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Chapter Four
Financial Markets in the Financial Systems
Financial Securities and Financial Markets
4.1.1. Securities and Financial Markets
Introduction
The objective of any financial decision, whether it is a financing or investment decision, should be to
maximize owners’ wealth. For a corporation, this translates into maximizing the market value of the
ownership interest – the value of the stock. So a financial manager’s decisions must be made with an
eye on the value of the firm’s stock and the markets in which the stock is traded. In general, financial
managers need to make choices in the course of making financing & investing decisions and give
answers for various questions that normally arise in the continuum.
For instance, if a firm needs funds, the question is should it issue stock or borrow?
 If it issues new stock, will present investors lose?
 If it borrows, what interest rates will its lenders – the investors in its bonds – require? How soon could
the loan be paid off? How soon should it be paid off?
On the contrary, if a firm has funds to invest, the question is should financial managers invest it until
it is needed? If this is so, then:
 In what kind of financial instrument?
 What characteristics must the investment vehicle have?
 What types of risk must they take on with their investment?
Financial managers must understand the wide range of securities available and the markets in which
bought and sold. The aspects of financing and investing decisions of businesses are covered in a course
Financial Management. This chapter, therefore, provides an overview of how securities and the
securities markets play major roles in the financial system in general and the decision making process
of businesses in particular.
Securities
A security is a document that gives the owner a claim on future cash flows. A security may represent
an ownership claim on an asset (such as a share of stock) or a claim on the repayment of borrowed
funds, with interest (such as a bond).
 The document may be a piece of paper (such as a stock certificate or a bond) or an entry in a
register (which may, in turn, be a computer record).
A securities market is an arrangement for buying and selling securities. It may be a physical location
or simply a computer or telephone network. Securities are classified into three groups – based on
their maturity and the source of their value: money market securities, capital market securities, and
derivative securities.
The word “maturity” is often used loosely to refer to the length of time before repayment of a debt.
Other terms using the word “maturity” are more specific.
 The maturity date of a security is the pre-set date on which the amount borrowed (called the face value,
the par value, the principal, or the maturity value) is repaid.
 The security is said to mature on its maturity date.
 The original maturity is the time between the date it is issued and its maturity date.

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4.1.1. Securities: Classifications
Based on the financial markets the securities are being traded, they are classified into three as Money
market, capital market and derivative securities.
Money Market Securities
Money market securities are short-term indebtedness. By “short term” we usually imply an original
maturity of one year or less. The most common money market securities are the following:
 Treasury bills,  Negotiable certificates of deposit, and
 Commercial paper,  Bankers’ acceptances.
Treasury bills (T-bills) are short-term securities issued by the U.S. government or other governments;
 T-bills have original maturities of four weeks et28days, three months91, or six months182.
 Unlike other money market securities, T-bills carry no stated interest rate. Instead, they are sold on a
discounted basis: Investors obtain a return on their investment by buying these securities for less than
their face value and then receiving the face value at maturity.
 T-Bills are sold in $10,000 denominations; that is, the T-Bill has a face value of $10,000.
Commercial paper is a promissory note – a written promise to pay – issued by a large, creditworthy
corporation.
 These securities have original maturities ranging from one day to 270 days and usually trade in
units of $100,000.
 Most commercial paper is backed by bank lines of credit, which means that a bank is standing
by ready to pay the obligation if the issuer is unable to pay.
 Commercial paper may be either interest-bearing or sold on a discounted basis.
Certificates of Deposit (CDs) are written promises by a bank to pay a depositor. Nowadays they have
original maturities from six months to three years.
 Negotiable certificates of deposit are CDs issued by large commercial banks that can be bought
and sold among investors.
 Negotiable CDs typically have original maturities between one month and one year and are
sold in denominations of $100,000 or more.
 Negotiable certificates of deposit are sold to investors at their face value and carry a fixed
interest rate.
 On the maturity date, the investor is repaid the amount borrowed, plus interest.
 Eurodollar Certificates of Deposit are CDs issued by foreign branches of U.S. banks, and
 Yankee Certificates of Deposit are CDs issued by foreign banks located in the United States.
 Both Eurodollar CDs and Yankee CDs are denominated in U.S. dollars.
 In other words, interest payments and the repayment of principal are both in U.S. dollars.
Bankers’ Acceptances are short-term loans, usually to importers and exporters, made by banks to
finance specific transactions. An acceptance is created when a draft (a promise to pay) is written by a
bank’s customer and the bank “accepts” it, promising to pay.
 The bank’s acceptance of the draft is a promise to pay the face amount of the draft to whoever
presents it for payment.

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 The bank’s customer then uses the draft to finance a transaction, giving this draft to her
supplier in exchange for goods.
 Since acceptances arise from specific transactions, they are available in a wide variety of
principal amounts.
 Typically, bankers’ acceptances have maturities of less than 180 days.
 Bankers’ acceptances are sold at a discount from their face value, and the face value is paid at
maturity.
 Since acceptances are backed by both the issuing bank and the purchaser of goods, the
likelihood of default is very small.
Money market securities are backed solely by the issuer’s ability to pay.
 With money market securities, there is no collateral; that is, no item of value (such as real estate)
is designated by the issuer to ensure repayment.
 The investor relies primarily on the reputation and repayment history of the issuer in expecting
that he or she will be repaid.
Capital Market Securities
Capital market securities are long-term securities issued by corporations and governments. Here
“long-term securities” refers to securities with original maturities greater than 1 year and perpetual
securities (those with no maturity). There are two types of capital market securities:
 Those that represent shares of ownership interest, also called equity, issued by corporations, and
 Those that represent indebtedness, issued by corporations and by the U.S. and state and local
governments.
1. Equity
The equity of a corporation is referred to as “stock”; ownership of stock is represented by shares.
Investors who own stock are referred to as shareholders. Every corporation has common stock, and
some corporations have another type of stock, preferred stock, as well.
 Common stock is the most basic ownership interest in a corporation.
 Common shareholders are the residual owners of the firm.
If the business is liquidated, the common shareholders can claim the business’ assets, but only those
assets that remain after all other claimants have been satisfied. Since common stock represents
ownership of the corporation, and since the corporation has a perpetual life,
 Common stock is a perpetual security; It has no maturity.
Common shareholders may receive cash payments – dividends – from the corporation.
 They may also receive a return on their investment in the form of increased value of their stock
as the corporation prospers and grows.
Preferred stock also represents ownership interest in a corporation and, like common stock, is a
perpetual security. However, preferred stock differs from common stock in several important ways.
 First, preferred shareholders are usually promised a fixed annual dividend, whereas common
shareholders receive what the board of directors decides to distribute. And although the
corporation is not legally bound to pay the preferred stock’s dividend, preferred shareholders
must be paid their dividends before any common dividends are paid.

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 Second, preferred shareholders are not residual owners; their claim on a liquidated corporation
takes precedence over that of common shareholders.
 And finally, preferred shareholders generally do not have a say in corporate matters, whereas
common stockholders have the right to vote for members of the board of directors and on major
issues.
2. Indebtedness
A capital market debt obligation is a financial instrument whereby the borrower promises to repay
the face amount of the obligation by the maturity date, and in most cases, to make periodic interest
payments to the holder of the debt obligation referred to as the lender. These debt obligations can be
broken into two categories:
 Bank loans and Debt securities.
While at one time, bank loans were not considered capital market instruments, in recent years a
market for the buying and selling of these debt obligations has developed. One form of bank loan that
is bought and sold in the market is a syndicated bank loan.
 This is a loan in which a group (or syndicate) of banks provides funds to the borrower.
 The need for a group of banks arises because the amount sought by a borrower may be too large
for any one bank to be exposed to the credit risk of that borrower.
Debt securities include:
 Bonds,
 Notes,
 Medium-term notes, and
 Asset-backed securities.
The distinction between a bond and a note has to do with the number of years until the obligation
matures when the security is originally issued.
 Historically, a note is a debt security with a maturity at issuance of 10 years or less;
 A bond is a debt security with a maturity greater than10 years.
The distinction between a note and a medium-term note has nothing to do with the maturity but
rather the way the security is issued. Throughout this material, the writer simply refers to a bond, a
note, or a medium-term note as simply a bond. The writer refers to the investors in any debt
obligation as the debt holder, bondholder, or note holder.
With regard to interests, a debt security may provide a promise to pay the investor periodic interest
(referred to as a coupon);
 A debt security that does not include a promise to pay interest is referred to as a zero-coupon
debt.
In the case of debt that pays interest, interest is generally paid at regular intervals (say, semi-
annually) and may be a fixed or floating (or variable) rate. The interest rate for a floating rate
security is usually tied to the following:
 Interest rate on a market interest rate,
 Price of a commodity, or
 Return on some financial instrument, for instance, on bonds, notes, and medium-term notes that
are issued by corporations, governments, government agencies, and municipal governments.
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Corporate debt securities backed by specific assets as collateral are referred to as secured notes or
secured bonds. If they are not backed by specific assets, they are referred to as debentures. If a debt
obligation is secured and the borrower is unable to make interest or principal payments when
promised, in theory the creditors may be able to force the sale of the collateral for the purpose of
collecting what is due them.
 Collateral, therefore, reduces the security’s riskiness and the level of return, or yield, the issuer
(the borrower) must pay.
 Riskiness is an important determinant of the return on as investment.
The claims of debt holders take precedence over those of shareholders
 But debt holders are unlikely to be paid the full face value for their securities if a corporation
must be liquidated.
U.S. government notes and bonds are interest-bearing securities backed by the “full faith and credit”
of the United States.
 There is little uncertainty regarding whether the interest and principal will be paid as promised.
 The bonds and notes of U.S. government agencies, such as the Tennessee Valley Authority, are
also backed by the government.
 The securities of government sponsored enterprises, such as the US Postal Service and the
Federal Home Loan Bank are not explicitly backed by the government;
 Yet there is little uncertainty whether the interest and principal on these securities will be
paid as promised.
This distinction between notes and bonds is not precisely true, but is consistent with common usage of
the terms “note” and “bond.” In fact, notes and bonds are distinguished by whether or not there is an
indenture agreement, which is:
 A legal contract specifying the terms of the borrowing and any restrictions, and
 Identifying a trustee to watch out for the debt holders’ interests.
A bond has an indenture agreement, whereas a note does not.
 For purpose of discussion in this chapter, the terms notes and bonds will be used in their
common usage, distinguished on the term to maturity.
Bonds issued by state and local governments are called municipal bonds.
 They are either general obligation bonds, which are backed by the general taxing power of the
issuing government, or
 Revenue bonds, which are bonds issued to finance a specific project and are repaid with the
revenues from that project.
Interest on federal government bonds is taxed as income by the federal government, but in most cases
not by the states. The interest on municipal bonds is generally taxed as income by the states, but not
by the federal government.
 The exclusion of interest on municipal bonds from federal income tax makes these bonds
attractive to investors.
 It also allows local governments to pay lower-than-average interest on their bonds.
The major financing instrument for corporations that developed in the 1990s was the asset-backed
security. This is a debt security that is backed by loans or receivables. For example, Ford Credit, a
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subsidiary of Ford Motor Company, has issued securities backed by a pool of automobile loans. The
process of issuing securities backed by a pool of loans or receivables is referred to as securitization.
Derivative Instruments
A derivative instrument is any contract that gets its value directly from another security, a market
interest rate, the price of a commodity, or a financial index. Derivative instruments include:
 Options,  Swaps, and
 Futures/forwards,  Caps and floors.
What is important to understand is that derivative instruments can be used to control the wide range
of risk faced by corporations and investors.
 This is one reason why derivatives are often referred to as risk control instruments.
 We must postpone a detailed discussion of the risk reducing role of derivative instruments at
this juncture since we have not discussed the various risks faced by corporations and investors.
This key role played by derivative instruments in global financial markets was stated in a 1994 report
published by the U.S. General Accounting Office as follows:
 Derivatives serve an important function of the global financial marketplace, providing end-users
with opportunities to better manage financial risks associated with their business transactions.
 The rapid growth and increasing complexity of derivatives reflect both the increased demand
from end-users for better ways to manage their financial risks and innovative capacity of the
financial services industry to respond to market demands.
Unfortunately, derivative markets are too often viewed by the general public – and sometimes
regulators and legislative bodies – as vehicles for pure speculation (that is, legalized gambling).
Without derivative instruments and the markets in which they trade, the financial systems
throughout the world would not be as integrated as they are today and it would be difficult for
corporations and investors to protect themselves against unwanted risks.

