t+1 is given by thefollowing formula:(13) Return Rate on V(t,t+1) + P(t+1) - P(t)Asset A From = ---------------------------time t to t+1 P(t)V(t,t+1) P(t+1) - P(t)= --------- + -------------P(t) P(t)= payments + Capital Gain (if +)received as or Loss (if -) aspercentagepercentage of P(t)of P(t)Formula (13) holds for any asset A, whether physical or financial. The questionthen arises: For financial assets, what is the connection between the return ratedefined by formula (13) and the interest rate on the financial asset defined bythe yield to maturity?
  • 21. The return rate on a financial asset is not necessarily equal to the yield tomaturity on the financial asset. Starting at any current time t, the return rate iscalculated for some specified holding period from t to t, whether or not thisholding period coincides with the maturity of the financial asset. Moreover, thereturn rate takes into account any capital gains or losses that occur during thisholding period, in addition to any payments received from the financial assetduring this holding period. In contrast, starting at any current time t, the yield tomaturity takes into account the payment stream generated by the financialasset over its entire remaining maturity, plus the overall anticipated capital gainor loss that will be incurred when the financial asset is held to maturity.Real vs. Nominal Interest RatesThe yield to maturity measure of an interest rate, as examined to date, has been"nominal" in the sense that it has not been adjusted for expected changes inprices. What actually concerns a "rational" saver considering the purchase of afinancial asset is not the nominal payment stream he or she expects to earn infuture periods but rather the command over purchasing power that this nominalpayment stream is expected to entail. This purchasing power depends on thebehavior of prices.Let infe(t) denote the expected inflation rate at time t, and let i(t) denote the(nominal) yield to maturity for some financial asset at time t. Then the realinterest rate associated with i(t) is defined by the following "Fisher equation:"An asset is anything of durable value, that is, anything that acts as a means to storevalue over time. Real assets are assets in physical form (e.g., land, equipment,houses,...), including "human capital" assets embodied in people (natural abilities,learned skills, knowledge,..). Financial assets are claims against real assets, eitherdirectly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claimsto future income streams that originate ultimately from real assets). Securities arefinancial assets exchanged in auction and over-the-counter markets (see below)whose distribution is subject to legal requirements and restrictions (e.g., informationdisclosure requirements).Lenders are people who have available funds in excess of their desired expendituresthat they are attempting to loan out, and borrowers are people who have a shortage offunds relative to their desired expenditures who are seeking to obtain loans.
  • 22. Borrowers attempt to obtain funds from lenders by selling to lenders newly issuedclaims against the borrowers real assets, i.e., by selling the lenders newly issuedfinancial assets.A financial market is a market in which financial assets are traded. In addition toenabling exchange of previously issued financial assets, financial markets facilitateborrowing and lending by facilitating the sale by newly issued financial assets.Examples of financial markets include the New York Stock Exchange (resale ofpreviously issued stock shares), the U.S. government bond market (resale ofpreviously issued bonds), and the U.S. Treasury bills auction (sales of newly issued T-bills). A financial institution is an institution whose primary source of profits isthrough financial asset transactions. Examples of such financial institutions includediscount brokers (e.g., Charles Schwab and Associates), banks, insurance companies,and complex multi-function financial institutions such as Merrill Lynch.Introduction to Financial Markets and Institutions:Financial markets serve six basic functions. These functions are briefly listed below:Borrowing and Lending: Financial markets permit the transfer of funds(purchasing power) from one agent to another for either investment orconsumption purposes.Price Determination: Financial markets provide vehicles by which prices are setboth for newly issued financial assets and for the existing stock of financialassets.Information Aggregation and Coordination: Financial markets act as collectorsand aggregators of information about financial asset values and the flow offunds from lenders to borrowers.Risk Sharing: Financial markets allow a transfer of risk from those whoundertake investments to those who provide funds for those investments.Liquidity: Financial markets provide the holders of financial assets with achance to resell or liquidate these assets.Efficiency: Financial markets reduce transaction costs and information costs.In attempting to characterize the way financial markets operate, one must considerboth the various types of financial institutions that participate in such markets and thevarious ways in which these markets are structured.
