Role of Financial mark

Financial Institutions
Assignment Topic :
Role and Functions of FinancialMarket
Submitted To:
WaqarAhsan
Submitted By:
Muhammad Asjadkhuram
Registration No:
1652-411036

Financial Market:
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.
Different Types of Financial Markets
Capital Market:
Capital Market consists of primary market and secondary market. In primary market newly
issued bonds and stocks are exchanged and in secondary market buying and selling of already
existing bonds and stocks take place. So, the Capital Market can be divided into Bond market
and Stock market. Bond market provides financing by bond issuance and bond trading. Stock
market provides financing by shares or stock issuance and by share trading . As a whole capital
market facilitates raising of Capital
Money Market
Money Market facilitates short term debt financing capital.
Derivatives Market
Derivatives Market provides instruments which help in controlling financial risk.
Foreign Exchange Market
Foreign Exchange Market facilitates the foreign exchange trading.
Insurance Market
Insurance Market helps in relocation of various risks.
Commodity Market
Commodity Market organizes trading of commodities
Contribution of Financial Markets
Financial Markets are essential for fund raising. Through Financial Market borrowers can
find suitable lenders. Banks also help in the process of financing by working as
intermediaries. 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 provide
financing in the form of loans and mortgages except banks othe intermediaries in the
financial market can be insurance companies and mutual funds. But more complicated
transactions of Financial Market take place in stock exchange. In stock exchange, a

company can buy others' company's shares or can sell own shares to raise funds or they
can buy their own shares existing in the market.
Basis of financial Market
Basis of financial markets are the borrowers and lenders.
Borrowers of the financial market can be individual persons, private companies, public
corporations, government and othe local authorities like municipalities. Individual persons
generally take short term or long term mortgage loans from banks to buy any property. Private
Companies take short term or long term mortgage loans from banks to buy any property. Private
companies take short or long term loans for expansion of business or for improvement of the
business infrastructure.
Lenders
in the Financial Market are actually the investors. Their invested money is used to finance the
requirements of borrowers. So, there are various types of investments which generate lending
activities. Some of these types of investments are depositing money in savings bank account,
paying premiums to Insurance Companies, investing in shares of different companies, investing
in 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, it
can be beneficial and can be harmful too. So, the ultimate outcome solely lies in the hands of the
people who use it to serve their purpose

An asset is anything of durable value, that is, anything that acts as a means to store
value 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, either
directly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claims
to future income streams that originate ultimately from real assets). Securities are
financial assets exchanged in auction and over-the-counter markets (see below)
whose distribution is subject to legal requirements and restrictions (e.g., information
disclosure requirements).
Lenders are people who have available funds in excess of their desired expenditures
that they are attempting to loan out, and borrowers are people who have a shortage of
funds relative to their desired expenditures who are seeking to obtain loans.
Borrowers attempt to obtain funds from lenders by selling to lenders newly issued
claims against the borrowers' real assets, i.e., by selling the lenders newly issued
financial assets.
A financial market is a market in which financial assets are traded. In addition to
enabling exchange of previously issued financial assets, financial markets facilitate
borrowing and lending by facilitating the sale by newly issued financial assets.
Examples of financial markets include the New York Stock Exchange (resale of
previously issued stock shares), the U.S. government bond market (resale of
previously 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 is
through financial asset transactions. Examples of such financial institutions include
discount 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 or
consumption purposes.

Price Determination: Financial markets provide vehicles by which prices are set
both for newly issued financial assets and for the existing stock of financial
assets.
Information Aggregation and Coordination: Financial markets act as collectors
and aggregators of information about financial asset values and the flow of
funds from lenders to borrowers.
Risk Sharing: Financial markets allow a transfer of risk from those who
undertake investments to those who provide funds for those investments.
Liquidity: Financial markets provide the holders of financial assets with a
chance 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 consider
both the various types of financial institutions that participate in such markets and the
various ways in which these markets are structured.
Who are the Major Players in Financial Markets?
By definition, financial institutions are institutions that participate in financial
markets, i.e., in the creation and/or exchange of financial assets. At present in the
United States, financial institutions can be roughly classified into the following four
categories: "brokers;" "dealers;" "investment bankers;" and "financial intermediaries."
Brokers:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by
locating a seller (or buyer) to complete the desired transaction. A broker does not take
a position in the assets he or she trades -- that is, the broker does not maintain
inventories in these assets. The profits of brokers are determined by the commissions
they 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 | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares ----------------- Shares

Dealers:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do
not 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 permit
the dealer to sell out of inventory rather than always having to locate sellers to match
every offer to buy. Also, unlike brokers, dealers do not receive sales commissions.
Rather, dealers make profits by buying assets at relatively low prices and reselling
them at relatively high prices (buy low - sell high). The price at which a dealer offers
to sell an asset (the "asked price") minus the price at which a dealer offers to buy an
asset (the "bid price") is called the bid-ask spread and represents the dealer's profit
margin 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:
------------>| |------------->
Bond | Dealer | Bond
Buyer | | 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 these
securities should offer;
Underwriting: Guaranteeing corporations a price on the securities they offer,
either individually or by having several different investment banks form a
syndicate 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, Merrill
Lynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs.
Financial Intermediaries:

Unlike brokers, dealers, and investment banks, financial intermediaries are financial
institutions that engage in financial asset transformation. That is, financial
intermediaries purchase one kind of financial asset from borrowers -- generally some
kind of long-term loan contract whose terms are adapted to the specific circumstances
of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to
savers, generally some kind of relatively liquid claim against the financial
intermediary (e.g., a deposit account). In addition, unlike brokers and dealers,
financial intermediaries typically hold financial assets as part of an investment
portfolio rather than as an inventory for resale. In addition to making profits on their
investment portfolios, financial intermediaries make profits by charging relatively
high 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); Contractual
Savings Institutions (life insurance companies, fire and casualty insurance companies,
pension funds, government retirement funds); and Investment Intermediaries (finance
companies, stock and bond mutual funds, money market mutual funds).
Diagrammatic Example of a Financial Intermediary: A Commercial Bank
Lending by B Borrowing by B
deposited
------- funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- loan ------- deposit -------
contracts accounts
Loan contracts Deposit accounts
issued by F to B issued by B to H
are liabilities of F are liabilities of B
and assets of B and assets of H
NOTE: F=Firms, B=Commercial Bank, and H=Households
Important Caution: These four types of financial institutions are simplified
idealized classifications, and many actual financial institutions in the fast-
changing financial landscape today engage in activities that overlap two or
more of these classifications, or even to some extent fall outside these
classifications. A prime example is Merrill Lynch, which simultaneously acts as
a broker, a dealer (taking positions in certain stocks and bonds it sells), a
financial intermediary (e.g., through its provision of mutual funds and CMA
checkable deposit accounts), and an investment banker.