4.1.1. Securities Markets

The primary function of a securities market – whether or not it has a physical location – is to bring
together buyers and sellers of securities. Securities markets can be classified on the basis of whether
they are involved in original sales or resale of securities and whether or not they involve a physical
trading location. In this regard, with respect to whether they are involved in original sales or resale of
securities, the securities market can be classified as primary and secondary; and with respect to
whether or not they involve a physical trading location, the securities market can be classified as
organized exchanges and over-the-counter markets.
I. Primary and Secondary Markets
A. Primary Market
When a security is first issued, it is sold in the primary market. This is the market in which new issues
are sold and new capital is raised. So it is the market whose sales directly benefit the issuer of the
securities.
There are three ways to raise capital in the primary market.
 The first is the direct sale, in which the investor purchases, say, stock directly from the issuer.
 Many venture capital firms invest in small, growing businesses in this way.

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 Also, many corporations sell securities directly to large investors, such as pension funds.
 By doing so, the issuer can tailor the features of the security (such as maturity) to suit the
desires of the investor.
 This type of selling is referred to as private placement.
 A second method is through financial institutions, which are firms that obtain money from
investors in return for the institution’s securities and then invest that money.
 For example, a bank issues bank accounts in return for depositors’ money and then loans
that money to a firm.
 Besides banks, firm such as mutual funds and pension funds operate as financial institutions.
 The third method for primary market transactions operates through investment bankers, who buy
the securities issued by corporations and then sell those securities to investors for a higher price.
 This process of buying shares from the issuer and reselling them to investors is called
underwriting.
 For example, Kraft Foods’ 2001 offering of newly issued common shares was underwritten
by a syndicate of 15 underwriters, including Credit Suisse First Boston, Salomon Smith
Barney, Deutsche Banc Alexander Brown, and J. P. Morgan.
 The offering raised $8.7 billion, with Kraft Foods receiving over $8.4 billion
The three methods of raising capital in the primary market can be direct, semi-direct, or indirect. In
a direct finance transaction, securities are directly sold to investors. That is, the exchange of funds
and securities take place between investors (ultimate lenders) and firms (ultimate borrowers).
In a semi-direct finance transaction, securities are sold to investors through brokers, dealers or
investment bankers.
 That is, ultimate borrowers (firms) sell the securities to the financial middlemen involved &
receive funds or else the financial middlemen just facilitate the sale of the securities to ultimate
lenders in the market.
 The ultimate lenders receive primary claims (securities) & provide funds to the financial
middlemen involved.
In an indirect finance transaction, however, financial intermediaries involve and hence, make the
exchange of funds for securities indirect.
 For instance, the ultimate lenders (investors) own a deposit account or deposited funds by
acquiring the secondary claims issued by financial intermediaries.
 The financial intermediaries, in turn, buy the primary claims issued by the ultimate borrowers
(firms) and provide funds.
B. Secondary Market
A secondary market is one in which securities are resold among investors. No new capital is raised in
this market.
 The issuer of the security does not benefit directly from the sale.
 Trading takes place among investors.
Investors who buy and sell securities on the secondary markets may obtain the services of stock
brokers.
 Stock brokers are individuals who buy or sell securities for their clients.
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We can use the market for college textbooks to illustrate the difference between primary and
secondary markets. Suppose one of your instructors decides to use a given book, let say, Financial
Management and Analysis, written by someone as the class text. The instructor notifies the school
bookstore, which buys copies of the text from the publisher, “X” Company, and then puts them up for
sale at a somewhat higher price than was paid. You then buy your new copy of this book from the
bookstore.
 The market for new books, in which you, the publisher, and the bookstore have operated as
buyer, seller, and intermediary, respectively, is a primary market.
 The bookstore has acted as a sort of textbook “investment banker,” but most of the money
invested in the book has gone to the issuer (the publisher).
The bookstore received a profit for performing as an intermediary, a facilitator of the transaction
between you and the publisher. The publisher would have been hard put to sell to each member of the
class individually. At the end of the term you may wish to sell your used copy of Financial
Management and Analysis.
 In this regard, you can sell it directly to a friend who is about to take the course or sell it back to
the bookstore for resale to another student.
 Both these transactions take place in the secondary textbook market.
 This is because the publisher (the issuer) is not a party to them.
If a firm can raise new funds only through the primary market, why should financial managers be
concerned about the secondary market on which the firm’s securities trade?
 Because investors may not be interested in buying securities that are not liquid—that they could
not sell at a fair price at any time. And the secondary markets provide the liquidity.
For example, suppose IBM wants to issue new common shares to pay for its expansion program.
Investors would not be willing to buy such shares if they could not expect to sell them on the
secondary market should the need arise. IBM counts on the existence of a healthy secondary market
to entice investors to buy its new stock issue.

II. Exchanges and Over-the-Counter Markets

There are two types of secondary securities markets: Exchanges and Over-the-counter markets.
Exchanges are actual places where buyers and sellers (or their representatives) meet to trade
securities.
 Examples are the New York Stock Exchange and the Tokyo Stock Exchange.
Over-the-counter (OTC) markets are arrangements in which investors or their representatives trade
securities without sharing a physical location.
 For the most part, computer and telephone networks are used for this purpose.
 These networks are owned and managed by the market’s members.
 An example is the NASDAQ system, which is operated by the National Association of Securities
Dealers (NASD).
Exchanges may be privately owned, as are those in the United States and the UK.
 Privately owned exchanges are managed by their owners, or members (typically brokerage
firms), who may pay hundreds of thousands of dollars for the privilege of owning a seat (a
membership) on the exchange.

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 Private exchanges are self-regulated; that is, they determine the rules and regulations that must
be followed by their members, traders, and companies whose securities are listed, or accepted
for trading, on the exchange.
Exchanges may be owned and operated by banks or banking organizations, as are many European
exchanges – those in Luxembourg and Germany, for example.
 If the exchanges are owned by the banking institutions, these institutions then control both the
primary and secondary markets for securities.
Both bank-owned and privately owned exchanges are, of course, subject to regulation by the
countries in which they are located. Finally, there are state-controlled exchanges, such as those in
France, Belgium, and several Latin American countries.
 These are generally the most restrictive exchanges ,and
 Are characterized by stringent listing standards, especially for foreign companies.
There are two types of pricing systems for securities: the pure auction and dealer market. In the pure
auction process, investors wanting to buy or sell shares of stock submit their bids through their
brokers.
 The brokers then relay (or pass on) these bids to a centralized location,
 The centralized location is where bids are matched and the transaction is executed.
 The party that does the matching is referred to as the specialist.
 For each stock in the market, there is only one matchmaker, one specialist.
In a dealer market, individual dealers buy and sell shares of stock, i.e. dealers trading with
individuals and other dealers.
 We refer to these dealers as market makers since they “make” a market in the stock, providing
liquidity to the market.
 In a dealer market, there may be many dealers for a given stock.
Though a market can use either or some combination of the two systems, exchanges tend to use the
auction process and over-the-counter markets use a dealer market.

Review Questions
1. Ahsin, Inc., is a publicly traded company, but it does not intend to raise any new capital in the next few
years. Why should Ahsin’s financial managers concern themselves with securities markets?
2. What is the primary distinction between a money market security and a capital market security? From an
investor perspective, which security would tend to be riskier? Why?
3. How risky is buying the commercial paper of a corporation relative to, say, buying its common stock?
What factors affect the riskiness of a corporation’s commercial paper? What factors affect the riskiness of
a corporation’s common stock?
4. How does collateral affect a security’s riskiness? How does collateral affect the return required by
investors?
5. Suppose individual income tax rates increase. Ignoring any other changes that may be made in the tax
law, how should this affect the demand for municipal bonds?
6. Consider a convertible security that gives the owner the right to exchange it for another security within a
specified period. Is this right to exchange a call or a put option? Explain.
7. What are derivative instruments and why are they used?