  • 23. Who are the Major Players in Financial Markets?By definition, financial institutions are institutions that participate in financialmarkets, i.e., in the creation and/or exchange of financial assets. At present in theUnited States, financial institutions can be roughly classified into the following fourcategories: "brokers;" "dealers;" "investment bankers;" and "financial intermediaries."Brokers:A broker is a commissioned agent of a buyer (or seller) who facilitates trade bylocating a seller (or buyer) to complete the desired transaction. A broker does not takea position in the assets he or she trades -- that is, the broker does not maintaininventories in these assets. The profits of brokers are determined by the commissionsthey charge to the users of their services (either the buyers, the sellers, or both).Examples of brokers include real estate brokers and stock brokers.Diagrammatic Illustration of a Stock Broker:Payment ----------------- Payment------------>| |------------->Stock | | StockBuyer | Stock Broker | Seller<-------------|<----------------|<-------------Stock | (Passed Thru) | StockShares ----------------- SharesDealers:Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they donot engage in asset transformation. Unlike brokers, however, a dealer can and does"take positions" (i.e., maintain inventories) in the assets he or she trades that permitthe dealer to sell out of inventory rather than always having to locate sellers to matchevery offer to buy. Also, unlike brokers, dealers do not receive sales commissions.Rather, dealers make profits by buying assets at relatively low prices and resellingthem at relatively high prices (buy low - sell high). The price at which a dealer offersto sell an asset (the "asked price") minus the price at which a dealer offers to buy anasset (the "bid price") is called the bid-ask spread and represents the dealers profitmargin on the asset exchange. Real-world examples of dealers include car dealers,dealers in U.S. government bonds, and Nasdaq stock dealers.Diagrammatic Illustration of a Bond Dealer:
  • 24. Payment ----------------- Payment------------>| |------------->Bond | Dealer | BondBuyer | | Seller<-------------| Bond Inventory |<-------------Bonds | | Bonds-----------------Investment Banks:An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs =Initial Public Offerings) by engaging in a number of different activities:Advice: Advising corporations on whether they should issue bonds or stock,and, for bond issues, on the particular types of payment schedules thesesecurities should offer;Underwriting: Guaranteeing corporations a price on the securities they offer,either individually or by having several different investment banks form asyndicate to underwrite the issue jointly;Sales Assistance: Assisting in the sale of these securities to the public.Some of the best-known U.S. investment banking firms are Morgan Stanley, MerrillLynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs.Financial Intermediaries:Unlike brokers, dealers, and investment banks, financial intermediaries are financialinstitutions that engage in financial asset transformation. That is, financialintermediaries purchase one kind of financial asset from borrowers -- generally somekind of long-term loan contract whose terms are adapted to the specific circumstancesof the borrower (e.g., a mortgage) -- and sell a different kind of financial asset tosavers, generally some kind of relatively liquid claim against the financialintermediary (e.g., a deposit account). In addition, unlike brokers and dealers,financial intermediaries typically hold financial assets as part of an investmentportfolio rather than as an inventory for resale. In addition to making profits on theirinvestment portfolios, financial intermediaries make profits by charging relativelyhigh interest rates to borrowers and paying relatively low interest rates to savers.Types of financial intermediaries include: Depository Institutions (commercial banks,savings and loan associations, mutual savings banks, credit unions); ContractualSavings Institutions (life insurance companies, fire and casualty insurance companies,
  • 25. pension funds, government retirement funds); and Investment Intermediaries (financecompanies, stock and bond mutual funds, money market mutual funds).Diagrammatic Example of a Financial Intermediary: A Commercial BankLending by B Borrowing by Bdeposited------- funds ------- funds -------| |<............. | | <............. | || F |.............> | B | ..............> | H |------- loan ------- deposit -------contracts accountsLoan contracts Deposit accountsissued by F to B issued by B to Hare liabilities of F are liabilities of Band assets of B and assets of HNOTE: F=Firms, B=Commercial Bank, and H=HouseholdsImportant Caution: These four types of financial institutions are simplifiedidealized classifications, and many actual financial institutions in the fast-changing financial landscape today engage in activities that overlap two ormore of these classifications, or even to some extent fall outside theseclassifications. A prime example is Merrill Lynch, which simultaneously acts asa broker, a dealer (taking positions in certain stocks and bonds it sells), afinancial intermediary (e.g., through its provision of mutual funds and CMAcheckable deposit accounts), and an investment banker.What Types of Financial Market Structures Exist?The costs of collecting and aggregating information determine, to a largeextent, the types of financial market structures that emerge. These structurestake four basic forms:Auction markets conducted through brokers;Over-the-counter (OTC) markets conducted through dealers;Organized Exchanges, such as the New York Stock Exchange, whichcombine auction and OTC market features. Specifically, organizedexchanges permit buyers and sellers to trade with each other in acentralized location, like an auction. However, securities are traded onthe floor of the exchange with the help of specialist traders who
  • 26. combine broker and dealer functions. The specialists broker trades butalso stand ready to buy and sell stocks from personal inventories if buyand sell orders do not match up.Intermediation financial markets conducted through financialintermediaries;Financial markets taking the first three forms are generally referred toas securities markets. Some financial markets combine features from morethan one of these categories, so the categories constitute only roughguidelines.Auction Markets:An auction market is some form of centralized facility (or clearing house) bywhich buyers and sellers, through their commissioned agents (brokers), executetrades in an open and competitive bidding process. The "centralized facility" isnot necessarily a place where buyers and sellers physically meet. Rather, it isany institution that provides buyers and sellers with a centralized access to thebidding process. All of the needed information about offers to buy (bid prices)and offers to sell (asked prices) is centralized in one location which is readilyaccessible to all would-be buyers and sellers, e.g., through a computer network.No private exchanges between individual buyers and sellers are made outsideof the centralized facility.An auction market is typically a public market in the sense that it open to allagents who wish to participate. Auction markets can either be call markets --such as art auctions -- for which bid and asked prices are all posted at one time,or continuous markets -- such as stock exchanges and real estate markets -- forwhich bid and asked prices can be posted at any time the market is open andexchanges take place on a continual basis. Experimental economists havedevoted a tremendous amount of attention in recent years to auction markets.Many auction markets trade in relatively homogeneous assets (e.g., Treasurybills, notes, and bonds) to cut down on information costs. Alternatively, someauction markets (e.g., in second-hand jewelry, furniture, paintings etc.) allowwould-be buyers to inspect the goods to be sold prior to the opening of theactual bidding process. This inspection can take the form of a warehouse tour, acatalog issued with pictures and descriptions of items to be sold, or (in televisedauctions) a time during which assets are simply displayed one by one toviewers prior to bidding.
