Basic Securities. – Introduction to Pricing. – Sizing the Capital Markets. –
Studying Capital Markets. – Function of Capital Markets. Economics of Capital
Markets.
Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Major Topics – – – – – – – –
Financial Markets Structure Financial Economics Capital Markets Basic Securities Introduction to Pricing Sizing the Capital Markets Studying Capital Markets Function of Capital Markets
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Financial Financial Markets Markets Structure Structure
Recall that physical capital is traded in the funds, or financial, markets and consumption is smoothed through the use of the financial markets
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Financial Financial Markets Markets Structure Structure (Continued) (Continued)
Financial markets are the focal point for much of our economic operations From an economic growth perspective, they are viewed as the main driver allowing growth
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Financial Financial Markets Markets Structure Structure (Continued) (Continued)
From an economic growth perspective (Continued)
– Sir J.R. Hicks
– J. Schumpeter
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Financial Financial Markets Markets Structure Structure (Continued) (Continued)
From an economic growth perspective (Continued)
– There is a preponderance of empirical evidence that there is a positive first-order relationship between financial development and economic growth
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Financial Financial Markets Markets Structure Structure (Continued) (Continued) Financial Markets
- Allocates Funds - Sets Prices
Capital Market
Credit Market
Money Market
- Claims or Ownership Traded - More Than One Year Maturity - Stocks, Bonds, Futures, Options - Standardized - Organized Exchanges
- Facilitates Borrowing and Lending - Combination Of ShortAnd Long-term - Nonstandardized - Usually Not Tradable - Financial Intermediaries
- Money and Short-term Near Monies - Less Than One Year Maturity - Money, Fed Funds, T-Bills - Financial Intermediaries And FED
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Financial Financial Markets Markets Structure Structure (Continued) (Continued) Financial Markets
Capital Market
Credit Market
Money Market
Only market in which long-term, impersonal investments and borrowings can occur
Long-term and short-term personal investments and borrowings
Strictly short-term finds transfers
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Financial Financial Economics Economics
Financial Economics studies how financial markets impact allocations via pricing of financial assets or securities – Methodology: micro-based via close substitutes – Capital markets one component: long-term
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Capital Capital Markets Markets
Terms for holding claims set in capital markets
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Capital Capital Markets Markets (Continued) (Continued)
A function of capital markets and contracts is to establish and provide for the exchange of claims to assets, the income they generate and the value or price of those claims
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Capital Capital Markets Markets (Continued) (Continued)
Only market in which long-term, impersonal investments and borrowings can occur
Capital Markets
Determine Title
Set Value - At a Point in Time - Capitalized Income Stream
- Assets - Income
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Capital Capital Markets Markets (Continued) (Continued)
Financial Markets
Capital Market
Credit Market
Money Market
- Long-term - Standardized - Organized Exchanges
- Nonstandardized - Financial Intermediaries
- Short-term Monies -Financial Intermediaries and FED
Bring Borrowers and Lenders Together Sets Value, Determines Title
No Ownership Claims to Assets Determined Jump to slide 20
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Capital Capital Markets Markets (Continued) (Continued)
Trading in terms of new issues and outstanding issues of claims – Exchange of outstanding issues represents transfer of property rights – Exchange of new issues represents transfer of funds from savers to borrowers
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Basic Basic Securities Securities
Equities or stock – Equities residual claims on “risky” and uncertain future income stream of assets – Holders have incentive to promote - or push company to promote - efficient use of assets to minimize costs – Example: common stock
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Basic Basic Securities Securities (Continued) (Continued)
Types of equities – Common stock » Last to be paid on dissolution of firm
– Preferred stock » Reduces “risks” to investor compared to common stock holder, but... – Preferred stock adds constraints on the firm – Would expect fewer issues of preferred stock than common stock Version 1.0 Outline
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Basic Basic Securities Securities (Continued) (Continued)
Common stock income components – Dividend payments » Dividends are profits distributed to owners; i.e., holders of stock
– Capital gains and losses » Stock price changes
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Basic Basic Securities Securities (Continued) (Continued)
Debt – Claim to a prespecified portion of future income stream of an asset » Portion: not whole income stream of asset » Prespecified: know portion before time