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8. Describe the maturity and cash flows of common stock, preferred stock, and corporate debt securities.
Rank these securities in terms of the uncertainty of their future cash flow.
9. What are the main differences between common and preferred stock? From the perspective of an
investor, which security is riskier? Why?
10. Suppose International Business Machines (IBM) needs to raise new capital. List and briefly describe the
three methods of raising capital.

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 Unit 2:The Money Market
4.2.1. Money Market: Characteristics and Importance
The money market is created by the financial relationship between suppliers and demanders of
short–term funds with maturities of one year or less.
 Money markets exist because investors (i.e. individuals, business entities, governments, and
financial institutions) often have temporarily idle funds that they wish to place in some type of
liquid asset or short term interest – earning instrument.
 At the same time, other entities (organizations) find themselves in need of seasonal
(temporary) financing.
 The money market brings together these suppliers and demanders of short–term liquid funds.
The broad objectives of money market are three fold. These are:
 An equilibrating mechanism for evening out short term surpluses and deficiencies in the
financial system;
 A focal point of intervention by the central bank for influencing liquidity in the economy; and
 A reasonable access to the users of short-term funds to meet their requirements at realistic
(reasonable) costs and temporary employment of funds for earning return to the suppliers of
funds.
4.2..1.1. Characteristics
Money markets provide a channel for the exchange of financial assets for money, with emphasis
upon loans to meet purely short-term cash needs. The money market is the mechanism through
which holders of temporary cash surpluses meet economic units that face temporary cash deficits.
 It is designed, on one hand, to meet the short-run cash requirements of corporations, financial
institutions, and governments by providing a mechanism for granting loans as short as overnight
and as long as one year to maturity.
 At the same time, the money market provides an investment outlet for those spending units (also
principally corporations, financial institutions, and governments) that hold surplus cash for short
period of time and wish to earn at least some return on temporarily idle funds.
The essential function of the money market, of course, is to bring these two groups in to contact in
order to make borrowing and lending possible.
4.2..1.2. The Need for a Money Market
For most individuals & institutions, inflows & outflows of cash are rarely in perfect harmony with
each other.
 There is often a time lag (gap) between collections & disbursements.
 When taxes are collected, governments usually will have funds that exceed their immediate
cash needs.
 At this time, they frequently enter the money markets as lenders and/or repurchase
Treasury Bills already issued, buy bank deposits, etc.
 As cash runs low relative to current expenditure, such units must once again enter the money
markets as borrowers of funds, issuing short–term notes attractive to money market
investors.

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Moreover, the checking account of active business firms fluctuates daily between large surpluses and
low or non-existent balances.
 A surplus cash position – bring such firms in to the money markets as net lenders of funds.
 Cash deficits force them in to the borrowing side.
The money market, thus, serves to bridge the gap between receipts and expenditures of funds. As
money is one of the most perishable of all commodities, the holding of idle surplus cash is expensive.
 This is because cash balance earns little or no income for their owners.
 When idle cash is not invested, the holder incurs an opportunity cost in terms of interest
income forgone.
4.2..1.3. The Goals of Money Market Investors
Investors in the money market seek mainly safety and liquidity plus the opportunity to earn some
interest income.
 This is because funds invested in the money market represent only temporary cash surpluses
and are usually needed in the near future to meet tax obligations, cover wage and salary costs,
pay stockholder dividends, and so on.
 For this reason, money market investors are especially sensitive to risk.
Money market investors strongly avert (or avoid) risks. This is especially evident when there is even
a hint of trouble concerning the financial conditions of a major money market borrower.
 That is, when a given financially strong or highly rated money market borrower defaults on
its short-term securities (for instance, commercial papers), the money market investors refuse
to buy newly issued commercial papers of even top–grade companies.
 As a result, the market for commercial papers virtually grounds to a halt (i.e. buy and sell
transactions, inter alia, commercial papers nearly stops).
What are the various risks that investors generally avoid and especially those risks that all money
market investors avoid?
 In this regard, there are different types of investment risks, which investors generally avoid or
else require to be compensated for taking those risks.
The major investment risks are discussed below.

Risks Confronting Investors in the Money and Capital Markets: Summary

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Money market instruments generally offer more protection against such risks than most other
investments.
 Their prices tend to be remarkably stable over time compared to long term securities and
actively traded commodities.
 They generally do not offer the prospect of significant capital gains for the investor and as
well do not entail substantial capital losses.
 Default risk is minimal in the money market.
 In fact, money market borrowers must be well established institutions with impeccable
credit ratings (i.e. perfect and/or faultless credit ratings) before their securities can be
offered for sale in this market.
 Few investments today adequately protect the investor against inflation risk.
 Money market securities are no exception.
 However, they do offer superior liquidity, allowing the investors to quickly cash them
in when a promising inflation-hedged investment opportunity comes along, i.e. in
periods where significant price increases is expected.
 Investors who purchase securities in foreign markets can not completely escape currency
risks, but they are probably less prone to such losses when buying money market instruments
due to the short term nature of these securities.
They also provide some hedge against political risk because fewer changes in government policy and
regulations are likely expected in the short run.

4.2..1.4. The Pattern of Interest Rates

Generally speaking, the money market rates are lower than yields on capital market instruments.
 Yet, yields on those money market instruments also vary from security to security.
In this regard, considering factors like default risk, market risk, and marketability, the money
market rates (i.e. yields on the short term instruments) might be listed in ascending order (i.e. from
the lowest yield to the highest yield on securities) as shown below:
 T-bills (T-bill yields are the lowest and often are considered base interest rates in determining
yields on other money and capital market instruments);
 Federal Agency Securities;

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  Federal Reserve Discount Rates (discount rate on loans to depository institutions, i.e. banks,
when they borrow reserve deposits of other Banks held in the Fed);
 Federal Funds Loans; and
 Bank Related Financial Instruments such as:
 Negotiable CD’s,
 Bankers’ Acceptances,
 Borrowing from Commercial Banks, and
 Marketable IOUs in the Commercial Paper Market.

4.2..1.5. Money Market Instruments

The principal financial instruments issued and traded in the money market are the following:
 Government Treasury Bills (T-Bills)  Federal Funds
 Federal Agency Securities  Commercial Paper
 Dealer Loans  Banker’s Acceptances
 Repurchase Agreements  Financial Futures
 Bank Certificates of Deposits (CDs)  Euro-Dollar Deposits
The next section discusses the characteristics of – and yields on – some of the money market
instruments.
4.2.2. Treasury Bills (T-Bills)
4.2..2.1. General
Treasury Bills represents the large volume of daily purchases or sales in the money markets.
 In this regard, the interest rates on T-Bills are the base for all other money market interest
rates.
 The government IOUs, which includes T-Bills, notes, and long-term bonds, carry great weight
in the financial system due to their zero default risk, ready marketability, and high liquidity.
 Security dealers, at the heart of the market, make the market go and aid the federal
government in selling billions of dollars in new securities each year.
 By law, they must have an original maturity of one year or less.
T-bills are suited to seasonal ebb and flow of treasury cash because their maturities are short, they
find a ready market among banks and other investors, and their prices adjust readily to changing
market conditions.
4.2..2.2. Types of Treasury Bills
There are different types of T-Bills. Considering the case of U.S., the following are the major types of
Treasury Bills issued in the money markets:
 Regular-Series Bills - issued routinely every week or month in competitive auctions. The
regular series bills comprise:
 Three-Month Bills that are auctioned “weekly”.

14
  Six-Month Bills that are auctioned “weekly” and provides the largest amount of
revenue for the treasury.
 One-Year Bills that are sold once “each month”.
 Irregular-Series Bills - issued only when the treasury has a special cash need.
 Strip Bills - are a package offering of bills (series of bills offered). In this regard, strip bills
 Require investors to bid for an entire series of different bill maturities; and
 Those who bid successfully must accept bills at their bid price each week for several
weeks running.
 Cash-Management Bills - are reopened issues of bills that were sold in prior weeks.
 Cash management bills normally are issued when there is an unusual or unexpected
treasury need for more cash.
4.2..2.3. How Bills are Sold
Bills are sold using the auction technique and hence, it is the market place, not government treasuries
(for instance, the U.S. or the Ethiopian Government Treasury) that sets bill prices and yields.
 In this regard, interested investors fill out a form tendering an offer to the treasury for a
specific bill issue at a specific price.
In general, there are two types of tenders – competitive and non-competitive – in order to offer (or
sale) bills to investors in the market; and the Treasury, in this regard, will entertain both competitive
and non-competitive tenders for bills.
 Competitive Tenders:
 Competitive tenders are submitted by large investors, including commercial banks and
government securities dealers, who buy several million dollars’ worth at one time.
 Institutions submitting competitive tenders bid aggressively for bills, offering a price
high enough to win an allotment of bills but not too high, because the higher the bid
price, the lower will be the rate of return to the investors.
 Non-Competitive Tenders:
 Non-competitive tenders (normally less than 1 million each) are submitted by small
investors who agree to accept the average price set in the weekly or monthly bill auction
(i.e. the Dollar-Weighted Average Auction Price).
The investors must pay the full par value (or face value) of the bill at the time the tender is made and
on the issue date, receives a refund check from Federal Reserve representing the difference between
the amount paid in by the investors and the auction price. Thus, the amount of refund check is
obtained as follows:
Refund Check = Par Value – Auction Price
Generally, the treasury tries to fill all non-competitive tenders for bills in the proportion of the
number of T-Bills required to be purchased relative to the total number of bills required by all
investors participating in non-competitive tenders.
 Officials open all the bids at the designated time and array them from the lowest yield (and
highest price) to the highest yield (and lowest price).
 All competitive bids must be expressed on a bank discount basis (the determination of which
will be discussed later in this section).
15
  The amount in excess of the allowed for non-competitive tenders will be offered in a
competitive basis.
 The highest bidder (offering the lowest yield) receives bills first, and those who bid
successively lower prices also receive their bills until all available securities have been
allocated (i.e. until the entire bills are offered to investors).
 Notwithstanding this, the lowest price at which at least some bills are awarded is called the
stop-out price.
 No one bidding less than the stop-out price in the competitive tendering will receive any bills
in the auction.
4.2..2.4. Calculating the Yield on Bills
Treasury bills do not carry a promised interest rate, but instead are sold at a discount from par.
 Thus, their yield is based on the appreciation in price between the time the bills are issued and
the time they mature or are sold by the investor.
 While the income earned from investing in T-bills is not exempt from Federal taxes, it is
exempt from state and local income taxes.
 Any price gain actually realized by the investor is treated not as a capital gain but as ordinary
income received during the year the bill matures for federal tax purposes.
The rate of return or yield on most debts is calculated as a yield to maturity.
 However, bill yields are determined by the “bank discount method”, which ignores the
compounding of interest rates and uses a 360-day year for simplicity.
The bank discount rate (denoted by DR) on bills is given by the following formula (in annualized
percentage):
Par Value – Purchase Price 360 Days
x X100
DR =
Par Value Number of Days to Maturity

