CHAPTER 3
FUNDAMENTALS OF
FINANCIAL MARKETS
Copyright  2000 by Harcourt, Inc.
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Examples of Capital Market
Claims
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Corporate Stock
Bonds
Mortgages
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Net Financial Position of
Major Sectors of the Economy
Year-End 1998 (In $Billions)
SECTOR
Households and Nonprofits
Nonfinancial business
State and local governments
U.S. Governments
All Financial Sectors
Foreign (Rest of World)
Total
FINANCIAL
ASSETS
$30,121
7,221
1,130
438
31,759
5,410
$76,079
NET FINANCIAL POSITION
LIABILITIES
EXCESS
(A-L)
$6250
$23,871
8,904
1,236
4,544
31,045
714
2,667
2,743
$54,646
$27,328
DEFICIT
(L-A)
$1,683
106
4,106
$5,895
Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, March 12, 1999.
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Capital Market Dept and Equity
Outstanding (In $Billions)
$45,000
Mutual Fund Shares
$40,000
Corporate Equity
Billions of Dollars
$35,000
Other Loans and Advances
$30,000
Open Market Paper
$25,000
Bank Loans
$20,000
Consumer Credit
$15,000
Mortgages
$10,000
Corporate and Foreign
Bonds
State and Local Securities
$5,000
U.S. Government Securities
$0
1994
1995
1996
1997
1998
Source: Board of Governors, Federal Reserve System, Flow of Funds Accounts, Federal Reserve Bulletin.
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Capital Market Efficiency

Allocational efficiency relates to whether or not
funds are being channeled to their most
productive (highest-valued) use.
– Are businesses with risky, but potentially
productive technology, able to find financing?
– Allocational efficiency depends upon high
informational and operational efficiency.
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Capital Market Efficiency (continued)

When market participants are able to obtain
sufficient,timely, and accurate information about
the relative values of securities, the market is
said to have high informational efficiency.
– Timely, accurate information assists market
participants in allocating funds to the most
productive use (allocational efficiency).
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Capital Market Efficiency (concluded)
– The various levels of market efficiency discussed
in finance relate to informational efficiency.
– In a market with high informational efficiency,
prices embody all relevant information about
securities.
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Capital Market Efficiency (concluded)

A market is operationally efficient if the costs of
conducting transactions are as low as possible.
– If broker/dealers are earning normal profit returns
(adequate based on risk assumed), the market is
operationally efficient.
– Operational efficiency is dependent upon the
competitiveness (ease of entry/exit) of
broker/dealers.
– Allocational efficiency is directly related to the level
of operational efficiency in any market.
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Overview of the Money Market
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Short-term debt market -- most under 120 days
A few high quality borrowers
Many diverse investors
Informal market centered in New York City
Standardized securities -- one security is a close
substitute for another
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Overview of the Money Market
(concluded)
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Good marketability -- secondary market
Large, wholesale open-market transactions
Many brokers and dealers are competitively
involved in the money market.
Payment in Federal Funds -- immediately
available funds.
Physical possession of securities seldom made -centralized safekeeping.
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Economic Role of Money Market
(MM)
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The money market is a market for liquidity
– Liquidity is stored in MM by investing in MM
securities.
– Liquidity is bought in MM by issuing securities
(borrowing).

There are few high-quality borrowers and many
diverse MM investors.
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Characteristics of Money Market
Instruments
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Low default risk
Short maturity
High marketability
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Selected Money Market
Instruments Outstanding
(December 31, 1998)
INSTRUMENT
U.S. Treasury securities
Treasury bills
Others under 1 year
Negotiable certificates of
deposit
Commercial paper
Banker’s acceptances
Repurchase agreements
AMOUNT OUTSTANDING
($ IN BILLIONS)
$1,181.6
662.8
518.8
805.0
1,161.0
11.5
877.7
Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, March 12, 1999 and The Bureau of Public Debt,
Monthly Statement of Public Debt, January 31, 1999.
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Characteristics of Money Market
Instruments
INSTRUMENT
U.S. Treasury bills and other securities maturing within
one year
Federal agency securities, maturing within a year
(FNMA, FHLMC, etc.)
Commercial paper (unsecured IOUs of major
corporations, maturity under 270 days)
Negotiable certificates of deposit (of major banks)
Bankers’s acceptances (company IOUs guaranteed
by major banks)
Federal Funds (overnight or short-term loans of
immediately available funds, usually transferred
via the Federal Reserve System)
Repurchase agreements (overnight or short-term loans
arranged by selling government securities along with
an agreement to repurchase them at a higher price
later)
TYPICAL
MATURITY
13 to 52 weeks
MARKETABILITY
Excellent
DEFAULT
RISK
None
Up to 1 year
Good
Very Low
1 to 270 days
Limited
Low
14 to 180 days
30 to 180 days
Good
Good
Low
Low
1 to 7 days
Excellent
Low
1 to 15 days
Good
Low
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Money Market Balance Sheet
Position of Major Participants
INSTRUMENT
Treasury bills
Agency securities
Negotiable CDs
Commercial paper
Banker’s acceptances
Federal Funds
Repurchase agreements
COMMERCIAL
BANKS
A
L
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FEDERAL
RESERVE
SYSTEM
A
L
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TREASURY
DEPARTMENT
A
L
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INVESTMENT
BANKS,
DEALERS,
AND BROKERS
A
L
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CORPORATIONS
A
L
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Types of Financial Markets
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Markets may be differentiated by when a security
is sold.
– The initial financing of the DSU is the primary
market; subsequent resale of the financial claims
of the DSU are traded in the secondary markets.
– Primary markets are important from a real
saving/investment perspective; secondary markets
provide liquidity and portfolio rebalancing capacity
for the investor.
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Types of Financial Markets
(continued)

Markets may be differentiated by how or where
they are traded.
– Organized exchanges provide a physical meeting
place and communication facilities.
– Securities may trade off the exchange in the overthe-counter (OTC) market. OTC markets have no
central location.
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Types of Financial Markets
(continued)
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Markets may be differentiated by maturity.
– High quality short-term (less than one-year) debt
securities are issued and traded in the money
market.
– Long-term (greater than one-year) securities are
issued and traded in the capital market.
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Types of Financial Markets
(continued)
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Spot and futures markets--variation in timing of
delivery and payment.
– Items traded in the market for immediate delivery
and payment are traded in the spot market.
– When delivery at a specific price(payment) is not
"spot," a "futures” or “forward” market transaction
has occurred.
» Futures contracts are traded on organized
exchanges.
» Forward contracts are traded over the counter.
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Types of Financial Markets
(continued)

Option markets trade contracts specifying price
and conditional delivery of a quantity of asset for
a specific period of time.
– A call option is an option to buy; a put is an option
to sell.
– Options are traded on major security and
commodity exchanges as well as in various overthe-counter markets.
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Types of Financial Markets
(concluded)
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Foreign exchange markets.
– Foreign exchange, the value of one currency
relative to another, is traded in the foreign
exchange market.
– Foreign exchange is traded in the spot, forward,
futures, and option markets.
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