CHAPTER 2: THE FINANCIAL

SYSTEM AND THE LEVEL OF

INTEREST RATES

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LEARNING OBJECTIVES (1 OF 2)

1. Describe the role of the financial system in the

economy and the two basic ways in which money flows
through the system
2. Discuss direct financing and the important role that
investment banks play in this process
3. Describe the primary, secondary, and money markets,
explaining the special importance of secondary and
money markets to business organizations
4. Explain what an efficient market is and why market
efficiency is important to financial managers
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LEARNING OBJECTIVES (2 OF 2)
5. Explain how financial institutions serve the needs
of consumers and small businesses
6. Compute the nominal and the real rates of interest,
differentiating between them

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THE FINANCIAL SYSTEM (1 OF 3)
• Financial markets and institutions
o Financial markets include markets for trading financial assets such
as stocks and bonds rather than real assets
o Financial institutions include banks, credit unions, insurance
companies, and finance companies
• The financial system at work
o The financial system is competitive
o Money is borrowed in small amounts and loaned in large amounts
o The system directs money to the best investment opportunities in the
economy
o Lenders earn profit from the spread between lending and borrowing
rates
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THE FINANCIAL SYSTEM (2 OF 3)
• How Funds Flow through the Financial System
o The primary function of a financial system is to efficiently transfer
funds from lender-savers to borrower-spenders

• Basic mechanisms by which funds are transferred in the

financial system
o Directly through financial markets
o Indirectly through financial institutions

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THE FINANCIAL SYSTEM (3 OF 3)

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DIRECT FINANCING
• Direct transfer of funds
o Lender-saver contracts with a borrower-spender
o Minimum transaction $1 million
o Investment banks and money center banks help with origination,
underwriting and distribution of new debt and equity

• Origination is the process of preparing a security issues for sale

• Underwriting is a service to assist firms in selling their debt or
equity securities in a direct financing market
• Distribution is the process of marketing and reselling the securities
to investors

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TYPES OF FINANCIAL MARKETS
• Primary and Secondary Markets
• Exchanges and Over-the-Counter Markets
• Money and Capital Markets

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WHOLESALE AND RETAIL MARKETS

• Primary Market
o Wholesale market where firms’ new securities are issued
and sold for the first time
• Secondary Market
o Retail market where previously issued securities are
resold (traded)

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MARKETABILITY AND LIQUIDITY
• Marketability: ease with which a seller or buyer for an asset
can be found
• Liquidity: ease with which an asset can be converted into
cash without loss of value
• Financial markets increase marketability and liquidity of
securities
• Financial markets lower the costs of making transactions
and make participants more willing and able to pay higher
prices
o A company like Scottrade or E-trade makes it easy for us to buy a share of
Exxon or a bond from Coca-Cola

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BROKERS AND DEALERS
• A broker brings a seller and a buyer together but does
not buy or sell in the transaction
o The broker does not take on risk
• A dealer participates in trades as a buyer or seller using
her own inventory of securities
o The dealer takes on risk

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EXCHANGES & OVER-THE-
COUNTER MARKETS
• Exchange: location where sellers and buyers meet to
conduct transactions
o New York Stock Exchange (NYSE)
o Chicago Board Options Exchange (C BOE)

• Over-the-Counter Market: dealers conduct transactions

over the phone or via computer
o National Association of Securities Dealers Automated
Quotations (NASDAQ)

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MONEY AND CAPITAL MARKETS
• Money Market: market for low-risk securities with
maturities of less than one year
o Treasury Bills (T-Bills)
o Commercial Paper

• Capital Market: market for securities with maturities

longer than one year
o Bonds
o Common stock

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PUBLIC AND PRIVATE MARKETS (1 OF 3)
• Public markets are organized financial markets where
the general public buys and sells securities through their
stockbrokers
• Private markets involve direct transactions between two
parties, often called private placements
o Advantages: faster, lower transaction costs
o Disadvantages:
• Privately placed securities cannot legally be sold in the
public markets because they lack SEC registration
• Dollar amounts that can be raised tend to be smaller

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PUBLIC AND PRIVATE MARKETS (2 OF 3)
Exhibit 2.2 Selected Money Market and Capital Market Instruments, December 2016 ($
billions)
The exhibit shows the size of the U.S. market for each of the most important money market and
capital market instruments. Notice that the largest security market is the market for corporate stock,
followed by those for mortgage debt, corporate bonds, and Treasury notes. Compared with money
market instruments, capital market instruments are less marketable, have higher default risk, and
have longer maturities.
Money Market Instruments

Treasury bills $ 1,818

Commercial paper 911
Total $ 2,729

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PUBLIC AND PRIVATE MARKETS (3 OF 3)
Capital Market Instruments