Example 1:
Suppose you purchased a $ 100 basis (par value) U.S. Government Treasury Bill that matures in 180
days at the auction price of $97. What is the discount rate (or DR) on this T-Bill as per the bank
discount method?
In order to find the DR or yield on this U.S. Government T-Bill and as well on all other T-Bills, we
can simply apply the above formula.
 In this regard, the percentage yield on this T-Bill, in other words, the discount rate (DR)
according to the bank discount method is determined to be 6%. This is obtained by using the
above formula for determining the yield on T-Bills as shown below:
(100 – 97) X 360
100 =
180 (in Annual Percentage)
6%
The monetary benefit to be obtained from the bill (in other words, income from investing in the T-
Bill, in this regard, is:
(100X 0.06) X180 = $3
360
Alternatively, the benefit (i.e. investment income on the T-Bill) can be obtained as:
= 100 X (0.06) = $3

16
Because the rate of return on T-bills is figured in a different way than the rate of return on most
other debt instruments, the investor must convert bill yields to an Investment (or Coupon
Equivalent) Yield in order to make realistic comparisons with other securities.
 In this regard, the Investment Rate of Returnor the Coupon Equivalent Yield on Treasury
Bills (which can be denoted by “IR”) is determined, in annual percentage, by the following
formula:
IR =
360 – (DR XDays to Maturity)

 Alternatively, the following formula can be used to determine the IR:

IR = Discount Amount 365 X100

X
Issue Price Number of Days to Maturity

The investment yield (IR) on bills reveals the effective yield on T-Bills as well as considers 365-day
year instead of 360-day year. See Example 2 below for the sake of clarity
Example 2:
It is to be recalled from Example 1 above that the yield or discount rate (DR) on the T-Bill issued by
the U.S. Government Treasury is 6% as determined by the bank discount method. Then, how much
is the investor’s yield (i.e. investment yield) on this T-Bill?
In order to find the Investment Return (or Yield), which is denoted by IR, we need to use any one of
the preceding two formulas. The investment rate of return (or yield) – IR, in this regard, is
determined to be 6.27% as shown below:
IR = 365 X 0.06 x 100 = 6. 27%
360 - (0.06 X 180)
Alternatively, the same investment rate of return or investment yield can be obtained as shown
below:
IR = 3 X 365 = 6.27%
97 180
 Because of the compounding of interests and the use of a 365 day-year, the investment yield on
bills is always greater than the yield determined in accordance with the bank discount
method.
Both the simple and investment yields on T-Bills, i.e. DR and IR, are computed on the basis of the
assumption that investors buy T-Bills and ultimately redeem the T-Bills with the treasury on the due
date.
 But what if investors need cash right away and sell bills to dealer(s) or other investors in
advance of their maturity?
In this instance, we may determine what we call the Holding Period Yield by using the following
formula:
Holding Period = DR when Change in DR over
Yield on Bill Purchased the Holding
where: Period
Days Held
–
4.2.3. Dealer Loans and Repurchase Agreements

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 4.2..3.1. General
The money market depends heavily up on the buying & selling activities of securities dealers in order
to move funds from cash-rich units to those with cash shortages. In this regard, dealers
 Are primary market makers for government securities, i.e. buy and sell government
securities;
 Trade in both new & previously issued T-bills, bonds, and notes;
 Also buy & sell other money market instruments;
 Are the principal points of contact with the money market for thousands of individual and
institutional investors and are essential to the efficient functioning of the market.
Dealers supply a huge volume of securities daily to the financial market place.
 They, in this regard, depend heavily on the money market for borrowed funds.
 Most of the dealer houses invest little of their own equity in the business.
 The bulk of their operating capital is obtained through short-term borrowings from
commercial banks, non financial corporations, and other institutions.
4.2..3.2. Sources of Dealer Funds
The two heavily used sources of dealer funds are Demand Loans from largest banks and Repurchase
Agreements (RPs).
1. Demand Loans
Demand Loans are obtained from largest banks.
 Such banks post rates at which they are willing to make short term loans to dealers, may be
every day.
The banks providing demand loans to dealers quote two rates. In this regard,
 One rate is quoted on new loans, and
 A second (lower) rate is posted for renewals of existing loans.
Demand loans may be called in at any time if the lending banks need cash in a hurry.
 However, such loans are virtually risk less because they usually are collateralized by
government securities, which may be transferred temporally to the lending bank or its agent.
2. Repurchase Agreements(RPs)
Repurchase Agreements are popular alternative to the demand loan. Under Repurchase Agreement:
 The dealer sells securities to a lender;
 But makes a commitment to buy back the securities at a later date at a fixed price plus
interest.
Thus, Repurchase Agreements are simply temporary extensions of credit collateralized by
marketable securities.
 Some RPs are for a set length of time (term), while others, known as continuing contracts,
carry no explicit maturity date but may be terminated by either party on short notice.
 Large commercial banks provide both Term Loans & RPs.
 Non-financial corporations have provided a growing volume of funds to dealers through RPs.

18
RPs often requires securities to be held as collateral behind the Loan transaction.
 Normally, the securities that form the collateral for the RP loan are supposed to be placed in a
separate bank held custodial account.
 However, this safety device is not always seriously followed.
The interest rate on RPs is the return that a dealer must pay a lender of short-term funds.
 They are closely related to other money market interest rates.
 The securities pledged are valued at their current market prices plus accrued interest (on
coupon bearing securities), less a small “haircut” (discount) to reduce the lender’s exposure to
market risk.
 The longer the term, the larger the “hair cut” will be to protect the lender in case security
prices fall.
Periodically, RPs are “Marked to Market”, and if the price of the pledged securities has dropped, the
borrower may have to pledge additional collateral.
 RP interest income is computed as follows:
RP Interest = Amount X Current XNumber of Days Income of Loan
RP Rate 360 Days
Example 1:How much interest income would a 7% RP rate loan of $ 100 million to a dealer
overnight would yield to a lender?
In this regard, we can just use the above formula to determine the RP interest income as shown
below:
RP Interest Income = $100,000,000 X 0.07 X (1/360)= $19,444.44
Under a continuing contract RP, the rate changes daily and interest income would be computed for
each day the funds were loaned, and the total interest owed paid to the lender when the contract is
ended by either party.

4.2.4. Commercial Paper

4.2..4.1. What is Commercial Paper?
Commercial paper is one of the oldest of all money market instruments.
 By definition, commercial paper consists of short term, unsecured promissory notes
issued by well known companies that are financially strong and carry high credit
ratings.
 The funds are used for current transactions – i.e., to purchase inventories, pay taxes, meet
payrolls, and cover other short-term obligations.
 However, a growing number of paper issues today are used provide “bridge financing” for
long term projects such as building of ships, office buildings, etc.
 In these instances, issuing companies usually plan to convert their short term paper
issues in to long term, more permanent financing when the capital market is more
favorable.
Commercial paper is generally issued in multiples of $1000 and in denominations designed to meet
the needs of the buyer.

19
  It is traded mainly in the primary market.
 Opportunities for resale in the secondary market are limited, although:
 Some dealers will redeem the notes they sell in advance of maturity.
 Others trade paper issued by large finance companies and bank holding companies.
Because of the limited resale possibilities, investors usually are quite careful to purchase those paper
issues whose maturity matches their planned holding periods.
4.2..4.2. Types of Commercial Paper
There are two types of Commercial Paper: Direct Paper and Dealer (or Industrial) Paper.
1. Direct Paper
Direct Paper is issued by large finance companies and bank-holding companies that deal directly
with investors rather than using a security dealer as an intermediary and that borrow continuously.
 These companies regularly extend installment credit to consumers and large working capital
loans and leases to business firms.
 They, in this regard, announce the rates they are currently paying on various maturities of
their paper.
 Interest rates may be adjusted during the day the paper is sold in order to regulate the inflow
of investor funds.
 Investors select the maturities that most closely approximate their expected holding periods
and buy the securities directly from the issuer.
Directly placed paper must be sold in large volume to cover the substantial costs of distribution and
marketing.
 Such issuers do not have to pay dealers commissions and fees.
 They must operate a marketing division to maintain constant contact with active investors.
 Some times they have to sell their paper even when they have no need for funds in order to
maintain good working relationship with active investors.
 These companies cannot escape paying fees to banks for supporting line of credit, to rating
agencies who rate their paper issues, and to agents (usually banks) who dispense required
payments and collect funds.
2. Dealer Paper (Industrial Paper)
Dealer Paper (also called Industrial Paper) is issued by security dealers on behalf of corporate
customers.
 Dealer paper is issued mainly by non-financial companies – including public utilities,
manufacturers, retailers, wholesalers, etc, as well as by smaller bank-holding companies and
finance companies, all of whom borrow less frequently than firms issuing direct paper.
 The issuing company may sell the paper directly to the dealer, who buys it less discount and
commission and then attempts to sell it at the highest possible price in the market.
 Alternatively, the issuing company may carry all the risk, with the dealer agreeing only to sell
the issue at the best price available less commission (often referred to as a best effort basis).

