1. Financial market is a market in which financial assets such as Market Efficiency: Because securities have market determined to invest in long term and short term assets. The quantity of
stocks and bonds can be purchased or sold. Funds are prices, their favorable or unfavorable characteristics as funds demended by business depends on the number
transferred in financial markets when one party purchases perceived by the market are reflected in their prices. When business projects to be implemented. Business evaluates a
financial assets previously held by another party. Financial security prices fully reflect all available information, the markets project by comparing the present value of its cash flows to its
market facilitates the flow of funds and thereby allows financing for these securities are said to be efficient. When markets are initial investment. Projects with a positive net present value
and investing by households, firms and govt agencies. Types of insufficient, investors can use available information ignored by are accepted because the present value of their benefits
Financial Markets: Each financial market is created to satisfy the market to earn abnormally high returns on their investments. outweighs the costs. The required return to implement a
particular preferences of market participants. There are many Even if markets are efficient this does not imply that individual or given project will be lower if interest rates are lower because
different types of financial markets and each market can be institutional investors should ignore the various investment the cost of borrowing funds to support the project will be
distinguished by the maturity structure and trading structure of its instruments are available. Investors differ with respect to the risk lower. Government Demand for Loanable Funds:
securities. Money Market: The financial markets that facilitate they are willing to incur the desired liquidity of securities and Whenever a government’s planned expenditures can not be
the flow of short term funds are known as money market, the their tax status, making some types of securities more desirable completely covered by its incoming revenues from taxes and
duration of the loan or debt is less than one year. Money market to some investors than to others. Some securities that are not as other sources, it demands loanable funds. Municipal
loan is used for daily activities of the institution and can create safe and liquid as desired may still be considered if the potential governments issue municipal bonds to obtain funds while the
deposit. Treasury bill, bill of exchange, commercial papers, return is sufficiently high. Investors normally attempt to balance federal government and its agencies issue treasury securities
bankers’ acceptance etc are used as the documents of loan. the objective of high return with their particular preference for and federal agency securities. These securities represent
Money market acts as a link between the investors and debtors. low risk and adequate liquidity. Surplus Unit: The main government debt. Federal government expenditure and tax
Capital Market: The financial markets that facilitate the flow of participants in financial markets can be classified as households, policies are generally thought to be independent of interest
long term funds are known as capital market. Duration of the businesses, and government agencies. Those participants who rates. Thus, the federal government demand for funds is said
loan or debt is more than one year. Capital market loan is used provide funds to the financial markets are called surplus units. to be interest inelastic or insensitive to interest rates.
for setting up the industry, purchasing heavy machinery and Deficit Units: Households are the main type of surplus unit. Foreign Demand for Loanable Funds: The demand for
other fixed assets. It can not create deposit. Share, debenture, Participants who use financial to obtain funds are called deficit loanable funds in a given market also includes foreign
bond, mortgage, stock etc is used as document of loan. Capital units. Many deficit units issue securities to surplus units in order demand by foreign governments or corporations. For
market acts as a middleman between the investors and to obtain funds. A security is a certificate that represents claim example, the British government may obtain financing by
entrepreneur. Primary market: Primary markets facilitate the on the issuer. issuing British Treasury securities to U.S. investors,
issuance of new securities. Its transaction provides funds to the Financial markets: Financial markets transfer funds from those representing a British demand for U.S. funds. Because
initial issuer of securities. The issuance of new corporate stock who have excess funds to those who need funds. They enable foreign financial transactions are becoming so common, they
or new treasury securities is a primary market transaction. college students to obtain student loans, families to obtain can have a significant impact on the demand for loanable
Secondary Market: Secondary Markets facilitate the trading of mortgages, businesses to finance their growth and govt to funds in any given country. A foreign country’s demand for
