1.7 Financial Instruments

Financial markets are the backbone of modern economies, connecting those with money to those who need it. They're split into money markets for short-term deals and capital markets for long-term investments. Each plays a crucial role in keeping the financial world spinning.

Money markets deal in quick, safe bets like T-bills, while capital markets handle riskier, long-term stuff like stocks and bonds. These markets help businesses grow, governments function, and investors make money. They're where the action happens in finance.

Financial Markets

Money markets vs capital markets

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• Money markets deal with short-term financial instruments (less than one year maturity) offer high liquidity and low risk are used for short-term financing and cash management (Treasury bills, commercial paper, certificates of deposit)
• Capital markets involve long-term financial instruments (more than one year maturity) have lower liquidity and higher risk compared to money markets are used for long-term financing and capital raising (stocks, bonds, derivatives)
• Financial markets serve key functions enable efficient allocation of resources facilitate the flow of funds from savers to borrowers provide price discovery through market forces of supply and demand offer liquidity for investors
• Primary markets facilitate the initial issuance of securities, while secondary markets allow for the trading of existing securities

Money Market and Capital Market Instruments

Common money market instruments

• Treasury bills (T-bills) are short-term debt securities issued by the U.S. government have maturities of 4, 8, 13, 26, or 52 weeks are considered risk-free due to government backing are issued at a discount and mature at par value
• Commercial paper refers to unsecured short-term debt issued by corporations typically has maturities ranging from 1 to 270 days offers higher yield than T-bills due to greater credit risk is used for short-term financing needs of large corporations
• Certificates of deposit (CDs) are time deposits offered by banks with fixed maturity and interest rate have maturities ranging from a few weeks to several years impose early withdrawal penalties are FDIC insured up to $250,000 per depositor per bank

Capital market instruments and financing

• Stocks represent equity securities denoting ownership in a corporation common stock provides voting rights and potential dividend payments preferred stock offers priority in dividend payments and asset claims over common stock stocks are used for long-term capital raising and expansion
• Bonds are debt securities representing a loan to the issuer coupon bonds provide regular interest payments and return principal at maturity zero-coupon bonds are issued at a discount and mature at par value without interim payments credit ratings assess the issuer's ability to repay debt obligations bonds are used for long-term financing by corporations and governments
• Derivatives are financial instruments whose value is derived from an underlying asset, index, or entity options grant the right to buy (call) or sell (put) an asset at a predetermined price and date futures contracts obligate parties to buy or sell an asset at a predetermined price and date swaps involve exchanging cash flows (interest rate or currency swaps) derivatives are used for hedging, speculation, and risk management in long-term financing strategies

Key Concepts in Financial Instruments

• Yield represents the return on investment, often expressed as a percentage
• Maturity refers to the time period until a debt instrument reaches its full value
• Liquidity indicates how quickly an asset can be converted to cash without significant loss in value
• Risk-return tradeoff describes the principle that higher potential returns are associated with higher levels of risk
• Financial intermediaries, such as banks and investment firms, facilitate transactions between buyers and sellers in financial markets