Money Markets versus Capital Markets
Money Markets. Money markets are markets that trade debt securities or instruments with maturities of one year or less (see Figure 1–2 ). In the money markets, economic agents with short-term excess supplies of funds can lend funds (i.e., buy money market instruments) to economic agents who have short-term needs or shortages of funds (i.e., they sell money market instruments). The short-term nature of these instruments means that fluctuations in their prices in the secondary markets in which they trade are usually quite small (see Chapters 3 and 19 on interest rate risk). In the United States, money markets do not operate in a specific location—rather, transactions occur via telephones, wire transfers, and computer trading. Thus, most U.S. money markets are said to be over-thecounter (OTC) markets.
Money Market Instruments.
Money Markets. Money markets are markets that trade debt securities or instruments with maturities of one year or less (see Figure 1–2 ). In the money markets, economic agents with short-term excess supplies of funds can lend funds (i.e., buy money market instruments) to economic agents who have short-term needs or shortages of funds (i.e., they sell money market instruments). The short-term nature of these instruments means that fluctuations in their prices in the secondary markets in which they trade are usually quite small (see Chapters 3 and 19 on interest rate risk). In the United States, money markets do not operate in a specific location—rather, transactions occur via telephones, wire transfers, and computer trading. Thus, most U.S. money markets are said to be over-thecounter (OTC) markets.
Money Market Instruments.
A variety of money market securities are issued by corporations and government units to obtain short-term funds. These securities include Treasury bills, federal funds, repurchase agreements, commercial paper, negotiable certificates of deposit, and banker’s acceptances. Table 1–3 lists and defines the major money market securities. Figure 1–3 shows outstanding amounts of money market instruments in the United States in 1990, 2000, and 2010. Notice that in 2010 negotiable CDs, followed b Treasury bills, federal funds and repurchase agreements, and commercial paper, had the largest amounts outstanding
Capital Markets.
Capital Markets.
Capital markets are markets that trade equity (stocks) and debt (bonds) instruments with maturities of more than one year (see Figure 1–2 ). The major suppliers of capital market securities (or users of funds) are corporations and governments. Households are the major suppliers of funds for these securities. Given their longer maturity, these instruments experience wider price fluctuations in the secondary markets in which they trade than do money market instruments
Capital Market Instruments.
Table 1–3 lists and defines each capital market security. Figure 1–4 shows their outstanding amounts by dollar market value. Notice that in both 2000 and 2010, corporate stocks or equities represent the largest capital market instrument, followed by securitized mortgages and corporate bonds. Securitized mortgages are those mortgages that FIs have packaged together and sold as bonds backed by mortgage cash flows . It was these securities that were at the very heart of the recent financial crisis. The relative size of the market value of capital market instruments outstanding depends on two factors: the number of securities issued and their market prices.
Capital Market Instruments.
Table 1–3 lists and defines each capital market security. Figure 1–4 shows their outstanding amounts by dollar market value. Notice that in both 2000 and 2010, corporate stocks or equities represent the largest capital market instrument, followed by securitized mortgages and corporate bonds. Securitized mortgages are those mortgages that FIs have packaged together and sold as bonds backed by mortgage cash flows . It was these securities that were at the very heart of the recent financial crisis. The relative size of the market value of capital market instruments outstanding depends on two factors: the number of securities issued and their market prices.
Foreign Exchange Markets
In addition to understanding the operations of domestic financial markets, a financial manager must also understand the operations of foreign exchange markets and foreign capital markets. Today’s U.S.-based companies operate globally. It is therefore essential that financial managers understand how events and movements in financial markets in other countries affect the profitability and performance of their own companies. For example, a currency and economic crisis in Argentina in the early 2000s, adversely impacted someU.S. markets and firms.
Cash flows from the sale of securities (or other assets) denominated in a foreign currency expose U.S. corporations and investors to risk regarding the value at which foreign currency cash flows can be converted into U.S. dollars. For example, the actual amount of U.S. dollars received on a foreign investment depends on the exchange rate between the U.S. dollar and the foreign currency when the nondollar cash flow is converted into U.S. dollars. If a foreign currency depreciates (declines in value) relative to the U.S. dollar over the investment period (i.e., the period between the time a foreign investment is made and the time it is terminated), the dollar value of cash flows received will fall. If the foreign currency appreciates, or rises in value, relative to the U.S. dollar, the dollar value of cash flows received on the foreign investment will increase.