existing securities. The sale of existing corporate stock or finance their expenditures. Without financial markets many U.S. funds is influenced by the differential between its
treasury security holdings by any business or individual is a students could not go to college, many families could not interest rates and U.S. rates. Aggregate Demand for
secondary market transaction. Securities traded in Financial purchase home, corporations could not grow, and the Loanable Funds: The aggregate demand for Loanable
markets: Securities can be classified as Money Market government could not provide as many public services. funds is the sum of the quantities demanded by the separate
Securities, Capital market Securities and Derivative securities. Households and businesses that supply funds to the financial sectors at any given interest rates. Because most of these
Each type of security tends to have specific return and risk markets earn a return on their return is necessary to ensure that sectors are likely to demand a larger quantity of funds at
characteristics. Money Market Securities are debt securities funds are supplied to the financial markets. If funds were not lower interest rates, the aggregate demand for loanable
that have a maturity of one year or less. They generally have a supplied, the financial markets would not be able to transfer funds is inversely related to interest rates at any point in
relatively high degree of liquidity. It tends to have a low expected funds to those who need them. Perfect Security Market: If time. If the demand schedule of any sector changes, the
return but also a low degree of risk. Capital market Securities: financial markets were perfect, all information about any aggregate demand schedule will be affected as well. Supply
Securities with a maturity of more than one year are called securities for sale in primary and secondary markets would be of Loanable Funds: The term “Supply of Loanable Funds” is
capital market securities. Three common types of capital market continuously and freely available to investors. All information commonly used to refer to funds provided to financial
securities are bonds, mortgages and stocks. Bonds and identifying investors interested in purchasing securities as well markets by severs. The household sector is the largest
Mortgages: Bonds are long term debt obligations issued by as investors planning to sell securities would be freely available. supplier, but loanable funds are also supplied by some govt
corporations and government agencies to support their Furthermore, all securities for sale could be broken down into units that temporarily generate more tax revenues than they
operations. Bonds provide a return to investors in the form of any size desired by investors and security transaction costs spend or by some businesses whose cash inflows exceed
interest income every six months. Mortgages are long term debt would be nonexistent. Under this condition, financial outflows. Equilibrium Interest Rate: There are several
obligations created to finance the purchase of real estate. Since intermediaries would not be necessary. Imperfect market different interest rates because some borrowers pay a higher
bonds and mortgages represent debt they specify the amount Securities: Because markets are Imperfect, Securities buyers rate than others. At this point however, the focus is on the
and timing of interest and principal payments to investors who and sellers do not have full access to information and can not forces that cause the general level of interest rates to
purchase them. At maturity investors holding the debt securities always break down securities to the precise size they desire. change, as interest rates across borrowers tend to change in
are paid to the principal. Some debt securities are risky because Financial institutions are needed to resolve the problems caused the same direction. The determination of an equilibrium
the issuer could default on its obligation to repay the debt. by market imperfections. They receive requests from surplus interest rate is presented first from an algebraic perspective
Stocks are certificates representing partial ownership in the and deficit units on what securities are to be purchased or sold and then from a graphic perspective. Algebraic
corporations that issued them. They are classified as capital and they use this information to match up buyers and sellers of Presentation: The equilibrium interest rate is the rate that
market securities because they have no maturity and therefore securities. Because the amount of a specific security to be sold equates the aggregate demand for funds with the aggregate
serve as a long term source of funds . does not always equal the amount desired by investors, financial supply of loanable funds. The algebraic demand for Funds
Derivative Securities are financial contracts whose values are institutions sometimes unbundled the securities by spreading (DA) can be written as,
derived from the values underlying assets. Many derivative them across several investors until the entire amount is sold. DA = D h + D b + D g + D m + D f
securities enable investors to engage in speculation and risk Without financial institutions, the information and transaction Where, Dh = Household demand for loanable funds.
