Financial Markets,
Instruments, and
Market Makers
Chapter 3
© 2003 South-Western/Thomson Learning
Learning Objectives

Classifying financial markets
 Primary & secondary
 Money and capital
 Spot and futures



Slide 2
Definitions & characteristics of financial
market instruments
Functions of market makers
Connection of various sectors of financial
markets
Introducing Financial Markets
A market for financial claims
(instruments) can be viewed
as the process or mechanism
that connects the buyers and
sellers of claims regardless of
where they happen to be
physically located.
Slide 3
Financial markets distinguished based
on type of security.
 Stock Market
 Bond Market
 Money Market
 Treasury Bill Market
 Commercial Paper Market
Slide 4
Introducing Financial Markets
Financial markets distinguished based on
term to maturity.
 Money market includes
 Markets where securities with original
maturities of one year or less are traded
Example: Treasury Bills, commercial
paper and CDs.

Slide 5
Capital market includes
 Markets where securities with original
maturities of more than one year are traded
 Example : Treasury Bonds, stocks,
mortgages, corporate bonds.
Introducing Financial Markets
Financial markets separated based on
the order of issue.
1. Primary market
2. Secondary market
Slide 6

Primary market :
 Security is initially sold for the first time.
 The primary market is where the public
(individuals or financial institutions) buy
newly issued bonds or stocks from the firms
issuing them.

Secondary market
 After the initial sale is completed. The
securities are then traded between investors
in the secondary market.
 Secondary market is essential for the
functioning of the securities market. It helps
in purchase and sale of securities
conveniently at a low cost.
Slide 7
Secondary Market
contd..




Slide 8
In the absence of secondary market, investors
will individually have to find their buyers or
sellers who would be willing to accept or pay the
acceptable price. This will not only take time and
cause inconvenience but also increase the cost
of investing.
Firms will not be able to raise as much money,
and therefore inhibit their growth and restrict
capital expenditure.
Restricting growth in industries restricts the
growth of the entire economy.
In short, smooth functioning and the quality of
the secondary market is crucial for the economy.
Exhibit 3–7
The Marketing and
Subsequent Trading of
a Corporate Bond
Slide 9
Conceptual distinction:
Selling of new securities in primary
market and trading of older
securities in secondary market
occur simultaneously.
Slide 10
Financial Markets
Financial markets separated based on time of
delivery :
 Spot Market :
 In spot markets, financial instruments trade
instantaneously, and the spot price is the price of
the financial instrument for immediate delivery.

Financial Futures and Forward Market :
 In the forward and futures market, commitment on price
and quality is made today for future delivery of the
financial instrument or commodity.
Slide 11
 In the futures market, quantities are standardized.
Example: Currency, Commodities like oil, corn, etc.
 In the forward market, transactions are
customized. Hence the quantities are not
standardized. Example : Currency
Futures and Forward Market
These fulfill two basic functions:
 Reduce risk associated with future price
changes
 Facilitates speculation - the buying or selling
of securities in hopes of profiting from future
price changes
Slide 12
Money Market
Short-term credit market:
where debt securities
having original maturities
of 1 year or less are
traded
Slide 13
Money Market Characteristics

Issued in large denominations
 Usually $1 million or more

Money market instruments have short
maturities
 Ranging from 1 day to 1 year

Money market instruments characterized
by:
 Low liquidity risk (active resale market for most
money market securities)
 Low default risk…because issuer of the security
is almost default free (U.S. Govt, Banks and
Large firms)
Does not occupy one particular geographic
location (exchange market like for stocks,
Slide 14
bonds etc) or trading floor

Money Market Benefits

More efficient source of credit for
largest:
 Financial institutions
 Non-Financial corporations
 Governmental bodies

Slide 15
Mismatch of cash receipts and
payments…they come in different
times, hence require to be saved or
borrowed for short term.
Money Market Participants







