Financial Markets and Institutions (2-downloads)

Stanley G. Eakins has notable

experience as a financial practi-

tioner, serving as vice president and

comptroller at the First National

Bank of Fairbanks and as a com-

mercial and real estate loan officer.

A founder of the Denali Title and

Escrow Agency, a title insurance

company in Fairbanks, Alaska, he

also ran the operations side of a bank

and was the chief finance officer for

a multimillion-dollar construction

and development company.

Professor Eakins received his Ph.D. from Arizona State

University. He is the Associate Dean for the College of Business

at East Carolina University. His research is focused primarily on

the role of institutions in corporate control and how they influence

investment practices. He is also interested in integrating multi-

media tools into the learning environment and has received grants

from East Carolina University in support of this work.

A contributor to journals such as the Quarterly Journal of

Business and Economics, the Journal of Financial Research, and

the International Review of Financial Analysis, Professor Eakins

is also the author of Finance, 3rd edition (Addison-Wesley, 2008).

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Why Study Financial

Markets and Institutions?

Preview

On the evening news you have just heard that the bond market has been

booming. Does this mean that interest rates will fall so that it is easier for you

to finance the purchase of a new computer system for your small retail busi-

ness? Will the economy improve in the future so that it is a good time to

build a new building or add to the one you are in? Should you try to raise

funds by issuing stocks or bonds, or instead go to the bank for a loan? If you

import goods from abroad, should you be concerned that they will become

more expensive?

This book provides answers to these questions by examining how financial

markets (such as those for bonds, stocks, and foreign exchange) and financial

institutions (banks, insurance companies, mutual funds, and other institutions)

work. Financial markets and institutions not only affect your everyday life but

also involve huge flows of funds—trillions of dollars—throughout our economy,

which in turn affect business profits, the production of goods and services, and

even the economic well-being of countries other than the United States. What

happens to financial markets and institutions is of great concern to politicians

and can even have a major impact on elections. The study of financial markets

and institutions will reward you with an understanding of many exciting issues.

In this chapter we provide a road map of the book by outlining these exciting

issues and exploring why they are worth studying.

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C H A P T E R

PA R T   O N E   I N T R O D U C T I O N

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Why Study Financial Markets?

Parts 2 and 5 of this book focus on financial markets, markets in which funds are

transferred from people who have an excess of available funds to people who have

a shortage. Financial markets, such as bond and stock markets, are crucial to pro-

moting greater economic efficiency by channeling funds from people who do not have

a productive use for them to those who do. Indeed, well-functioning financial mar-

kets are a key factor in producing high economic growth, and poorly performing finan-

cial markets are one reason that many countries in the world remain desperately poor.

Activities in financial markets also have direct effects on personal wealth, the behav-

ior of businesses and consumers, and the cyclical performance of the economy.

Debt Markets and Interest Rates

A security (also called a financial instrument) is a claim on the issuer’s future

income or assets (any financial claim or piece of property that is subject to owner-

ship). A bond is a debt security that promises to make payments periodically for

a specified period of time.

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Debt markets, also often referred to generically as the

bond market, are especially important to economic activity because they enable cor-

porations and governments to borrow in order to finance their activities; the bond

market is also where interest rates are determined. An interest rate is the cost

of borrowing or the price paid for the rental of funds (usually expressed as a per-

centage of the rental of $100 per year). There are many interest rates in the econ-

omy—mortgage interest rates, car loan rates, and interest rates on many different

types of bonds.

Interest rates are important on a number of levels. On a personal level, high inter-

est rates could deter you from buying a house or a car because the cost of financ-

ing it would be high. Conversely, high interest rates could encourage you to save

because you can earn more interest income by putting aside some of your earnings

as savings. On a more general level, interest rates have an impact on the overall health

of the economy because they affect not only consumers’ willingness to spend or

save but also businesses’ investment decisions. High interest rates, for example, might

cause a corporation to postpone building a new plant that would provide more jobs.

Because changes in interest rates have important effects on individuals, finan-

cial institutions, businesses, and the overall economy, it is important to explain fluc-

tuations in interest rates that have been substantial over the past 20 years. For

example, the interest rate on three-month Treasury bills peaked at over 16% in 1981.

This interest rate fell to 3% in late 1992 and 1993, and then rose to above 5% in the

mid to late 1990s.  It then fell below 1% in 2004, rose to 5% by 2007, only to fall to

zero in 2008 where it remained close to that level into 2010.

Because different interest rates have a tendency to move in unison, economists

frequently lump interest rates together and refer to “the” interest rate. As Figure 1.1

shows, however, interest rates on several types of bonds can differ substantially.

The interest rate on three-month Treasury bills, for example, fluctuates more than

the other interest rates and is lower, on average. The interest rate on Baa (medium-

quality) corporate bonds is higher, on average, than the other interest rates, and

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Part 1 Introduction

http://www.federalreserve

.gov/econresdata/releases/

statisticsdata.htm

Access daily, weekly,

monthly, quarterly, and

annual releases and

historical data for selected

interest rates, foreign

exchange rates, and so on.

G O   O N L I N E  

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The definition of bond used throughout this book is the broad one in common use by academics,

which covers both short- and long-term debt instruments. However, some practitioners in financial

markets use the word bond to describe only specific long-term debt instruments such as corporate

bonds or U.S. Treasury bonds.

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Chapter 1 Why Study Financial Markets and Institutions?

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Interest

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