  • 27. Auction markets depend on participation for any one type of asset not being too"thin." The costs of collecting information about any one type of asset are sunkcosts independent of the volume of trading in that asset. Consequently, auctionmarkets depend on volume to spread these costs over a wide number ofparticipants.Over-the-Counter Markets:An over-the-counter market has no centralized mechanism or facility fortrading. Instead, the market is a public market consisting of a number of dealersspread across a region, a country, or indeed the world, whomake the market insome type of asset. That is, the dealers themselves post bid and asked prices forthis asset and then stand ready to buy or sell units of this asset with anyone whochooses to trade at these posted prices. The dealers provide customers moreflexibility in trading than brokers, because dealers can offset imbalances in thedemand and supply of assets by trading out of their own accounts. Many well-known common stocks are traded over-the-counter in the United Statesthrough NASDAQ (National Association of Securies Dealers AutomatedQuotation System).Intermediation Financial Markets:An intermediation financial market is a financial market in which financialintermediaries help transfer funds from savers to borrowers by issuing certaintypes of financial assets to savers and receiving other types of financial assetsfrom borrowers. The financial assets issued to savers are claims against thefinancial intermediaries, hence liabilities of the financial intermediaries,whereas the financial assets received from borrowers are claims against theborrowers, hence assets of the financial intermediaries. (See the diagrammaticillustration of a financial intermediary presented earlier in these notes.)Additional Distinctions Among Securities MarketsPrimary versus Secondary Markets:Primary markets are securities markets in which newly issued securities areoffered for sale to buyers. Secondary markets are securities markets inwhich existing securities that have previously been issued are resold. Theinitial issuer raises funds only through the primary market.
  • 28. Debt Versus Equity Markets:Debt instruments are particular types of securities that require the issuer (theborrower) to pay the holder (the lender) certain fixed dollar amounts atregularly scheduled intervals until a specified time (the maturity date) isreached, regardless of the success or failure of any investment projects forwhich the borrowed funds are used. A debt instrument holder onlyparticipates in the management of the debt instrument issuer if the issuergoes bankrupt. An example of a debt instrument is a 30-year mortgage.In contrast, an equity is a security that confers on the holder an ownershipinterest in the issuer.There are two general categories of equities: "preferred stock" and "commonstock."Common stock shares issued by a corporation are claims to a share of theassets of a corporation as well as to a share of the corporations net income --i.e., the corporations income after subtraction of taxes and other expenses,including the payment of any debt obligations. This implies that the returnthat holders of common stock receive depends on the economic performanceof the issuing corporation.Holders of a corporations common stock typically participate in any upsideperformance of the corporation in two ways: by receiving a share of netincome in the form of dividends; and by enjoying an appreciation in the priceof their stock shares. However, the payment of dividends is not a contractualor legal requirement. Even if net earnings are positive, a corporation is notobliged to distribute dividends to shareholders. For example, a corporationmight instead choose to keep its profits as retained earnings to be used fornew capital investment (self-financing of investment rather than debt orequity financing).On the other hand, corporations cannot charge losses to their common stockshareholders. Consequently, these shareholders at most risk losing thepurchase price of their shares, a situation which arises if the market price of
  • 29. their shares declines to zero for any reason. An example of a common stockshare is a share of IBM.In contrast, preferred stock shares are usually issued with a par value (e.g.,$100) and pay a fixed dividend expressed as a percentage of par value.Preferred stock is a claim against a corporations cash flow that is prior to theclaims of its common stock holders but is generally subordinate to the claimsof its debt holders. In addition, like debt holders but unlike common stockholders, preferred stock holders generally do not participate in themanagement of issuers through voting or other means unless the issuer is inextreme financial distress (e.g., insolvency). Consequently, preferred stockcombines some of the basic attributes of both debt and common stock and isoften referred to as a hybrid security.Money versus Capital Markets:The money market is the market for shorter-term securities, generally thosewith one year or less remaining to maturity.Examples: U.S. Treasury bills; negotiable bank certificates of deposit (CDs);commercial paper, Federal funds; Eurodollars.Remark: Although the maturity on certificates of deposit (CDs) -- i.e., on largetime deposits at depository institutions -- can run anywhere from 30 days toover 5 years, most CDs have a maturity of less than one year. Those with amaturity of more than one year are referred to as term CDs. A CD that can beresold without penalty in a secondary market prior to maturity is known asa negotiableCD.The capital market is the market for longer-term securities, generally thosewith more than one year to maturity.Examples: Corporate stocks; residential mortgages; U.S. government securities(marketable long-term); state and local government bonds; bank commercialloans; consumer loans; commercial and farm mortgages.Remark: Corporate stocks are conventionally considered to be long-termsecurities because they have no maturity date.
