Chapter 2 - Financial Markets and Interest Rates It is...

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Financial
Markets and
Interest Rates
“It is better to give than to lend, and it
costs about the same.”
—Philip Gibbs
A Flight to Quality and a Flight to Liquidity
In 2008 financial markets were in turmoil. Common stocks plunged as seen
in the S&P 500 Index that dropped 39% in that year. So too did bonds
except for the highest quality bonds such as U.S. Treasury securities. The
benchmark ten year U.S. Treasury note was up 21% in 2008. Gold prices
also rose as investors looked for a safe haven for their money.
Corporations and municipalities with anything less than super high
bond ratings had great difficulty raising funds. Investors wanted safety. The
financial crisis has taught us what can happen when financial markets break
down. What are financial markets? How do they help businesses, individuals,
and government entities to raise funds? How do they help investors adjust
their portfolios when needs and preferences change? These are some of the
questions addressed in this chapter.

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Learning Objectives
After reading this chapter,
you should be able to:
1. Describe how the U.S.
financial system works.
2. Define financial securities.
3. Explain the function of
financial intermediaries.
4. Describe the securities
traded in the money and
capital markets.
5. Identify the determinants of
the nominal interest rate.
6. Construct and analyze a
yield curve.
Chapter Overview
One of the central duties of a financial manager is to acquire capital—that is,
to raise funds. Few companies are able to fund all their activities solely with
funds from internal sources. Most find it necessary at times to seek funding
from outside sources. For this reason, all business people need to know about
financial markets.
As we see in this chapter, there are a number of financial markets, and
each offers a different kind of financial product. In this chapter we discuss the
relationship between firms and the financial markets and briefly explain how the
financial system works, including the role of financial intermediaries —investment
bankers, brokers, and dealers. Next, we explore the markets themselves and
describe financial products ranging from government bonds to corporate stocks.
Finally, we examine interest rates.
The Financial System
In the U.S. economy, several types of individuals or entities generate and spend
money. We call these economic units . The main types of economic units include
governments, businesses, and households (households may be one person or more
than one person). Some economic units generate more income than they spend and
have funds left over. These are called surplus economic units . Other economic
units generate less income than they spend and need to acquire additional funds
in order to sustain their operations. These are called deficit economic units .

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Part I The World of Finance
The purpose of the financial system is to bring the two groups—surplus economic
units and deficit economic units—together for their mutual benefit.