Financial Markets, Instruments, and Market Makers1

CHAPTER 6

Financial Markets, Instruments, And Market Makers

Learning Objectives

The various ways of classifying financial markets, including primary and secondary markets, money and capital markets, and spot and futures markets
The definitions and characteristics of the major financial market instruments
The functions of the key participants—the market makers
How the various sectors of financial markets are connected

Chapter Outline

Game Talk
Introducing Financial Markets
Major Financial Market Instruments

A.Money Market Instruments

B.Capital Market Instruments

The Role of Market Makers

A.Why Market Makers Make Markets

B.Market Making and Liquidity

C.Substitutability, Market Making, and Market Integration

Answers to Review Questions

Distinguish between primary and secondary markets and between money and capital markets.

Primary markets are markets where new securities, issued to finance current deficits, are bought and sold.

Secondary markets are markets where outstanding (previously issued) securities are bought and sold.

The money market is the market where securities with original maturities of one year or less are traded.

The capital market is the market where securities with original maturities of more than one year are traded.

The secondary market for T-bills is active while the secondary market for federal agency securities is limited. How does this affect the primary market for each security? Why are well-developed secondary markets important for the operation of an efficient financial system?

The more active the secondary market for a particular security, the more active the primary market for that security will be. Well organized, smoothly functioning, high quality secondary markets facilitate the trading of outstanding securities at relatively low cost and little inconvenience. This, in turn, facilitates the financing of planned deficits in primary markets.

T-bills have a more active secondary market than federal agency securities. Federal agency securities are initially issued as long term securities. However, previously issued federal agency securities that have remaining maturities similar to T-bills are perceived to have similar risk to T-bills. Given the more active secondary markets, T-bills interest rates are lower than rates on federal agency securities with comparable maturities remaining.

What is the difference between financial futures and financial forward markets?

In both financial futures and financial forward markets, transactions are consummated today for the purchase or sale of financial instruments on a date in future.

Financial futures markets trade financial futures agreements that are standardized with regard to the financial instrument, quantities, and delivery dates. Financial futures agreements exist for U.S. government securities of several maturities, several stock market indexes, and foreign currencies.

Financial forward markets trade financial forward agreements that are usually arranged by banks or other brokers and dealers and that are not standardized with regard to quantities or delivery dates.

Discuss the major function of market makers in securities markets. What is the difference between a broker and a dealer?

Market makers link up buyers and sellers of financial instruments. They arrange and execute trades. In addition, market makers provide information and advice to potential buyers and issuers of securities in the primary market.

In addition to disseminating information about market conditions to buyers and sellers, market makers connect the various markets by buying and selling in the market themselves, and by providing financial services that determine the quality of primary and secondary markets.

A broker simply arranges trades between buyers and sellers. A dealer, in addition to arranging trades between buyers and sellers, is ready to be a principal in a transactionthat is, they will purchase and hold securities sold by investors. Dealers are market makers.

If you call a local brokerage firm, you will find that the commission or brokerage fee charged for purchasing $10,000 of T-bills is less than the fee associated with purchasing $10,000 of, say, municipal bonds issued by the City of Cincinnati. Explain why.

Because the secondary Tbills market is so well established, the cost associated with buying or selling in this market is much less than the cost associated with buying or selling municipal bonds. In turn, the difference between both markets will be reflected in brokerage fees.

Explain why it would be incorrect to view the various sectors of the financial markets as totally separate entities.

The markets for particular types of financial claims are connected via the buying and selling (trading) of securities by the “participants” in the marketsthat is, the substitution among alternative instruments available. It is incorrect to view the various sectors of financial markets as totally separate entities because when relative rates of return change, market participants move in and out of the various sectors in response to relative price changes. In this way, all financial markets and rates are connected.

In Chapter 3, we saw that the Fed can change the amount of reserves available to depository institutions and the required reserve ratio. Why do market makers pay so much attention to what the Federal Reserve is doing?

Actions taken by the Fed have a tremendous effect on interest rates and the prices of securities. Market makers must pay close attention to what the Fed is doing because interest rates and the prices of securities affect the profits and losses of the various market participants.

Define commercial paper, negotiable certificates of deposit, repurchase agreements, bankers’ acceptances, federal funds, and Eurodollars. In what ways are they similar, and in what ways are they different?

Commercial paper:Shortterm debt instruments issued by domestic and foreign corporations.

Negotiable certificates of deposit (CDs): Short-term debt instruments with typical maturities of 1 to 12 months that are sold by depository institutions and that make interest payments and repay the principal at maturity; certificates of deposit have a minimum denomination of $100,000 and can be traded in secondary markets.

Repurchase agreements: Shortterm agreements where the seller sells a government security to a buyer with the simultaneous agreement to buy the government security back on a later date at a higher price; the difference between what the seller sells the government security for and what the seller buys it back for is in effect interest.

Bankers’ acceptances: Money market instruments created in the course of international trade to guarantee bank drafts due on a future date.