– Example: bonds » Value depends on value of underlying asset; i.e., its income stream – If income stream is “risky”, bond is “risky” Version 1.0 Outline
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Basic Basic Securities Securities (Continued) (Continued)
Bond income components – Coupon payments: C = λF » Fixed income stream » Based on
– Coupon rate (λ ) – Fixed at time of issue – Face value of bond (F) – What it is worth – Usually $1000 face value
– Repayment of loan: F Version 1.0 Outline
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Basic Basic Securities Securities (Continued) (Continued)
Example coupon bond – Face value: amount of bond » Example: $1000
– Coupon rate: rate attached to bond at issuance and is amount issuer promises to pay each period » Example: 6%
– Coupon amount: $1000*0.06 = $60 Version 1.0 Outline
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Basic Basic Securities Securities (Continued) (Continued)
Simple equations Income from stocks: Income = Dividend Stream + Gains/Losses Income from bonds: Income = Coupon Payments + Repayment
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Basic Basic Securities Securities (Continued) (Continued)
The dollar income from any security is the dollar return from that security – Denote the dollar return in period t by Rt
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing
Introduce simple pricing concepts – Begin with bonds and then do stocks – Assumptions » No risk – Adjust for risk later
» No inflation – Adjust for inflation later – All dollar amounts are in real terms
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing (Continued) (Continued)
Bond prices set where suppliers and demanders agree – Can prove that bond price is present value of future expected coupon amounts – Use infinite-lived bond called a perpetuity or consol
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing (Continued) (Continued)
Bond price is C PB = B rf
where C is the constant real coupon amount and rfB is the bond real discount factor devoid of risk – Follows from simple supply and demand framework: agreement at the margin Version 1.0 Outline
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing (Continued) (Continued)
Key observation – Price of bond and real interest rate vary inversely » Know one, then other is known automatically » Only need to know one of these
– Bond real discount factor is called the yield or rate of return - it is an interest rate C – Clearly B
rf =
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PB
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing (Continued) (Continued)
Stock price is similar – Present value of dividends plus value of stock tomorrow if sold – Assume just one holding period so that PS1 D1 0 PS = + 1 + rfS 1 + rfS where D1 is the real dividend tomorrow, PS1 Is price tomorrow and rfS is the stock real discount factor devoid of risk
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing (Continued) (Continued)
Simple algebra shows that stock discount factor is D1 PS1 − PS0 S rf = 0 + PS PS0 Dividend %Appreciation Yield In Value
– Stock real discount factor is called the rate of return - it is an interest rate Version 1.0 Outline
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing (Continued) (Continued)
Notice that the rates of return for stocks and bonds were presented as different amounts rfS and rfB – What is their relationship? » The two rates of return must be equal – If not, then rational investor can earn a profit by buying the higher yielding security driving its price up and the rate of return down; conversely for the lower yielding security – Process is called arbitrage
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing (Continued) (Continued)
Law of One Rate of Return – Must have just one rate of return in the market – Therefore,
rfS = rfB = rf – Actual rates of return will differ at times because there are different “drivers” for each market (e.g., economy, policy, psychology) Version 1.0 Outline
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Introduction Introduction to to Pricing Pricing (Continued) (Continued)
For stocks and bonds, basically have rf =
$ Re turn PToday
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets
1994 Capital Market (Debt + Equity) $843.5B
Underwritten $702.5B
Private Placement $141.0B
Debt $625.5B Straight Corp $367.4B
Equity $77.1B
Conv $4.7B
Asset Backed $253.4B
Preferred $15.5B
Debt $117.1B
Equity $23.9B
Common $51.6B
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
Value of US Corp. Underwritings and Private Placements $1,400
$ Billions
$1,200 $1,000 $800 $600 $400 $200 $0 1980 1994 ($ Billions)
Total $843.5
Underwritten $702.5
Private Placements $141.0
1982
1984 Total
1986
1988 Underwritten
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1990
1992
1994
Private
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
Value of US Private Placements $200
$ Billions
$150 $100
$50 $0 1980
1982
1984
1994 Total $141.0
Debt $117.1
1986 Total
($ Billions)
Equity $23.9
1988 Debt
1990
1992
1994
Equity
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
1994 ($ Billions)
Total Value of US Corp. Underwritings
Total $702.5
Debt $625.5
Equity $77.1
$1,200
$ Billions
$1,000 $800 $600 $400 $200 $0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Total
Total Debt
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Total Equity
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
1994 ($ Billions)
Total Debt Underwritten
Total
St. Corp.