management. Speculation derivative securities allow an investor costs of financial market transactions would be excessive. The Db = Business demand for loanable funds
to speculate on movements in the underlying assets without Securities Act 1933: The securities act of 1933 was intended to Dg = Federal government demand for loanable funds
having to purchase those assets. Some derivative securities ensure complete disclosure of relevant financial information on Dm= Municipal government demand for loanable funds
allow investors to benefit from an increase in the value of debt publicity offered securities and to prevent fraudulent practices in Df = Foreign demand for loanable funds
securities, while others allow investors to benefit from a selling these securities. The Securities Act of 1934: The Graphic Presentation: By combining the aggregate demand
decrease in the value of debt securities Valuation of securities securities act of 1934 extended the disclosure requirements to and aggregate supply schedules for loanable funds, it is
in Finance Markets: Each type of security generates a unique secondary market issues. possible to compare the total amount of funds that would be
stream of expected cash flows to investors. The valuation of a It also declared illegal a variety of deceptive practices, such as demanded to the total amount of funds that would be
security is measured as the present value of its expected cash misleading financial statements and trading strategies designed supplied at any particular interest rate. Impact of Economic
flows, discounted at a rate that reflects the uncertainty. Market to manipulate the market price. It established the Securities and growth on Interest Rates: As a result of more optimistic
Pricing of Securities: Securities are priced in the market Exchange Commission to oversee the security market and the economic projections most businesses increase their
according to how they are valued by market participants.Impact SEC has implemented additional laws over time. Securities laws planned expenditures for expansion, which translates into
of Information on Valuations: Although all investors rely on do not prevent investors from making poor investment decision additional borrowing. The aggregate demand schedule will
valuation to make investment decisions, different investors may but only attempt to ensure full disclosure of information and thus shift outward. The supply of loanable funds schedule may
derive different valuations of security based on the existing set of protect against fraud. A security’s market price is driven by new also shift, but it is more difficult to know how it will shift. It is
information. That is investors interpret and use information in information that affects its valuation. When information is possible that the increased expansion by businesses will
different ways. Some investors may rely mostly on economic or disclosed to only a small set of investors, those investors have lead to more income for construction crews and others who
industry information to value a security, while others may rely on major advantages over other investors. Loan able Funds service the expansion. In this case, the quantity of savings,
published opinions about the firms’ management. Each security Theory: The loan able funds theory, commonly used to explain and therefore of loanable funds supplied at any possible
has an equilibrium market price at which the demand for that interest rate movements, suggests that the market interest rate interest rate, could increase, causing an outward shift in the
security is equal to the supply of that security for sale. Impact is determined by the factors that control the supply of and supply schedule. Yet there is no assurance that the volume
valuation on Pricing: When investors receive new information demand for loanable funds. the theory is especially useful for of savings will actually increase. Overall, the expected
that clearly indicates likelihood of higher cash flows or less explaining movements in the general level of interest rates for a impact of the increased expansion by businesses is an
uncertainty, they revise all of their valuations of that security particular country. Further more it can be used along with other outward shift in the demand schedule and no obvious
upward. Consequently, the prevailing price is no longer in concepts to explain why interest rates among some debt change in the supply schedule. Fisher Effect: More than 50
demand for the security as undervalued at the price. The securities of a given country vary. Household demand for years ago, Irving Fisher proposed a theory of interest rate
demand for the security increases at that price and the supply of Loanable Funds: Households commonly demand loanable determination that is still widely used today. It does not
that security for sale decrease. Impact of the internet on the funds housing expenditures. They finance the purchases of contradict the loanable funds theory but simply offers an
valuation process: The internet has improved the valuation of automobiles and household items which result in installment additional explanation for interest rate movements. Fisher
securities in several ways. Prices of securities are quoted online debt. As the aggregate level of household income rises over proposed that nominal interest payments compensate savers
and can be obtained at any given moment by investors. The time, so does installment debt. The level of installment debt as a in two ways. First, they compensate for a savers reduced
actual sequence of transaction is provided for some securities. percentage of disposable income has been increasing since purchasing power. Second, they provide an additional
Much more information about the firms that issue securities is 1983. It is generally lower in recessionary periods. Business premium to savers for forgoing present consumption. Savers
available online, which allows securities to be priced more Demand for Loanable Funds: Business demand loanable are willing to forgo consumption only if they receive a

2. Above the anticipated rate of inflation, as shown the following Account and payments received from the treasury when the
equation, securities mature are deposited electronically into the account.