What Types of Financial Market Structures Exist?
The costs of collecting and aggregating information determine, to a large
extent, the types of financial market structures that emerge. These structures
take 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, which
combine auction and OTC market features. Specifically, organized
exchanges permit buyers and sellers to trade with each other in a
centralized location, like an auction. However, securities are traded on
the floor of the exchange with the help of specialist traders who
combine broker and dealer functions. The specialists broker trades but
also stand ready to buy and sell stocks from personal inventories if buy
and sell orders do not match up.
Intermediation financial markets conducted through financial
intermediaries;
Financial markets taking the first three forms are generally referred to
as securities markets. Some financial markets combine features from more
than one of these categories, so the categories constitute only rough
guidelines.
Auction Markets:
An auction market is some form of centralized facility (or clearing house) by
which buyers and sellers, through their commissioned agents (brokers), execute
trades in an open and competitive bidding process. The "centralized facility" is
not necessarily a place where buyers and sellers physically meet. Rather, it is
any institution that provides buyers and sellers with a centralized access to the
bidding 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 readily
accessible to all would-be buyers and sellers, e.g., through a computer network.
No private exchanges between individual buyers and sellers are made outside
of the centralized facility.
An auction market is typically a public market in the sense that it open to all
agents 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 -- for
which bid and asked prices can be posted at any time the market is open and
exchanges take place on a continual basis. Experimental economists have
devoted a tremendous amount of attention in recent years to auction markets.
Many auction markets trade in relatively homogeneous assets (e.g., Treasury
bills, notes, and bonds) to cut down on information costs. Alternatively, some
auction markets (e.g., in second-hand jewelry, furniture, paintings etc.) allow
would-be buyers to inspect the goods to be sold prior to the opening of the
actual bidding process. This inspection can take the form of a warehouse tour, a
catalog issued with pictures and descriptions of items to be sold, or (in televised
auctions) a time during which assets are simply displayed one by one to
viewers 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 sunk
costs independent of the volume of trading in that asset. Consequently, auction
markets depend on volume to spread these costs over a wide number of
participants.
Over-the-Counter Markets:
An over-the-counter market has no centralized mechanism or facility for
trading. Instead, the market is a public market consisting of a number of dealers
spread across a region, a country, or indeed the world, whomake the market in
some type of asset. That is, the dealers themselves post bid and asked prices for
this asset and then stand ready to buy or sell units of this asset with anyone who
chooses to trade at these posted prices. The dealers provide customers more
flexibility in trading than brokers, because dealers can offset imbalances in the
demand and supply of assets by trading out of their own accounts. Many well-
known common stocks are traded over-the-counter in the United States
through NASDAQ (National Association of Securies Dealers' Automated
Quotation System).
Intermediation Financial Markets:
An intermediation financial market is a financial market in which financial
intermediaries help transfer funds from savers to borrowers by issuing certain
types of financial assets to savers and receiving other types of financial assets
from borrowers. The financial assets issued to savers are claims against the
financial intermediaries, hence liabilities of the financial intermediaries,
whereas the financial assets received from borrowers are claims against the

borrowers, hence assets of the financial intermediaries. (See the diagrammatic
illustration of a financial intermediary presented earlier in these notes.)
Additional Distinctions Among Securities Markets
Primary versus Secondary Markets:
Primary markets are securities markets in which newly issued securities are
offered for sale to buyers. Secondary markets are securities markets in
which existing securities that have previously been issued are resold. The
initial issuer raises funds only through the primary market.
Debt Versus Equity Markets:
Debt instruments are particular types of securities that require the issuer (the
borrower) to pay the holder (the lender) certain fixed dollar amounts at
regularly scheduled intervals until a specified time (the maturity date) is
reached, regardless of the success or failure of any investment projects for
which the borrowed funds are used. A debt instrument holder only
participates in the management of the debt instrument issuer if the issuer
goes 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 ownership
interest in the issuer.
There are two general categories of equities: "preferred stock" and "common
stock."
Common stock shares issued by a corporation are claims to a share of the
assets of a corporation as well as to a share of the corporation's net income --
i.e., the corporation's income after subtraction of taxes and other expenses,
including the payment of any debt obligations. This implies that the return
that holders of common stock receive depends on the economic performance
of the issuing corporation.
Holders of a corporation's common stock typically participate in any upside
performance of the corporation in two ways: by receiving a share of net

income in the form of dividends; and by enjoying an appreciation in the price
of their stock shares. However, the payment of dividends is not a contractual
or legal requirement. Even if net earnings are positive, a corporation is not
obliged to distribute dividends to shareholders. For example, a corporation
might instead choose to keep its profits as retained earnings to be used for
new capital investment (self-financing of investment rather than debt or
equity financing).
On the other hand, corporations cannot charge losses to their common stock
shareholders. Consequently, these shareholders at most risk losing the
purchase price of their shares, a situation which arises if the market price of
their shares declines to zero for any reason. An example of a common stock
share 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 corporation's cash flow that is prior to the
claims of its common stock holders but is generally subordinate to the claims
of its debt holders. In addition, like debt holders but unlike common stock
holders, preferred stock holders generally do not participate in the
management of issuers through voting or other means unless the issuer is in
extreme financial distress (e.g., insolvency). Consequently, preferred stock
combines some of the basic attributes of both debt and common stock and is
often referred to as a hybrid security.
Money versus Capital Markets:
The money market is the market for shorter-term securities, generally those
with 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 large
time deposits at depository institutions -- can run anywhere from 30 days to
over 5 years, most CDs have a maturity of less than one year. Those with a
maturity of more than one year are referred to as term CDs. A CD that can be

