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finance chapter 2
Terms in this set (68)
The transfer of monetary items for securities
ownership or right to future Cash Flow: stocks, bonds (debt), etc.
banks and firms that link deficit & surplus units
surplus economic units
Business, person or government with income > expenditures
deficit economic unit
those needing additional funds
initial time firms sell securities to raise money
investors trade previously-issued securities
Compensation lenders demand and borrowers pay for the use of money. Rate (%) or amount
real rate of interest
Cost when all risks are removed. Compensates for the lender's lost opportunity to consume.
Loss of purchasing power
debtor fails to pay
The time to repay the debt
The difficulty in selling a security based on demand by other investors
Named rate. Includes all risks
No risks other than inflation (Note: Interest rate is usually applied to debt while required return is usually applied to stock.)
Graph that illustrates the relationship between the rate and the term of the debt.
normal yield curve
Rate increases with longer term debt
flat yield curve
Rate does not change with debt term
The purpose of the financial system is to bring together individuals, businesses, and government entities (economic units) that _______________________funds.
that generate and spend
surplus economic units
have funds left over after spending all they wish to spend.
deficit economic units
need to acquire additional funds to sustain their operations.
To enable funds to move through the financial system, funds are exchanged for____________.
Securities are documents that represent the right to receive funds in the _______________
what can help facilitate financial systems?
The primary market
where deficit economic units sell new securities to raise needed funds.
The secondary market
is where investors trade previously-issued securities with each other.
-Trade short- term(1 year or less) debt instruments (e.g., T-Bills, Commercial Paper)
-Major money centers in Tokyo, London and New York
-Trades long-debt securities (Bonds, Stocks)
-NYSE, ASE, over-the-counter (Nasdaq and other OTC)
long term debt and stocks
what helps facilitate the financial market
intermediaries such as commercial banks and insurance companies
market efficiency refers to
the ease, speed, and cost of trading securities
The market for the securities of large companies
is generally efficient: Trades can be executed in a matter of seconds and commissions are very low.
the real estate market
is not generally efficient: It can take months to sell a house and the commission is 6% to 7% of the price.
why is market efficiency important?
-The more efficient the market, the easier it is to transfer idle funds to those parties that need the funds.
-If funds remain idle, this results in lower growths for the economy and higher unemployment.
-Investors can adjust their portfolios easily and at low cost as their needs and preferences change.
money market securities
Highly liquid , low risk
-Treasury Bills (T-Bills)
-Certificates of Deposit (CDs)
money market securities; highly liquid, low risk
•T-Bills: are short-term securities issued by the federal government.
•After initial sale, they have an active secondary market.
•They are bought at a discount, and at maturity the investor receives the full face value.
money market securities; treasury bills (t-bills)
•Negotiable CDs: interest-bearing securities issued by financial institutions.
•They have maturities of 1 year or less.
money market securities; certificates of deposits
•Commercial paper: unsecured debt issued by corporations with good credit ratings.
•Most buyers are large institutions .
money market securities; commercial paper
•Eurodollars: dollar denominated, deposits, located in non-US banks.
•Buyers and sellers are large institutions.
money market securities; eurodollars
•Banker's Acceptances: debt securities that have been guaranteed by a bank . They are used to facilitate international transactions.
capital market securities
-The issuer promises to repay the full amount on the maturity date and to pay interest each year in the amount of the coupon rate times the face value.
-IOUs" issued by the borrower and sold to investors.
issued by the federal government.
issued by state and local governments
issued by corporations
within a capital market companies can raise funds
by selling shares
- involved with stock
- own a portion of the company and can vote on major decisions.
-They receive a return on their investment in the form of dividends and capital gains.
- involved with common stock
- do not generally have voting rights, but have priority in receiving dividends and are paid dividends at a preset rate.
3 factors that influence the equilibrium interest rate
1. inflation, which is a rising trend in the prices.
2. risk, which leads investors to expect a higher return
3. liquidity preference, which refers to the general tendency of investors to prefer short-term securities
r^ + IP represents
risk free rate
The nominal rate can be viewed as having two basic components:
a risk free rate of return, RF, and a risk premium, RP1:
net rate =
real rate + inflation prem + risk premiums
risk premiums can include risks for
risk free rate =
real rate+ inflation premium
-For most securities, there is some risk that the borrower will not repay the interest and/or principal on time, or at all.
-The greater the chance of default, the greater the interest rate the investor demands and the issuer must pay.
Inflation erodes the purchasing power of money.
If you loan someone $1,000 and they pay it back one year later with 10% interest, you will have $1,100. But if prices have increased by 5%, then something that would have cost $1,000 at the outset of the loan will now cost $1,000(1.05) =
- If interest rates rise, lenders may find that their loans are earning rates that are lower than what they could get on new loans.
- The risk of this occurring is higher for longer maturity loans.
- Lenders will adjust the premium they charge for this risk depending on whether they believe rates will go up or down.
- Investments that are easy to sell without losing value are more liquid.
- Illiquid securities have a higher interest rate to compensate the lender for the inconvenience of being "stuck."
safe storage premium
-Some investors, especially those with huge amounts to invest, may be willing to accept a lower interest rate in return for safety.
-The $250,000 FDIC limit is of little use to an investor with $10 billion.
-When market interest rates are very low, this lower rate for a safe investment could even push the interest rate into negative territory.
nominal rate =
real rate of interest + inflation risk prem + default risk prem + maturity risk prem + illiquidity risk prem + safe storage prem
the term structure of interest rates
is the relationship between the maturity and rate of return for bonds with similar levels of risk.
graphic depiction of the term structure of interest rates is called
the yield curve
yield to maturity
is the compound annual rate of return earned on a debt security purchased on a given day and held to maturity.
nominal yield curve
is an upward_-sloping yield curve indicates that long-term interest rates are generally higher than short-term interest rates.
inverted yield curve
-is a downward-sloping yield curve indicates that short-term interest rates are generally higher than long-term interest rates.
-Rate decreases with longer term debt
flat yield curve
is a yield curve that indicates that interest rates do not vary much at different maturities.
What is the real rate of return for investors if the 3 month T-bill rate is 5.5% and the rate of change in the CPI (as a proxy for inflation) is 3%?
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