Chapter 2: Fundamentals of Financial Management

Physical Asset Markets
Products such as wheat, autos, real estate, computers, and machinery.
Also known as “Tangible” or “Real” asset markets
Financial Asset Markets
– Deal with stocks,bonds,notes, and mortgages.
– This market deal with derivative securities whose value are derived from changes in the prices of other assets.
Spot Markets
Markets in which assets are brought or sold for “on-the-spot” delivery.
Futures Markets
Markets in which participants agree today to buy or sell an asset at some future date.
– for example, a farmer may enter into a futures contract in which he agrees today to sell 5,000 bushels of soybeans 6 months from now at a price of $9.30 a bushel.
Money Markets
Markets for short-term, highly liquid debt securities.
– the New York, London, and Tokyo money markets are among the world’s largest.
Capital Markets
Markets for intermediate – or long-term debt and corporate stocks.
– the New York stock exchange, where the stocks of the largest U.S. corporations are traded, is a prime example of a capital Market.
Short-term
Less than 1 year
Intermediate-term
1 to 10 years
Long-term
more than 10 years
Primary Markets
Markets in which corporations raise new capital.
Secondary Markets
Markets in which existing, already outstanding securities are traded among investors.
Private Markets
Markets in which transactions are worked out directly between two parties.
– Bank loans and private debt placements with insurance companies are private, they may be structured in any manner to which the two parties agree.
Public Markets
Markets in which standardized contracts are traded on organized exchanges.
– Securities that are traded in public markets (for example, common stock and corporate bonds) are held by a large number of individuals.
Investment Banks
Traditionally Help companies Raise capital
They (A) help corporations design securities with features that are currently attractive to investors,(B) buy these securities from the corporation, and(C) resell them to savers.
Commercial Banks
The traditional “department stores of finance” serving a variety of savers and borrowers.
– Banks such as, Bank of America, Citibank, Wells Fargo, and JPMorgan Chase.
Financial Services Corporations
A Firm that offers a wide range of financial services, including investment banking, brokerage operations, insurance, and commercial banking.
Credit Unions
Cooperative associations whose members are supposed to have a common bond, such as being employees of the same firm.
– Members’ savings are loaned only to other members, generally for auto purchases, home improvement loans, and home mortgages.
– Credit unions are often the cheapest source of funds available to individual borrowers.
Pension Funds
Retirement plans funded by corporations or government agencies for their workers and administered primarily by the trust departments of commercial banks or by life insurance companies.
– Pension funds invest primarily in bonds, stocks, mortgages, and real estate.
Life Insurance Companies
Take savings in the form of annual premiums; invest these funds in stocks, bonds, real estate, and mortgages; and make payments to the beneficiaries of the insured parties.
Mutual Funds
Corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units.
– People come together and let a corporation invest it in some sort of bond issued by businesses or governments.
Money Market Funds
mutual funds that invest in short-term, low-risk securities and allow investors to write checks against their accounts
Exchange Traded Funds (ETFs)
Similar to regular mutual funds and are often operated by mutual fund companies.
– ETF shares are generally traded in the public markets, so an investor who wants to invest in the Chinese market, for example, can buy shares in an ETF that holds stocks in that particular market.
Hedge Funds
Also similar to mutual funds because they accept money from savers and use the funds to buy various securities, but there are some important differences.
– Mutual funds and ETFs are registered and regulated by the securities and Exchange Commission, Hedge Funds are Largely unregulated.
Private Equity Companies
operate like hedge funds but instead of purchasing stock of a firm, they buy and manage entire firms
U.S. Treasury Bills
Market – Money
Major Participants – Sold by U.S. Treasury to finance federal expenditures.
Riskiness – Default-free, close to risk-less
Original Maturity – 91 days to 1 year
Interest Rate – 0.175%
Bankers’ Acceptances
Market – Money
Major Participants – A firm’s note, but one guaranteed by a bank.
Riskiness – low degree of risk if guaranteed by a strong bank
Original Maturity – up to 180 days
Interest rate – 0.26%
Dealer Commercial Paper
Market – Money
Major Participants – issued by financially secure firms to large investors
Riskiness – Low default risk
Original Maturity – up to 270 days
Interest Rate – 0.28%
Negotiable Certificates of Deposit(Certificates of deposits)
Market – Money
Major Participants – Issued by major money-center commercial banks to large investors
Riskiness – Default risk depends on the strength of the issuing bank
Original Maturity – up to 1 year
Interest rate – 0.28%
Money Market Mutual Funds
Market – Money
Major Participants – Invest in Treasury bills, CDs(Certificates of deposits), and commercial paper; held by individuals and businesses
Riskiness – Low degree of risk
Original Maturity – No specific maturity (instant liquidity)
Interest rate – 0.01%
Eurodollar Market time Deposits
Market – Money
Major Participants – Issued by banks outside the United States
Riskiness – Default risk depends on the strength of the issuing bank
Original Maturity – up to 1 year
Interest rate – 0.4%
Consumer Credit, including credit card debt
Market – Money
Major Participants – Issued by banks, credit unions, and finance companies to individuals
Riskiness – Risk is variable
Original Maturity – Variable
Interest Rate – Variable, but average APR is 12.24%-20.17%
U.S. Treasury notes and bonds
Market – Capital
Major Participants – Issued by U.S. government
Riskiness – No default risk, but price will decline if interest rates rise; hence, there is some risk.
Original Maturity – 2 to 30 years
Interest Rate – 1.105% on 2 year to 4.775% on 30 year bonds
Mortgages
Market – Capital
Major Participants – Loans to individuals and businesses secured by real estate; bought by banks and other institutions.
Riskiness – Risk is variable; risk is high in the case of subprime loans
Original Maturity – up to 30 years
Interest Rate – 4.25% adjustable 5-year rate, 5.21% 30-year fixed rate
State and Local Government bonds
Market – Capital
Major Participants – issued by state and local governments; held by individuals and institutional investors
Riskiness – Riskier than U.S. government securities but exempt from most taxes
Original Maturity – up to 30 years
Interest Rate – 5.08% to 5.62% for A-rate, 20 to 40 year bonds
Corporate Bonds
Market – capital
Major Participants – Issued by corporations; Held by individuals and institutional investors
Riskiness – Riskier than U.S. government securities but less risky than preferred and common stocks; varying degree of rick within bonds depends on strength of issuer
Original Maturity – up to 40 years
Interest Rate – 5.36% on AAA bonds, 6.35% on BBB bonds
Leases
Market – Capital
Major Participants – similar to debt in that firms can lease assets rather than borrow and then the assets.
Riskiness – Risk similar to corporate bonds
Original maturity – generally 3 to 20 years
interest rate – Similar to bond yields
Preferred Stocks
Market – Capital
Major Participants – Issued by corporations to individuals and institutional investors
Riskiness – Generally riskier than corporate bonds but less risky than common stock.
Original Maturity – unlimited
Interest Rate – 5.5% to 9%
Common Stocks
Market – Capital
Major Participants – Issued by corporations to individuals and institutional investors.
Riskiness – riskier than bonds and preferred stock; risk varies from company to company.
Original Maturity – Unlimited
Interest Rate – NA
Market Efficiency
A market in which prices are close to intrinsic values and stock seem to be in equilibrium.