  • 30. Domestic Versus Global Financial Markets:Eurocurrencies are currencies deposited in banks outside the country of issue.For example, eurodollars, a major form of eurocurrency, are U.S. dollarsdeposited in foreign banks outside the U.S. or in foreign branches of U.S.banks. That is, eurodollars are dollar-denominated bank deposits held in banksoutside the U.S.An international bond is a bond available for sale outside the country of itsissuer.Example of an International Bond: a bond issued by a U.S. firm that is availablefor sale both in the U.S. and abroad.A foreign bond is an international bond issued by a country that isdenominated in a foreign currency and that is for sale exclusively in thecountry of that foreign currency.Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated inJapanese yen and that is for sale exclusively in Japan.A Eurobond is an international bond denominated in a currency other thanthat of the country in which it is sold. More precisely, it is issued by aborrower in one country, denominated in the borrowers currency, and soldoutside the borrowers country.Example of a Eurobond: Bonds sold by the U.S. government to Japan that aredenominated in U.S. dollars.Asymmetric Information in Financial MarketsAsymmetric information in a market for goods, services, or assets refers todifferences ("asymmetries") between the information available to buyers andthe information available to sellers. For example, in markets for financialassets, asymmetric information may arise between lenders (buyers of financialassets) and borrowers (sellers of financial assets).
  • 31. Problems arising in markets due to asymmetric information are typicallydivided into two basic types: "adverse selection;" and "moral hazard." Thissection explains these two types of problems, using financial markets forconcrete illustration.1. Adverse SelectionAdverse selection is a problem that arises for a buyer of goods, services, orassets when the buyer has difficulty assessing the quality of these items inadvance of purchase.Consequently, adverse selection is a problem that arises because of different("asymmetric") information between a buyer and a seller before any purchaseagreement takes place.An Illustration of Adverse Selection in Loan Markets:In the context of a loan market, an adverse selection problem arises if thecontractual terms that a lender sets in advance in an attempt to protecthimself against the consequences of inadvertently lending to high riskborrowers have the perverse effect of encouraging high risk borrowers to self-select into the lenders loan applicant pool while at the same timeencouraging low risk borrowers to self-select out of this pool. In this case, thelenders pool of loan applicants is adversely affected in the sense that theaverage quality of borrowers in the pool decreases.2. Moral HazardMoral hazard is said to exist in a market if, after the signing of a purchaseagreement between the buyer and seller of a good, service, or asset:the seller changes his or her behavior in such a way that theprobabilites (risk calculations) used by the buyer to determine theterms of the purchase agreement are no longer accurate;the buyer is only imperfectly able to monitor (observe) this change inthe sellers behavior.For example, a moral hazard problem arises if, after a lender purchases a loancontract from a borrower, the borrower increases the risks originally associated
  • 32. with the loan contract by investing his borrowed funds in more risky projectsthan he originally reported to the lender.The Concept of Present ValueSuppose someone promises to pay you $100 in some future period T. Thisamount of money actually has two different values: a nominal value of $100,which is simply a measure of the number of dollars that you will receive inperiod T; and a present value (sometimes referred to as a present discountedvalue), roughly defined to be the minimum number of dollars that you wouldhave to give up today in return for receiving $100 in period T.Stated somewhat differently, the present value of the future $100 payment isthe value of this future $100 payment measured in terms of current (or present)dollars.The concept of present value permits financial assets with different associatedpayment streams to be compared with each other by calculating the value ofthese payment streams in terms of a single common unit: namely, currentdollars.A specific procedure for the calculation of present value for future paymentswill now be developed.Present Value of Payments One Period Into the Future:If you save $1 today for a period of one year at an annual interest rate i,the nominal value of your savings after one year will be(1) V(1) = (1+i)*$1 ,where the asterisk "*" denotes multiplication.On the other hand, proceeding in the reverse direction from the future to thepresent, the present value of the future dollar amount V(1) = (1+i)*$1 is equalto $1. That is, the amount you would have to save today in order to receiveback V(1)=(1+i)*$1 in one years time is $1.
