FINANCIAL MARKETS AND INTEREST RATES

FINANCIAL MARKETS

Are institutions and procedures that facilitate transactions in all types of financial claims.

CLASSIFICATIONS OF

FINANCIAL MARKETS

* PHYSICAL ASSET MARKETS – “ tangible” or “real” asset markets.

*FINANCIAL ASSET MARKETS- represent claims for future payment.

*SPOT MARKET- trading mechanism use to move funds on day to day basis.

*FUTURE MARKET- participants agree today to buy for sale an asset at some future date.

* MONEY MARKET- all institutions and procedures that provide for transactions in short term debt instruments.

* CAPITAL MARKET- all institutions and procedures that provide for transaction in long term financial instruments.

* PRIMARY MARKET- market in which corporations raise capital by issuing new securities.

INITIAL PUBLIC OFFERING (IPO)- subset of primary market where in firms decides to sell stocks to public for the first time.

* SECONDARY MARKETS- markets in which existing, already outstanding securities are traded among investors.

* PRIVATE MARKETS- where transactions are worked out directly between two parts.

* PUBLIC MARKETS- markets in which standardized contracts are traded on organized exchanges.

THE COST

OF MONEY

INTEREST RATE – is the price paid to borrow debt capital.

o POINT OF VIEW OF BORROWER – the cost of borrowing money (borrowing rate)

o POINT OF VIEW OF LENDER- fee charged for lending money ( lending rate)

FACTORS OF AFFECTING THE COST

OF MONEY

Time preferences for consumption

Production opportunities

Risk

Inflation

DETERMINANTS OF MARKET

INTEREST RATE

Quoted interest rate=k=k*+IP+DRP+LP+MRP

• The real risk- Free rate of interest, k- The rate of interest that would exist on default-free securities if no inflation were expected.

• Nominal (Quoted) Risk- Free rate ,KRF- The rate of interest on security that is free of all risk that includes an inflation premium.

• Inflation premium (IP)- A premium equal to expected inflation that investors add to the real risk-free rate of return.

• DEFAULT RISK PREMIUM (DRP)- The risk that a borrower will default on a loan.

• LIQUIDITY PREMIUM (LP)- A premium added if the security cannot be converted to cash on short notice.

• MATURITY RISK PREMIUM (MRP)

• REINVESTMENT RATE RISK

Thank you! =)