resold without penalty in a secondary market prior to maturity is known as
a negotiableCD.
The capital market is the market for longer-term securities, generally those
with more than one year to maturity.
Examples: Corporate stocks; residential mortgages; U.S. government securities
(marketable long-term); state and local government bonds; bank commercial
loans; consumer loans; commercial and farm mortgages.
Remark: Corporate stocks are conventionally considered to be long-term
securities 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. dollars
deposited 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 banks
outside the U.S.
An international bond is a bond available for sale outside the country of its
issuer.
Example of an International Bond: a bond issued by a U.S. firm that is available
for sale both in the U.S. and abroad.
A foreign bond is an international bond issued by a country that is
denominated in a foreign currency and that is for sale exclusively in the
country of that foreign currency.
Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated in
Japanese yen and that is for sale exclusively in Japan.
A Eurobond is an international bond denominated in a currency other than
that of the country in which it is sold. More precisely, it is issued by a
borrower in one country, denominated in the borrower's currency, and sold
outside the borrower's country.

Example of a Eurobond: Bonds sold by the U.S. government to Japan that are
denominated in U.S. dollars.
Asymmetric Information in Financial Markets
Asymmetric information in a market for goods, services, or assets refers to
differences ("asymmetries") between the information available to buyers and
the information available to sellers. For example, in markets for financial
assets, asymmetric information may arise between lenders (buyers of financial
assets) and borrowers (sellers of financial assets).
Problems arising in markets due to asymmetric information are typically
divided into two basic types: "adverse selection;" and "moral hazard." This
section explains these two types of problems, using financial markets for
concrete illustration.
1. Adverse Selection
Adverse selection is a problem that arises for a buyer of goods, services, or
assets when the buyer has difficulty assessing the quality of these items in
advance of purchase.
Consequently, adverse selection is a problem that arises because of different
("asymmetric") information between a buyer and a seller before any purchase
agreement takes place.
An Illustration of Adverse Selection in Loan Markets:
In the context of a loan market, an adverse selection problem arises if the
contractual terms that a lender sets in advance in an attempt to protect
himself against the consequences of inadvertently lending to high risk
borrowers have the perverse effect of encouraging high risk borrowers to self-
select into the lender's loan applicant pool while at the same time
encouraging low risk borrowers to self-select out of this pool. In this case, the
lender's pool of loan applicants is adversely affected in the sense that the
average quality of borrowers in the pool decreases.

2. Moral Hazard
Moral hazard is said to exist in a market if, after the signing of a purchase
agreement between the buyer and seller of a good, service, or asset:
the seller changes his or her behavior in such a way that the
probabilites (risk calculations) used by the buyer to determine the
terms of the purchase agreement are no longer accurate;
the buyer is only imperfectly able to monitor (observe) this change in
the seller's behavior.
For example, a moral hazard problem arises if, after a lender purchases a loan
contract from a borrower, the borrower increases the risks originally associated
with the loan contract by investing his borrowed funds in more risky projects
than he originally reported to the lender.
The Concept of Present Value
Suppose someone promises to pay you $100 in some future period T. This
amount 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 in
period T; and a present value (sometimes referred to as a present discounted
value), roughly defined to be the minimum number of dollars that you would
have to give up today in return for receiving $100 in period T.
Stated somewhat differently, the present value of the future $100 payment is
the value of this future $100 payment measured in terms of current (or present)
dollars.
The concept of present value permits financial assets with different associated
payment streams to be compared with each other by calculating the value of
these payment streams in terms of a single common unit: namely, current
dollars.
A specific procedure for the calculation of present value for future payments
will 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 the
present, the present value of the future dollar amount V(1) = (1+i)*$1 is equal
to $1. That is, the amount you would have to save today in order to receive
back V(1)=(1+i)*$1 in one year's time is $1.
Notice that this calculation of $1 as the present value of V(1)=(1+i)*$1 satisfies
the 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 be
received 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 been
discounted back to the present using the annual interest rate i, so that the value
of 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 of
your savings in one year's time? In two year's time?In n year's time?
If you save $1 at a fixed annual interest rate i, the nominal value of your
savings in one year's time will be V(1)=(1+i)*$1. If you then put aside V(1) as
savings for an additional year rather than spend it, the nominal value of your
savings 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 n
Value of $1 (1+i)*$1 (1+i) *$1 (1+i) * $1
Savings:
Now consider the present value of V(n) = (1+i)n
*$1 for any year n. By
construction, V(n) is the nominal value obtained after n years when a single
dollar 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 the
value of n.
Notice, however, that the present value of V(n) -- namely, $1 -- can be obtained
from 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) to
be received n years from today, the present value of V(n) can be calculated by
using formula (5).
Present Value of Any Arbitrary Payment Stream:
Now suppose you will be receiving a sequence of three payments over the next
three years. The nominal value of the first payment is $100, to be received at
the end of the first year; the nominal value of the second payment is $150, to be
received at the end of the second year; and the nominal value of the third
payment 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 payment
stream ($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 the
following two steps:
Step 1: Use formula (5) to separately calculate the present value of
each of the individual payments in the payment stream, taking care to

note how many years into the future each payment is going to be
received.
Step 2: Sum the separate present value calculations obtained in Step 1
to 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 be
received 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 payment
to be received at the end of the third year is
$200
----------
(7) 3
(1+i)
Consequently, adding together these three separate present value calculations in
accordance 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)3
More generally, given any fixed annual interest rate i, and given any payment
stream (V1,V2,V3,...,VN) consisting of individual payments to be received
over the next N years, the present value of this payment stream can be found by
following the two steps outlined above.
In particular, then, given any fixed annual interest rate, and given any payment
stream paid out on a yearly basis to the owner of some financial asset, the
present (current dollar) value of this payment stream can be found by following
Steps 1 and 2 outlined above. Consequently, regardless how different the