20
  The open – rate method may be used in which the borrowing company receives some
money in advance from dealers, but the balance depends on how well the issue sells in
the open market.
4.2..4.3. Recent Growth of Commercial Paper
The volume of Commercial Paper outstanding has rapidly increased in the various financial markets.
The question is what factors explain the rapid growth in Commercial Paper? The following, in this
regard, are among the key factors:
 Relative cost of other sources of credit compared to interest rates on commercial paper.
 It is efficient & cost–effective substitute for bank loan and other forms of borrowing.
 The high quality of most commercial paper obligations.
 Many investors regard commercial paper as close substitutes for T – bills & CDs.
 Yields on commercial papers move in the same direction and by similar amounts as do the
yields on other money market securities.
 Provide higher yields than on comparable maturity T- bills, due to higher risk, lower
marketability, and T- Bills are tax exempt (i.e. state and local taxes are not paid on T-
Bills).
 Expanding use of letters of credit and other payment guarantees.
 Commercial banks issue certificates promising to pay upon default by the issuers of
commercial papers.
 Other groups recently entering the market on the borrowing side include foreign banks &
industrial companies, international financial conglomerates, and state and local governments
(which offer tax exempt commercial paper).
 Paper issued in the U.S by foreign firms is called “Yankee Paper”.
 Frequently can be sold at lower rates in America than abroad (preferred by issuers).
 Recently the market has expanded overseas with the rapid rise of European
commercial paper.
4.2..4.4. Maturities of Commercial Paper
Maturities of Commercial Paper range from 3 days (“Weekend Paper”) to 9 months.
 Most carry original maturity of 60 days or less.
 Commercial paper is generally not issued for longer maturities than 270 days.
 This is because any security sold in the U.S. open market for a longer term must be
registered with the SEC.
 This, in turn, requires the fulfillment of a lot of issuance criteria.
 Yields to investors are calculated by the bank discount method.
 Most Commercial Paper is issued at discount.
 Coupon – bearing paper is also available.
 Commercial paper is typically issued in “bearer form”, which makes their resale easier.
 The commercial paper market is highly volatile and difficult to predict.

21
  The yields fluctuate.

4.2.5. International Money Market Instruments

4.2..5.1. Bankers’ Acceptances
A. Meaning of Bankers’ Acceptances
A banker’s acceptance is a time draft drawn on a bank by an exporter or an importer to pay for
merchandise or to buy foreign currencies.
 If the bank honors the draft, it will stamp “Accepted” on its face and endorse the instrument.
 By so doing, the issuing bank has unconditionally guaranteed to pay the face value of the
acceptance at maturity, shielding exporters and investors in international markets from
default risk.
 Acceptances carry maturities ranging from 30 to 270 days.
 They are actively traded among bank and non-bank financial institutions, manufacturing and
industrial corporations, and securities dealers as a high quality investment and source of
ready cash.
B. Why Acceptances are used in International Trade
Bankers’ Acceptances are used in import & export trade because most exporters are uncertain of the
credit standing of the importers to whom they ship goods.
 Exporters may also be concerned about business conditions or political developments in
foreign countries.
 Nations experiencing terrorist violence or even civil war have serious problems in attracting
financing for imports of goods and services because of the obvious risks of extending credit to
them.
 However, exporters usually are quite content to rely up on acceptance financing by a foreign
bank.
 Thus, an acceptance is a financial instrument designed to shift the risk of international
trade to a third party willing to take on that risk for a known cost.
 Banks are usually willing to take on such risks because they are specialists in granting
credit, assessing credit risk, and spreading that risk over thousands of different loans.
C. How Acceptances Arise
The creation of Bankers’ Acceptances usually begins when an importer goes to a bank to secure a
line of credit to pay for a shipment of goods from abroad. Once the line of credit is approved, the
bank will issue a letter of credit in favor of the foreign exporter.
 This document authorizes the exporter to draw a time draft for a specified amount against the
issuing bank, provided the exporter agrees to send appropriate shipping documents giving the
issuing bank temporary title to the exported goods.
Because the letter of credit authorizes the drawing of a time draft and not a sight draft (the latter
being payable immediately up on presentation), the exporter must wait until the draft matures to be
paid.
 Such a delay is unacceptable for most export firms.
 They may need cash right away for various purposes (i.e. to meet expenditure requirements).

22
  Moreover, the time draft will generally be redeemed in the home currency of the issuing bank
(i.e. currency of the importer’s nation), and this particular currency may not be needed by the
exporter.
For example, a U.S. exporter holding a time draft from an Ethiopian Bank would be paid in Birr on
its maturity date, even though the foreign exporter probably needs Dollars to pay for employees and
meet other expenses.
 In this case, the exporter will discount the time draft in advance of maturity to his/her
principal bank in U.S.
 The exporter then receives timely payment in his home currency (dollars) and avoids the risk
of trading in foreign currencies.
 The foreign bank that has now acquired the time draft from the exporter will forward it (plus
shipping documents if goods are being traded) to the bank issuing the original letter of credit
in the importer’s country.
 The issuing bank checks to see that the draft and any accompanying documents are correctly
drawn and then stamps “Accepted” on its face.
Two things happen as a result of this action:
i. A banker’s Acceptance - a high quality, negotiable money market instrument – has been
created; and
ii. The issuing bank has acknowledged an absolute liability, which must be paid in full at
maturity.
Frequently, the issuing bank will discount the new acceptance for the foreign bank which sent it, i.e.
pay the liability to the foreign bank now, and credit that bank’s correspondent account for the
proceeds (i.e. increase the balance of the foreign bank’s correspondent account held in a bank found
in the importer’s country).
 The acceptance may then be held by the issuing bank as an asset or sold to a dealer (or
directly to an investor in the money market through the bank’s own dealer).
 Meanwhile, shipping documents for any goods that accompanied the acceptance are handed
to the importer against a trust receipt, permitting the importer to pick up and market the
goods.
 However, under the terms of the letter of credit, the importer must deposit the proceeds from
selling those goods at the issuing bank in sufficient time to pay for the acceptance.
 When the time draft matures, the acceptance, which was discounted to investors in the money
market, will be presented to the issuing bank for payment by its holder.
It should be clear that all the three principal parties to the acceptance transaction, i.e. the exporter,
the importer, and the issuing bank benefit from this method of financing international trade. In this
regard,
 The exporter receives good funds with little or no delay.
 The importer may delay payment for a time until the related bank line of credit expires.
 The issuing bank regards the acceptance as a readily marketable financial instrument that
can be sold before maturity through an acceptance dealer in order to cover short-term cash
needs.
However, there are costs associated with all these benefits:

23
  A discount fee is charged off the face value of the acceptance whenever it is discounted in
advance of maturity.
 The accepting bank earns a commission (for instance 1% or 2%), which may be paid by either
exporter or importer, in addition to the fees associated with the original line of credit.
D. Acceptance Rates
Acceptances do not carry a fixed rate of interest, but are sold at a discount in the open market like
Treasury Bills.
 The prime borrower under an acceptance contract is charged commitment fee for this line of
credit, which is usually 1 percent for top-quality customers. (U.S. Case)
U.S. banks are limited in the dollar amount of acceptances they can create to 150% of their paid-in-
capital and surplus, or by special permission, up to 200% of capital and surplus.
 If the bank wishes to sell the acceptance in advance of its maturity, the rate of discount it must
pay is determined by the current bid rate on acceptances of similar maturity in the open
market.
The yield on acceptances is usually only slightly higher than on T-Bills because banks that issue them
are among the largest and have solid international reputations.

4.2..5.2. Eurodollars
A. General
Eurodollars are international money market instruments.
 Comparable to the domestic market, a chain of international money markets trade in deposits
that are denominated in the world’s most convertible currencies (such as Dollars, Marks,
Pound, Francs, and Yen) stretches around the globe.
This so called Eurocurrency Market has arisen because of a tremendous need world-wide for funds
denominated in the above major currencies.
 Firms may need huge amount of other nation’s currencies to carry out transactions in the
countries where they are represented.
 To meet this kind of need, in the 1950s, large international banks head quartered in London,
Paris, Zurich, Tokyo, etc began to accept deposits from businesses, individuals, and
governments denominated in currencies other than that of the host country and to make loans
in those same foreign currencies.
 Thus, the Eurocurrency market was born.
B. What is a Eurodollar?
Because the Dollar is the chief international currency today, the market for Eurodollars dominates
the Eurocurrency markets. What are Eurodollars in this regard?
 Eurodollars are deposits of U.S. Dollars in banks located outside U.S. or U.S. based banks free
of U.S. deposit regulations.
 The banks in question record the deposits on their books in U.S. Dollars, not in the home
currency.
While the large majority of Eurodollar (and other currency) deposits are held in Europe, these
deposits have spread world-wide, and Europe’s share of the total is actually declining.

24
  Frequently, banks accepting Eurodollar deposits are foreign branches of American Banks.
 For example, in London, the center of the Eurocurrency market today, branches of American
banks outnumber British Banks and bid aggressively for deposits denominated in U.S.
Dollars.
 Many of these funds will then be loaned to the home office in the United States to meet reserve
requirements and other liquid needs.
 The remaining funds will be loaned to private corporations and governments abroad who
need U.S. Dollars.
No one knows exactly how large the Eurodollar market is. One reason is that the market is almost
completely unregulated. Moreover, many international banks refuse to disclose publicly their deposit
balances in various currencies. Another reason for the relative lack of information on market activity
is that Eurocurrencies are merely bookkeeping entries on a bank’s ledger and not really currencies
at all.
 You cannot put Eurodollars in your pocket like bank notes.
 Moreover, Eurodollar deposits are continually on the move in the form of loans.
Eurodollars are employed to:
 Finance the import and export of goods,
 Provide working capital for the foreign operations of U.S. multinational corporations,
 Supplement government tax revenues, and
 Provide liquid reserves for the largest banks head quartered in the U.S.
C. Eurodollar Maturities, Risks and Interest rate
Most Eurodollar deposits are short-term time deposits (ranging from overnight to call money loaned
for a few days out to one year) and, therefore, are true money market instruments.
 However, small percentages are long-term time deposits, extending in some instances to about
five years.
 Most Eurodollar deposits carry one-month maturities to coincide with payments for
shipments of goods.
 Other common maturities are 2, 3, 6, and 12 months.
 The majority are interbank liabilities that pay a fixed interest rate.
Eurodollar loan rates have two components:
i. The cost of acquiring Eurodollar deposits (usually measured by the London Inter Bank
Offer Rate (LIBOR) on three or six month Euro deposits); and
ii. A profit margin/“spread” based on riskiness of the loan &degree of competition.
Profit margins generally are very low on Eurodollar loans because the market is highly competitive,
the cost of lending operations is low, and the risk is normally low.
 Borrowers are generally well-known institutions with substantial net worth and solid credit
standing.
 Market transactions are usually carried out in large, even denominations ranging from about
$500,000 to $5 million or more.

