Every financial instrument, except stock, has a principal, interest, and maturity. Principal is the loan amount the borrower received from the lender.Then the borrower pays interest as periodic payments to the lender because the lender allows the borrower to use the funds.Interest is a cost to the borrower, but income to the lender.Finally, maturity is the date the security expires, or the final date when the borrower pays the last payment for the principal plus interest.
Analysts and economists categorize financial instruments into two broadly defined classes: money market and capital market.Money market comprises of short-term securities with a maturity less than one year.Money market securities are popular and are simply a loan of funds from one party to another.Money market securities are highly liquid and almost as good as money – hence the name money market.Second category, the capital market, includes long-term securities with a maturity greater than a year.Capital market includes common stock because stock has no expiration date because the corporation, in theory, could live forever.Thus, we define stock as a long-term security.
You should memorize the following securities because we continually refer to these financial instruments throughout this book.For students to understand these securities, remember who issues the security, and whether it is a money market or capital market security.All these securities have one purpose.One party owes another party money plus interest except stocks.Stocks represent ownership in a corporation and are not loans.
Money market securities have maturities less than one year, and we list the common ones:
U.S.Treasury bills or T-bills are loans to the U.S. government.Maturities range from 15 days to one year.T-bills do not have an interest rate stamped on them, and they start at $10,000.If an investor buys a T-bill for $19,000, and the T-bill has a face value of $20,000 with a maturity of six months.Then six months later, the government will pay $20,000.The $1,000 reflects the interest.
Commercial paper is a loan to a well-known bank or corporation for a short-time period.Corporations use commercial paper to raise funds without issuing new stocks or bonds.Commercial paper is a form of direct finance, and the loan has no collateral.
Banker's Acceptances are used in international trade.For example, a firm wants to buy from a foreign exporter.Firm deposits money at a bank, and the bank guarantees payment by issuing a banker's acceptance.That way, the export accepts the banker's acceptance and ships the goods to the firm.If the firm does not deposit money at the bank and the bank guarantees payment, then the bank must pay the foreign exporter, even if the firm bankrupts.These securities are liquid because holders can sell them on a secondary market.
Negotiable Bank Certificates of Deposit (CDs) are loans to banks that banks sell directly to depositors.CDs have a fixed time period.If a depositor withdraws a CD early, then the depositor forfeits the interest.Consequently, CDs usually pay a greater interest rate than a savings account.
Repurchase Agreements (repos) are short-term loans.For example, a bank sells T-bills to a customer and promises to buy it back the next day for a higher price.Greater price reflects interest.Banks used repos to circumvent the law, so banks could pay businesses interest on their checking accounts.Before the 1980s, U.S. banks could not pay interest on checking accounts.For example, IBM has excess funds in their checking account.Bank sells IBM T-bills and uses IBM's funds.Next day, the bank returns IBM's funds with interest and takes the T-bills back.Consequently, the bank paid interest on a checking account, although the U.S. law prohibited banks to pay interest on checking accounts.
Federal Funds are overnight loans between banks.For example, a bank with excess funds deposited at the Federal Reserve can lend these funds to another bank.Market analysts and the Fed scrutinize the interest rate in this market because monetary policy influences immediately the federal funds interest rate.
Eurodollars are U.S. dollars that people deposit in foreign commercial banks outside the United States and in foreign branches of U.S. banks.Eurodollars are an important source of funds in the international market.Furthermore, the euro has become a popular currency for investors, who have bank accounts denominated in euros that are located outside the Eurozone.The Eurozone comprises of the 17 countries within the European Union that usethe euro as its currency.If people and investors have euro denominated accounts outside the Eurozone, then we still call it Eurodollars.
Capital market securities have maturities longer than a year, and we list the common ones.
U.S.Treasury securities are loans to the U.S. government.The U.S. government issues
Treasury Notes or T-notes from one to 10 years, while Treasury Bonds or T-bonds have maturities greater than 10 years.These Treasury securities have a stated interest rate, and government usually pays interest every six months.
State and local governments can issue bonds, called municipal bonds.The U.S. federal government encourages investors to buy these bonds by exempting investors from U.S.income taxes.Furthermore, municipal bonds fall under two categories: General-obligation bonds and revenue bonds.For general-obligation bonds, a state or local government guarantees the bonds payment with its taxing power.For instance, a city government buildsa new firehouse.Then the city government guarantees payment of the bonds with its power to tax.For revenue bonds, local or state government secures the bonds' payment by the revenues that the project generates.For example, a college builds a new dormitory, using revenue bonds.When the students pay to live there, the university pays the bondholders some of the revenue.
We include stocks and bonds that we had defined earlier in this chapter.
Mortgage is a loan on a house or property and the loan duration ranges from 15 to 30 years.Usually, the property becomes the collateral.For instance, if a homeowner loses his job and cannot repay the mortgage, then the bank takes possession of his house.We call this process foreclosure as a bank takes the property and evicts the homeowners.A variety of savings institutions and banks grants mortgages, making mortgages the largest debtmarket.
Commercial bank loans are banks lending to businesses.These loans do not have well developed secondary markets.
Government agencies can issue securities.For example, Sallie Mae is a quasi-government agency and lends to college students.Then Sallie Mae pools the student loans into a fund and issues bonds, allowing investors to buy into the fund.Subsequently, the investors indirectly earn the interest from the students' monthly payments.Thus, Sallie Mae increases the liquidity of student loans.
Sallie Mae may experience financial hardship.U.S. economy has been plagued with weak economic growth since the 2007 Great Recession, and many college graduates cannot find jobs and start to default on their student-loan payments.Many call this the College Bubble.As college tuition soars into the stratosphere, many college students accumulate large amounts of debt to pay for their education, and some of these students have slim chances of finding good payingjobs after they graduate.Consequently, high school graduates may shun college to avoid accumulating debt, sparking a financial crisis for the U.S. colleges and universities.Then the colleges and universities could contract similarly to the U.S. housing market after 2007.