  • 33. Notice that this calculation of $1 as the present value of V(1)=(1+i)*$1 satisfiesthe following formula:V(1)(2) Present Value = -------- .of V(1) (1+i)Indeed, given any fixed annual interest rate i, and any payment V(1) to bereceived one year from today, the present value of V(1) is given by formula (2).In effect, then, the payment V(1) to be received one year from now has beendiscounted back to the present using the annual interest rate i, so that the valueof V(1) is now expressed in current dollars.Present Value of Payments Multiple Periods Into the Future:If you save $1 today at a fixed annual interest rate i, what will be the value ofyour savings in one years time? In two years time?In n years time?If you save $1 at a fixed annual interest rate i, the nominal value of yoursavings in one years time will be V(1)=(1+i)*$1. If you then put aside V(1) assavings for an additional year rather than spend it, the nominal value of yoursavings at the end of the second year will be(3)V(2) = (1+i)*V(1) = (1+i)*(1+i)*$1 = (1+i)2*$1 .And so forth for any number of years n.(4) START --------------------------------///-------->YEAR| 1 2 n|Nominal 2 nValue of $1 (1+i)*$1 (1+i) *$1 (1+i) * $1Savings:Now consider the present value of V(n) = (1+i)n*$1 for any year n. Byconstruction, V(n) is the nominal value obtained after n years when a singledollar is saved for n successive years at the fixed annual interest rate i.Consequently, the present value of V(n) is simply equal to $1, regardless of thevalue of n.
  • 34. Notice, however, that the present value of V(n) -- namely, $1 -- can be obtainedfrom the following formula:V(n)(5) Present Value = ------------ .of V(n) n(1+i)Indeed, given any fixed annual interest rate i, and any nominal amount V(n) tobe received n years from today, the present value of V(n) can be calculated byusing formula (5).Present Value of Any Arbitrary Payment Stream:Now suppose you will be receiving a sequence of three payments over the nextthree years. The nominal value of the first payment is $100, to be received atthe end of the first year; the nominal value of the second payment is $150, to bereceived at the end of the second year; and the nominal value of the thirdpayment is $200, to be received at the end of the third year.Given a fixed annual interest rate i, what is the present value of the paymentstream ($100,$150,$200) consisting of the three separate payments $100, $150,and $200 to be received over the next three years?To calculate the present value of the payment stream ($100,$150,$200), use thefollowing two steps:Step 1: Use formula (5) to separately calculate the present value ofeach of the individual payments in the payment stream, taking care tonote how many years into the future each payment is going to bereceived.Step 2: Sum the separate present value calculations obtained in Step 1to obtain the present value of the payment stream as a whole.Carrying out Step 1, it follows from formula (5) that the present value of the$100 payment to be received at the end of the first year is $100/(1+i). Similarly,it follows from formula (5) that the present value of the $150 payment to bereceived at the end of the second year is$150(6) ----------2(1+i)
  • 35. Finally, it follows from formula (3) that the present value of the $200 paymentto be received at the end of the third year is$200----------(7) 3(1+i)Consequently, adding together these three separate present value calculations inaccordance with Step 2, the present value PV(i) of the payment stream($100,$150,$200) is given by(8)PV(i) = $100 + $150 + $200(1 + i)1(1 + i)2(1 + i)3More generally, given any fixed annual interest rate i, and given any paymentstream (V1,V2,V3,...,VN) consisting of individual payments to be receivedover the next N years, the present value of this payment stream can be found byfollowing the two steps outlined above.In particular, then, given any fixed annual interest rate, and given any paymentstream paid out on a yearly basis to the owner of some financial asset, thepresent (current dollar) value of this payment stream can be found by followingSteps 1 and 2 outlined above. Consequently, regardless how different thepayment streams associated with different financial assets might be, one cancalculate the present values for these payment streams in current dollar termsand hence have a way to compare them.Measuring Interest Rates by Yield to MaturityBy definition, the current annual yield to maturity for a financial asset is theparticular fixed annual interest rate i which, when used to calculate the presentvalue of the financial assets future stream of payments to the financial assetsowner, yields a present value equal to the current market value of the financialasset.
