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

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24 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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25 Morguefile.com (http://morguefile.com/archive/?display=31962&) 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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26 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.
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