FM chapter 1

• Financial market


  A market in which financial assets (securities) such as stocks and bonds can be purchased or sold
• Funds transfer in financial markets

  One party purchases financial assets previously held by another party
• Role of financial markets

  Transfer funds from those who have excess funds to those who need funds
• Entities that access funds from financial markets

  • College students
  • Families
  • Businesses
  • Governments
• Surplus units


  Participants who receive more money than they spend and provide their net savings to the financial markets
• Deficit units


  Participants who spend more money than they receive and access funds from financial markets
• Many individuals provide funds to financial markets in some periods and access funds in other periods
• College students are typically deficit units, as they often borrow from financial markets to support their education
• After obtaining a degree, college students earn more income than they spend and thus become surplus units by investing their excess funds
• A few years later, college students may become deficit units again by purchasing a home
• At this stage, they may provide funds to and access funds from financial markets simultaneously
• Debt securities


  Represent debt (also called credit, or borrowed funds) incurred by the issuer
• Equity securities (stocks)


  Represent equity or ownership in the firm
• Corporate finance


  • Involves corporate decisions such as how much funding to obtain and what types of securities to issue when financing operations
• Investment management


  • Involves decisions by investors regarding how to invest their funds
• Primary markets


  Facilitate the issuance of new securities
• Secondary markets


  Facilitate the trading of existing securities, which allows for a change in the ownership of the securities
• Primary market transactions provide funds to the initial issuer of securities, while secondary market transactions do not
• Types of securities traded in financial markets

  • Money market securities
  • Capital market securities
  • Derivative securities
• Money market securities


  Debt securities that have a maturity of one year or less
• Common types of money market securities

  • Treasury bills
  • Commercial paper
  • Negotiable certificates of deposit
• Capital market securities


  Long-term securities issued to finance the purchase of capital assets
• Common types of capital market securities

  • Bonds
  • Mortgages
  • Stocks
• Bonds


  Long-term debt securities issued by the Treasury, government agencies, and corporations to finance their operations
• Treasury bonds


  Perceived to be free from default risk because they are issued by the U.S. Treasury
• Corporate bonds


  Subject to default risk because the issuer could default on its obligation to repay the debt
• Mortgages


  Long-term debt obligations created to finance the purchase of real estate
• Residential mortgages


  Obtained by individuals and families to purchase homes
• Prime mortgages


  Offered to borrowers who qualify based on criteria such as income level relative to home value
• Subprime mortgages


  Offered to borrowers who do not have sufficient income to qualify for prime mortgages or who are unable to make a down payment
• Commercial mortgages


  Long-term debt obligations created to finance the purchase of commercial property
• Mortgage-backed securities


  Debt obligations representing claims on a package of mortgages
• Stocks (equity securities)


  Represent partial ownership in the corporations that issue them
• Derivative securities


  Financial contracts whose values are derived from the values of underlying assets
• Speculation using derivative securities

  • Allows investors to benefit from movements in the value of underlying assets without having to purchase those assets
• Risk management using derivative securities

  • Allows firms to adjust the risk of their existing investments in securities
• Valuation of securities


  Measured as the present value of expected cash flows, discounted at a rate that reflects the uncertainty surrounding the cash flows
• Debt securities are easier to value because they promise specific payments (interest and principal) until maturity
• The stream of cash flows generated by stocks is more difficult to estimate because some stocks do not pay dividends, and investors receive cash flow only when they sell the stock
• Some investors choose to value a stock by valuing the company and then dividing that value by the number of shares of stock