The Financial Environment: Markets, Institutions, and Interest Rates

Financial Markets and Institutions

• Efficiently transfer funds from lenders to borrowers.

• Borrowers receive funds at lowest possible costs;
  lenders earn high returns.

Types of Financial Markets

• Primary Market: New securities for sale for the first time (e.g., IPOs).

• Secondary Market: Trading of securities already issued (e.g., NYSE).

Primary Market Transactions

• Public Offering: General sale to the public.

• Rights Offering: Existing shareholders offered the right to buy new shares.

• Private Placement: Sale of securities to a select group.

The Role of Secondary Market

• Price Determination: Helps establish market prices.

• Liquidity: Investors can buy/sell securities easily.

• Comprised of:

  • Physical location exchanges (e.g., NYSE)

  • Electronic Dealer Markets

  • Electronic Communications Networks (ECNs)

Stock Trading Orders

• Market Order: Buy at the lowest price available.

• Limit Order: Buy at or below a specified price.

• Stop Order: Buy at or above a specified stop price.

Financial Intermediaries

• Facilitate transactions between savers and borrowers.

• Examples:

  • Commercial Banks

  • Pension Funds

  • Mutual Funds

Interest Rates

• Determined by the supply and demand for money.

• Components:

  • Real Interest Rate (r^*) : offers real return for change in the economy

  • Inflation Premium (IP) : shows the expected rate of inflation that lenders require to compensate for the decrease in purchasing power over time.

  • Default Risk Premium (DRP) :

  • Liquidity Premium (LP)

  • Maturity Risk Premium (MRP)

• r(rf) = r^* + IP (both factors help account and give

• Nominal Interest Rate: r = r^* + IP + DRP + LP + MRP

Yield Curve

• Plots interest rates of bonds differing by maturity.

• Shows the relationship between yields and time to maturity.