$702.5
$367.4
Conv. Corp. $4.7
Asset Backed $253.4
$1,000
$ Billions
$800 $600 $400 $200 $0 1980
1982
1984
Straight Corp. Debt
1986
1988
Conv. Debt
1990
1992
Asset Backed Debt
1994
Total Debt
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing the Sizing1994 the Capital Capital Markets Markets (Continued) (Continued) ($ Billions)
Total $77.1
Preferred $15.5
Common $61.6
Total Equity Underwritten
$140 $120
$ Billions
$100 $80 $60 $40 $20 $0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Pref. Stock
Common Stock
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Total Equity
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
Equity and Debt Outstanding $7,000 $6,000
$ Billions
$5,000 $4,000 $3,000 $2,000 $1,000 $0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Corp. Equities
Corp. Bonds
US Gov't Sec.
Mun. Bonds
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
1994 Equity and Debt Outstanding Mun. Bonds (7.86%)
Corp. Equities (39.51%)
US Gov't Sec. (36.85%)
Corp. Bonds (15.79%)
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued) Holders of US Equities Outstanding $6049B
Households $2913B
Institutions $3136B Private Pension Funds $1047B Public Pension Funds $520B Mutual Funds $738B Closed End Funds $33B Foreign $341B Life Ins. Cos. $159B Other Ins. Cos. $105B Bank Personal Trusts $156B Brokers/Dealers $20B Savings Inst. $10B Commercial Banks $7B
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
Holdings of US Equities Outstanding (% of Market Value) 60.0%
Percent
55.0% 50.0% 45.0% 40.0% 1980
Households Institutions 48.2% 51.8%
1982
1984
1986
Households
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1988
1990
1992
1994
Institutions
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
Share of Household Liquid Financial Assets 60.0%
Perecnt
50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 1980
1982
1984
1986
1988
1990
Equities
Bk. Dep/CDs
Mut. Funds
Muni. Bonds
Money Mkt. Funds
Corp. Bonds
1992
1994
US Gov't Secs.
