Financial Claims

In a broad sense, there are as many financial markets as there are financial instruments. There are, however, two distinct types of market. One is the centralized market such as the stock exchange on which stocks and bonds are traded. The other is the decentralized market like the market for deposits. The type of market is itself a differentiating characteristic of the financial instrument.

For every financial claim in existence, there must be a demand and a supply. In some cases, such as stocks and bonds, demand and supply in­teract freely to determine price. In other cases, such as deposits, the prices or yields have been regulated by government agencies. Here, supply and demand may be equilibrated through nonprice competition, such as the provision of checking services at below cost. Alternatively, there may be disequilibrium in this market, necessitating some form of rationing.

There is also a distinction between primary and secondary markets. Markets for newly issued financial claims are primary markets. Markets for “used” financial claims are secondary markets. The existence of an effi­cient secondary market increases a financial claim’s liquidity because a secondary market facilitates liquidation. Financial claims serve the purpose of transferring purchasing power from the buyer to the seller. In the primary market, the transfer takes place from lender to borrower. This transfer increases the aggregate volume of credit and could be used, for example, to finance new investment. Transactions on secondary markets, on the other hand, take place between one lender and another lender. There can be no direct net increase in credit from secondary market ac­tivity. However, newly issued and used financial claims with identical char­acteristics are perfect substitutes. Hence, prices of identical new and used claims are always the same. Because secondary markets are so large in comparison to primary markets, they actually dominate the price deter­mination process. For example, if demand in the secondary market in­creases, prices of financial claims rise and their yields fall. Borrowers can then issue new financial claims on the primary markets at lower rates of interest and borrowing becomes cheaper.

Present Value

If offered $100 now or $100 in a year’s time, people would normally prefer $100 now. Aside from the risk of nonpayment or default in a year’s time, $100 now could be invested to produce more than $100 a year later. In other words, a dollar in the future is worth less than a dollar now. This would be the case even if the price level remained stable, provided that interest rates were positive.

What is the value of $100 in a year’s time? Today’s value or the present value of $100 in a year’s time is $100 discounted by the market rate of interest i. The present value of future receipts can be calculated from the general formula where PV is the present value, FV is the future value or dollar amount to be received in the future, i is the market rate of interest expressed as a proportion (0.05) rather than as a percentage (5 percent), and n represents the number of years before the receipt of FV. One hundred dollars to be received in one year’s time is worth $90.91 today with a 10 percent interest rate ($100/1.1). Investing $90.91 at 10 percent today would yield exactly $100 in a year’s time—$90.91 principal plus $9.09 interest.

The discounting technique described above is used to calculate the present value of commercial paper and treasury bills. These short-term financial claims offer no direct coupon or interest payments. (A few longer-term claims are also zero coupon assets.) They simply possess a face value and a maturity date at which that value will be paid. Therefore, the face value is discounted by the market rate of interest to obtain the current market price. For example, with an annual rate of interest of 10 percent, a new six month $1000 commercial note would be discounted by 5 percent to give its market value of $952.38 ($1000/1.05).

In fact, the market price of this commercial note would be somewhat higher than $952.38 with an effective annual rate of interest of 10 percent. This is due to the fact that interest is compounded when payments occur more than once a year. In this particular case, $952.38 invested in a six month commercial note yields $1000 in six month’s time. This $1000 could then be reinvested to produce $1050 at the end of the year. The growth of $952.38 to $1050 represents a yield of 10.25 percent over the year on the original investment—$ 100 • (1050/952.38 — 1). The 10.25 percent is known as the effective annual rate of interest.

1. Direct financial claims are issued by non financial units. Financial in­stitutions sell indirect claims. New issues of financial claims are sold on primary markets, whereas used ones are traded on secondary markets.

2. Financial claims are differentiated from one another by characteristics such as maturity, callability, marketability, taxability, type of yield, and risk.

3. The market price of a financial claim is equal to the present value of all future payments—dividends plus principal—due under that claim.

4. The present value depends on the amount and timing of future pay­ments and on the market rate of interest.

5. For any given nominal interest rate, the effective annual rate is higher the more frequently is interest compounded.

6. Level payment mortgages involve gradual repayment or amortization of the loan principal throughout the mortgage’s life. Early on the pay­ment is mainly interest, but towards the end it is mainly principal repayment.

7. The market value of any financial asset with a fixed coupon rate or dividend moves inversely to the market rate of interest.

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