payment streams associated with different financial assets might be, one can
calculate the present values for these payment streams in current dollar terms
and hence have a way to compare them.
Measuring Interest Rates by Yield to Maturity
By definition, the current annual yield to maturity for a financial asset is the
particular fixed annual interest rate i which, when used to calculate the present
value of the financial asset's future stream of payments to the financial asset's
owner, yields a present value equal to the current market value of the financial
asset.
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 Purchase
Receives: Price Pb
| MATURITY
START |_______________________ /// _____ DATE
| | |
| | |
Coupon Coupon ... Coupon
Buyer Payment C Payment C Payment C
Receives: + Face Value F
Consider a coupon bond whose purchase price is Pb=$94, whose face value is
F = $100, whose annual coupon payment is C = $10, and whose maturity is 10
years.
The payment stream to the buyer (new owner) generated by this coupon bond is
given 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 the
payment stream (9) is given by the sum of the separate present value
calculations for each of the annual payments in this payment stream as
determined 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. It
then follows by definition that the yield to maturity for this coupon bond is
found 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, but
tables have been published that permit one to read off the yield to maturity i for
a coupon bond once the purchase price, the face value, the coupon rate, and the
maturity 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 of
(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

Given any asset A held over any given time period T, the return to A over the
holding 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 the
period,
PLUS the capital gain (+) or loss (-) in the market value of A over period
T, measured as the market value of A at the end of period T minus the
market 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 the
return on A over period T divided by the market value of A at the beginning of
period T.
More precisely, suppose that an asset A is held over a time period that starts at
some time t and ends at time t+1. Let the market value of A at time t be denoted
by P(t) and the market value of A at time t+1 be denoted by P(t+1). Finally, let
V(t,t+1) denote the sum of all payments accruing to the holder of asset A from t
to 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 the
following 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 -) as
percentagepercentage of P(t)
of P(t)
Formula (13) holds for any asset A, whether physical or financial. The question
then arises: For financial assets, what is the connection between the return rate
defined by formula (13) and the interest rate on the financial asset defined by
the yield to maturity?

The return rate on a financial asset is not necessarily equal to the yield to
maturity on the financial asset. Starting at any current time t, the return rate is
calculated for some specified holding period from t to t', whether or not this
holding period coincides with the maturity of the financial asset. Moreover, the
return rate takes into account any capital gains or losses that occur during this
holding period, in addition to any payments received from the financial asset
during this holding period. In contrast, starting at any current time t, the yield to
maturity takes into account the payment stream generated by the financial
asset over its entire remaining maturity, plus the overall anticipated capital gain
or loss that will be incurred when the financial asset is held to maturity.
Real vs. Nominal Interest Rates
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 in
prices. What actually concerns a "rational" saver considering the purchase of a
financial asset is not the nominal payment stream he or she expects to earn in
future periods but rather the command over purchasing power that this nominal
payment stream is expected to entail. This purchasing power depends on the
behavior 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 real
interest 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 store
value 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, either
directly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claims
to future income streams that originate ultimately from real assets). Securities are
financial assets exchanged in auction and over-the-counter markets (see below)
whose distribution is subject to legal requirements and restrictions (e.g., information
disclosure requirements).
Lenders are people who have available funds in excess of their desired expenditures
that they are attempting to loan out, and borrowers are people who have a shortage of
funds relative to their desired expenditures who are seeking to obtain loans.

Borrowers attempt to obtain funds from lenders by selling to lenders newly issued
claims against the borrowers' real assets, i.e., by selling the lenders newly issued
financial assets.
A financial market is a market in which financial assets are traded. In addition to
enabling exchange of previously issued financial assets, financial markets facilitate
borrowing and lending by facilitating the sale by newly issued financial assets.
Examples of financial markets include the New York Stock Exchange (resale of
previously issued stock shares), the U.S. government bond market (resale of
previously 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 is
through financial asset transactions. Examples of such financial institutions include
discount 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 or
consumption purposes.
Price Determination: Financial markets provide vehicles by which prices are set
both for newly issued financial assets and for the existing stock of financial
assets.
Information Aggregation and Coordination: Financial markets act as collectors
and aggregators of information about financial asset values and the flow of
funds from lenders to borrowers.
Risk Sharing: Financial markets allow a transfer of risk from those who
undertake investments to those who provide funds for those investments.
Liquidity: Financial markets provide the holders of financial assets with a
chance 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 consider
both the various types of financial institutions that participate in such markets and the
various ways in which these markets are structured.

Who are the Major Players in Financial Markets?
By definition, financial institutions are institutions that participate in financial
markets, i.e., in the creation and/or exchange of financial assets. At present in the
United States, financial institutions can be roughly classified into the following four
categories: "brokers;" "dealers;" "investment bankers;" and "financial intermediaries."
Brokers:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by
locating a seller (or buyer) to complete the desired transaction. A broker does not take
a position in the assets he or she trades -- that is, the broker does not maintain
inventories in these assets. The profits of brokers are determined by the commissions
they 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:
------------>| |------------->
Stock | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares ----------------- Shares
Dealers:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do
not 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 permit
the dealer to sell out of inventory rather than always having to locate sellers to match
every offer to buy. Also, unlike brokers, dealers do not receive sales commissions.
Rather, dealers make profits by buying assets at relatively low prices and reselling
them at relatively high prices (buy low - sell high). The price at which a dealer offers
to sell an asset (the "asked price") minus the price at which a dealer offers to buy an
asset (the "bid price") is called the bid-ask spread and represents the dealer's profit
margin 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:

