Financial Markets and
Interest Rates
Financial Management
Outline
Meaning of Financial Markets
Significance of Financial Markets
Types of Financial Markets
Money versus Capital Markets
Spot versus Futures Market
Primary versus Secondary Markets
Interest Rate Determination
Meaning of Financial Markets
A place where borrowers and lenders
are brought in contact
A place where people and organizations
in need of money are brought in
contact with those that have excess
funds and are willing to lend
Significance of Financial
Markets
Help in collecting the savings of the
economy and
Make them available for investment
Helps in capital formation
Helps in resource allocation in the
economy
Helps in growth of the economy by
transferring funds from the household
sector to investment sector
Funds are transferred in three ways:
Direct transfer
Indirect transfer through investment banks
Indirect transfer through financial
intermediaries
Types of Financial Markets
Money Markets versus Capital Markets
Money market is for short-term funds up to one
year
• Treasury bills
• Commercial paper
• Banker’s acceptances
Capital market is for long-term funds beyond one
year
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•
•
•
Corporate Bonds
Treasury Bonds
Treasury Notes
Stocks
Spot versus Futures Market
Spot market deals with cash transactions
or transactions that will be settled within
two business days
Futures market deals with transactions that
will be settled beyond two business days
Primary versus Secondary
Markets
Primary Markets
A market for issuing of new securities
A market where securities are being issued for the
first time by new or existing companies
Contributes directly towards capital formation
Secondary Market
A market that deals with buying and selling of
existing securities
Contributed to capital formation indirectly
Secondary Markets
Auction Markets: Stock Exchanges
Have a physical location
Have governing bodies
Trading takes place on the trading floor
known as trading pits
Only members are allowed to enter trading
floor
Deal in listed securities only
Negotiated Markets: Over-the-Counter
Market (OTC)
A network of dealers and brokers
connected through
• Telephones
• Computers networks all over the world
Deals in unlisted securities
Interest Rates
Represent cost of money
Helps in allocation of capital
Nominal interest rate is composed of
real risk free rate of interest plus
inflation premium and liquidity risk
premium
K = K* + IRP + DRP + MP + LP
K = nominal interest rate
K* = real risk free interest rate
IRP = inflation risk premium
DRP = default risk premium
MP = maturity premium
LP = liquidity premium
Factors Impacting Level of Interest
Rates
Federal Reserve Policy
Federal Deficits
Business Activity
Interest rates and stock markets
Shapes of Yield Curve:
Upward sloping
inverse/downward sloping
flat shaped
hump shaped