Financial Markets I The Stock, Bond, and Money Markets Every economy must solve the basic problems of production and distribution of goods and

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1 Financial Markets I The Stock, Bond, and Money Markets Every economy must solve the basic problems of production and distribution of goods and services. Financial markets perform an important function by allocating or channeling funds for production and distribution. To produce goods, purchase inventory, and invest in new machinery, firms must first obtain funds in financial markets. Most financial markets consist of people who have money and are willing to lend these resources, as well as people who need funds and are willing to borrow money. The financial industry is essentially a service industry. Another important function which financial markets perform is in reducing individual risks. Whenever assets are held or transacted, certain risks can arise. Financial markets can help spread these risks among a large group of people. Financial markets do not lower the total amount of risk in the economy, but they can efficiently distribute the risk over many individuals. Financial markets also help to separate the ownership of assets from the management and use of assets. People who have little knowledge of how to produce a particular good can nevertheless own a company which produces that good. These people only care that the good has been produced at the lowest cost possible and sold at the highest price the market will bear. Therefore, financial markets help to allocate funds for production and distribution, reduce individual risks to investors and asset holders, and separate the ownership from the management of productive assets. 1. The Stock Market The stock market can be divided into two large markets called the primary and secondary markets. In the primary market, newly issued shares of stock are offered for sale. These shares have never been offered for sale to the public. The newly issued shares are usually sold via big brokerage firms who act as underwriters or investment bankers for the corporations selling the newly issued shares. After the shares have been sold to the public, people can trade the shares on the secondary market. If the shares are listed on an exchange, they can be traded on the exchange using a broker as a go-between. If the shares are instead quoted on the over-the-counter (OTC) market, you can buy and sell shares to dealers at any large brokerage house. The dealers buy and sell over the counter. The New York Stock Exchange is a good example of an exchange that lists stocks for trading. The NASDAQ is the computerized system used for trading OTC shares. Both the NYSE and the NASDAQ are examples of secondary stock markets. What is corporate stock? It is a fantastic invention that lets business separate owners and managers. In fact, you can own a corporation and know absolutely nothing about it. The shares of stock are sold having a face value, say $100. The shares may be sold in the primary market for $120/ share. In this case, $100 is entered into stock equity and $20 into surplus. Then, the $120 in funds are used to buy assets that let the company earn profits. If there are profits, the stockholders will get some of these earnings (say 50%) and the rest of the earnings are retained in the business to be used for investment, research, and expansion. As a stockholder, you own a small piece of the corporation. If anything goes bad, the maximum amount of your losses are capped at whatever you

2 invested. If you invested $10,000 in the corporation by purchasing its stock, then the maximum you can lose is $10,000. This is called limited liability, and it is a crucial feature of the corporate structure of business. To trade effectively you may want to become familiar with a company's balance sheet and income statement, An annual corporate balance sheet lists the assets, liabilities and owners' equity of a corporation. By definition, owners' equity is equal to all assets minus all liabilities. The basic assets of a company include such things as cash, accounts receivable, inventory, and plant and equipment. These assets are used to produce revenue for the company. Total liabilities consist of mainly bank loans, accounts payable, and corporate bonds outstanding. Each of these will require future payments of money by the company. Owners' equity (or net worth) is composed of stock outstanding, surplus, and retained earnings. It is important to note that the balance sheet shows the above information for one point in time, usually the last day of the year. By contrast, the quarterly income statement shows the revenues and expenditures made by the corporation during the past three months, usually compared with the same period in the previous year. The income statement gives a concise picture of how profits were made, income taxes were paid, and typically shows the earnings per share of common stock. Often it is important to understand how net earnings were made and not just how large they were. The NYSE has thousands of listed stocks, so it can often be difficult to judge the overall direction of the market. To judge general movements in the market, we must rely on a stock index. The most popular indexes are the three Dow Jones indexes: one each for industrials, transportation companies, and utilities. There is also a very broad-based index called the NYSE Composite Index which considers the whole market. In addition, there is the S&P 500 index which covers the top 500 corporations. The NASDAQ index gives an average of a particular set of stocks trading OTC. Over a period of a year, the stock index will be affected by the health of the economy. Over shorter periods of time, there are many factors which affect the index, such as changes in interest rates, money supply, earnings reports, trade and budget deficits, and important political developments. When the index rises steadily, we call it a bull market. By contrast, when most stockholders and investors are wanting to sell their stock, we call it a bear market. Sometimes, the market will rise too far and then suddenly drop. This is called a market correction since the index was unrealistically high. We often say that the market fell because of profit-taking. Sometimes an investor feels that the market is going lower. He may choose to short a particular stock. Selling stock short means that the investor borrows stock from a broker and sells it now, with the intention of buying the same stock back at a lower price. The investor must maintain a margin account with the broker. If the stock the investor is shorting rises in price, he is required to increase the deposit in his margin account. Shorting stock creates a risk of unlimited losses for the investor, since the stock he is shorting can theoretically experience an unlimited rise in price. Short sellers can limit this risk by hedging with call options, which we will discuss later on.