I = E(INF) + ig Estimating the yield: T-bills do not offer coupon payments but
Where, I = Nominal or quoted rate of interest are sold at a discount from par value. Their yield is influenced
E(INF) = Expected inflation rate by the difference between the selling price and the purchase
Ig = Real interest rate. price. If an investor purchases a newly issued T-bill and holds it
Nominal Interest Rate & Real interest rate: The relationship until maturity, the return is based on the difference between the
between interest rates and expected inflation often referred as par value and the purchase price. If the T-bill is sold prior to
the Fishers effect. The difference between the nominal interest maturity, the return is based on the difference between the price
rate and the expected inflation rate is the real return to a saver for which the bill was sold in the secondary market and the
after adjusting for the reduced purchasing power over the time of purchase price. The annualized yield from investing in a T-bill
period of concern. It is referred to as the real interest rate, (YT) can be determined as
because unlike the nominal rate of interest, it adjusts for the SP − PP 365
YT = X
expected rate of inflation. If the nominal interest rate was equal PP n
to the expected inflation rate, the real interest rate would be Where, SP= Selling Price
zero. Savings would accumulate interest at the same rate that PP= Purchase Price
prices were expected to increase, so that the purchasing power n = Holding Period
of savings would remain stable. The real interest rate over an Estimating the Treasury Bill Discount: Business periodicals
upcoming period can be forecasted by subtracting the expected frequently quote the T-bill discount along with the T-bill yield.
inflation rate over that period from the nominal interest rate The T-bill discount represents the present discount of the
quoted for that period. Because the expected inflation rate is purchase price from par value for newly issued T-bills and is
difficult to estimate, the real interest rate is difficult to forecast. computed as,
When the inflation rate is higher than anticipated, the real Par − PP 360
Discount = X
interest rate is relatively low. Par n
Crowding-out Effect: When the federal government enacts Commercial Paper: Commercial paper is a short term debt
fiscal’s policies that result in more expenditures than tax instrument issued only by well known, credit-worthy firms and is
revenue, the budget deficit is increased. A higher federal typically unsecured. It is normally issued to provide liquidity or
government deficit increases the quantity of loanable funds finance a firm’s investment in inventory and accounts receivable.
demanded at any prevailing interest rate causing an outward The issue of commercial paper is an alternative to short term
shift in the demand schedule. Assuming no offsetting increase in bank loans. Financial institutions such as finance companies and
the supply schedule, interest rates will rise. Given a certain bank holding companies are major users of commercial papers.
amount of loanable funds supplied to the market, excessive Ratings: Since commercial paper is used by corporations that
government demand for these funds tends to “crow out” the are susceptible to business failure, the commercial paper could
private sector may not be willing to pay whatever is necessary to possibly default. The risk of default is influenced by the issuer’s
borrow these funds, but the private sector may not. This impact financial condition and cash flow. Investors can attempt to
is known as the Crowding-out Effect. Forecasts of Interest assess the probability that commercial paper will default by
rates: Some analysts focus more on changes in demands of monitoring the issuer’s financial condition. The focus on the
fund and supply of funds than on estimating the aggregate level issuer’s ability to repay its debt over the short term because the
of demands of fund and supply of funds. This interest rate will payments will be completed within a short term period. The
change only if demands of fund and supply of funds change to ratings serves as an indicator of the potential risk of default.