Slide 16
Commercial banks and savings
associations. Some of these banks are
also primary dealers for U.S. securities.
Government Sponsored Enterprises
The Federal Reserve
Corporations and finance companies
Pension funds and insurance companies
Brokers and dealers…primarily help in
marketing these securities and stand
ready to purchase these securities.
Money Market Mutual Funds and
individuals
FEDERAL GOVERNMENT DEBT
For most part, U.S. federal Government has had
budget deficits (except 1998 to 2001). That is
expenses far exceeds revenues. These deficits are
financed through debt.
As of the end of 2002, the federal government debt
stands at $6.2 trillion of which $2.6 trillion is held by
Federal Government (primarily Social Security Trust
Fund) and $3.6 trillion is held by outside of federal
government including foreign investors. About one
third of outside loan is owned by foreign investors.
Of the $3.6 trillion outside debt, the Federal Reserve
System holds $604 billion.
Slide 17
What is the difference between the debt and the deficit?
The deficit is the fiscal year difference between what
the Government takes in from taxes and other revenues,
called receipts, and the amount of money the
Government spends, called outlays. The items included
in the deficit are considered either on-budget or offbudget. (The off-budget items are typically comprised
of the two Social Security trust funds, old-age and
survivors insurance and disability insurance, and the
Postal-Service fund.) Generally, on-budget outlays tend
to exceed on-budget receipts, while off-budget receipts
tend to exceed off-budget outlays.
Slide 18
Slide 19
You can think of the total debt as accumulated
deficits plus accumulated off-budget
surpluses. The on-budget deficits require the
Treasury to borrow money to raise cash
needed to keep the Government operating. We
borrow the money by selling Treasury
securities like T-bills, notes, bonds and savings
bonds to the public. Additionally, the
Government Trust Funds are required by law
to invest accumulated surpluses in Treasury
securities. The Treasury securities issued to
the public and to the Government Trust Funds
(Intragovernmental Holdings) then become
part of the total debt.
Money Market Instruments
U.S. Treasury’s primary function is to
role over the debt and to manage the
ongoing mismatch in the timings of
tax inflows and government
expenditures.
To manage these tasks, the Treasury
issues variety of securities in various
denomination and various terms to
maturity, long and short term.
Slide 20
U.S.
TREASURY BILLS
Sold to a variety of different types of buyers with:
Low minimum denominations (In the past the par
value was $10,000, but now it is $1000)
Sold on a discount basis
Most liquid and free of default risk.
Original issues are sold at regularly scheduled
auctions
T Bills have maturities of 4 weeks (28 days), 13 weeks
( 91 days) or 26 weeks (182 days). In Feb 2001, the 52
week T bills were discontinued.
Slide 21
The biggest participants in the T Bill market are
commercial banks, money market, mutual funds,
Federal Reserve and individuals (not as much
nondepository or nonfinancial corporation).
 Existing T-bills can be sold in the secondary market
through government securities dealers, who profit by
buying at a slightly lower price and selling at an higher
price.
 For list of Treasury Primary Dealers, see Exhibit 10-2
presented in chapter 10.
 “Primary Dealers” are large banks and securities brokers
and dealers that trade Treasury securities directly with the
New York Fed and are the main participants in the
Treasury auctions.
 To become a primary dealer, the firm must apply to the
New York Fed and must demonstrate that it meets certain
criteria. Brokers and dealers must have at least $50
million in regulatory capital. Foreign owned firms that
meet the criteria can also apply to become a primary
dealer.
Slide 22
T
Bills are sold each week and the volumes of sale are
announced each Tuesday by the Treasury.
Bids
must be submitted to the Federal Reserve by Monday at
1:00 p.m. Eastern time. Results are typically announced on
Tuesdays at 1:30 p.m. and the securities are issued 3 days
later on Thursday.
Example
: Bid quote : 3.90% ; Ask quote: 3.89% for 90 day bill.
Bid price (Price at which dealer buys) =
100 – [(100*.039)/4] = 99.025 = $9902.50
Ask price (Price at which dealer sells) =
100 – [(100*.0389)/4] = 99.0275 = $9902.75
Profit of $0.25 per ‘T’ bill and the annualized yield will
be 3.986%
(PV = -9902.75, FV = 10,000, n=0.25, CPT i = 3.986)
Slide 23
Treasury Bidding process

