🏦Financial Institutions and Markets Unit 6 – Money Markets and Capital Markets

Key Concepts and Definitions

• Money markets short-term financial instruments with maturities of one year or less
• Capital markets long-term financial instruments with maturities exceeding one year
• Liquidity refers to the ease with which an asset can be converted into cash without affecting its market price
• Yield the return an investor earns on a financial instrument, expressed as a percentage of the instrument's price
• Credit risk the risk that a borrower may default on their obligations
• Market risk the risk of losses due to changes in market prices or rates
• Primary markets where new securities are issued and sold to investors for the first time
• Secondary markets where previously issued securities are traded among investors

Money Market Instruments

• Treasury bills short-term debt securities issued by the U.S. government with maturities ranging from a few days to one year
• Commercial paper unsecured promissory notes issued by corporations to finance short-term liabilities
  • Maturities typically range from 2 to 270 days
  • Issued at a discount and redeemed at face value upon maturity
• Certificates of deposit (CDs) time deposits offered by banks that pay a fixed interest rate until a specific maturity date
• Repurchase agreements (repos) short-term borrowing arrangements in which the seller of securities agrees to buy them back at a specified price and date
• Bankers' acceptances time drafts drawn on and accepted by banks, used to finance international trade
• Eurodollar deposits U.S. dollar-denominated deposits held in banks outside the United States
• Federal funds unsecured interbank loans with maturities of one day (overnight) to one week

Capital Market Instruments

• Bonds long-term debt securities that obligate the issuer to make periodic interest payments and repay the principal at maturity
  • Corporate bonds issued by companies to raise capital for various purposes
  • Municipal bonds issued by state and local governments to finance public projects
  • Government bonds issued by national governments (Treasury notes and bonds in the U.S.)
• Equities represent ownership in a company, also known as stocks or shares
  • Common stock entitles the holder to voting rights and a share of the company's profits through dividends and capital appreciation
  • Preferred stock provides a fixed dividend and priority over common stockholders in the event of liquidation
• Mutual funds investment vehicles that pool money from many investors to purchase a diversified portfolio of securities
• Exchange-traded funds (ETFs) marketable securities that track an index, commodity, or basket of assets, and trade like stocks on exchanges
• Derivatives financial instruments whose value is derived from an underlying asset, such as options, futures, and swaps
  • Options contracts that give the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a predetermined price and date
  • Futures contracts that obligate the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price

Market Participants and Their Roles

• Investors individuals and institutions that allocate capital with the expectation of earning a return
  • Retail investors individual investors who buy and sell securities for their personal accounts
  • Institutional investors large organizations (pension funds, insurance companies, mutual funds) that invest large sums of money
• Issuers entities (corporations, governments, agencies) that offer securities to raise capital
• Intermediaries facilitate transactions between buyers and sellers and provide market liquidity
  • Brokers execute trades on behalf of clients and charge a commission for their services
  • Dealers trade securities for their own account and profit from the bid-ask spread
• Regulators government agencies and self-regulatory organizations that oversee and enforce rules to ensure fair and efficient markets
  • Securities and Exchange Commission (SEC) primary regulator of U.S. securities markets
  • Financial Industry Regulatory Authority (FINRA) self-regulatory organization for U.S. broker-dealers
• Credit rating agencies (Moody's, Standard & Poor's, Fitch) assess the creditworthiness of issuers and assign ratings to debt securities

Trading Mechanisms and Platforms

• Exchange-based trading securities are traded on organized exchanges with standardized contracts and transparent pricing
  • New York Stock Exchange (NYSE) largest stock exchange in the world by market capitalization
  • Nasdaq electronic stock market known for trading technology companies
• Over-the-counter (OTC) trading decentralized market where participants trade directly with each other, often through dealer networks
• Electronic communication networks (ECNs) automated trading systems that match buy and sell orders electronically
• Dark pools private exchanges or forums for trading securities, often used by institutional investors to execute large orders without impacting market prices
• High-frequency trading (HFT) algorithmic trading that uses powerful computers to transact a large number of orders at extremely high speeds
• Algorithmic trading uses computer programs to automate trading decisions based on predefined rules and market conditions

Regulatory Framework

• Securities Act of 1933 requires issuers to register securities offerings with the SEC and disclose material information to investors
• Securities Exchange Act of 1934 created the SEC and grants it broad authority to regulate securities markets
  • Prohibits insider trading and manipulative practices
  • Requires periodic reporting by publicly traded companies
• Investment Company Act of 1940 regulates mutual funds and other investment companies to protect investors
• Investment Advisers Act of 1940 regulates investment advisers and requires them to register with the SEC
• Sarbanes-Oxley Act of 2002 (SOX) enhances corporate responsibility, financial disclosures, and combats accounting fraud
• Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 comprehensive financial regulatory reform aimed at preventing another financial crisis
  • Created the Consumer Financial Protection Bureau (CFPB) to protect consumers from abusive financial practices
  • Introduced the Volcker Rule to restrict banks from engaging in proprietary trading and investing in hedge funds and private equity funds

Market Analysis and Trends

• Fundamental analysis evaluates securities by examining economic, industry, and company-specific factors to determine intrinsic value
  • Macroeconomic factors interest rates, inflation, GDP growth, unemployment
  • Industry analysis competitive landscape, regulatory environment, growth prospects
  • Company analysis financial statements, management quality, competitive advantages
• Technical analysis studies past market data (price and volume) to identify patterns and predict future price movements
  • Chart patterns head and shoulders, cup and handle, triangles, flags
  • Technical indicators moving averages, relative strength index (RSI), MACD
• Behavioral finance studies the influence of psychology on investor behavior and market outcomes
  • Herd mentality investors following the crowd without independent analysis
  • Loss aversion investors feel the pain of losses more intensely than the pleasure of gains
• Sustainable investing incorporates environmental, social, and governance (ESG) factors into investment decisions
• Fintech financial technology innovations (blockchain, robo-advisors, mobile banking) disrupting traditional financial services
• Globalization increasing interconnectedness of global financial markets and the impact of cross-border capital flows

Practical Applications and Case Studies

• Portfolio management constructing and managing a diversified portfolio of investments to meet specific goals and risk tolerance
  • Asset allocation dividing a portfolio among different asset classes (stocks, bonds, cash) based on risk and return objectives
  • Rebalancing periodically adjusting the portfolio to maintain the desired asset allocation
• Initial public offerings (IPOs) the process by which a private company offers shares to the public for the first time
  • Underwriters investment banks that manage the IPO process and help determine the initial price
  • Prospectus legal document that provides investors with information about the issuing company and the offering
• Bond valuation determining the fair value of a bond based on its coupon rate, face value, maturity, and yield to maturity
  • Yield curve graphical representation of the relationship between bond yields and maturities
  • Credit spreads difference in yield between a corporate bond and a government bond of similar maturity, reflecting the issuer's credit risk
• Mergers and acquisitions (M&A) consolidation of companies through various types of transactions
  • Synergies potential benefits (cost savings, revenue growth) from combining two companies
  • Leveraged buyouts (LBOs) acquisitions financed primarily with debt, often involving private equity firms
• Risk management identifying, assessing, and prioritizing risks to minimize their impact on an organization
  • Hedging using derivatives (options, futures, swaps) to offset the risk of adverse price movements in an underlying asset
  • Value at Risk (VaR) statistical measure that quantifies the potential loss a portfolio may incur over a given time horizon and confidence level