create a temporary disequilibrium. If the government demands Negotiable Certificates of Deposit: NCD’s are certificates that
for fund is expected to increase substantially and no other are issued by large commercial banks and other depository
components are expected to change, demands of fund will institutions as a short term source of funds. The minimum
exceed the demand of supply, placing upward pressure on denomination is $1,00,000, although a $1 million denomination
interest rates. Thus, the forecast of future interest rates can be is more common. Nonfinancial corporations often purchase
derived without estimating every component comprising NCD’s. Although NCD denominations are typically too large for
demands of fund and supply of funds. Forecasts of interest rates individual investors, they are sometimes purchased by money
are wrong when forecasts of the components comprising market funds that have pooled individual investor’s fund. Thus
demands of fund and supply of funds are wrong. For example, if money market funds allow individuals to be indirect investors in
the government demand for loanable funds is overestimated NCDs, creating a more active NCD market. Maturities on NCDs
while all the components are properly estimated, demands of normally range from two to one year. A secondary market for
fund will be overestimated. Consequently, interest rates will NCDs exists, providing investors with some liquidity. However,
probably be lower than forecast. Money Market Securities: institutions prefer not to have their newly issued NCDs compete
Securities with maturities within one year are referred to as with their previously issued NCDs that are being resold in the
money market securities. They are issued by corporations and secondary market. An oversupply of NCDs for sale can force
government to obtain short-term funds. They are originally them to sell their newly issued NCDs at a lower price. Bankers
issued in the primary market through a telecommunications Acceptances: A banker’s acceptance indicates that a bank
network that informs investors that new securities are for sale. accepts responsibility for a future payment. Banker’s
Money market securities are commonly purchased by the acceptances are commonly used for international trade
corporations and government agencies that have funds available transactions. An exporter that is sending goods to an importer
for a short term period. Because money market securities have whose credit rating is not known will often prefer that a bank act
short term maturity and can typically be sold in the secondary as a guarantor. The bank therefore facilitates the transaction by
market, they provide liquidity to investors. Most firms and stamping ACCEPTED on a draft, which obligates payment at a
financial institutions maintain some holdings of money market specified point in time. In turn, the importer will pay the bank
securities for this reason. The more popular money market what is owed to the exporter along with a fee to the bank for
securities are: Treasury bills, Commercial Paper, Negotiable guaranteeing the payment. Exporters can hold bankers
certificates of deposit, Repurchase agreements, Federal funds, acceptance until the date at which payment is to be made, but
and bankers’ acceptance. Treasury uses the primary market they frequently sell the acceptance before then at a discount to
to obtain adequate funding: The treasury issues treasury bills obtain cash immediately. The investor who purchases the
through a weekly auction. Investors can submit competitive bids, acceptance then receives the payment guaranteed by the bank
where the treasury will accept the highest bids first. Alternatively, in the future. The investor’s return on a banker’s acceptance, like
investors can submit noncompetitive bids, which will that on commercial paper, is derived from the difference
automatically be accepted. The price to be paid by between the discounted price paid for the acceptance and the
noncompetitive bidders is the weighted average price of amount to be received in the future. Risk of Money Market
accepted bids. After accounting for noncompetitive bids, the Securities: When corporate treasurers, institutional investors
treasury accepts the highest competitive bids first and works it and individual investors invest in money market securities, they
way down until it has generated the amount of funds from are subject to the risk that the return on their investment will be
competitive bids that that it needs. Any bids below that cutoff less than anticipated. The forces that influence price
point are not accepted. Thus the price paid by the competitive movements of money market securities can not be perfectly
and noncompetitive bidders reflects the lowest price of the anticipated, so future money market prices can not be perfectly
competitive bids. Investors using the primary T-bill market anticipated either.
are assured that their bid will be accepted: The primary T-bill
market is an auction by mail. Investors submit bids on T-bill
applications for the maturity of their choice. Applications can be
obtained at no charge from a Federal Reserve district or branch
bank. Alternatively, investors can ask a broker or a commercial
bank to obtain and send in the application for them. Financial
institutions can arrange to submit their bid for T-bills online using
the treasury automated auction processing system. Financial
institutions using this arrangement set up an account with the
treasury. Then they can select the specific maturity and face
value that they desire and submit their bids electronically.
Payments to the treasury are withdrawn electronically from the