Derivative Security Markets
Derivative security markets are the markets in which derivative securities trade. A derivative security is a financial security (such as a futures contract, option contract, swap contract, or mortgage-backed security) whose payoff is linked to another, previously issued security such as a security traded in the capital or foreign exchange markets. Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. As the value of the underlying security to be exchanged changes, the value of the derivative security changes. While derivative securities have been in existence for centuries, the growth in derivative security markets occurred mainly in the 1990s and 2000s. Table 1–4 shows the dollar (or notional) value of derivatives held by commercial banks from 1992 through 2010.
In addition to understanding the operations of domestic financial markets, a financial manager must also understand the operations of foreign exchange markets and foreign capital markets. Today’s U.S.-based companies operate globally. It is therefore essential that financial managers understand how events and movements in financial markets in other countries affect the profitability and performance of their own companies. For example, a currency and economic crisis in Argentina in the early 2000s, adversely impacted someU.S. markets and firms.
Cash flows from the sale of securities (or other assets) denominated in a foreign currency expose U.S. corporations and investors to risk regarding the value at which foreign currency cash flows can be converted into U.S. dollars. For example, the actual amount of U.S. dollars received on a foreign investment depends on the exchange rate between the U.S. dollar and the foreign currency when the nondollar cash flow is converted into U.S. dollars. If a foreign currency depreciates (declines in value) relative to the U.S. dollar over the investment period (i.e., the period between the time a foreign investment is made and the time it is terminated), the dollar value of cash flows received will fall. If the foreign currency appreciates, or rises in value, relative to the U.S. dollar, the dollar value of cash flows received on the foreign investment will increase.
Derivative Security Markets
Derivative security markets are the markets in which derivative securities trade. A derivative security is a financial security (such as a futures contract, option contract, swap contract, or mortgage-backed security) whose payoff is linked to another, previously issued security such as a security traded in the capital or foreign exchange markets. Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. As the value of the underlying security to be exchanged changes, the value of the derivative security changes. While derivative securities have been in existence for centuries, the growth in derivative security markets occurred mainly in the 1990s and 2000s. Table 1–4 shows the dollar (or notional) value of derivatives held by commercial banks from 1992 through 2010.
As major markets, the derivative security markets are the newest of the financial security markets. Derivative securities, however, are also potentially the riskiest of the financial securities. Indeed, at the center of the recent financial crisis were losses associated with off-balance-sheet mortgage-backed (derivative) securities created and held by FIs. Signs of significant problems in the U.S. economy first arose in late 2006 and the first half of 2007 when home prices plummeted and defaults held by subprime mortgage borrowers began to affect the mortgage lending industry as a whole, as well as other parts of the economy. Mortgage delinquencies, particularly on subprime mortgages, surged in the last quarter of 2006 through 2008 as homeowners, who had stretched themselves financially to buy a home or refinance a mortgage in the early 2000s, fell behind on their loan payments.
Financial Market Regulation
Financial instruments are subject to regulations imposed by regulatory agencies such as the Securities and Exchange Commission (SEC) the main regulator of securities markets since the passage of the Securities Act of 1934 as well as the exchanges (if any) on which the instruments are traded. For example, the main emphasis of SEC regulations (as stated in the Securities Act of 1933) is on full and fair disclosure of information on securities issues to actual and potential investors. Those firms planning to issue new stocks or bonds to be sold to the public at large (public issues) are required by the SEC to register their securities with the SEC and to fully describe the issue, and any risks associated with the issue, in a legal document called a prospectus.
Financial instruments are subject to regulations imposed by regulatory agencies such as the Securities and Exchange Commission (SEC) the main regulator of securities markets since the passage of the Securities Act of 1934 as well as the exchanges (if any) on which the instruments are traded. For example, the main emphasis of SEC regulations (as stated in the Securities Act of 1933) is on full and fair disclosure of information on securities issues to actual and potential investors. Those firms planning to issue new stocks or bonds to be sold to the public at large (public issues) are required by the SEC to register their securities with the SEC and to fully describe the issue, and any risks associated with the issue, in a legal document called a prospectus.
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