Slide 24
Bids are of two types : competitive and
noncompetitive bids.
 Competitive bids specify both the quantity
desired and the discount rate (not the price)
offered. Lower discount means higher price.
 After accounting for non-competitive bids, the
Treasury accepts the highest competitive bids
first and works it way down until it has
generated the amount of funds from
competitive bids that it needs (this method is
known as Uniform-price Method).
 The Treasury then applies the lowest accepted
bid (also called as stop-out yield) to all
competitive bids that are accepted and to all
noncompetitive bids. Competitive bids are still
submitted, because noncompetitive bids can
be up to a maximum of $1 million.
 Noncompetitive bids include only the number of bills
desired. They are guaranteed to receive the amount of T
bills requested at the market determined price and
discount yield.
 Noncompetitive bids are limited to $1 Mn maximum
per bidder, therefore only small firms and individuals
participate in this manner.
 To avoid transaction costs, noncompetitive bids can
be made by individuals directly to the Federal
Reserve Bank or U.S. Treasury. Transactions
through brokers or dealers could reduce the yield.
Slide 25
U.S.
Treasury Bills – Auction Methods
Multiple-Price Method
Seller accepts bids prior to selling securities
Sales awarded beginning with highest bidder
Buyers end up paying different prices for same securities
based upon their respective bids
Treasury discontinued this method in November 1998
Stop-Out Yield
Lowest accepted bid yield in securities auction
Uniform Price Method continued since November
1998
Seller accepts bids prior to selling securities
Sales awarded beginning with highest bidder
Buyers pay same price for securities based on stop-out yield
Slide 26

CERTIFICATES of DEPOSIT (CDs)
 Debt instruments issued by commercial banks
with:
 Minimum denomination of $100,000, but $1 Mn is more
typical
 Maturities range from 1 week to 12 months, generally
though the maturity is 1 to 3 months.
 Fixed interest rate
 Return the principal at maturity
 Debt instruments issued by commercial banks
that may be:
 Negotiable (tradable)
 Non-negotiable (not tradable)
 Most negotiable CDs are sold directly by a bank to
an investor. However, brokers and dealers do
assist with the sale of negotiable CDs and
typically deal in round lots of $25 Mn.
Slide 27
Negotiable Certificates of Deposit (CDs)

Slide 28
Interest rates on negotiable CDs tend to be higher
than T-bill rates:
 CD holders exposed to default risk - only a
portion of deposit ($100,000) is insured
 Unlike T-bills, earnings on CDs subject to
state/local income taxes
 Secondary market for CDs much thinner than
T-bills, making negotiable CDs less liquid than
T-bills
Commercial paper
 Unsecured, short-term promissory
notes as alternative to short-term bank
loans.
 Primary benefit to largest & most
creditworthy issuers is that cost of
borrowing is lower than at a commercial
bank.
 Most commercial papers are backed by
the line of credit. This would mean that,
bank guarantees the payment and
should the issuer default, the bank will
pay on maturity. Reduces default risk
Slide 29
Commercial paper
 Financial companies and non-bank
financial companies like GM
Acceptance Corporation, Ford Motor
Credit, GE Credit etc. are responsible
for issuing these papers.
 78% of financial companies and 22% of
non-financial companies issue this
paper.
Slide 30
 75% of the issues are sold through
dealers and 25% of the issues are sold
through direct placement.

Commercial paper
 Characteristics largely defined by
legislation and issuers’ attempt to avoid
costly disclosure requirements mandated
for other types of securities
 Expensive requirements avoided if these
are met:
 Paper issued must mature in less than 270
days
 Paper must be issued in large denomination
so that it is not typically purchased directly by
public
 Proceeds must be used to fund current
transactions
Slide 31
Money Market Instruments

Bankers’ Acceptances



Slide 32
Instruments created in course of financing international
trade
A banker’s acceptance is a bank draft (guarantee of
payment) issued by a firm and payable on some future date.
For a fee, the bank on which the draft is drawn stamps it as
“accepted”, thereby guaranteeing that the draft will be paid
even in the event of default by the firm.
The exporter takes the draft, and presents it to its bank or
some other investor. The exporter’s bank or the investor,
most likely will pay the exporter immediately for a fee. The
exporter’s bank or the investor can then, before the date,
resell the draft at a discount in the secondary market or it
can hold the instrument until maturity as an investment.
A
C
C
E
P
T
A
N
C
E
Slide 33
(1) Purchase Order
Importer
(2) Letter of credit application
B
A
N
K
E
R
S
(5) Shipment of Goods
Exporter
(3) Approved Letter of credit
American Bank
Japanese Bank
(Importer’s Bank)
Exporter’s Bank
(7) Shipping docs
(8) Accepted B/A
Investor or the
same exporter’s
bank.
Money Market Instruments

Federal (Fed) Funds
 When institutions anticipate insufficient
reserves, they often turn to Federal (fed) funds
market.
 Here they can borrow reserves from other
institutions on an overnight basis.

Slide 34
Institutions with excess reserves can turn to
the fed funds market to loan these reserves
and earn interest.