Federal funds: Loans of reserves between depository institutions, typically overnight.

Eurodollars:Originally considered to be deposits denominated in dollars in a foreign bank. Today, the term Eurodollar has come to mean any deposit in a foreign (host) country where the deposit is denominated in the currency of the country from which it came rather than that of the host country.

The terms defined in this question are all money market instruments with original maturities of less than one year. They differ with regard to who issues the claim, whether it be a bank, a corporation, or government. They differ with regard to who the usual participants are in the market. For example, depository institutions are the borrowers and lenders in the fed funds market.

What are mortgages?

Mortgages areloans to purchase singleor multiple family residential housing, land, or other real structures, where the structure or land serves as collateral for the loan.

Manymortgages are packaged together according to lending guidelines and then sold as securities. They are called mortgagebacked securities. Mortgagebacked securities are more liquid than individual mortgages because mortgagebacked securities have an active secondary market.

Define and contrast stocks and bonds. What are the advantages of owning preferred stock? What are the advantages of owning common stock?

Stocks are equity claims that represent ownership of the net income and assets of a corporation. The income that stockholders receive for their ownership is called dividends. Corporate bonds are longterm debt instruments issued by corporations, usually (although not always) with excellent credit ratings. The owners of such bonds receive interest payments twice a year and the principal at maturity. Bondholders are paid interest before stockholders are paid any dividends. Government bonds are issued by the federal government and are considered risk-free. The proceeds of the bonds are used to finance the deficits of the federal government.

Preferred stock pays a fixed dividend and, in the event of bankruptcy, the owners of preferred stock are entitled to be paid first after other creditors of the corporation have been paid.

Common stock pays a variable dividend, which is dependent on the profits that are left over after preferred stockholders have been paid and retained earnings set aside. Owning common stock may result in higher profit rates when the company is growing and electing to pay high dividends.

What is the difference between a government security and a government agency security? Which asset would you prefer to own if safety and liquidity were important to you?

U.S. government securities are long-term debt instruments with maturities of 2-30 years issued by the U.S.Treasury to finance current deficits. Government agency securities are long term debt instruments issued by various government agencies including those that support commercial, residential, and agricultural real estate lending and student loans. Some are guaranteed by the federal government and some are not, even though all of the securities are issued by agencies that are federally sponsored. If your main concern was safety, you would prefer government securities or those agency securities that were guaranteed by the federal government. Although government agency securities have secondary markets, the secondary markets for government securities are more highly developed and therefore, government securities are more liquid.

Would you rather own the stocks or bonds of a particular corporation if you believed that the corporation was going to earn exceptional profits next year?

With bonds, the investor is paid a return agreed on when the bonds are purchased. With stocks, the investor’s return can grow as the corporation profits increase. Therefore, if you expect a corporation to earn exceptional profits, it is better to own stocks.

Why are municipals attractive to individuals and corporations with high income or profits?

Individuals and corporations in high tax brackets are attracted to municipals because their interest payments are exempt from federal income taxes and from state taxes for investors living in the issuing state.

What are the fed funds rate, the Treasury bill rate, the discount rate, and the LIBOR?

Fed funds rate:The interest rate charged on overnight loans of reserves from one depository institution to another. The rate is determined by the forces of supply and demand.

Treasury bill rate: The interest rate on Treasury bills that is determined by the forces of supply and demand; an indicator of general levels of short-term interest rates.

Discount rate:The interest rate charged by Federal Reserve Banks on discount loans to depository institutions that need to borrow reserves from the Fed. The rate is set by the Fed.

LIBOR rate:The interbank rate for dollardenominated deposits in the London market among international banks. The rate serves as a basis for quoting other international rates.

Can the bid price ever be greater than the asked price?

The bid price is the price a market maker is willing to pay for a security and the asked price is the price the market maker is willing to sell the security for. At any given moment, market makers would not purchase a security for a higher price (the bid price) than what they would be willing to re-sell it for (the asked price).

Answers to Analytical Questions

Rank the following financial instruments in terms of their safety and liquidity:

a.U.S. T-bills

b.Large negotiable CDs

c.Mortgages

d.Government bonds

e.Government agency securities

f.Commercial paper

g.Eurodollars

The following financial instruments are ranked (top to bottom) from most to least liquid or secure.

Liquidity Rank Security Rank

EurodollarsU. S. Tbills

Large negotiable CDs Government bonds

U. S. Tbills Government agency securities

Commercial paper Large negotiable CDs

Government bonds Mortgages

Government agency securities Commercial paper

Mortgages Eurodollars

In June 2001, John pays $9,700 for a one-year T-bill that can be redeemed for $10,000. What is the effective interest? What is the yield?

The effective interest is the difference between the price of the T-bill ($9,700) and what the T-bill will be redeemed for in one year. In this example, the amount is $300 ($10,000 - $9,700). The yield is the interest payment divided by the price of the T-bill ($300/$9,700 = 3.09 percent).