------------>| |------------->
Bond | Dealer | Bond
Buyer | | 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 these
securities should offer;
Underwriting: Guaranteeing corporations a price on the securities they offer,
either individually or by having several different investment banks form a
syndicate 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, Merrill
Lynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs.
Financial Intermediaries:
Unlike brokers, dealers, and investment banks, financial intermediaries are financial
institutions that engage in financial asset transformation. That is, financial
intermediaries purchase one kind of financial asset from borrowers -- generally some
kind of long-term loan contract whose terms are adapted to the specific circumstances
of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to
savers, generally some kind of relatively liquid claim against the financial
intermediary (e.g., a deposit account). In addition, unlike brokers and dealers,
financial intermediaries typically hold financial assets as part of an investment
portfolio rather than as an inventory for resale. In addition to making profits on their
investment portfolios, financial intermediaries make profits by charging relatively
high 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); Contractual
Savings Institutions (life insurance companies, fire and casualty insurance companies,

pension funds, government retirement funds); and Investment Intermediaries (finance
companies, stock and bond mutual funds, money market mutual funds).
Diagrammatic Example of a Financial Intermediary: A Commercial Bank
Lending by B Borrowing by B
deposited
------- funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- loan ------- deposit -------
contracts accounts
Loan contracts Deposit accounts
issued by F to B issued by B to H
are liabilities of F are liabilities of B
and assets of B and assets of H
NOTE: F=Firms, B=Commercial Bank, and H=Households
Important Caution: These four types of financial institutions are simplified
idealized classifications, and many actual financial institutions in the fast-
changing financial landscape today engage in activities that overlap two or
more of these classifications, or even to some extent fall outside these
classifications. A prime example is Merrill Lynch, which simultaneously acts as
a broker, a dealer (taking positions in certain stocks and bonds it sells), a
financial intermediary (e.g., through its provision of mutual funds and CMA
checkable deposit accounts), and an investment banker.
What Types of Financial Market Structures Exist?
The costs of collecting and aggregating information determine, to a large
extent, the types of financial market structures that emerge. These structures
take 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, which
combine auction and OTC market features. Specifically, organized
exchanges permit buyers and sellers to trade with each other in a
centralized location, like an auction. However, securities are traded on
the floor of the exchange with the help of specialist traders who

combine broker and dealer functions. The specialists broker trades but
also stand ready to buy and sell stocks from personal inventories if buy
and sell orders do not match up.
Intermediation financial markets conducted through financial
intermediaries;
Financial markets taking the first three forms are generally referred to
as securities markets. Some financial markets combine features from more
than one of these categories, so the categories constitute only rough
guidelines.
Auction Markets:
An auction market is some form of centralized facility (or clearing house) by
which buyers and sellers, through their commissioned agents (brokers), execute
trades in an open and competitive bidding process. The "centralized facility" is
not necessarily a place where buyers and sellers physically meet. Rather, it is
any institution that provides buyers and sellers with a centralized access to the
bidding 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 readily
accessible to all would-be buyers and sellers, e.g., through a computer network.
No private exchanges between individual buyers and sellers are made outside
of the centralized facility.
An auction market is typically a public market in the sense that it open to all
agents 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 -- for
which bid and asked prices can be posted at any time the market is open and
exchanges take place on a continual basis. Experimental economists have
devoted a tremendous amount of attention in recent years to auction markets.
Many auction markets trade in relatively homogeneous assets (e.g., Treasury
bills, notes, and bonds) to cut down on information costs. Alternatively, some
auction markets (e.g., in second-hand jewelry, furniture, paintings etc.) allow
would-be buyers to inspect the goods to be sold prior to the opening of the
actual bidding process. This inspection can take the form of a warehouse tour, a
catalog issued with pictures and descriptions of items to be sold, or (in televised
auctions) a time during which assets are simply displayed one by one to
viewers 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 sunk
costs independent of the volume of trading in that asset. Consequently, auction
markets depend on volume to spread these costs over a wide number of
participants.
Over-the-Counter Markets:
An over-the-counter market has no centralized mechanism or facility for
trading. Instead, the market is a public market consisting of a number of dealers
spread across a region, a country, or indeed the world, whomake the market in
some type of asset. That is, the dealers themselves post bid and asked prices for
this asset and then stand ready to buy or sell units of this asset with anyone who
chooses to trade at these posted prices. The dealers provide customers more
flexibility in trading than brokers, because dealers can offset imbalances in the
demand and supply of assets by trading out of their own accounts. Many well-
known common stocks are traded over-the-counter in the United States
through NASDAQ (National Association of Securies Dealers' Automated
Quotation System).
Intermediation Financial Markets:
An intermediation financial market is a financial market in which financial
intermediaries help transfer funds from savers to borrowers by issuing certain
types of financial assets to savers and receiving other types of financial assets
from borrowers. The financial assets issued to savers are claims against the
financial intermediaries, hence liabilities of the financial intermediaries,
whereas the financial assets received from borrowers are claims against the
borrowers, hence assets of the financial intermediaries. (See the diagrammatic
illustration of a financial intermediary presented earlier in these notes.)
Additional Distinctions Among Securities Markets
Primary versus Secondary Markets:
Primary markets are securities markets in which newly issued securities are
offered for sale to buyers. Secondary markets are securities markets in
which existing securities that have previously been issued are resold. The
initial issuer raises funds only through the primary market.

