Comprehensive Guide to Financial Markets, Instruments, and Institutions

Primary markets

Markets in which users of funds (e.g., corporations) raise funds through new issues (IPOs) of financial instruments, such as stocks and bonds

Secondary markets

Markets that trade financial instruments once they are issued; NYSE, NASDAQ

Money markets

Trade debt securities or instruments with maturities of one year or less; most U.S. money markets are over-the-counter (OTC) markets

Capital markets

Trade debt (bonds) and equity (stocks) instruments with maturities of more than one year; wider price fluctuations than money market instruments

Commercial Banks

Depository institutions whose major assets are loans and whose major liabilities are deposits

Thrifts

Depository institutions in the form of savings associations, savings banks, and credit unions

Insurance companies

Financial institutions that protect individuals and corporations (policyholders) from adverse events

Security firms and investment banks

Financial institutions that help firms issue securities and engage in related activities such as securities brokerage and securities trading

Finance companies

Financial intermediaries that make loans to both individuals and businesses

Investment funds

Financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets

Pension funds

Financial institutions that offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years

FinTechs

Refers to the use of technology to deliver financial solutions in a manner that competes with traditional financial methods; cryptocurrencies, blockchain

Supply of loanable funds

Describes funds provided to the financial markets by net suppliers of funds; generally, the quantity of loanable funds supplied increases as interest rates rise.

Demand for loanable funds

Describes the total net demand for funds by fund users; In general, the quantity of loanable funds demanded is higher as interest rates fall.

Required rate of return

Interest rate an investor should receive on a security given its risk. Required rate of return is used to calculate the fair present value on a security.

Expected rate of return

Interest rate an investor expects to receive on a security if he or she buys the security at its current market price, receives all expected payments, and sells the security at the end of his or her investment horizon.

Realized rate of return

Actual interest rate earned on an investment in a financial security. Realized rate of return is a historical (ex post) measure of the interest rate.

Coupon rate

Interest rate on a bond instrument used to calculate the annual cash flow the bond issuer promises to pay the bond holder.

The Federal Reserve

The central bank of the United States

Federal Open Market Committee (FOMC)

The major monetary policy-making body of the Federal Reserve System; main responsibilities are to promote full employment, economic growth, price stability and a sustainable pattern of international trade

Open Market Operations

Involves buying or selling U.S. Treasury securities and agency mortgage-backed securities (MBS) to manage bank reserves and influence interest rates.

Discount Rate

The rate of interest Federal Reserve Banks charge on loans to FI's in their district; raising it tightens monetary conditions; lowering signals expansionary conditions; primary method used by the Fed since 1993

Reserve requirements

Determine the minimum amount of reserve assets that D I's must maintain by law to back transaction deposit accounts held as liabilities on their balance sheets.

Board of Governors

7-member board in Washington, D.C. where each member is appointed by the president of the U.S. and confirmed by the Senate, serving a nonrenewable, 14-year term.

Federal Reserve Banks

12 banks in cities throughout the U.S. that act as a depository institution for the banks in their district and operate under general supervision of the Board of Governors.

Treasury bills

Short-term obligations issued by the U.S. government.

Federal funds

Short-term funds transferred between financial institutions usually for no more than one day.

Repurchase agreements

Agreements involving the sale of securities by one party to another with a promise to repurchase the securities at a specified date and price.

Commercial paper

Short-term unsecured promissory notes issued by a company to raise short-term cash.

Negotiable certificates of deposit

Bank-issued time deposits that specify an interest rate and maturity date and are negotiable (saleable on a secondary market).

Banker's acceptances

Time drafts payable to a seller of goods, with payment guaranteed by a bank.

Bonds

Long-term debt obligations issued by corporations and government units.

Treasury notes (T-notes) and bonds (T-bonds)

Issued by the U.S. Treasury to finance the national debt and other government expenditures.

Municipal bonds

Securities issued by state and local governments.

Corporate bonds

Long-term obligations issued by corporations.

Speculative grade bonds (junk bonds/high-yield bonds)

Bonds rated below Baa by Moody's and BBB by S&P and Fitch.

Mortgages

Loans to individuals or businesses to purchase homes, land, or other real property.

Securitization

Occurs when securities are packaged and sold as assets backing a publicly traded or privately held debt instrument.

Home mortgages

Used to purchase one to four family dwellings (called "single-family mortgages").

Multifamily dwelling mortgages

Used to purchase apartment complexes, townhouses, and condominiums.

Commercial mortgages

Used to finance the purchase of real estate for business purposes.

Farm mortgages

Used to finance the purchase of farms.

Federally insured mortgages

Repayment is guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA).

Conventional mortgages

Not federally insured.

Fully amortized mortgage

The fixed principle and interests payments fully pay off the mortgage by its maturity date.

Balloon payment mortgage

Require fixed monthly interest payments for a 3 to 5 year period, at which point full payment of the mortgage principal is due.

Second mortgages

Loans secured by a piece of real estate already used to secure a first mortgage.

Home equity loans

Lets customers borrow on a line of credit secured with a second mortgage on their homes.

Reverse-annuity mortgages (RAM's)

Attractive mainly to older homeowners who have accumulated substantial equity in their homes.

Primary stock markets

When corporations raise money through new issues, called IPOs.

Secondary stock markets

Where shares of stock are traded.

Why are commercial banks referred to as depository institutions?

Because a significant proportion of their funds are derived from customer deposits.

What are the primary assets and liabilities of a commercial bank?

