Saving v. Consumption
Consumption satisfies immediate wants
Saving satisfies future wants
Saving also funds investment

Surplus Units
Households, firms, and government entities
Do not spend whole income
These are the saving units

Deficit Spending Units
Households, firms & government entities
Spend more than their whole income
These are the borrowing units

Direct Credit Markets v. Financial Intermediaries
Direct Credit Markets allow surplus units to lend directly to deficit-spending units
Financial Intermediaries like banks borrow money from surplus units and lend it to deficit-spending units

Direct Credit Markets: The Money Market
Lenders buy bonds, bills, paper, and notes, with maturities less than one year
Sold by borrowers
No equity in borrowing firms

Direct Credit Markets: The Capital Market
Lenders buy stocks and bonds or bills with maturities of one year or more
Sold by borrowers
Government cannot sell stocks, only bonds or notes
Corporations can issue both stocks and bonds
Non-corporate firms cannot issue stocks, but can issue bonds

Financial Intermediaries
Commercial Banks
Life Insurance Companies
Savings and Loans
Mutual Savings Banks
Money Market Mutual Funds

Attributes of Financial Instruments
Liquidity
Risk
Yield

Liquidity
From most liquid to least:
Currency, demand deposits, and ODD (M1 assets)
Non-checkable savings deposits
MMMF shares
Time deposits and CDs
U.S. Treasury Securities
Bills
Notes
Bonds
Municipal & State Bonds
Corporate Bonds
Corporate Stocks

Risk
Default Risk
Exposure to possible bankruptcy or insolvency of issuer
Assumed zero for federal government
Market Risk
Exposure to changes in prevailing yields and interest rates which may make an investment less attractive
e-rate risk is a form of market risk

Yield
Current yield
= yearly return/price or initial principal
Yield to maturity
= yearly return plus discounted capital gain or loss/price or initial principal

Liquidity, Risk, Yield
Instruments are worth more the higher their liquidity & yield, and the lower their risk

Financial Markets
Debt v. Equity
Primary v. Secondary
Capital v. Money Markets
Organized v. OTC

U.S. Government Securities
Traded in deep secondary markets
Highly liquid with zero default risk
Exposed to market risk if interest rates rise
Used by Federal Reserve System to control the money supply through Open Market Operations (OMO)

U.S. Treasury Securities
T-bills – 91 day, 182 day, & 1 year maturities
T-notes – 1-10 year maturities
T-bonds – 10-30(40) year maturities

T-bill Tables
Maturity     Days to Maturity      Bid      Asked     Change      Ask Yield

Discount rate =
r = (1000 – P)360/1000(dtm)

Solving for Asked Price P,

P = $1000 - $1000(r)(dtm)/360

T notes and bonds
Current yield
Yc = R/P

Yield to maturity
Ym = (R + (C/N))/P

Money Market Instruments
T-bills
Commercial paper
Banker’s Acceptances
Negotiable CDs
Federal Funds
Repurchase Agreements (RPs)
Eurodollars

Capital Market Instruments
Stocks
Corporate Bonds
State & Municipal Bonds
U.S. Government Notes & Bonds
Mortgages
Mortgage-backed Securities