Fed Funds
 Fed funds are lent on an overnight basis in
denominations of $5 million or more
Fed Funds Rate:
 Interest rate charged on overnight loans of
reserves among commercial banks. One
bank charges another bank for overnight
loans of reserves. The fed fund rate is
influenced by the demand for funds in the
federal funds market
 Discount rate
Slide 35
 discount rate is not automatic it is set by
the Fed, which mostly depends on the
economic conditions in the market.
 Interest rate charged and set by the Fed to
another depository institution borrowing
loans to meet reserve requirement.

Slide 36
Federal Funds
 Depository institutions, when in short of required
reserve may borrow directly from the Fed (at the
discount rate), through the “discount window” or from
other depository institutions at the Fed Fund Rate.
 Federal funds are overnight loans between depository
institutions of their deposits (reserves) at the Fed.
 The depository institution with excess reserves lends,
at an interest, to the depository institution with less
reserves.
 Financial market participants watch the federal funds
rate very closely to judge the tightness of credit in the
financial system.
 When the fed fund rate is high, it means reserves are
in short supply (also unanticipated early withdrawals by
the customer’s of the bank) and vice versa.
The Federal Reserve System can also affect the Fed
Fund rate through its open market operation.
 The Federal Reserve will buy treasury security when
it wants to decrease fed fund rate.
 When the federal reserve buys treasury security,
money goes from Fed to the economy/bank as
deposits. Deposits in banks increase. Bank’s balance
of excess reserve will increase does causing the
downward pressure on Fed Fund rate.
 Excess reserve is reserve over and above the
required reserve, available with bank to lend to other
banks. If no bank are willing to borrow then this
reserve will lie idle with bank earning no interest.
 Vice versa when the Federal Reserve wants to
increase the Fed Fund Rate, it will sell Treasury
security.
Slide 37
Money Market Instruments
Repurchase Agreements

The same shortage of reserves that leads banks
to borrow funds in the federal funds market leads
some banks to engage in repurchase agreements.
Short-term agreements in which seller
Slide 38
 Sells government security to buyer, and simultaneously
 Agrees to buy government security back on later date at
higher price
In effect, the seller has borrowed funds for a short term
and the buyer has made a secured loan, where the
government security is used as a collateral.
 Repos are like collateralized loans, hence are charged
lower interest rate than the Fed fund rate.
Reverse
Repurchase Agreements or Matched
Sale-Purchase (MSP) Agreement – looked from
the lender’s perspective
Repurchase agreement viewed from perspective of
of the lender or the initial buyer of the govt.security.
Reverse repos are short-term agreements in which:
 Buyer (dealer or the Fed) buys a government security from
seller
 Agrees to sell it back on a later date at a higher price
When the Fed is involved in the repo, the
term use is Matched Sale-Purchase
Agreement.
Slide 39

Slide 40
Matched sale–purchase
transactions are typically arranged
in Treasury bills. The Federal
Reserve selects a bill in which it
has a substantial holding and
invites dealers to state an interest
rate at which they are willing to
purchase the bills for same-day
delivery and to sell them back for
delivery on a subsequent day. It
then accepts the most
advantageous (lowest rate) bids to
the point that sufficient reserves
are withdrawn.
Repos can be sold by a dealer or direct
placement.
Transaction amount on 1-15 days maturity is
generally $25 Mn and above. Transaction
amount on 1,3,6 months maturity is generally
$10 Mn.
Short term repos can be renewed or arranged
on a continuous basis.
No secondary market exist for repos.
Slide 41
The rate of return or the coupon rate on the
underlying collateralized security has no
bearing on the repo rate. Repo rate is the
rate the dealer will charge for buying the
security.
 number of days 
Interest earned  funds invested  RP rate 

360


RP rate 
Slide 42
selling price - purchace price
360

purchace price
number of days
Two differences between repo and fed fund
market :
Slide 43
1.
In the repo market, depository and nondepository institutions can participate.
Pension funds, state and local governments,
nonfinancial corporation, security dealers
can participate. In the Fed fund market only
depository institutions can participate.
2.
In repo market, funds and collateralized
securities are transferred simultaneously. In
the fed fund market, only fund is transferred
between institutions.
Money Market Instruments
EURODOLLARS
Dollar-denominated deposits held in banks outside the
United States are called Eurodollars deposits.
 Example: An American holds a U.S. dollar denominated
deposit in a bank outside U.S.
 Dollar-denominated deposit liabilities exempt from U.S.
banking regulations
 Since 1981, non-U.S. residents can hold eurodollar deposits
within the borders of the U.S. at financial institutions called
International Banking Facilities (IBFs).
 International Banking Facilities (IBFs)
 Financial institutions in U.S.
 Cater to needs of foreign individuals, corporation,
and/or governments
 Allow non-U.S. residents to hold unregulated
Slide 44
Eurodollar deposits

