12.1 Overview of US Financial Markets
4 min read•june 18, 2024
The US financial markets are a complex ecosystem of interconnected components. deal with short-term debt , while bond markets involve longer-term government and corporate debt. Equity markets facilitate the buying and selling of company shares through exchanges and over-the-counter trading.
Understanding these markets is crucial for investors and companies alike. Key concepts include securities, , and . Factors like , , and play important roles in shaping market dynamics and investment strategies.
Overview of US Financial Markets
Components of US money markets
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- Money markets involve short-term debt securities with maturities of one year or less (, , )
- Highly liquid investments can be quickly converted to cash with minimal impact on their value
- Considered safe investments due to their short maturities and high credit quality of issuers
- Functions of money markets include:
- Providing short-term funding for governments, financial institutions, and corporations to meet their immediate cash needs
- Enabling investors to earn interest on their cash reserves while maintaining liquidity
- Facilitating the implementation of monetary policy by central banks through
Government vs corporate bond markets
- consist of debt securities issued by federal, state, and local governments
- Considered low-risk investments due to the backing of the government's taxing authority
- U.S. Treasury securities include (maturities of 2-10 years), (maturities of 20-30 years), and (TIPS) which adjust principal based on
- issued by state and local governments often offer tax advantages to investors
- involve debt securities issued by corporations to raise capital for various purposes (expansion, acquisitions, working capital)
- Higher risk compared to government bonds due to the possibility of the issuing company defaulting on its obligations
- Offer higher yields to compensate investors for the increased risk
- Credit ratings assigned by agencies like and assess the creditworthiness of the issuing company
- Key differences between government and corporate bond markets:
- Default risk: Government bonds have significantly lower default risk than corporate bonds
- Yield: Corporate bonds generally offer higher yields to attract investors and compensate for the higher risk
- Liquidity: Government bonds are typically more liquid and easier to trade than corporate bonds
- Taxation: Interest from municipal bonds is often exempt from federal income tax and sometimes state and local taxes
Structure of US equity markets
- refers to the (IPOs) where companies issue new shares to raise capital
- Investment banks act as underwriters to facilitate the IPO process, setting the initial price and allocating shares to investors
- involves the trading of previously issued securities among investors
- Exchanges like the and provide centralized platforms for equity trading
- NYSE utilizes an auction-based trading system with designated market makers to facilitate orderly trading
- NASDAQ operates as an electronic trading platform with multiple market makers competing for orders
- Over-the-counter (OTC) markets enable decentralized trading directly between buyers and sellers without the involvement of an exchange
- Exchanges like the and provide centralized platforms for equity trading
- Trading mechanisms in equity markets include:
- which execute a trade immediately at the best available current price
- which specify a maximum price to buy or a minimum price to sell, providing investors more control over execution prices
- which are triggered to buy or sell when the stock reaches a predetermined price, helping to limit potential losses or lock in profits
- Key participants in equity markets include:
- Retail investors who are individual investors trading for their personal accounts
- Institutional investors such as mutual funds, pension funds, and insurance companies which manage large portfolios on behalf of their clients
- Broker-dealers who facilitate trades, provide investment advice, and offer various financial services to their clients
- , the total value of a company's outstanding shares, is used to classify stocks (e.g., large-cap, mid-cap, small-cap)
Additional Financial Market Concepts
- Securities: Financial instruments that represent ownership (stocks) or debt (bonds) traded in financial markets
- Capital markets: Long-term financial markets where securities are bought and sold, including both equity and debt markets
- Financial intermediaries: Institutions that facilitate transactions between lenders and borrowers in capital markets
- Liquidity refers to the ease with which an asset can be bought or sold without significantly affecting its price
- Volatility measures the degree of price fluctuation in a security or market over time
- Derivatives are financial contracts whose value is derived from the performance of an underlying asset, index, or entity
Key Terms to Review (74)
Alphabet (Google): Alphabet Inc. is the parent company of Google and several former Google subsidiaries. It was created through a corporate restructuring of Google on October 2, 2015.