3 2. The Bond Market The bond market in the US is a vast market for debt claims which have maturities longer than one year. Bonds can be broadly classified as (1) Federal government, (2) municipal, (3) corporate, and (4) Federal agency bonds. All bonds are issued in the primary market, but new issues of Federal government bonds can be bought at any Federal Reserve Bank, and therefore are not sold by underwriters or investment bankers. The bond market is an important source of funds for government and business. For example, the US Treasury issues bonds to finance Federal government spending. Usually, if the maturity of the debt is greater than one year and less than 10 years, then these bonds are called Treasury Notes. The face value of T-Notes is usually $1000, so they can be easily bought by individual investors. If the Treasury issues debt longer than 10 years, then the bonds are called T-Bonds. The longest maturity for a T-Bond is the bellwether 30 year bond, sometimes called the "benchmark bond" The interest rate on the 30 year T-Bond is very closely watched, since it is quite sensitive to economic and political developments. It also will be a major factor in influencing long term corporate bond rates; an important determinant of private capital expansion and modernization. Most bonds have a face value, coupons, and a maturity. Corporate bonds are generally registered bonds, while some types of government bonds are bearer bonds. A registered bond is one in which the buyer's name is recorded and interest payments are mailed directly to him. Bearer bonds do not involve the transfer of names when bought and sold, and therefore losing them is like losing currency. The number of years left till maturity of a bond is called the term of the bond. Therefore, a 20-year bond that has been held for 5 years has a term of 15 years. When the current price of a bond is greater than its face value, we say that the bond is selling at a premium. If the price and face value are equal, then we say that it is selling at par. Whenever the price is below the face value, we say that the bond is selling at a discount. Bonds often carry special features that must be considered by the investor. These include such things as whether the bond is callable, whether the bond has a rating, whether there are coupons, and whether the bond is convertible. A bond is callable if the issuer can reclaim the bond, usually any time after 5 to 10 years. When a bond is called, the holder must sell the bond back to the issuer. Call provisions allow the issuers an opportunity to refinance their debt at lower interest. If bond prices are expected to rise in the future, then the issuer can call the current debt and issue debt later at lower interest. Ratings on bonds are done by Moody's and Standard and Poors. These companies give a highest rating (AAA) to corporations which are highly unlikely to default on their obligations. Low ratings, such as C or D, are for corporations that may not be able to service their debts -- some may even be in default. These bonds are sometimes called junk bonds. Ratings give the potential investors important information on the relative riskiness of a bond. Sometimes bonds do not have coupons. These are called zero coupon bonds. What happens is that a brokerage firm will buy US T-Bonds and will then issue a zero-coupon bond having a face