Debt Versus Equity Markets:
Debt instruments are particular types of securities that require the issuer (the
borrower) to pay the holder (the lender) certain fixed dollar amounts at
regularly scheduled intervals until a specified time (the maturity date) is
reached, regardless of the success or failure of any investment projects for
which the borrowed funds are used. A debt instrument holder only
participates in the management of the debt instrument issuer if the issuer
goes 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 ownership
interest in the issuer.
There are two general categories of equities: "preferred stock" and "common
stock."
Common stock shares issued by a corporation are claims to a share of the
assets of a corporation as well as to a share of the corporation's net income --
i.e., the corporation's income after subtraction of taxes and other expenses,
including the payment of any debt obligations. This implies that the return
that holders of common stock receive depends on the economic performance
of the issuing corporation.
Holders of a corporation's common stock typically participate in any upside
performance of the corporation in two ways: by receiving a share of net
income in the form of dividends; and by enjoying an appreciation in the price
of their stock shares. However, the payment of dividends is not a contractual
or legal requirement. Even if net earnings are positive, a corporation is not
obliged to distribute dividends to shareholders. For example, a corporation
might instead choose to keep its profits as retained earnings to be used for
new capital investment (self-financing of investment rather than debt or
equity financing).
On the other hand, corporations cannot charge losses to their common stock
shareholders. Consequently, these shareholders at most risk losing the
purchase price of their shares, a situation which arises if the market price of

their shares declines to zero for any reason. An example of a common stock
share 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 corporation's cash flow that is prior to the
claims of its common stock holders but is generally subordinate to the claims
of its debt holders. In addition, like debt holders but unlike common stock
holders, preferred stock holders generally do not participate in the
management of issuers through voting or other means unless the issuer is in
extreme financial distress (e.g., insolvency). Consequently, preferred stock
combines some of the basic attributes of both debt and common stock and is
often referred to as a hybrid security.
Money versus Capital Markets:
The money market is the market for shorter-term securities, generally those
with 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 large
time deposits at depository institutions -- can run anywhere from 30 days to
over 5 years, most CDs have a maturity of less than one year. Those with a
maturity of more than one year are referred to as term CDs. A CD that can be
resold without penalty in a secondary market prior to maturity is known as
a negotiableCD.
The capital market is the market for longer-term securities, generally those
with more than one year to maturity.
Examples: Corporate stocks; residential mortgages; U.S. government securities
(marketable long-term); state and local government bonds; bank commercial
loans; consumer loans; commercial and farm mortgages.
Remark: Corporate stocks are conventionally considered to be long-term
securities 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. dollars
deposited 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 banks
outside the U.S.
An international bond is a bond available for sale outside the country of its
issuer.
Example of an International Bond: a bond issued by a U.S. firm that is available
for sale both in the U.S. and abroad.
A foreign bond is an international bond issued by a country that is
denominated in a foreign currency and that is for sale exclusively in the
country of that foreign currency.
Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated in
Japanese yen and that is for sale exclusively in Japan.
A Eurobond is an international bond denominated in a currency other than
that of the country in which it is sold. More precisely, it is issued by a
borrower in one country, denominated in the borrower's currency, and sold
outside the borrower's country.
Example of a Eurobond: Bonds sold by the U.S. government to Japan that are
denominated in U.S. dollars.
Asymmetric Information in Financial Markets
Asymmetric information in a market for goods, services, or assets refers to
differences ("asymmetries") between the information available to buyers and
the information available to sellers. For example, in markets for financial
assets, asymmetric information may arise between lenders (buyers of financial
assets) and borrowers (sellers of financial assets).

Problems arising in markets due to asymmetric information are typically
divided into two basic types: "adverse selection;" and "moral hazard." This
section explains these two types of problems, using financial markets for
concrete illustration.
1. Adverse Selection
Adverse selection is a problem that arises for a buyer of goods, services, or
assets when the buyer has difficulty assessing the quality of these items in
advance of purchase.
Consequently, adverse selection is a problem that arises because of different
("asymmetric") information between a buyer and a seller before any purchase
agreement takes place.
An Illustration of Adverse Selection in Loan Markets:
In the context of a loan market, an adverse selection problem arises if the
contractual terms that a lender sets in advance in an attempt to protect
himself against the consequences of inadvertently lending to high risk
borrowers have the perverse effect of encouraging high risk borrowers to self-
select into the lender's loan applicant pool while at the same time
encouraging low risk borrowers to self-select out of this pool. In this case, the
lender's pool of loan applicants is adversely affected in the sense that the
average quality of borrowers in the pool decreases.
2. Moral Hazard
Moral hazard is said to exist in a market if, after the signing of a purchase
agreement between the buyer and seller of a good, service, or asset:
the seller changes his or her behavior in such a way that the
probabilites (risk calculations) used by the buyer to determine the
terms of the purchase agreement are no longer accurate;
the buyer is only imperfectly able to monitor (observe) this change in
the seller's behavior.
For example, a moral hazard problem arises if, after a lender purchases a loan
contract from a borrower, the borrower increases the risks originally associated

with the loan contract by investing his borrowed funds in more risky projects
than he originally reported to the lender.
The Concept of Present Value
Suppose someone promises to pay you $100 in some future period T. This
amount 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 in
period T; and a present value (sometimes referred to as a present discounted
value), roughly defined to be the minimum number of dollars that you would
have to give up today in return for receiving $100 in period T.
Stated somewhat differently, the present value of the future $100 payment is
the value of this future $100 payment measured in terms of current (or present)
dollars.
The concept of present value permits financial assets with different associated
payment streams to be compared with each other by calculating the value of
these payment streams in terms of a single common unit: namely, current
dollars.
A specific procedure for the calculation of present value for future payments
will 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 the
present, the present value of the future dollar amount V(1) = (1+i)*$1 is equal
to $1. That is, the amount you would have to save today in order to receive
back V(1)=(1+i)*$1 in one year's time is $1.

Notice that this calculation of $1 as the present value of V(1)=(1+i)*$1 satisfies
V(1)
(2) Present Value = -------- .
of V(1) (1+i)
Indeed, given any fixed annual interest rate i, and any payment V(1) to be
received 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 been
discounted back to the present using the annual interest rate i, so that the value
of 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 of
your savings in one year's time? In two year's time?In n year's time?
If you save $1 at a fixed annual interest rate i, the nominal value of your
savings in one year's time will be V(1)=(1+i)*$1. If you then put aside V(1) as
savings for an additional year rather than spend it, the nominal value of your
savings 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 n
Value of $1 (1+i)*$1 (1+i) *$1 (1+i) * $1
Savings:
Now consider the present value of V(n) = (1+i)n
*$1 for any year n. By
construction, V(n) is the nominal value obtained after n years when a single
dollar 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 the
value of n.