Amazon: Amazon is a multinational technology and e-commerce company founded by Jeff Bezos in 1994. It is one of the largest companies by market capitalization and a key player in various market sectors including cloud computing, digital streaming, and artificial intelligence.
BlackRock: BlackRock is a global asset management firm known for its extensive range of investment products, including mutual funds and ETFs. It is one of the largest financial institutions in the world, with significant influence over global markets.
Capital Markets: Capital markets are financial systems that facilitate the exchange of long-term debt or equity-backed securities between investors and companies or governments seeking to raise funds. They provide a platform for the trading of financial instruments, enabling the efficient allocation of capital and risk management.
Certificates of Deposit: Certificates of Deposit (CDs) are a type of savings account offered by banks and credit unions that provide a fixed interest rate in exchange for the account holder agreeing to keep their money deposited for a specific period of time. They are considered a low-risk, conservative investment option that provides a guaranteed return on the principal amount.
Commercial Paper: Commercial paper is a short-term, unsecured debt instrument issued by corporations and other entities to raise funds for their immediate operational needs. It is a flexible and cost-effective way for companies to manage their cash flow and meet their short-term financial obligations.
Commercial paper (CP): Commercial paper (CP) is an unsecured, short-term debt instrument issued by corporations to finance their immediate needs. It typically has a maturity period of up to 270 days and is usually issued at a discount from face value.
Corporate Bond Markets: Corporate bond markets are financial markets where companies issue debt securities, known as corporate bonds, to raise capital. These markets facilitate the trading of corporate bonds between investors, allowing companies to access funding for their operations and expansion plans.
Debenture: A debenture is a type of long-term debt instrument issued by corporations or governments to secure capital, backed only by the issuer's creditworthiness. Unlike secured bonds, debentures do not have specific collateral tied to them.
Derivatives: Derivatives are financial instruments whose value is derived from the value of an underlying asset, reference rate, or index. They are used to manage risk, speculate on market movements, or gain exposure to an asset without directly owning it.
Discount window: The discount window is a lending facility provided by central banks, allowing financial institutions to borrow money at a discounted interest rate. It serves as a mechanism for maintaining liquidity and stability in the financial system.
Exchange-traded funds (ETFs): Exchange-Traded Funds (ETFs) are investment funds traded on stock exchanges, much like stocks. They hold a diversified portfolio of assets such as stocks, bonds, or commodities.
Facebook: Facebook is a social media platform that allows users to connect, share content, and communicate with each other. It has grown into one of the largest digital advertising platforms, influencing market trends and corporate valuations.
Federal funds: Federal funds are overnight loans between banks to help them meet reserve requirements. These transactions are conducted in the federal funds market and involve unsecured loans.
Federal Reserve Bank of New York: The Federal Reserve Bank of New York is one of the 12 regional banks in the Federal Reserve System. It plays a key role in implementing monetary policy, managing foreign exchange, and supervising financial institutions.
Fidelity: Fidelity is the accuracy and integrity with which financial information and investments are managed and communicated. It ensures that financial transactions, performance data, and investor relations meet high standards of trustworthiness and reliability.
Financial crisis of 2008: The financial crisis of 2008 was a severe worldwide economic downturn triggered by the collapse of the housing bubble in the United States. It led to massive bank failures, significant declines in consumer wealth, and prolonged unemployment.
Financial Intermediaries: Financial intermediaries are entities that facilitate the flow of funds between savers and borrowers, serving as a bridge between these two parties. They play a crucial role in the financial markets and instruments by providing various services and products that help channel capital to where it is needed most.
Fitch: Fitch Ratings is a global credit rating agency that evaluates the creditworthiness of borrowers, including corporations, financial institutions, and governments. It provides investors with insights into the risk levels associated with different debt instruments.
