Chapter 2: Money Markets and Capital Markets PDF

CHAPTER 2: THE MONEY MARKETS AND CAPITAL MARKETS Learning Objectives: At the end of the discussion, the student will able to: 1. Explain the concept and importance of Money Market 2. Discuss the participants in Money Market and Its example 3. Explain the concept and importance of Capital Market 4. D...

CHAPTER 2: THE MONEY MARKETS AND CAPITAL MARKETS Learning Objectives: At the end of the discussion, the student will able to: 1. Explain the concept and importance of Money Market 2. Discuss the participants in Money Market and Its example 3. Explain the concept and importance of Capital Market 4. Discuss the participants in Capital Market and Its example The Money Markets Defined The term money market is actually a misnomer. Money—currency—is not traded in the money markets. Because the securities that do trade there are short-term and highly liquid, however, they are close to being money. Money market securities, which are discussed in detail in this chapter, have three basic characteristics in common:  They are usually sold in large denominations.  They have low default risk.  They mature in one year or less from their original issue date. Most money market instruments mature in less than 120 days. Money market transactions do not take place in any one particular location or building. Instead, traders usually arrange purchases and sales between participants over the phone and complete them electronically. Because of this characteristic, money market securities usually have an active secondary market. This means that after the security has been sold initially, it is relatively easy to find buyers who will purchase it in the future. An active secondary market makes money market securities very flexible instruments to use to fill short- term financial needs. Another characteristic of the money markets is that they are wholesale markets. This means that most transactions are very large, usually in excess of $1 million. The size of these transactions prevents most individual investors from participating directly in the money markets. Instead, dealers and brokers, operating in the trading rooms of large banks and brokerage houses, bring customers together. Why Do We Need the Money Markets? In a totally unregulated world, the money markets should not be needed. The banking industry exists primarily to provide short-term loans and to accept short-term deposits. Banks should have an efficiency advantage in gathering information, an advantage that should eliminate the need for the money markets. Thanks to continuing relationships with customers, banks should be able to offer loans more cheaply than diversified markets, which must evaluate each borrower every time a new security is offered. Furthermore, short-term securities offered for sale in the money markets are neither as liquid nor as safe as deposits placed in banks and thrifts. The banking industry exists primarily to mediate the asymmetric information problem between saver- lenders and borrower-spenders, and banks can earn profits by capturing economies of scale while providing this service. However, the banking industry is subject to more regulations and governmental costs than are the 1 money markets. In situations where the asymmetric information problem is not severe, the money markets have a distinct cost advantage over banks in providing short-term funds. The Purpose of the Money Markets The well-developed secondary market for money market instruments makes the money market an ideal place for a firm or financial institution to “warehouse” surplus funds until they are needed. Similarly, the money markets provide a low-cost source of funds to firms, the government, and intermediaries that need a short-term infusion of funds. Most investors in the money market who are temporarily warehousing funds are ordinarily not trying to earn unusually high returns on their money market funds. Rather, they use the money market as an interim investment that provides a higher return than holding cash or money in banks. They may feel that market conditions are not right to warrant the purchase of additional stock, or they may expect interest rates to rise and hence not want to purchase bonds. It is important to keep in mind that holding idle surplus cash is expensive for an investor because cash balances earn no income for the owner. Idle cash represents an opportunity cost in terms of lost interest income. The money markets provide a means to invest idle funds and to reduce this opportunity cost. Investment advisers often hold some funds in the money market so that they will be able to act quickly to take advantage of investment opportunities they identify. Most investment funds and financial intermediaries also hold money market securities to meet investment or deposit outflows Who Participates in the Money Markets? Figure 1: Money Market Instruments Treasury Bills 2  Treasury bills (T-bills) are short-term notes issued by the Philippine government. They come in three different lengths to maturity: 91, 182, and 364 days. The two shorter types are auctioned on a weekly basis, while the annual types are auctioned monthly. T-bills can be purchased directly through the auctions or indirectly through the secondary market. Purchasers of T-bills at auction can enter a competitive bid (although this method entails a risk that the bills may not be made available at the bid price) or a noncompetitive bid. T- bills for noncompetitive bids are supplied at the average price of all successful competitive bids. Certificates of Deposit Certificates of deposit (CDs) are certificates issued by a federally chartered bank against deposited funds that earn a specified return for a definite period of time. They are one of several types of interest-bearing "time deposits" offered by banks. An individual or company lends the bank a certain amount of money for a fixed period of time, and in exchange the bank agrees to repay the money with specified interest at the end of the time period. The certificate constitutes the bank's agreement to repay the loan. The maturity rates on CDs range from 30 days to six months or longer, and the amount of the face value can vary greatly as well. There is usually a penalty for early withdrawal of funds, but some types of CDs can be sold to another investor if the original purchaser needs access to the money before the maturity date Commercial paper, In the global financial market, is an unsecured promissory note with a fixed maturity of not more than 270 days. Commercial paper is a money-market security issued (sold) by large corporations to obtain funds to meet short-term debt obligations (for example, payroll) and is backed only by an issuing bank or company promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized credit rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value and generally carries lower interest repayment rates than bonds due to the shorter maturities of commercial paper. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution pays. Interest rates fluctuate with market conditions but are typically lower than banks' rates. Bankers' Acceptances A banker's acceptance is an instruments produced by a nonfinancial corporation but in the name of a bank. It is document indicating that such-and-such bank shall pay the face amount of the instrument at some future time. The bank accepts this instrument, in effect acting as a guarantor. To be sure the bank does so because it considers the writer to be credit-worthy. Bankers' acceptances are generally used to finance foreign trade, although they also arise when companies purchase goods on credit or need to finance inventory. The maturity of acceptances ranges from one to six months. Repurchase Agreements Repurchase agreements—also known as repos or buybacks—are Treasury securities that are purchased from a dealer with the agreement that they will be sold back at a future date for a higher price. These agreements are the most liquid of all money market investments, ranging from 24 hours to several months. In fact, they are very similar to bank deposit accounts, and many corporations arrange for their banks to transfer excess cash to such funds automatically Purpose of the Capital Market Firms that issue capital market securities and the investors who buy them have very different motivations than those who operate in the money markets. Firms and individuals use the money markets 3 primarily to warehouse funds for short periods of time until a more important need or a more productive use for the funds arises. By contrast, firms and individuals use the capital markets for longterm investments. Capital Market Participants The primary issuers of capital market securities are federal and local governments and corporations. The federal government issues long-term notes and bonds to fund the national debt. State and municipal governments also issue long-term notes and bonds to finance capital projects, such as school and prison construction. Governments never issue stock because they cannot sell ownership claims. Corporations issue both bonds and stock. One of the most difficult decisions a firm faces can be whether it should finance its growth with debt or equity. The distribution of a firm’s capital between debt and equity is its capital structure. Corporations may enter the capital markets because they do not have sufficient capital to fund their investment opportunities. Alternatively, firms may choose to enter the capital markets because they want to preserve their capital to protect against unexpected needs. In either case, the availability of efficiently functioning capital markets is crucial to the continued health of the business sector. The largest purchasers of capital market securities are households. Frequently, individuals and households deposit funds in financial institutions that use the funds to purchase capital market instruments such as bonds or stock. Capital Market Trading Capital market trading occurs in either the primary market or the secondary market. The primary market is where new issues of stocks and bonds are introduced. Investment funds, corporations, and individual investors can all purchase securities offered in the primary market. You can think of a primary market transaction as one where the issuer of the security actually receives the proceeds of the sale. When firms sell securities for the very first time, the issue is an initial public offering (IPO). Subsequent sales of a firm’s new stocks or bonds to the public are simply primary market transactions (as opposed to an initial one). The capital markets have well-developed secondary markets. A secondary market is where the sale of previously issued securities takes place, and it is important because most investors plan to sell long-term bonds before they reach maturity and eventually to sell their holdings of stock. There are two types of exchanges in the secondary market for capital securities: organized exchanges and over-the-counter exchanges. Whereas most money market transactions originate over the phone, most capital market transactions, measured by volume, occur in organized exchanges. An organized exchange has a building where securities (including stocks, bonds, options, and futures) trade. Exchange rules govern trading to ensure the efficient and legal operation of the exchange, and the exchange’s board constantly reviews these rules to ensure that they result in competitive trading Types of Bonds a. Treasury Securities Bonds, bills, and notes issued by the. government are generally called “Treasuries” and are the highest- quality securities available. They are issued by the Bureau Treasury through the Bureau of Public Debt. All treasury securities are liquid and traded on the secondary market. They are differentiated by their maturity dates, which range from 30 days to 30 years. One major advantage of Treasuries is that the interest earned is exempt from state and local taxes. Treasuries are backed by the full faith and credit of the government as to the timely payment of principal and interest, so there is little risk of default. b. Municipal Bonds 4  Municipal bonds (“munis”) are issued by state and local governments to fund the construction of schools, highways, housing, sewer systems, and other important public projects. These bonds tend to be exempt from federal income tax and, in some cases, from state and local taxes for investors who live in the jurisdiction where the bond is issued. Munis tend to offer competitive rates but with additional risk because local governments can go bankrupt. Note that, in some states, investors will have to pay state income tax if they purchase shares of a municipal bond fund that invests in bonds issued by states other than the one in which they pay taxes. In addition, although some municipal bonds in the fund may not be subject to ordinary income tax, they may be subject to federal, state, and local alternative minimum tax, if an investor sells a tax-exempt bond fund at a profit, there are capital gains taxes to consider. There are two basic types of municipal bonds. General obligation bonds are secured by the full faith and credit of the issuer and supported by the issuer’s taxing power. Revenue bonds are repaid using revenue generated by the individual project the bond was issued to fund c. Corporate Bonds Corporations may issue bonds to fund a large capital investment or a business expansion. Corporate bonds tend to carry a higher level of risk than government bonds, but they generally are associated with higher potential yields. The value and risk associated with corporate bonds depend in large part on the financial outlook and reputation of the company issuing the bond. Bonds issued by companies with low credit quality are high-yield bonds, also called junk bonds. Investments in high-yield bonds offer different rewards and risks than investing in investment-grade securities, including higher volatility, greater credit risk, and the more speculative nature of the issuer. Variations on corporate bonds include convertible bonds, which can be converted into company stock under certain conditions. d. Zero-Coupon Bonds This type of bond (also called an “accrual bond”) doesn’t make coupon payments but is issued at a steep discount. The bond is redeemed for its full value upon maturity. Zero-coupon bonds tend to fluctuate in price more than coupon bonds. They can be issued by the Bureau of Treasury, corporations, and state and local government entities and generally have long maturity dates Money Market versus Capital Market 5 Prepared by: John Lee J. Mamaril, CFPP, LPT, MBA Instructor - Financial Market 6