The primary assets are loans, and the primary liabilities are deposits.

What is the formal name for a commercial bank's balance sheet?

The Report of Condition.

Define credit risk in the context of commercial banking.

The risk that promised cash flows from loans and securities held by the bank may not be paid in full.

What is liquidity risk for a commercial bank?

The risk that a sudden, unexpected increase in liability withdrawals forces the bank to liquidate assets quickly at low prices.

When does a commercial bank incur interest rate risk?

When the maturities of its assets and liabilities are mismatched and interest rates are volatile.

What is insolvency risk?

The risk that a bank may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities.

What has been the largest asset class for commercial banks from 1992 to 2019?

Loans secured by real estate.

What are transaction accounts in banking?

Checkable deposits, including demand deposits and NOW accounts.

What are negotiable CDs?

Large time deposits of $100,000 or more.

What are two examples of nondeposit liabilities for banks?

Federal funds (interbank market) and Repurchase agreements.

How does the maturity structure of bank liabilities compare to their assets?

Bank liabilities tend to have a shorter maturity structure than their asset portfolio.

What was the purpose of the Capital Purchase Program under TARP?

To encourage U.S. financial institutions to build capital and increase the flow of financing to businesses and consumers.

What does the CAMELS rating system evaluate?

The safety and soundness of banks.

What does the 'S' in CAMELS stand for?

Sensitivity to market risk.

What does a CAMELS composite rating of '5' indicate?

The institution has an extremely high immediate or near-term probability of failure.

What are off-balance-sheet assets and liabilities?

Contingent assets and liabilities that may affect the future status of the bank's balance sheet, such as loan commitments or letters of credit.

What is the formal name for a commercial bank's income statement?

The Report of Income.

What is correspondent banking?

The provision of banking services to other banks that lack the staff resources to perform those services themselves.

Why is monetary policy regulation imposed on commercial banks?

To control and implement monetary policy by requiring minimum levels of cash reserves against deposits.

What is the primary goal of credit allocation regulation?

To support bank lending to socially important sectors such as housing and farming.

What are the four primary regulators of U.S. commercial banks?

The FDIC, the OCC, the Federal Reserve, and state bank regulators.

Why was the FDIC created in 1933?

To maintain the stability of and public confidence in the U.S. financial system following the banking panics of 1930-1933.

What is the primary focus of 'Asset Quality' in the CAMELS rating?

The level, distribution, and severity of adversely classified assets and the adequacy of the allowance for loan losses.

What is the primary focus of 'Earnings' in the CAMELS rating?

The ability to cover losses, provide capital protection, and the quality/composition of net income.

What is the primary focus of 'Liquidity' in the CAMELS rating?

The volatility of deposits, frequency of borrowings, and availability of assets readily convertible into cash.

Why were savings institutions (SIs) originally created in the early 1800s?

They were created because commercial banks focused on business enterprises rather than individuals needing home loans.

What is the primary ownership structure of credit unions?

They are nonprofit depository institutions mutually owned by their members.

What are the three primary functions of finance companies?

Consumer lending, business lending, and mortgage financing.

What was the historical name for savings associations?

Savings and loans (S&Ls) associations.

What is the primary lending focus of savings banks?

Residential mortgage lending.

What is the common bond requirement for credit union membership?

Members must share a common bond of occupation, association, or reside in a well-defined neighborhood, community, or rural district.

Why are credit unions able to offer higher interest rates on deposits and lower rates on some loans?

Because they are nonprofit organizations and their earnings are not taxed.

What is the role of the National Credit Union Share Insurance Fund (NCUSIF)?

It provides deposit insurance guarantees of up to $250,000 for insured state and federal credit unions.

What do sales finance institutions specialize in?

Making loans to customers of a specific retailer or manufacturer.

What is the function of business credit institutions regarding accounts receivable?

They engage in factoring, where they purchase accounts receivable at a discount and assume the responsibility for collection.

What is a 'captive' finance company?

A finance company that is a wholly owned subsidiary of a major manufacturing company, providing financing for that manufacturer's products.

What is the primary function of insurance companies?

To compensate policyholders if a prespecified event occurs in exchange for premiums.

What is the difference between an insurance underwriter and an insurance broker?

Underwriters assess the risk of an applicant for coverage, while brokers sell insurance contracts.

What is the difference between life insurance and property-casualty insurance?

Life insurance protects against untimely death, illness, and retirement; property-casualty insurance protects against personal injury and liability from accidents, theft, or fire.

What is an annuity contract?

A savings contract that involves the liquidation of funds saved over a period of time.

What is 'ordinary life' insurance?

Life insurance marketed on an individual basis with periodic premium payments, including term, whole, endowment, variable, and universal life.

What is 'credit life' insurance?

Insurance that protects lenders against a borrower's death before a debt contract, such as a mortgage or car loan, is repaid.

At what level are most insurance companies regulated?

At the state level.

What is the primary role of investment banks?

To help net suppliers of funds transfer capital to net users of funds efficiently, specifically through the origination, underwriting, and placement of securities.

What is the difference between investment banking and securities services?

Investment banking focuses on the origination and underwriting of new securities, while securities services focus on the trading of existing securities in secondary markets.

Who is the primary regulator of the securities industry?

The Securities and Exchange Commission (SEC).

What is the role of FINRA in the securities industry?

FINRA is involved in the day-to-day regulation of trading practices.

What is the primary focus of venture capital (VC) firms?

They focus on funding startup business concerns and emerging technologies.