Notice, however, that the present value of V(n) -- namely, $1 -- can be obtained
from 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) to
be received n years from today, the present value of V(n) can be calculated by
using formula (5).
Present Value of Any Arbitrary Payment Stream:
Now suppose you will be receiving a sequence of three payments over the next
three years. The nominal value of the first payment is $100, to be received at
the end of the first year; the nominal value of the second payment is $150, to be
received at the end of the second year; and the nominal value of the third
payment 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 payment
stream ($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 the
following two steps:
Step 1: Use formula (5) to separately calculate the present value of
each of the individual payments in the payment stream, taking care to
note how many years into the future each payment is going to be
received.
Step 2: Sum the separate present value calculations obtained in Step 1
to 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 be
received 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 payment
to be received at the end of the third year is
$200
----------
(7) 3
(1+i)
Consequently, adding together these three separate present value calculations in
accordance 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)3
More generally, given any fixed annual interest rate i, and given any payment
stream (V1,V2,V3,...,VN) consisting of individual payments to be received
over the next N years, the present value of this payment stream can be found by
following the two steps outlined above.
In particular, then, given any fixed annual interest rate, and given any payment
stream paid out on a yearly basis to the owner of some financial asset, the
present (current dollar) value of this payment stream can be found by following
Steps 1 and 2 outlined above. Consequently, regardless how different the
payment streams associated with different financial assets might be, one can
calculate the present values for these payment streams in current dollar terms
and hence have a way to compare them.
Measuring Interest Rates by Yield to Maturity
By definition, the current annual yield to maturity for a financial asset is the
particular fixed annual interest rate i which, when used to calculate the present
value of the financial asset's future stream of payments to the financial asset's
owner, yields a present value equal to the current market value of the financial
asset.

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 Purchase
Receives: Price Pb
| MATURITY
START |_______________________ /// _____ DATE
| | |
| | |
Coupon Coupon ... Coupon
Buyer Payment C Payment C Payment C
Receives: + Face Value F
Consider a coupon bond whose purchase price is Pb=$94, whose face value is
F = $100, whose annual coupon payment is C = $10, and whose maturity is 10
years.
The payment stream to the buyer (new owner) generated by this coupon bond is
given 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 the
payment stream (9) is given by the sum of the separate present value
calculations for each of the annual payments in this payment stream as
determined 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. It
then follows by definition that the yield to maturity for this coupon bond is
found 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, but
tables have been published that permit one to read off the yield to maturity i for
a coupon bond once the purchase price, the face value, the coupon rate, and the
maturity 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 of
(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
Given any asset A held over any given time period T, the return to A over the
holding 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 the
period,
PLUS the capital gain (+) or loss (-) in the market value of A over period
T, measured as the market value of A at the end of period T minus the
market 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 the
return on A over period T divided by the market value of A at the beginning of
period T.
More precisely, suppose that an asset A is held over a time period that starts at
some time t and ends at time t+1. Let the market value of A at time t be denoted

by P(t) and the market value of A at time t+1 be denoted by P(t+1). Finally, let
V(t,t+1) denote the sum of all payments accruing to the holder of asset A from t
to 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 the
following 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 -) as
percentagepercentage of P(t)
of P(t)
Formula (13) holds for any asset A, whether physical or financial. The question
then arises: For financial assets, what is the connection between the return rate
defined by formula (13) and the interest rate on the financial asset defined by
the yield to maturity?
The return rate on a financial asset is not necessarily equal to the yield to
maturity on the financial asset. Starting at any current time t, the return rate is
calculated for some specified holding period from t to t', whether or not this
holding period coincides with the maturity of the financial asset. Moreover, the
return rate takes into account any capital gains or losses that occur during this
holding period, in addition to any payments received from the financial asset
during this holding period. In contrast, starting at any current time t, the yield to
maturity takes into account the payment stream generated by the financial
asset over its entire remaining maturity, plus the overall anticipated capital gain
or loss that will be incurred when the financial asset is held to maturity.
Real vs. Nominal Interest Rates

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 in
prices. What actually concerns a "rational" saver considering the purchase of a
financial asset is not the nominal payment stream he or she expects to earn in
future periods but rather the command over purchasing power that this nominal
payment stream is expected to entail. This purchasing power depends on the
behavior 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 real
interest rate associated with i(t) is defined by the following "Fisher equation:"
The function of financial markets in the economy
A market is a place where supply for a particular good is able to meet demand for it. In the
case of financial markets, the good in question is money.
In capital markets, supply agents are those with "positive savings capacity", i.e. mainly
households (surprising as that may seem!), and businesses, although the latter generally
prefer to reinvest profits or distribute dividends to shareholders. The demand side comes
from governments, the modern welfare state having substantial cash requirements, or other
companies. Such agents are said to have "financing requirements".
Far from being an abstract entity, often described as both irrational and all-powerful, capital
markets 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 between
agents with savings capacity and agents with financing requirements. For a market to
function, it is not enough that a good and its supply and demand exist; agents also have to
want to trade it! However, agents with savings capacity, mainly households it should be
recalled, are generally deeply averse to risk. An aversion furthermore which can be justified
by common sense. Any book on the stock market for budding investors will begin with a
warning urging readers to only invest funds in the stock market that will not be needed in
the near future. Consequently, the bulk of savings generated by households are held on
deposit 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 financing
for 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 agents
with financing requirements is several years! This difference makes actual exchange in
markets more complex.

