Abstract
This chapter provides an intuitive understanding of how interest rates, financial markets and the financial system work from a practical standpoint. It introduces basic concepts about infrastructures of securities markets and market liquidity; and terminologies about a bewildering array of interest rates, money, credit/debt and leverage, as well as some economic indicators. These concepts and terminologies will be directly or indirectly needed in later chapters.
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Notes
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See Chapters 6, 7 and 8.
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Due to the Fed’s quantitative easings (QEs) in the last few years, where QEs were programs for large-scale purchases of assets from the banks that drove up the volume of excess reserves to unprecedented levels, presently many US banks can meet their reserve requirements without borrowing.
While the discussion on developed world central banks starting to impose negative interest rates is beyond the scope of this book, it is worth noting that on June 5, 2014, the European Central Bank cuts its deposit rate for banks from 0 to -0.1% to encourage banks to lend rather than hold on to money; on January 29, 2016, the Bank of Japan announced that it would cut the interest rate, set at -0.1%, further into negative territory if necessary, that compared with -0.65% in Denmark, -1.1% in Sweden, and -0.75% in Switzerland already (Source: WSJ, 01/29/2016).
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See Section 2.10
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These 18 banks include Bank of America, Barclays, Credit Suisse, Deutsche Bank, HSBC, and JP Morgan Chase. For a complete list, visit the website at https://en.wikipedia.org/wiki/Libor.
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Conceptually speaking, the most basic debt instrument is a zero-coupon bond or simply a zero, which is a bond with a single cash flow equal to face value at maturity.
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See Chapter 2 for the concept of discount cash flows.
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See Section 7.1.1 for more detailed explanation. Examples of securities are stocks and bonds.
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The market where new securities are issued.
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Otherwise, a public company is traded on OTC and the stock is referred to as unlisted stock, whereas those stocks traded on exchanges are referred to as listed stocks.
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These satisfactions include paying both the exchange’s entry and yearly listing fees. Listing requirements usually include minimum stockholder’s equity, a minimum share price, and a minimum number of shareholders. The standards vary by exchange. For example, listing on the NASDAQ is considerably less expensive than listing on the NYSE, which partially explains why newer companies often opt for the NASDAQ if they meet its requirements.
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A stock traded on pink sheets is considered to be riskier than that on OTCBB. In general, a stock traded on pink sheets is very speculative.
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The US Securities and Exchange Commission (SEC) defines a “market maker” as “a firm that stands ready to buy and sell stock on a regular and continuous basis at a publicly quoted price.” (Source: http://www.sec.gov/answers/mktmaker.htm)
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See Chapter 8 for details.
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Note that the bid-ask spread is the ask price minus the bid price.
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Note: the smaller the spreads, the lower the trading costs resulting in a higher return for investors. To a certain extent, tightening spreads is the single most important factor in improving security returns.
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Gross domestic product is the monetary value of all the finished goods and services produced within a country in a specific time period.
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Consumer price index is a measure of average change over time in the prices paid by urban consumers for a market basket of consumer goods and services, such as transportation, food, and medical care.
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© 2016 Arlie O. Petters and Xiaoying Dong
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Petters, A.O., Dong, X. (2016). Preliminaries on Financial Markets. In: An Introduction to Mathematical Finance with Applications. Springer Undergraduate Texts in Mathematics and Technology. Springer, New York, NY. https://doi.org/10.1007/978-1-4939-3783-7_1
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