General obligation (GO) bonds: General obligation (GO) bonds are municipal bonds backed by the full faith and credit of the issuing government entity. These bonds are typically supported by the issuer's taxing power rather than revenue from a specific project.
Government Bond Markets: Government bond markets refer to the trading and exchange of debt securities issued by national governments. These markets facilitate the raising of capital by governments to finance public spending and manage fiscal policies.
IEI: IEI stands for Intermediate-Term Treasury ETF, which tracks the performance of U.S. Treasury securities with maturities between 3 and 10 years. It is commonly used by investors seeking moderate exposure to interest rate risk and steady income from government bonds.
Indenture: A formal legal agreement, contract, or document between two parties, typically used in the issuance of bonds. It specifies the terms and conditions under which the bond is issued and obligations of both issuer and bondholder.
Inflation: Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power. It is commonly measured by the Consumer Price Index (CPI) or Producer Price Index (PPI).
Initial public offering: An Initial Public Offering (IPO) is the process through which a private company offers its shares to the public for the first time. This marks the transition of a company from private to public ownership.
Initial Public Offerings: An initial public offering (IPO) is the first sale of stock shares by a private company to the public. It marks the transition of a company from private to public ownership, allowing the company to raise capital by offering its shares on a stock exchange for the first time.
Johnson & Johnson: Johnson & Johnson is a multinational corporation specializing in pharmaceuticals, medical devices, and consumer health products. It is one of the largest companies in the healthcare sector, with a significant impact on US financial markets.
Limit Orders: A limit order is a type of order placed with a securities exchange to buy or sell a stock at a specified price or better. It is used to control the price at which a trade is executed, ensuring that the transaction does not occur at an undesirable price.
Liquidity: Liquidity refers to the ease and speed with which an asset can be converted into cash without significant loss in value. It is a crucial concept in finance that encompasses the ability of individuals, businesses, and markets to readily access and transact with available funds or assets.
Lower-volatility investments: Lower-volatility investments are financial assets that exhibit smaller price fluctuations over time compared to higher-volatility investments. These assets are often considered safer and more stable, making them attractive for risk-averse investors.
Malkiel: Burton G. Malkiel is an American economist and author of the influential book 'A Random Walk Down Wall Street.' He is a proponent of the efficient-market hypothesis, which argues that asset prices fully reflect all available information.
Market capitalization: Market capitalization, or market cap, is the total value of a company's outstanding shares of stock. It is calculated by multiplying the current share price by the total number of outstanding shares.
Market Capitalization: Market capitalization, often shortened to 'market cap,' is the total value of a company's outstanding shares of stock. It is calculated by multiplying the current market price of a single share by the total number of shares outstanding. Market capitalization provides a measure of a company's size and is an important factor in various financial analyses and investment decisions.
Market Orders: A market order is a type of order to buy or sell a security at the best available current market price. It is the most basic and commonly used order type, executed immediately at the prevailing market rate without any price limitations.
Money Markets: Money markets are financial markets that facilitate the exchange of short-term debt instruments, typically with maturities of one year or less. These markets provide a platform for borrowers to obtain short-term financing and for lenders to invest in low-risk, highly liquid assets, thereby supporting the efficient flow of capital and liquidity in the broader financial system.
Moody’s: Moody's is a leading credit rating agency that provides financial research on bonds issued by commercial and government entities. It helps investors assess the risk associated with different securities.
Moody's: Moody's is a leading global credit rating agency that assesses the creditworthiness of organizations and financial instruments. It plays a crucial role in the US financial markets by providing independent and authoritative credit ratings that help investors, lenders, and issuers make informed decisions.
Municipal Bonds: Municipal bonds are debt securities issued by state and local governments to fund public projects and operations. They are considered relatively low-risk investments due to the taxing power and revenue sources of the issuing municipalities.
Municipal bonds (“munis”): Municipal bonds, or 'munis,' are debt securities issued by local governments, states, or municipalities to finance public projects. They offer tax advantages, often being exempt from federal income tax and sometimes state and local taxes as well.