4 value equal to the face value of the T-Bond. Wall Street investors call these kinds of zero-coupon bonds Treasury Strips. The coupon on the T-Bond can also be sold in the same way. Finally, corporations sometimes issue convertible bonds. These are the same as regular bonds except that they have a feature that the bondholder can exchange the bond for a fixed number of shares of stock. Convertibles combine many of the characteristics of equity and debt. They offer fixed interest payments, while giving the holder a chance to share in profits and ownership in the company. The price of convertible bonds will move with the stock market, unlike regular types of bonds. Often state and local governments will issue bonds. These are called municipals and are free of Federal income tax. Because of this, the rate of interest is usually lower than the same quality corporate bonds. Municipals are traded over the counter and their prices are quoted on a bid-offer basis. A bid price is the price which dealers are willing to buy the municipal. An offer (or asked) price is the price that the dealer is willing to sell the municipal. Naturally, bid prices are lower than offer prices. A dealer will keep an inventory of municipals to sell to investors at any time over the counter. Dealers therefore buy and sell for their own account. 3. The Money Market In the field of finance, the money market refers to a market for short term debt. Any transaction, which involves the exchange of debt claims, having maturities less than or equal to one year, are part of the money market. Sometimes these transactions are for overnight credit only, and often they take the form of a short-term loan or accommodation. Most small investors cannot transact in the money market because the face values (or the denominations) of the instruments are too high, usually $10,000 and often above $100,000. This means that most transactions are among banks, corporations, pension funds, insurance companies, and the government. In addition to primary markets in these debt claims, some instruments trade on secondary markets, usually OTC. The list of money market instruments is quite long and includes such things as Treasury Bills (T- Bills), negotiable certificates of deposit (NCD's), bankers' acceptances (BA's), repurchase agreements (repos), commercial paper (CP's), Federal funds and central bank loans, and Eurodollar loans. Each of these instruments are created for a specific purpose. For example, the US Federal government issues T-Bills to fund its spending rather than use taxes. Bankers acceptances result from international trade, while commercial paper is often used to finance short term expenses of business. Once this debt has been issued, it can often be traded in secondary markets. This is especially true of NCD's and T-Bills. However, CP's are generally not traded in the US on a secondary market. The 90-day T-bill is a closely watched financial instrument. Like all money market debt, its maturity is less than one year, and its interest rate is quoted on a discount basis. This means that the T-Bill always sells for less than its face value. The discount rate on the T-Bill is calculated by expressing the discount as a percentage of the face value, multiplying by 360, and then dividing by the term of the bill. For example, a $1,000, day T-Bill having 30 days left till maturity

5 which is selling for $995,000 has a discount rate of 6.0%. Note however that this does not mean that the annual rate of interest is 6.0%. The annual rate of interest for this T-Bill is slightly higher at 6.2%. Discount rates are always less than their annualized rates. Care must be taken when reading rates to avoid confusing discount rates with annualized interest rates. The money market is where short term interest rates (or more precisely, discount rates) are determined. When more money market instruments are issued, the supply of short-term debt increases and their prices fall. This causes short term interest rates to rise. The supply of short-term debt increases whenever there is a stronger demand for liquidity. An increase in the supply of short-term debt is often associated with an increase in the demand for money the most liquid of all assets. This is why we call this market the "money market. As one might expect, demand for short term debt is largely governed by the amount of liquidity in the economy. That is, it is determined mainly by the supply of money. If the government supplies more money to the economy, the short run effect should be to raise the prices on money market instruments, and therefore to lower their yields. Short term interest rates would therefore tend to fall when the supply of money increases. The importance of short-term interest rates is that they are related to long term interest rates through the term structure. The term structure of interest rates is a curve showing the yields to maturity for short, middle, and long-term debt. In general, the term structure curve slopes upward since long term interest rates are greater than short term interest rates. Unfortunately, there is no generally accepted theory explaining the relationship between short term and long-term rates. Higher short-term rates may at times cause long term rates to rise if credit is sufficiently restricted. At other times, it may lower long term rates, if expected inflation falls. Ideally, reductions in short term rates would lead to lower long-term rates, and this would stimulate business and consumer spending. Another important aspect of the money market is that short term rates can have a substantial effect on the movement of exchange rates. A change in short term interest rates tends to attract funds from abroad. When these foreign funds are sold for US dollars, the exchange rate falls and the US dollar appreciates. When the dollar appreciates, US firms find it difficult to export, and therefore this source of demand for US goods is weakened. Short term interest rates generally rise when the economy is expanding and fall during recessions. The reason for this is simple. As demand increases, firms find it useful to borrow short term to finance greater inventory. Also, an expansion in the economy causes new business starts to increase and leads to a rise in the demand for liquidity to finance these startups. Consumer spending also rises during expansions and creates an increased demand for funds in the banking sector, leading to greater Fed Funds transactions and more repos. Recessions have exactly the opposite effect on short term interest rates.

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