  • 36. Below we illustrate this calculation for coupon bonds.Yield to Maturity for Coupon Bonds:The basic contractual terms of a coupon bond are as follows:Seller PurchaseReceives: Price Pb| MATURITYSTART |_______________________ /// _____ DATE| | || | |Coupon Coupon ... CouponBuyer Payment C Payment C Payment CReceives: + Face Value FConsider a coupon bond whose purchase price is Pb=$94, whose face value isF = $100, whose annual coupon payment is C = $10, and whose maturity is 10years.The payment stream to the buyer (new owner) generated by this coupon bond isgiven by(9)( $10, $10, $10, $10, $10, $10, $10, $10, $10, [$10 + $100] ).For any given fixed annual interest rate i, the present value PV(i) of thepayment stream (9) is given by the sum of the separate present valuecalculations for each of the annual payments in this payment stream asdetermined by formula (5). That is,(10)PV(i) = $10/(1+i) + $10/(1+i)2+ ... + $10/(1+i)10+ $100/(1+i)10.The current value of the coupon bond is its current purchase price Pb = $94. Itthen follows by definition that the yield to maturity for this coupon bond isfound by solving the following equation for i:(11)
  • 37. Pb = PV(i) .The calculation of the yield to maturity i from formula (11) can be difficult, buttables have been published that permit one to read off the yield to maturity i fora coupon bond once the purchase price, the face value, the coupon rate, and thematurity are known.More generally, given any coupon bond with purchase price Pb, face value F,coupon payment C, and maturity N, the yield to maturity i is found by means ofthe following formula:(12a)Pb = PV(i) ,where the present value PV(i) of the coupon bond is given by(12b)PV(i) = C/(1+i) + C/(1+i)2+ ... + C/(1+i)N+ F/(1+i)N.Interest Rates vs. Return RatesGiven any asset A held over any given time period T, the return to A over theholding period T is, by definition:the sum of all payments (rents, coupon payments, dividends, etc.)generated by A during period T, assumed paid out at the end of theperiod,PLUS the capital gain (+) or loss (-) in the market value of A over periodT, measured as the market value of A at the end of period T minus themarket value of A at the beginning of period T.The return rate on asset A over the holding period T is then defined to be thereturn on A over period T divided by the market value of A at the beginning ofperiod T.More precisely, suppose that an asset A is held over a time period that starts atsome time t and ends at time t+1. Let the market value of A at time t be denoted
  • 38. by P(t) and the market value of A at time t+1 be denoted by P(t+1). Finally, letV(t,t+1) denote the sum of all payments accruing to the holder of asset A from tto t+1, assumed to be paid out at time t+1.Then, by definition, the return rate on asset A from t to t+1 is given by thefollowing formula:(13) Return Rate on V(t,t+1) + P(t+1) - P(t)Asset A From = ---------------------------time t to t+1 P(t)V(t,t+1) P(t+1) - P(t)= --------- + -------------P(t) P(t)= payments + Capital Gain (if +)received as or Loss (if -) aspercentagepercentage of P(t)of P(t)Formula (13) holds for any asset A, whether physical or financial. The questionthen arises: For financial assets, what is the connection between the return ratedefined by formula (13) and the interest rate on the financial asset defined bythe yield to maturity?The return rate on a financial asset is not necessarily equal to the yield tomaturity on the financial asset. Starting at any current time t, the return rate iscalculated for some specified holding period from t to t, whether or not thisholding period coincides with the maturity of the financial asset. Moreover, thereturn rate takes into account any capital gains or losses that occur during thisholding period, in addition to any payments received from the financial assetduring this holding period. In contrast, starting at any current time t, the yield tomaturity takes into account the payment stream generated by the financialasset over its entire remaining maturity, plus the overall anticipated capital gainor loss that will be incurred when the financial asset is held to maturity.Real vs. Nominal Interest Rates
  • 39. The yield to maturity measure of an interest rate, as examined to date, has been"nominal" in the sense that it has not been adjusted for expected changes inprices. What actually concerns a "rational" saver considering the purchase of afinancial asset is not the nominal payment stream he or she expects to earn infuture periods but rather the command over purchasing power that this nominalpayment stream is expected to entail. This purchasing power depends on thebehavior of prices.Let infe(t) denote the expected inflation rate at time t, and let i(t) denote the(nominal) yield to maturity for some financial asset at time t. Then the realinterest rate associated with i(t) is defined by the following "Fisher equation:"The function of financial markets in the economyA market is a place where supply for a particular good is able to meet demand for it. In thecase of financial markets, the good in question is money.In capital markets, supply agents are those with "positive savings capacity", i.e. mainlyhouseholds (surprising as that may seem!), and businesses, although the latter generallyprefer to reinvest profits or distribute dividends to shareholders. The demand side comesfrom governments, the modern welfare state having substantial cash requirements, or othercompanies. Such agents are said to have "financing requirements".Far from being an abstract entity, often described as both irrational and all-powerful, capitalmarkets are in fact a driving force in the economy since they are places where the fuel,money, is made available to propel the machine forward, in other words generate wealth.This is the concept, but in practice of course the mechanism is a little more complex.The first difficulty resides in the fact that an exchange actually needs to take place betweenagents with savings capacity and agents with financing requirements. For a market tofunction, it is not enough that a good and its supply and demand exist; agents also have towant to trade it! However, agents with savings capacity, mainly households it should berecalled, are generally deeply averse to risk. An aversion furthermore which can be justifiedby common sense. Any book on the stock market for budding investors will begin with awarning urging readers to only invest funds in the stock market that will not be needed inthe near future. Consequently, the bulk of savings generated by households are held ondeposit in demand accounts or savings accounts where money is immediately available.In contrast, agents with financing needs, i.e. businesses, need to find long-term financingfor development. The time horizon of agents with savings capacity is typically a few weeks(next pay day) to a few months (next tax payment date ...). The time horizon of agentswith financing requirements is several years! This difference makes actual exchange inmarkets more complex.