25
 Review Questions
1. What is money market? What are the broad objectives of the money market? Explain why
there is a critical need for money market instruments.
2. Who are the principal lenders and borrowers active in the U.S. money markets? What are the
goals of money market investors?
3. Define the following:
A. Money risk C. Inflation risk E. Political risk
B. Default risk D. Currency risk
Which of these risks are minimized by investing in money market instruments? Does a money
market investor avoid all of these risk factors? Why or why not?
4. Discuss the breadth and width of the money market.
5. What are federal funds? Clearing house funds? Explain which is more important in the
money market, and why.
6. Describe the structure of interest rates in the money market. What are the common money
market instruments? Which instrument anchors the market and appears to be the foundation
for other interest rates? Can you explain why this is so?
7. Why has the volume of Treasury Bills grown so rapidly in recent years? Explain why T-Bills
are so popular with money market investors. List and define the various types of Treasury
Bills. Why are there so many different varieties?
8. Explain how a Treasury Bill auction works. Can you cite some advantages of this method of
sale? Disadvantages? Explain the difference between competitive and non-competitive
tenders. How prices are determined? How bills are offered to each class of investors?
9. How are the yields on U.S. Treasury Bills calculated? How does this method differ from the
method used to calculate bond yields? Why is this difference important?
10. Who are the principal investors in U.S. Treasury Bills? What factors motivate these investors
to buy bills?
11. Explain why dealers are essential to the smooth functioning of securities markets. Where do
most dealer funds come from?
12. What is a demand loan? An RP? Explain their role in dealer financing.
13. In what ways do dealers earn income and possibly make a profit? To what risk is each source
of dealer income subject?
14. Are the majority of government securities dealers’ positions in short term or long term
securities? What causes their position to change?
15. What is commercial paper? What features make it attractive to money market investors?
16. Describe the role dealers play in the functioning of the commercial paper market. How is the
yield (or rate of return) on commercial paper calculated?
17. What are the principal advantages accruing to a company large enough to tape the
commercial paper market for funds? Are any disadvantages to issuing commercial paper?
18. Who are the principal investors in the commercial paper? How and why is this paper rated?
19. What is a banker’s acceptance? What does the word accepted mean?

26
20. Explain why acceptances are popular with exporters and importers of goods? Why are these
instruments not as widely used within the United States as they are in financing international
trade?
21. Evaluate bankers’ acceptances as a security investment. What are their principal advantages
and disadvantages from an investment point of view?
22. What is a Euro currency? Market? Why is it needed?Define the term Eurodollar. Can a U.S.
bank create Eurodollars? Why?
23. Describe the process by which Eurodollars are created. Explain what happens to the total
volume of U.S. bank reserves and deposits in the creation process.Can Eurodollars be
destroyed? How?
24. List the sources of Eurodollar deposits. List their principal uses.
25. What role do Eurodollar deposits play in the reserve management operations of major U.S.
banks? What are the advantages of Eurodollar borrowings over sources of bank reserves?
26. Evaluate the Euro currency markets fro a social point of view. What are the major benefits
and costs of these rapidly growing institutions? Would you support closer regulation of the
Euro currency markets? Why or why not?

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 Unit 3:The Capital Market
4.3.1. Introduction
The capital market is a financial relationship created by a number of institutions and is an arrangement
that allows suppliers and demanders of long–term funds (i.e. funds with maturities exceeding one year)
to make exchange transactions (provide funds via receiving securities).
 The capital market is a market for long-term funds.
 Included among the instruments used to raise long-term funds are securities issues of businesses
and government units.
 The backbone of the capital markets is formed by the various security exchanges (equity
markets) that provide a forum for equity transactions (i.e. trading of stocks).
 The long-term debt securities are also traded in another segment of the capital market (referred
to as long-term debt markets).
Mechanisms for efficiently offering and trading securities contribute to the functioning of capital
markets, which is important to the long-term growth of business.
 The capital market comprises the following two markets:
 New Issues (Primary) Markets – Markets for Initial Public Offering (IPO), and
 Stock (Security) Exchanges or Stock Markets – Secondary Markets.
 It should be noted also that secondary markets exist Over-the-Counter (OTC) for trading long-
term debt securities such as bonds.
Capital markets are markets for long term funds that are formed by the various securities exchanges (or
organized exchanges) and over-the-counter (OTC) markets.
 The capital markets comprise the Long-Term Debt Markets and Corporate Stock Markets (also
called Equity Markets).
The next section discusses the underlying features, basic instruments, as well as the general structure of
capital markets, which are by definition markets for long term funds.
4.3.2. Long-Term Debt Markets
The popular forms of long-term debt financing instruments are corporate bonds (or corporate notes).
 These instruments are issued by largest corporations with high credit standing and sold in the
open market.
 This is especially true for the largest corporations whose credit standing & reputation is so
strong that they can avoid dealing directly with an institutional lender such as a bank, financial
company, or insurance company and sell their IOUs in the open market.]
Smaller companies without the necessary standing in the eyes of security investors usually must confine
their long-term financing operations to negotiated-loans with an institutional lender, an occasional stock
issue, and heavy use of internally generated cash.

4.3.2.1. The Most Common Types of Corporate Bonds

The most common types of corporate bonds often issued in the capital markets are discussed next:
1. Debentures
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There are many different types of corporate bonds issued every day in the financial markets.
 Among the most common is the debenture, which is not secured by any specific asset or assets
owned by the issuing corporation.
 Instead, the holder of a debenture is a general creditor of the company and looks to the earning
power and reputation of the borrower as the main source of the bond’s value.
2. Subordinated Debentures
A related form of bond is the subordinated debenture, frequently called a junior security.
 If a company goes out of business and its assets are liquidated, the holders of subordinated
debentures will be paid only after all secured and unsecured senior creditors receive the monies
to which they are entitled.
3. Mortgage Bonds
Debt securities representing a claim against specific assets (normally plant and equipment) owned by a
corporation are known as mortgage bonds.
 These bonds may be either closed end or open end.
 Closed-end mortgages do not permit the issuance of any additional debt against the assets already
pledged under the mortgage.
 Open-end bonds, on the other hand, do allow additional debt to be issued against pledged assets,
and this may dilute the position of the current bondholder.
 For this reason, open-end mortgage bonds typically carry higher yields than closed-end bonds.
Sometimes several different mortgages bonds with varying priorities of claim will be issued against the
same asset.
 For example, the initial issue of bonds against a corporation’s fixed assets may be designated first
mortgage bonds, and later second mortgage bonds may be issued against those same assets.
 If the company were liquidated and the pledged assets sold, holders of second mortgage bonds
would receive only funds left over after holders of the first mortgage bonds were paid off.
4. Collateral Trust Bonds
A debt instrument secured by stocks, bonds, and notes issued by units of government or by other
corporations is called a collateral trust bond.
 Such a bond is really an interest in a pool of securities held by the bond issuer.
 The pledged securities are held in trust for the benefit of the bondholders, though the borrowing
company usually receives any interest and dividend payments generated by the pledged securities
and retains voting rights on any stock that is pledged.
5. Income Bonds
Bonds often used in corporate reorganizations and in other situations when a company is in financial
distress are known as income bonds.
 Interest on income bonds is paid only when enough income is actually earned, making an income
bond similar to common stock.
 However, holders of income bonds do have a prior claim on earnings over both stockholders and
holders of subordinated debentures.

29
  Moreover, some income bonds carry a cumulative feature under which unpaid interest
accumulates and must be fully paid before the stockholders receive any dividends.
6. Equipment Trust Certificates
Resembles a lease in form, equipment trust certificates are used most frequently to acquire industrial
equipment or rolling stock (such as trucks, railroad cars, or airplanes).
 Title to the assets acquired is vested in a trustee (often a bank trust department) who leases these
assets to the company issuing the certificates.
 Periodic lease payments are made to the trustee who passes them along to certificate holders.
 Title to the assets passes to the borrowing company only after all lease payments is made.
7. Industrial Development Bonds
In recent years, state and local governments have become much more active in aiding private
corporations to meet their financial needs.
 One of the most controversial forms of government-aided, long-term business borrowings is the
industrial development bond (IDB). Developed originally in the southern states during Great
Depression of the 1930s and used today by local governments throughout the United States.
 These bonds are issued by a local government borrowing authority in order to provide buildings,
land, and/or equipment to a business firm.
 Because governmental units can borrow more cheaply than most private corporations, the lower
debt costs may be passed along to the firm as an added inducement to move to a new location,
bringing new jobs to the local economy.
 The business firm normally guarantees both interest and principal payments on the IDBs by
renting the buildings, land, and/or equipment at a rental fee high enough to cover debt service
costs.
8. Pollution Control BondsRelated to industrial development bonds, pollution control bonds are used
to aid private companies in financing the purchase of pollution control equipment.
 In this case, local governments frequently will purchase pollution control equipment with the
proceeds of a bond issue and lease that equipment to business firms in the area.
4.3.2.2. New Types of Corporate Notes and Bonds
Corporate bonds are traditionally called fixed-income securities because most bonds pay a fixed amount
of interest each year, as determined by their coupon rate and par value.
 This creates a problem for bondholders when interest rates rise, inflation increases, or both,
because then the real market value of fixed-income securities falls.
In recent years, repeated bouts (short-term attacks) with inflation and high interest rates and reduced
quality ratings on corporate bonds have spurred borrowers and investment bankers to develop new
types of corporate bonds whose return to the investor is sensitive to changing inflation and changing
bond values and interest rates.
 Among the most popular of these innovative securities are discount bonds, stock-indexed bonds,
floating-rate bonds, commodity-backed bonds, and warrant bonds.
i. Discount Bonds
Discount bonds, first used extensively in 1981, are sold at a price well below par and appreciate toward
par as maturity approaches.
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  Thus, the investor earns capital gains as well as interest, while the issuing corporation usually can
issue discount bonds at a lower after-tax cost than on conventional bonds.
 Some discount bonds, known as zero-coupon bonds, pay no interest at all.
 First used by J.C. Penny in 1981, “zeros” pay a return based solely on their appreciation in
market price as they approach maturity.
 However, the annual price increase in zeros is taxable as ordinary income, not as capital gain,
under current IRS regulations.
ii. Stock-Indexed Bonds
Stock-indexed bonds have an interest rate tied to stock market trends.
 For example, one $25 million issue sold in 1981 had its annual interest rate tied to the annual
trading volume on the New York Stock Exchange.
 A rise in stock trading volume (on the theory that stocks are more eagerly sought by investors as
a hedge when inflation increases) rises the bond’s promised rate of return to the holder.
iii.Floating-Rate Bonds
Floating-rate bonds have their annual promised rate tied to changes in the long-term or short-term
interest rate or both.
 Many investors regard floaters as realistic alternatives to buying money market securities.
iv.Commodity-Backed Bonds
Commodity-backed bonds carry a face value tied to the market price of an internationally traded
commodity, such as gold, silver, or oil, which presumably is sensitive to inflation.
v. Warrant and Usable Bonds
Warrant bonds permit an investor to purchase additional bonds at the same yield as the original bonds
or sale the detachable warrants to another investor.
 A related bond, called a usable bond, has warrants to purchase at par the issuing company’s
stock, and those warrants can be traded separately from the bonds themselves.
 Warrants and usable bonds are obviously most valuable when interest rates are expected to
decline.
While many of these new types of bonds do reasonably well in inflationary periods, they often prove
difficult to sell when inflation decreases or when investors become very risk conscious.
4.3.2.3. Markets for Corporate Notes and Bonds (Primary Markets)
Corporate bonds and/or notes may be issued in the primary market through one of the following
alternative techniques:
1. Initial Public Offering (IPO) – represents security issuance to the public (i.e. offering new
securities in the open market for the first time).
 It is a competitive sale (offering).
2. Private Placement (where securities are sold privately to a limited number of investors).
 It is a negotiated sale (i.e. non-competitive offering).
4.3.2.4. Secondary Markets for Corporate Bonds