Treasury notes $ 8,659

Treasury bonds* 3,444

State and local government bonds 3,051

Corporate bonds 9,741

Corporate stock (at market value) 30,077

Mortgage debt 14,188

Total $69,160

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FUTURES AND OPTIONS
MARKETS
• Derivative securities derive their value from some
underlying asset
o Futures contracts: contracts for the future delivery of
assets such as securities, foreign currencies, interest cash
flows, or commodities
o Options contracts call for the option writer to buy or sell
an asset if called upon to do so by the option buyer
o Both futures and options can be used to hedge risk

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EFFICIENT MARKET
HYPOTHESIS (1 OF 2)
• An efficient market in one in which current prices of
securities incorporate the knowledge and expectations of all
participants
• Security prices are correct; securities are not over-valued or
under-valued
• Participants are confident they pay or receive the intrinsic
(fair) value of a security
• Operational Efficiency: extent to which transaction costs
are minimized
• Informational Efficiency: extent to which security prices
reflect all relevant information
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EFFICIENT MARKET
HYPOTHESIS (2 OF 2)
• Strong-Form Efficiency
o Security prices reflect all information, both public and private
o Even inside information is reflected in prices

• Semistrong-Form Efficiency
o Security prices always reflect all public information
o Inside, or confidential information, is not reflected in prices

• Weak-Form Efficiency
o Security prices only reflect historical information

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MARKET EFFICIENCY

• Public markets, such as the NYSE, are more efficient than

private markets due to the information provided by a large
number of participants and effective regulation

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INDIRECT FINANCING
• Institutions, such as banks and insurance companies, are
both borrowers and savers
o An institution borrows money from a saver, lends money to a borrower,
and must repay funds to the saver – whether or not it is repaid by the
borrower
o The process of converting financial securities with one set of characteristics
into securities with another set of characteristics is called financial
intermediation

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FINANCIAL INSTITUTIONS AND
THEIR SERVICES (1 OF 3)
Financial Institutions:
o Provide lending and borrowing opportunities at the retail level for small
customers and wholesale level for large customers
o Efficiently collect funds in small amounts and lend them in larger amounts
o Tailor loan amounts and contract terms to fit the needs of consumers,
corporations, and small businesses

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FINANCIAL INSTITUTIONS AND
THEIR SERVICES (2 OF 3)
• Types of Financial Institutions
o Commercial Banks
o Life and Casualty Insurance Companies
o Pension Funds
o Investment Funds
o Business Finance Companies

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THE DETERMINANTS OF INTEREST
RATE LEVELS
• The Real Rate of Interest
• Loan Contracts and Inflation
• The Fisher Equation and Inflation
• Cyclical and Long-Term Trends in Interest Rates

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INTEREST RATES
• The interest rate is the fee for borrowing money expressed
as a percentage of a loan
• The nominal rate of interest is the interest rate we observe
in the marketplace
• The real rate of interest
o The interest rate that would exist in the absence of inflation/deflation
o Determined by the expected return on investment and time preference for
consumption

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EQUILIBRIUM RATE OF
INTEREST (1 OF 2)
• The equilibrium rate of interest is a function of supply and
demand
o Savers supply more funds at higher rates
o Borrowers demand less at higher rates
o Equilibrium is the rate at which the quantity of funds supplied equals the
quantity of funds demanded
o Any economic factor that causes a shift in lending or borrowing will cause
a change in the equilibrium rate of interest

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EQUILIBRIUM RATE OF INTEREST (2 OF 2)

Copyright ©2018 John Wiley & Sons, Inc. 27

INFLATION AND LOAN
CONTRACTS
• Lenders want the interest rates in loan contracts to
include compensation for the inflation predicted to
occur over the life of the contract
• Compensation for expected inflation adjusts loan rates
to offset the higher prices for goods and services
expected to exist when a loan is repaid and a lender
spends the money

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FISHER EQUATION & NOMINAL
INTEREST RATE (2 OF 2)
Simplified Fisher Equation Example:
Equation 2.2
i  r  Pe
Example: If the real rate is 4% and the expected inflation rate
is 10%, what is the approximate expected nominal rate?
i  r  Pe
i  0.04  0.10
i  0.14 or 14%
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CYCLICAL & LONG-TERM INTEREST
RATE LEVELS (1 OF 2)
• Interest rates tend to rise and fall with changes in the rate of
inflation
• Rates tend to rise when the growth rate of the economy
increases and tend to fall when the growth rate of the
economy slows
• Interest Rate, Business Cycle & Inflation
o Interest rates tend to follow the business cycle
o Interest rates tend to increase during an economic expansion
o Interest rates tend to decrease during an economic contraction

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CYCLICAL & LONG-TERM
INTEREST RATE LEVELS (2 OF 2)

Copyright ©2018 John Wiley & Sons, Inc. 31