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Banks
This is where a third category of economic agents comes in, the banks. Banks are the only
agents 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 therefore
establish 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 on
its current accounts (but not all! see below) as loans. However, loans made available in this
way by banks do not cancel the deposits that were made, which continue to be available for
the customer to use. Banks therefore create money. The loans, granted in the form of
demand deposits, increase the cash resources of banks and thus their ability to distribute
new loans etc.. Deposits create loans, which themselves create deposits, etc.. This is what
is called the "credit multiplier".
Fortunately, the money creation power of banks is not infinite. It is limited firstly by the fact
that only part of the loans granted will remain in the form of deposits. The remainder will be
converted into cash (notes) through cash withdrawals. Furthermore, to ensure that banks
have the capacity to cope with withdrawals, the central bank requires them to lock-up a
percentage of their deposits in the form of reserves, not available for lending. The
compulsory reserves ratio is one of the instruments used by central banks to control the
quantity of money in circulation.
Furthermore, companies cannot finance themselves solely through loans; beyond a certain
level of debt, the financial cost has an unsustainable impact on results and banks would no
longer 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 very
long maturities, for example bonds. The total of the capital and long-term debt of a
company 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 provide
companies with equity capital, economic agents ready to lock-up large sums over long
periods, obviously with the aim of generating profit, are required: investors.
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Institutional investors
The main investors in capital markets today are "institutional investors" (often referred to
simply as "institutionals"), namely insurance companies, fund managers (asset managers),
retirement funds and their US equivalent, the pension funds. Institutionals also drain public

savings, but these savings are locked up and cannot be immediately withdrawn in the same
way as sums deposited in current accounts. In addition, the institutions in question
generally have a regulatory, contractual or legal obligation to build up savings in order to be
able to pay, for insurance companies insurance benefits, and for retirement funds
retirement benefits to policyholders.
Instead of distributing loans like banks, institutional investors buy securities issued by
companies requiring financing. These securities represent either equity capital: shares, or
long-term borrowing: bonds. Purchases are made on the primary market, i.e. at the time
the 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 institutional
investors' needs to invest savings in their care, it is clear that there has to be a way for
supply and demand to meet. However for this to happen, the market has to be organised
appropriately to facilitate the process; a number of different players contribute to this. In
this regard, banks once again play an important role. As account-keepers and liquidity
providers, they assume a key intermediation role.
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The issuance of securities
Issuers wishing to raise capital from the market turn to a bank or group of banks (a "bank
syndicate") which acts as an agent for the issue. The agent arranges all the economic
characteristics of the issue. The agent "underwrites" the issue, in other words undertakes to
buy all the securities issued and has a responsibility to find final investors willing to buy the
securities 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 ensuring
smooth operations throughout the life of the security: payment of coupons for bond issues
or dividends for shares, repayments, capital increases etc.
Lastly, rating agencies are independent organisations which assess the quality of issuers
and assign a rating designed to determine their reliability as debtors.
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Custodians
The agent of the issuer manages the relationship with the central custodian, a key player in
securities markets. For each issue it manages, the central custodian keeps up-to-date
records in its accounts of the total amount of securities that have been issued and the

amount held by each institution that has a registered account with it (the total amount held
by all institutions clearly has to match the total amount of the issue!). In France the central
custodian for almost every issue is Euroclear France, formerly SICOVAM.
Each member of Euroclear France is a local custodian. Any investor that does not have a
registered account with Euroclear France must open an account with a local custodian in
order to be able to hold securities. However, while investors increasingly tend to
internationalise their investments, the central custodian practically only manages securities
issued in its own country. As a result, the function of "global custodian" has developed. A
global custodian is appointed by investors to act as account keeper for all transactions
involving the purchase and sale of securities in markets worlwide. To this end, the global
custodian works hand-in-hand with local custodians in every market in the world, each one
responsible 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 keep
securities accounts on behalf of investors but also cash accounts. Such institutions are
therefore usually banks.
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Market transactions
Investors typically buy securities through a broker. The broker provides a number of
services to investors. Financial analysts study markets and issuers and make
recommendations. Salesmen pass on the recommendations of analysts to investors and
collect their orders. Lastly, traders buy or sell securities in the market.
Trading between brokers is carried out either directly through an "OTC" market or organised
market, 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 "after
trade" aspects. For a transaction to be registered correctly, securities provided by the seller
have to be exchanged for cash provided by the buyer. This process is referred to as
settlement and delivery.
The custodian is also responsible for maintaining the accounts of investor customers to take
account of the many transactions that can have an impact on investment portfolios: coupon
or dividend payments, repayments, but also exercise of subscription rights, takeover bids,
exchange offers etc.
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Trading floors

Market transactions by institutional investors are not limited to the purchase and sale of
securities. Given the sums involved and the large number of markets in which investors
trade, additional needs arise. An investor may need to obtain foreign currency, hence the
necessity 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 the
need for derivative products.
Non-financial companies ("corporates") face similar types of need: importers may require
foreign currency and processing companies may have to protect themselves against
fluctuations in raw material prices. All have special cash management needs and may have
to hedge against movements in prices or interest rates.
Banks are able to respond to these needs; at the branch level for small and medium-sized
companies or directly via the trading room for the largest customers. Total cumulative
positions 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 the
bank’s customers!
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Speculation and arbitrage
Financial institutions and funds dedicated to this type of activity use some of their resources
for speculation. This aspect of trading activity, whether or not it be as extensive as many
claim, nevertheless remains necessary. Speculation involves taking a position that is
contrary to current market trends: it means becoming a seller when you think that prices
will fall (and are therefore at their highest!), or becoming a buyer when you think they will
rise. By adopting a stance, speculators provide liquidity to the market: they are the sellers
for investors who want to buy and the buyers for those who want to sell. It is a risky
activity, as, unlike investors or corporates, speculators bet on the future.
Arbitragists also play a harmonising role: they take advantage of price differences between
different markets to generate gains. For example, in currency markets they buy dollars in a
market where it is cheap and sell in a market where it is most demanded, and therefore
more 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.
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Conclusion

Economic literature, after drawing a sharp distinction between the financing of companies
through bank lending (debt financing) and financing through the issuance of securities
(market-based economy), now attributes a complementary role to both. Studies suggest
that for an economy to grow, there is a need for both an active organised financial market
and a reliable banking system.
The purpose of this website is not to discuss the whys and wherefores of financial markets
or 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.

Role of Financial mark

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