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The resale (secondary) market for corporate notes and bonds is relatively limited as compared to the
resale markets for common stocks, municipal bonds, and other long term securities.
 Trading volume is thin, even for some bonds issued by the largest and best-known companies.
Part of the reason is the following:
 No central exchange for bond trading exists.
 Corporate bonds are traded on all major exchanges.
 Most secondary market trading for bonds is conducted over the telephone through brokers and
dealers.
 Dealers act as middlemen between institutional investors and issuers (sellers).
 “OTC” brokers arrange trading for a commission.

4.3.3. Corporate Stock Market (Equity Market)

4.3.3.1. Organized Exchanges Vs OTC Markets
Corporate stocks can be traded in organized exchanges (stock exchanges), over-the-counter (OTC)
markets, or both. The major stock exchanges and the basic characteristics of OTC markets is discussed
below.
1. Major Organized Exchanges
In the U.S., there are a number of organized exchanges for trading in corporate stocks. The following
are the major ones:
 New York Stock Exchange (NYSE);  Philadelphia Exchange (PHLX);
 American Stock Exchange (ASE or AMEX);  Boston Stock Exchange (BSE); and
 Pacific Stock Exchange (PSE);  Cincinnati Stock Exchange (CSE).
 Mid West Stock Exchange (MSE);
In this regard, while the NYSE and ASE (or AMEX) are national exchanges, the rest are Regional
Exchanges. Apart from the NYSE and AMEX, the following are among the leading Stock Exchanges in
the world:
 Tokyo Stock Exchange (Japan)  Stockholm Stock Exchange (Sweden)
 London Stock Exchange (Britain)  Brussels Stock Exchange (Belgium)
 Singapore Stock Exchange (Singapore)  Sydney Stock Exchange (Australia)
 Frankfurt Stock Exchange (Germany)  Hong Kong Stock Exchange (Hong Kong)
 Zurich Stock Exchange (Switzerland)  Johannesburg Stock Exchange (South Africa)
 Paris Stock Exchange (France)  Taipei Stock Exchange (Taiwan)
 Manila Stock Exchange (Philippines)  Toronto Stock Exchange (Canada)
 Milan Stock Exchange (Italy)  Wellington Stock Exchange (New Zealand)
 Amsterdam Stock Exchange (Netherlands)
Today, all the exchanges use similar procedures for controlling membership, regulating trade, and
recording purchases and sales of stock.
 Trading is governed by regulation & formal procedures.

32
  This is designed to ensure both competitiveness (pricing) and create active market for
the stock of the largest, financially stable companies.
2. Over-The-Counter (OTC) Market
Trading of stock through brokers operating off the major exchanges (i.e. in the OTC markets) also
occurs. In this regard,
 Over-The-Counter (OTC) markets are “over the telephone markets”.
 They are much more informal.
Trading in the OTC markets includes stocks & bonds of many small and medium sized companies.
4.3.3.2. Organized Stock Exchanges: Case of the NYSE
In the United States, the NYSE is awell known national stock exchange followed by the ASE (or AMEX).
 The NYSE and ASE (or AMEX) are national markets for trading of corporate stocks that
compete with regional exchanges.
 They are markets for “Listed Stocks”.
 Stock brokers & specialists play major role in these markets.
In general, exchanges provide a “physical location for trading”.
 Trading by member firms must be carried on at the specific location.
 On the floor of NYSE, for instance, there are 18 counters, each with several windows for trading
posts.
 Exchanges permit the enforcement of formal trading rules in order to achieve efficient & speedy
allocation of available equity shares.
In order to trade in organized exchanges, the stock(s) must be issued by a firm listed with the exchange.
In this regard,
 Strong listing qualifications are demanded in order to get companies listed in organized
exchanges.
 The listing requirements limit exchange participants (stock issuers) to strong & largest firms.
 The rigorous listing requirements help to ensure listed companies to:
 Have sufficient volume of shares available to create an active national market for their
stocks; and
 Disclose sufficient data so that interested investors can make informed decisions.
The NYSE, as a stock exchange, requires approval of admission by NYSE Board of Directors.
 Listed companies (in NYSE), in this regard,
 Must make an annual disclosure of their financial condition;
 Limit trading by insiders;
 Publish quarterly earning reports; and
 Help maintain an active and deep public market for their shares.
 If trading interest in a particular firm’s stock falls off significantly, the firm may be delisted.
4.3.3.3. Advantages of Listing and Role of Member Firms

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Listing on the exchanges has different advantages. The following are the major ones:
 Improves liquidity and enable sale of future issuance.
 Eases sale of subsequent issuances without significantly depressing its price.
 A corporation can improve the market for its stock by getting it listed on a securities exchange.
Member firms of the exchange, in this regard, are the only ones who may trade in listed securities on the
exchange floor, either for their:
 Own account (i.e. for their own portfolio), or
 Customers (i.e. buy or sale shares of a given listed company as per the orders of their customers
or investors).
Most members actually own “Seats” on the exchange and hold claims against the exchanges net assets.
 The majority of seat owners are directors or partners of brokerage firms, and some of these
firms own several seats.
 Member firms are allowed to sell or lease their seats with the approval of the Exchange’s
Governing Board.
Member firms fulfill a variety of roles on an exchange. In this regard,
 Floor Traders:
 They are members who buy & sell only for their own account.
 They are really speculators whose portfolios turnover rapidly as they drift from post to
post on the exchange floor looking for profitable trading opportunities.
 Commission Brokers:
 They are employed by member brokerage firms to represent the orders of their
customers on the exchange floor.
 Floor Brokers:
 Floor Brokers are usually individual entrepreneurs carrying out buy and sell orders from
other brokers not present on the exchange floor.
A few traders holding exchange seats are Specialists, who trade in one or a limited number of stocks.
 The specialist firms operating on the NYSE act as both brokers and dealers, buying & selling for
other brokers and for themselves when there is an imbalance between supply and demand for
the stocks in which they specialize.
 When sell orders pile up for the stocks a specialist firm is responsible for, it will move in to buy
some of the offered shares.
 Specialists help to create orderly and continuous markets and stabilize price by agreeing to
undertake immediate trading to cover unfilled customer orders.
 In return for this service of immediate trading, specialists profit by purchasing stocks from
public sellers at discounts from the market price and by selling stocks at a premium above the
market price.
4.3.3.4. Origin of Exchanges
Stock exchanges are among the oldest financial institutions.

34
  For instance, the NYSE was set up following an agreement among 24 Wall Street Brokers in
May 1792, just 3 years after the U.S. Constitution was adopted.
In general, exchanges
 Provide a continuous market centered in an established location for buying & selling equity
shares;
 Have rigid rules to ensure fairness in the trading process; and
 Bring buyers & sellers together and, thus,
 Make stock a liquid investment;
 Promote efficient pricing of securities; and
 Make possible the placement of huge amounts of financial capital.
4.3.3.5. NYSE Requirement for Listing a Company
The NYSE has set the following minimum requirement for initial listing:
i. Demonstrated earning power, with before tax earning of at least $2.5 million in the most recent
year and $ 2 million during the previous two years.
ii. Adequate size of company operations, with net tangible assets at least $16 million.
iii. Adequate minimum market value of publicly held shares, adjusted for market conditions.
iv. A sufficient number (currently 1 million) of common shares held by the public.
v. Shares which are held widely enough to promote an active market - currently at least 2000
shareholders with 100 or more shares each are required to qualify.
The following are the requirements for continued listing:
i. Periodic public disclosure of financial condition & earning.
ii. Maintenance of an adequate number of publicly traded shares outstanding.
The Exchange would consider suspending or removing a company’s security (also called delisting a
company) from the trading list:
 If there are fewer than 1200 round-lot investors;
 If 600,000 or fewer shares in public hands; and
 When the aggregate market value of publicly held shares fall below acceptable limits.