Eurodollars are exempt from U.S. banking regulations.
The foreign branch of a U.S. bank receiving Eurodollar deposit avoids
non-interest bearing reserve requirement
The advantages allow Eurodollar-accepting institutions to pay higher
rates of interest to their depositors and charge lower rates of interest to
their borrowers.
Typical denomination range from $250,000 to $10 Mn.
Eurodollar deposits were initially held as non-negotiable, fixed rate
time deposits.
However, they are now negotiable, therefore, secondary market exists.
When interest rates in the domestic market increases, investors will
invest in local market at higher rate and the demand for euro-dollar
deposits will decline. When interest rates in the local market declines,
borrowers will borrow in the local market and invest in euro-dollar
market.
Slide 45
London Interbank Bid Rate (LIBID)
Interest rate at which the London banks are willing to
borrow Eurodollar.
London Interbank Offered Rate (LIBOR)
Interest rate at which the London banks are willing to loan
Eurodollars.
Slide 46
The Anatomy of
Eurodollar
Borrowing
Slide 47
Money Market Instruments

MONEY MARKET MUTUAL FUNDS
(MMMFs)
 Short-term investment pools use
proceeds they raise from selling shares to
invest in various money market
instruments.
Slide 48
Exhibit 3–2
The Money Market
Slide 49
M1 = currency + checking deposits
M2 = M1 + savings deposits, money
market deposit accounts, overnight
repurchase agreements, eurodollars,
and small time deposits. noninstitutional money market mutual
funds
M3 = M2 + institutional money market
mutual funds, large time deposits,
and repurchase agreements and
eurodollars lasting more than one day.
Slide 50
Capital Market Instruments
The capital market raises the
funds needed by DSUs to
carry out their spending and
investment plans.
Slide 51
Exhibit 3–4
The Principal Capital Market Instruments: Amount
Outstanding, End of the Year (in Billions of Dollars)
a Excludes federally sponsored mortgage pools.
b As of June 30, 2001.
Source: Federal Reserve Flow of Funds Accounts, Z1, 2nd Quarter 2001, September 18, 2001; Federal Reserve Bulletin, various issues; Banking and Monetary Statistics
1941–1970.
Slide 52
Exhibit 3–5
The Capital Market
Slide 53
Capital Market Instruments

Stocks
 Equity claims
 Represent ownership of net income and assets
of corporation
 Preferred stock
 Pays fixed dividend; in event of bankruptcy, preferred
stock owners entitled to be paid first
 Common stock
 Pays variable dividend depending on profits left over
after
 preferred stockholders have been paid
 retained earnings set aside
Slide 54
Capital Market Instruments

Mortgages

Loans to purchase
Single-multiple family residential housing
Land
Other real structures
… land or structures serve as collateral for loan

Government has created two government-sponsored
enterprises,
Federal National Mortgage Association (Fannie Mae)
Federal Home Loan Mortgage Corporation (Freddie Mac)

Slide 55
that sell bonds and use the proceeds to purchase
mortgages.
A third government agency, Government National
Mortgage Association (Ginnie Mae) insures the timely
payment of principal and interest on mortgages.

Corporate Bonds
 Long-term bonds
 Issued by corporations
Maturities range from 2 – 30 years
 Interest is paid twice a year

U.S. Government Securities
 Long-term debt instruments
 Maturities of 2 – 30 years (now Treasury issues only 10
year ‘T’ bonds)
 Issued by U.S. Treasury to finance deficits of federal
government
Slide 56
Capital Market Instruments

U.S. Government Agency Securities
 Long-term bonds issued by various
government agencies that support
 Commercial, residential, & agricultural real estate
lending
 Student loans
 Some of these securities are guaranteed by the
federal government, and some are not.
Slide 57
Capital Market Instruments

State and local government bonds
(municipals)
Long-term instruments issued by state and local
governments to finance expenditures on schools,
roads, college dorms and the like.
Slide 58
 Revenue bonds - finance specific projects.
Proceeds from these projects will be used to
pay back the interest and principal.
 General obligation bonds - backed by full faith
and credit of issuer. Taxes can be increased to
pay the interest and principal on GBOs.