Financial Markets
Facilitate transactions between
borrowers and lenders
Lenders -- earn return on
funds
Borrowers -- permits increased
flexibility for expenditure
Motivations for Borrowing
Consumers -- allows for nonsynchronous patterns of desired
consumption and income
Business -- financing short-term needs
(e.g. inventories) and long-term
investment projects
Government (Federal as well as State
and Local)-- financing existing debt
and new deficits
Types of “Borrowing”
Debt -- A contract to pay specified
amounts over a predetermined
time interval (e.g. bonds, bank
loans)
Equity -- Purchases of shares of
ownership (e.g. stock)
Direct Vs Indirect Finance
Direct Finance -- Borrower borrows
directly from lender.
Examples -- Personal transactions, Bonds
Indirect Finance -- Lender loans to
Financial Intermediary, who then loans
to borrowers.
Examples -- Mutual Funds, Banks
Exchanges Versus “Over
the Counter” Markets
Exchange -- Buyers and sellers
meet in one central location
Over the Counter -- Trades made
from home or office, via
computers.
Primary Versus
Secondary Markets
Primary Markets -- Markets for
new issues.
Secondary Markets -- Markets for
issues sold before maturity
Money Vs Capital Markets
Money Market -- Market for bonds
with maturity one year or less
high denominations
excellent secondary markets
Capital Market -- Market for longterm bonds and equity
lower denominations
lower volume -- relatively narrow
secondary markets
Interest: Compensation to
Lender for Inconvenience
Inconvenience  Interest Rate
Sources of Inconvenience
Liquidity -- ability to convert
instrument into a medium of
exchange
Default (Credit) Risk -- likelihood
that borrower will not meet promised
payments
Applications to
Money Supply Components
Passbook Savings Deposits versus
Small Time Deposits
Relative liquidity
Money Market Deposit Accounts (MMDA)
versus Money Market Mutual Funds (MMMF)
MMDA -- deposit insurance
MMMF -- none, more default risk
Money Market Instruments
Group #1 -Short-Term Bonds
Buyers (Lenders): Looking for
interest (or, more broadly, return),
willing to tolerate various degrees
of inconvenience.
Sellers (Borrowers): Issued by
different entities for different
reasons.
(1) Treasury Bills
Issued by the Federal Government, to
finance national debt and new deficits
3 month, 6 month, and 1 year
maturities
Generally viewed as having zero
default risk
Best secondary market within group
Commonly Used by the Federal
Reserve to perform Open Market
Operations
Generally lowest interest rate of
group
(2) Negotiable
Certificates of Deposit (CDs)
Denominations: $100,000 and above (Large
Time Deposits)
Issued by banks to raise money for loans.
Represents cost of funds for banks -changes in iCD induce changes in bank loan
rates.
Low Default Risk -- deposit insurance
Good secondary market
(3) Commercial Paper (CP)
Issued by firms to finance shortterm debt (e.g. inventories)
Flexible maturities.
Rated according to default risk of
issuing company.
Good secondary market.
(4) Bankers Acceptances
Issued by banks to carry out
international transactions.
Characteristics similar to
Negotiable CDs.
Overall -- Group #1
Close -- but not perfect -substitutes
Interest rates --different due to
“non-price differences”
Liquidity (secondary market)
Default Risk
Group #2 -- Banks Seeking
Very Short-Term Funds
Eurodollars -- dollar denominated
deposits in foreign banks (banks
can borrow from these),
Repurchase Agreements (RP) -banks selling one of their bonds to
a deposit holding customer, with
the promise to buy it back at a
specific date and price.
Another Option
Federal Funds (FF) -- one bank
borrowing from another bank, usually
overnight.
Key rate in monetary policy, Federal
Reserve “targets” iFF
Cost of obtaining bank reserves “in
the market”
Major increase in volume over the
years
Still Another Option
Discount Window -- banks borrowing
from the Federal Reserve, paying the
discount rate.
only non-market determined rate,
preset by Federal Reserve
small usage as borrowing source for
short-term reserve adjustment, due
to expensiveness and attraction of
alternatives
Typically, iDISC = 0.5% + Target iFF
Capital Market Instruments
Stocks -- equity, returns compete
with bonds
Group #1 -Long-Term Bonds
(1) Treasury Bonds
Issued by the Federal Government to finance
debt
Generally viewed as having zero default risk
Best secondary market of bonds within
group
Financial analysts track rates of various
maturities on a given date, a plot of which is
called the “yield curve”
(2) US Government
Agency Securities
Issued by the US government
agencies to finance their
operations (e.g. EPA)
Characteristics very similar to
Treasury Bonds
(3) Corporate Bonds
Issued by corporations to finance
investment projects
Rated according to default risk
AAA -- least risky
AA -- next grade
A -- next grade
BAA -- more risky
Junk Bonds -- bonds rated below B
Corporate Bonds, continued
Narrow secondary market
Typical maturity -- 20 years
Difference between BAA rate and
AAA rate called risk premium,
 economic interpretation: difference
in compensation required to take on
increased default risk
tends to increase during economic
slowdowns and recessions
(4) Municipal Bonds
Issued by State and Local Governments to
finance projects in capital budget.
Positive default risk
Narrow secondary market
Tends to have lowest interest rate within this
group
Interest is exempt from taxes (Federal taxes
and within the state where they’re issued)
The After-Tax Interest Rate
After-tax rate = (i)(1 - ), where  is the
marginal tax rate.
For Municipal Bonds, after-tax rate =
pre-tax rate (since  = 0)
Example: iCORP = 8.00%,  = 0.28,
After-tax rate = 8.00(1 - 0.28) = 5.76%
Compare with Municipal Bond rate.
Group #2 -- Bank Loans
“Issued” by various borrowers, “held”
by banks.
Secured versus unsecured loans
Secured Loans -- Has collateral (e.g.
consumer and commercial
mortgages)
Unsecured Loans -- No collateral
(e.g. credit cards)
(1) Mortgages
Loans to individuals or business to
purchases housing, land, or building
structure
Some default risk (e.g. sub-prime
mortgages with falling house prices),
but risky in other ways as well
Availability highly valued in American
culture (tax system)
Secondary Markets -Consumer Mortgages
Government National Mortgage
Association (GNMA)
Federal National Mortgage Association
(FNMA)
Federal Home Loan Mortgage
Corporation (FHLMC)
Securitized Mortgages – bundling
mortgages into a bond, then selling in
the capital market
(2) Other Types
of Bank Loans
Commercial Loans: Prime Rate -interest rate given to firms with the
lowest perceived default risk
Consumer Loans (e.g. auto loans)
Credit Card Balances -- unsecured 
high default risk
Tend to be shorter-term relative to
consumer mortgages.
(3) US Savings Bonds
Issued by Federal Government to finance
debt.
Low denominations, available to the small
saver.
Generally viewed as having zero default risk.
Interest assigned each year, tax-deferred
until savings bond is redeemed.
Tax advantages, particularly for use in
funding college education
What Makes
Interest Rates Different?
Secondary Market
Maturity
Default Risk
Taxability
Above characteristics constitute structural
differences that bring about various degrees
of inconvenience.