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
1994 Share of Household Financial Assets Corp. Bonds (2.30%) Money Mkt. Funds (4.10%) Muni. Bonds (4.70%) Equities (33.57%)
US Gov't Secs. (12.49%)
Mut. Funds (11.19%)
Bk. Dep/CDs (31.67%)
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Sizing Sizing the the Capital Capital Markets Markets (Continued) (Continued)
Household ownership characteristics - 1990 – Number of individual shareholders: 51,440K » Female: 17,750K » Male: 30,220K
– – – –
Adult shareholder incidence: 1 in 4 Median household income: $43,800 Median age: 43 Median portfolio: $11,400
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets
Studying and understanding capital markets goes beyond just understanding how terms for holding capital are set – Major issue is resource allocation, but there are other issues
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets (Continued) (Continued)
The capital markets, especially Wall Street, exert large influence on investment decisions of firms – Firms have been accused of favoring short-term investments just to meet investor demands – Implication: innovation and R&D stifled negatively impacting long-term economic growth and competitiveness
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets (Continued) (Continued)
Understanding capital markets, especially global capital markets, important for understanding international developments and U.S. competitiveness – Capital markets not restricted to national borders – Investments can take place electronically – One implication: trying to regulate or control capital markets next to impossible
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets (Continued) (Continued)
Understanding capital markets (Continued) – Example » Japanese government tried to prevent trading of some “modern complex financial derivatives” tied to the Nikkei in Tokyo » Trading simply moved to Singapore » A trader for Barings Securities (Nick Leeson) Placed A $29B bet in Singapore on the Nikkei (and lost!) – Barings, one of the world’s oldest banks, collapsed
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets (Continued) (Continued)
Understanding capital markets (Continued) – Everyone effectively borrows capital on an “equal-access basis” on the world capital markets in New York, London, Tokyo » For investing, “there are no rich or poor countries.”
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets (Continued) (Continued)
Understanding capital markets (Continued) – Global capital markets and electronic trading systems enable huge sums of money to move around the world quickly » On a normal day, world capital markets move $1.3T but world’s exports are only $3T in a year » In 2 days, the world’s capital markets can move as much money as all economies can move in a year
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets (Continued) (Continued)
Understanding capital markets (Continued) – Problem this creates » Linkages make potential crashes potentially larger and more far reaching than previous crashes
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets (Continued) (Continued)
Capital markets and crashes – Dramatic movements in the capital markets, in particular, the stock market, can have big impact on the business cycle and growth » We are all aware of the 1929 Stock Market Crash » In 1987, the stock market fell but was so short-lived that it had minimal impact – We will discuss both briefly later in course
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Studying Studying Capital Capital Markets Markets (Continued) (Continued)
Capital markets and crashes (Continued) – From 12/89 To 8/92, at least, the Nikkei fell from 38916 to 14309 » Bigger decline than American stock market decline in 1929 and 1932 » Led to recession in Japan that seems to still be continuing
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Function Function of of Capital Capital Markets Markets
Previously viewed the capital markets as a way to bring borrowers and lenders of loanable funds together – Naive view of this market since all markets bring two parties together – Capital markets do more...
Capital Markets manage risk Version 1.0 Outline
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Function Function of of Capital Capital Markets Markets (Continued) (Continued)
To understand the management function, we must understand… – The operations of capital markets – The concepts of risk and uncertainty
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Review Review Questions Questions
Describe the structure of Financial Markets and the individual submarkets. How does the capital market differ from the credit and money markets? Discuss the international linkages in the capital markets. What is the function of the financial markets? Describe some common income streams.
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets RReview eview Questions Questions (Continued) (Continued)
Describe the basic structure of the capital markets. Distinguish between common and preferred stock. What is debt?
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Key Key Concepts Concepts and and Terms Terms
Capital Markets Debt Financial Economics Financial Markets Money Markets New issues Outstanding issues Preferred and common stock
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Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Suggested Suggested Readings Readings
Friedman, B. M. 1987. “Capital, Credit and Money Markets” in The New Palgrave. Hakansson, N.H. 1987. “Financial Markets” in The New Palgrave Hicks, J.R. 1946. Value and Capital. 2nd. ed. London: Oxford Un. Press. Hirshleifer, J. 1970. Investment, Interest and Capital. Englewood Cliffs, NJ: Prentice-Hall. Ross, S.A. 1987. “Finance” in The New Palgrave Tobin, J. 1987. “Financial Intermediaries” in The New Palgrave
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Notes
Economics of Capital Markets
Structure Structure and and Function Function of of Capital Capital Markets Markets Suggested Suggested Readings Readings (Continued) (Continued)
Campbell, T.S. 1982. Financial Institutions, Markets, and Economic Activity. NY: McGraw-Hill.
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