  • 40. TopBanksThis is where a third category of economic agents comes in, the banks. Banks are the onlyagents that have the power to transform very short-term resources (demand deposits i.e.current accounts) into medium and long term resources: bank loans. Banks thereforeestablish an essential link between households and businesses; they have always played,and indeed still play, a crucial role in the financing of the economy.Each bank has the right to distribute virtually all of the money deposited by customers onits current accounts (but not all! see below) as loans. However, loans made available in thisway by banks do not cancel the deposits that were made, which continue to be available forthe customer to use. Banks therefore create money. The loans, granted in the form ofdemand deposits, increase the cash resources of banks and thus their ability to distributenew loans etc.. Deposits create loans, which themselves create deposits, etc.. This is whatis called the "credit multiplier".Fortunately, the money creation power of banks is not infinite. It is limited firstly by the factthat only part of the loans granted will remain in the form of deposits. The remainder will beconverted into cash (notes) through cash withdrawals. Furthermore, to ensure that bankshave the capacity to cope with withdrawals, the central bank requires them to lock-up apercentage of their deposits in the form of reserves, not available for lending. Thecompulsory reserves ratio is one of the instruments used by central banks to control thequantity of money in circulation.Furthermore, companies cannot finance themselves solely through loans; beyond a certainlevel of debt, the financial cost has an unsustainable impact on results and banks would nolonger be willing to lend. Companies therefore have to find ways of obtaining even longer-term financing, only repayable in the event of dissolution of the company, or debt with verylong maturities, for example bonds. The total of the capital and long-term debt of acompany constitutes its "equity capital".Banks, in particular investment banks, are also involved in long-term corporate financing,but it is not their primary purpose which is to ensure that money circulates. To providecompanies with equity capital, economic agents ready to lock-up large sums over longperiods, obviously with the aim of generating profit, are required: investors.TopInstitutional investorsThe main investors in capital markets today are "institutional investors" (often referred tosimply as "institutionals"), namely insurance companies, fund managers (asset managers),retirement funds and their US equivalent, the pension funds. Institutionals also drain public
  • 41. savings, but these savings are locked up and cannot be immediately withdrawn in the sameway as sums deposited in current accounts. In addition, the institutions in questiongenerally have a regulatory, contractual or legal obligation to build up savings in order to beable to pay, for insurance companies insurance benefits, and for retirement fundsretirement benefits to policyholders.Instead of distributing loans like banks, institutional investors buy securities issued bycompanies requiring financing. These securities represent either equity capital: shares, orlong-term borrowing: bonds. Purchases are made on the primary market, i.e. at the timethe securities are issued, or on the secondary market, more commonly referred to as the"Stock Exchange".Given the needs of companies to obtain financing from the market and institutionalinvestors needs to invest savings in their care, it is clear that there has to be a way forsupply and demand to meet. However for this to happen, the market has to be organisedappropriately to facilitate the process; a number of different players contribute to this. Inthis regard, banks once again play an important role. As account-keepers and liquidityproviders, they assume a key intermediation role.TopThe issuance of securitiesIssuers wishing to raise capital from the market turn to a bank or group of banks (a "banksyndicate") which acts as an agent for the issue. The agent arranges all the economiccharacteristics of the issue. The agent "underwrites" the issue, in other words undertakes tobuy all the securities issued and has a responsibility to find final investors willing to buy thesecurities issued.After the issue, and once the securities trade on the market, the paying agent of the issuer(which may be the same as the agent or another institution) will be responsible for ensuringsmooth operations throughout the life of the security: payment of coupons for bond issuesor dividends for shares, repayments, capital increases etc.Lastly, rating agencies are independent organisations which assess the quality of issuersand assign a rating designed to determine their reliability as debtors.TopCustodiansThe agent of the issuer manages the relationship with the central custodian, a key player insecurities markets. For each issue it manages, the central custodian keeps up-to-daterecords in its accounts of the total amount of securities that have been issued and the