4.3.3.6. The Informal Over the Counter Market (OTC)

Especially, large majority of debt securities are traded in the OTC markets, and not on organized
exchanges. In this case, the
 Customer places buy or sell orders with a bank, broker, or dealer.
 Information is transmitted via telephone, by wire, or by computer terminal to the particular
dealer or broker with securities to sell or an order to buy.
 Market Makers are electronically linked.
 Each broker or dealer seeks the best possible price on behalf of himself or his customer.
 The resulting competition to find the best deal brings together traders located far apart.

35
Prices of actively traded securities respond almost instantly to the changing forces of DD & SS so that
security prices constantly hover (or float) at near competitive, market determined levels.
 All money market instruments and the large majority of government bonds and corporate
bonds are traded in the OTC markets.
 Few stocks (i.e. common stocks) of listed companies and the entire stocks of unlisted
companies (the latter being usually small firms) are traded in the OTC market.
 Most common stocks are traded on organized exchanges.
The OTC market is generally preferred by financial institutions like:
 Commercial banks,  Mutual funds,
 Bank holding companies,  Insurance companies, etc.
Financial institutions prefer trading in the OTC Markets due to the fact that:
 Their shares are not actively traded, and
 OTC trading & disclosure rules are less restrictive.
 The presence of financial institutions tends to give the OTC market a more conservative tone
(short term liquidity preference) than the exchanges.
Many dealers in the OTC market act as “principals” instead of brokers as on the organized exchanges.
 That is, they take “positions of risk” by buying securities outright for their own portfolio as well
as for retail customers.
 Several dealers will handle the same stock so that customers can shop around.
 All prices are determined by negotiation with dealers acquiring securities at bid price and selling
them at asked prices
With regard to regulations, the U.S. OTC market is regulated by a code of ethics.
 This code of ethics was established by the National Association of Security Dealers (NASD).
 The NASD, in this regard, is a private organization.
 The NASD encourages ethical behavior among its members.
 Breaking NASD’s regulations by trading firms or their employees may result in:
 Fine (punishment in the form of money),
 Suspension, or
 Removal out of the organization.
 One of the most important contributions of NASD has been the development of NASDAQ.
NASDAQ is an abbreviation to National Association of Security Dealers Automated Quotation system,
which is a nation-wide communication network that enhances the process of security trading and
pricing.
 The NASDAQ displays bid & asked prices of the OTC traders & securities on video screens
connected electronically to a central computer system.
 All NASD member firms trading in a particular stock report their bid – ask price quotations
immediately to NASDAQ.

36
  The NASDAQ, thus, allows dealers, brokers, and customers to determine instantly the terms
currently offered by major securities dealers.

4.3.3.7. The Third Market

The Third Market is a market for securities listed on a stock exchange but traded over the counter.
 Brokerage & Dealer Firms not members of an organized exchange are active in this market.
The original purpose of the third market was to supply large blocks of shares to institutional investors,
especially mutual funds, bank trust accounts, and pension funds.
 These investors engage in Block Trades.
 Block Trades are transactions involving 1000 shares or more.
Large block traders, presumably,
 Possess technical knowledge (know how) to make informed investment decisions.
 Carry out transaction with out assistance from a stock exchange and the high brokerage
commissions that may entail.
By trading with third market broker & dealer firms, who compete directly with specialists on the
exchanges, a large institutional investor frequently can lower transactions costs and trade securities
faster.
 The Third Market provides additional competition for the organized exchanges.
 Moreover, along with the over-the-counter markets, the Third Market has been a catalyst in
reducing brokerage fees and promoting trading efficiency.
 For example, the growth of the Third Market and other OTC trading during the 1970s
encouraged the unbundling of commissions at many U.S. broker and dealer firms to more
accurately reflect the true cost of each security trade.
 Many brokerage firms, especially those active in odd-lot trading, offer customers an
array (or range) of peripheral services, such as research on market trends and security
credit accounting for purchases and sales, and often the customer pays for these services
whether or not he/she uses them.
 The largest institutional investors, however, have little need for such services and they
seek brokers and dealers offering their services at minimum cost.
For instance, the NYSE was charging fixed commissions on trading.
 This increased the flight of major stock investors in to the third market & in to other OTC
markets.
 This has later brought about pricing policies in the industry geared more directly to actual
services used.
While major stock brokers and dealers used to quote set commissions, the practice of charging fixed
brokerage commissions to stock investors ended on the New York Stock Exchange (NYSE) on May1,
1975.
 The result was an upward surge in the volume of trading on the organized exchanges.
 In fact, stock trading on Wall Street multiplied fivefold between 1975 and 1985.
37
More recently, numerous “discount” brokerage houses have appeared in exchanges, leading many
institutional customers to:
 Abandon the third market.
 Return to more traditional channels for executing their security orders as trading prices
continue to decline.
Discount Brokerage Firms, in this regard, offer trading services at commission rates as much as 80%
less than the rates quoted by so-called full-service firms.
 The more than 600 discount houses currently operating (many organized by banks) cut costs by
not giving investment advice or offering personal account management to customers.

4.3.3.8. Stock and Bond Market Indicators

Stock market indicators have come to perform a variety of functions, from serving as benchmarks for
evaluating the performance of professional investors to answering the question “How did the market do
today?”
 Thus, stock market indicators (indexes or averages) have become part of everyday life.
 The most commonly quoted stock market indicator is Dow Jones Industrial Average (DJIA).
 Other stock market indicators cited in the financial press are the:
 Standard & Poor’s 500 Composite (S&P 500),
 New York Stock Exchange Composite Index (NYSE Composite),
 NASDAQ Composite Index, and
 Value Line Composite Average (VLCA).
 Other stock market indicators include the Wilshire stock indexes and the Russell stock indexes,
which are followed primarily by institutional money managers.
In general, market indexes rise and fall in fairly similar patterns.
 Although the correlation is high, the indexes do not move in exactly the same ways at all times.
 The differences in movement reflect the different ways in which the indexes are constructed.
Three factors enter into that construction:
 The universe of stocks represented by the sample underlying the index,
 The relative weights assigned to the stocks included in the index, and
 The method of averaging across all the stocks.
Some indexes represent only stocks listed on an exchange.
 Examples are DJIA and the NYSE Composite, which represent only stocks listed on the Big
Board.
By contrast, the NASDAQ Composite Index includes only stocks traded over the counter.
 A favorite of professionals is the S&P 500 because it contains both NYSE-listed and OTC-traded
shares.
 Each index relies on a sample of stocks from its universe, and that sample may be small or quite
large.
Does it matter in which market a corporation’s securities are traded?
38
  Yes and no.
 It is desirable to have your securities traded in a market where there is sufficient activity so that
an investor who wants to buy or sell the security can do so readily.
 Therefore, the marketability that the market provides to the security is important.
 The more easily a security can be bought and sold, the less its marketability risk, which is the risk
than an owner will not be able to sell the security when he or she wants to sell it.
 Investors are willing to take a lower return when the marketability risk is lower, allowing the
corporation to raise additional funds at a lower cost.
 Therefore, firms want to list their stocks in a market that provides marketability for the stock.
As with the stock market, there are bond market indexes that are followed by investors.
 The wide range of bond market indexes available can be classified as broad-based bond market
indexes and specialized bond market indexes.
 The three broad-based bond market indexes most commonly used by institutional investors are
the
 Lehman Brothers U.S. Aggregate Index,
 Salomon Smith Barney (SSB) Broad Investment-Grade Bond Index (BIG), and
 Merrill Lynch Domestic Market Index.
There are more than 5,500 issues in each index.
 The specialized bond market indexes focus on one sector of the bond market or a subsector of the
bond market.
 Indexes on sectors of the market are published by the three firms that produce the broad-based
bond market indexes.
 Non-brokerage firms have created specialized indexes for sectors.

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 Review Questions
1. Explain what is meant by the phrase, “the financial markets are a supplemental funds source for
business.” What factors appear to affect the volume of business fund raising from the money and
capital markets?
2. List the principal external sources of business working capital. Of long term business investment
funds. What factors influence which of these various funds sources a business firm will draw
upon?
3. Carefully define each of the following terms:
A.Indenture F. Debenture K. Equipment-trust
B.Trustee G. Subordinated debenture certificate
C.Term bond H. Mortgage bond L. Convertible bond
D.Call privilege I. Collateral trust bond M. Industrial dev’t bond
E.Sinking fund J. Income bond N. Pollution control bond
4. Explain how the true cost of a corporate bond to the issuing company may be determined.
5. Who are the principal investors in corporate bonds and notes? Why?
6. Describe the role of investment bankers in the corporate bond market. What are the principal
risks encountered by these firms? Discuss the factors that must be considered in pricing a new
bond issue.
7. What is a private placement? Who buys privately placed bonds and why? What are the principal
advantages to the borrower in a private placement of securities?
8. Provide a definition for each of the following terms:
A. Term loan C. Prime rate
B. Floating rate D. Compensating balance
9. For what purpose are commercial mortgages issued? What changes have occurred recently in the
terms on commercial mortgages? What is an equity kicker?
10. Explain the term indexing. Why is this device necessary in today’s economy?
11. What is the difference between exchanges and OTC markets? List the major stock exchanges
available in the world.
12. Discuss origin of exchanges. Major aspects of the NYSE. NYSE listing requirements. What are
the minimum requirements for continued listing? When do company’s shares delisted from
exchanges?
13. Discuss the major advantages of listing on exchanges. What is the role of member firms?
14. Explain the roles of the following members of exchanges:
A. Floor traders C. Floor traders
B. Commission brokers D. Specialists
15. What are institutional investors? Why do financial institutions prefer OTC market?
16. What is NASD? NASDAQ? What is the role of NASDAQ?
17. What is the third market? Who are the traders in the third market? How is it created? What are
the recent developments? What are discount brokerage houses?

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18. Discuss the registration requirements of the SEC. What is a prospectus? Waiting period? What
are the most important duties of an underwriter? What is the theme of Rule 145? What
advantage did Rule 415 bring?
19. What are bond and stock indices? Give examples of the most commonly quoted stock market
indexes. What are the factors entering into construction of stock market indexes?
20. Discuss the classification of stock market indicators. Approaches for weighting.
21. What are the major bond market indexes?

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