  • 42. amount held by each institution that has a registered account with it (the total amount heldby all institutions clearly has to match the total amount of the issue!). In France the centralcustodian for almost every issue is Euroclear France, formerly SICOVAM.Each member of Euroclear France is a local custodian. Any investor that does not have aregistered account with Euroclear France must open an account with a local custodian inorder to be able to hold securities. However, while investors increasingly tend tointernationalise their investments, the central custodian practically only manages securitiesissued in its own country. As a result, the function of "global custodian" has developed. Aglobal custodian is appointed by investors to act as account keeper for all transactionsinvolving the purchase and sale of securities in markets worlwide. To this end, the globalcustodian works hand-in-hand with local custodians in every market in the world, each oneresponsible for maintaining relations with the central depository in its country.To be a global or local custodian, an institution must be authorised not only to keepsecurities accounts on behalf of investors but also cash accounts. Such institutions aretherefore usually banks.TopMarket transactionsInvestors typically buy securities through a broker. The broker provides a number ofservices to investors. Financial analysts study markets and issuers and makerecommendations. Salesmen pass on the recommendations of analysts to investors andcollect their orders. Lastly, traders buy or sell securities in the market.Trading between brokers is carried out either directly through an "OTC" market or organisedmarket, a stock exchange, or through fast-growing electronic markets.Once a trade has been completed, the investor turns to a custodian to take charge of "aftertrade" aspects. For a transaction to be registered correctly, securities provided by the sellerhave to be exchanged for cash provided by the buyer. This process is referred to assettlement and delivery.The custodian is also responsible for maintaining the accounts of investor customers to takeaccount of the many transactions that can have an impact on investment portfolios: couponor dividend payments, repayments, but also exercise of subscription rights, takeover bids,exchange offers etc.TopTrading floors
  • 43. Market transactions by institutional investors are not limited to the purchase and sale ofsecurities. Given the sums involved and the large number of markets in which investorstrade, additional needs arise. An investor may need to obtain foreign currency, hence thenecessity to carry out transactions in currency markets. An investor may also require loans,or on the contrary need to invest liquidity on a temporary basis to optimise cash flow.Lastly, he may want to protect a portfolio against market fluctuations, giving rise to theneed for derivative products.Non-financial companies ("corporates") face similar types of need: importers may requireforeign currency and processing companies may have to protect themselves againstfluctuations in raw material prices. All have special cash management needs and may haveto hedge against movements in prices or interest rates.Banks are able to respond to these needs; at the branch level for small and medium-sizedcompanies or directly via the trading room for the largest customers. Total cumulativepositions generated for the various products are processed by traders in the trading rooms.The activity of a trading room reflects the total amount of requests coming from all of thebank’s customers!TopSpeculation and arbitrageFinancial institutions and funds dedicated to this type of activity use some of their resourcesfor speculation. This aspect of trading activity, whether or not it be as extensive as manyclaim, nevertheless remains necessary. Speculation involves taking a position that iscontrary to current market trends: it means becoming a seller when you think that priceswill fall (and are therefore at their highest!), or becoming a buyer when you think they willrise. By adopting a stance, speculators provide liquidity to the market: they are the sellersfor investors who want to buy and the buyers for those who want to sell. It is a riskyactivity, as, unlike investors or corporates, speculators bet on the future.Arbitragists also play a harmonising role: they take advantage of price differences betweendifferent markets to generate gains. For example, in currency markets they buy dollars in amarket where it is cheap and sell in a market where it is most demanded, and thereforemore expensive. It is a risk-free activity, since the assets purchased are immediately resold.However, this requires substantial financing as capital gains on each transaction are low.The activity of arbitragists helps eliminate marketing inconsistencies.TopConclusion
  • 44. Economic literature, after drawing a sharp distinction between the financing of companiesthrough bank lending (debt financing) and financing through the issuance of securities(market-based economy), now attributes a complementary role to both. Studies suggestthat for an economy to grow, there is a need for both an active organised financial marketand a reliable banking system.The purpose of this website is not to discuss the whys and wherefores of financial marketsor their beneficial or harmful role. Instead, the content of this site focuses on "how"aspects: who are the players, how do they interact, the financial products that are traded,and the functions that they provide.

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