Municipal bonds (munis): Municipal bonds (munis) are debt securities issued by state, local, or other governmental entities to finance public projects. They often offer tax-exempt interest income to investors.
NASDAQ: NASDAQ is a major stock exchange in the United States, known for its focus on technology and innovation. It serves as a marketplace for trading securities, providing a platform for companies to offer their shares to the public and for investors to buy and sell these shares.
Negotiable certificates of deposit (NCDs): Negotiable Certificates of Deposit (NCDs) are fixed-term deposits issued by banks that can be traded in secondary markets. They typically offer higher interest rates than regular savings accounts because they require a larger minimum deposit.
New York Stock Exchange: The New York Stock Exchange (NYSE) is the world's largest stock exchange, located in New York City. It is a marketplace where publicly traded companies' stocks are bought and sold, allowing investors to participate in the growth and success of these businesses.
New York Stock Exchange (NYSE): The New York Stock Exchange (NYSE) is the largest and one of the oldest stock exchanges in the world, located in New York City. It facilitates the buying and selling of publicly traded stocks and other securities.
Open Market Operations: Open market operations refer to the actions taken by a central bank, such as the Federal Reserve in the United States, to influence the money supply and interest rates by buying and selling government securities in the open market. These operations are a key monetary policy tool used to manage the economy and achieve the central bank's objectives.
Over-the-counter (OTC) market: The over-the-counter (OTC) market is a decentralized market where securities not listed on major exchanges are traded directly between parties. Transactions occur via a network of dealers and brokers rather than through a centralized exchange.
Over-the-Counter Markets: Over-the-counter (OTC) markets are decentralized financial markets where securities are traded directly between two parties without the supervision of a central exchange. In these markets, dealers act as market makers, providing bid and ask prices to facilitate trading in a wide range of financial instruments.
Primary market: The primary market is a financial market where new securities, such as stocks and bonds, are issued and sold to investors for the first time. Companies use this market to raise capital by offering shares directly to institutional or retail investors.
Primary Market: The primary market is the financial market where new securities, such as stocks and bonds, are issued and sold to investors for the first time. It is the initial public offering (IPO) of securities, where companies or governments raise capital by offering their shares or debt instruments to the public.
Renaissance Capital: Renaissance Capital, often referred to as the Renaissance period in finance, marks a significant era of economic growth and market development following the Middle Ages. It is characterized by the establishment of modern banking institutions and financial markets.
Revenue bonds: Revenue bonds are municipal bonds that finance income-producing projects and are secured by the revenue generated from those projects. They differ from general obligation bonds, which are backed by the issuer's credit and taxing power.
S&P Global Ratings: S&P Global Ratings is a prominent credit rating agency that assesses the creditworthiness of borrowers, ranging from corporations to governments. It assigns ratings based on financial health and ability to repay debt obligations.
Seasoned equity offering (SEO): A seasoned equity offering (SEO) is the process by which a publicly traded company issues additional shares to raise capital. Unlike an initial public offering (IPO), an SEO is conducted after the company has already gone public.
Secondary market: The secondary market is a financial market where previously issued securities, such as stocks and bonds, are bought and sold by investors. It provides liquidity for investors looking to sell their holdings and allows new investors to buy existing securities.
Secondary Market: The secondary market refers to the trading of securities, such as stocks and bonds, after they have been initially issued in the primary market. It is where investors can buy and sell existing financial instruments, providing liquidity and price discovery for these assets.
Securities: Securities are financial instruments that represent ownership or debt in a company or other entity. They are tradable assets that can be bought and sold on financial markets, providing investors with a way to participate in the growth and performance of various entities.
Shelf registration: Shelf registration is a procedure that allows companies to register a new issue of securities without having to sell the entire issue at once. This enables the company to sell portions of the issue over time, up to three years, as market conditions become favorable.
Special purpose acquisition companies (SPACs): Special Purpose Acquisition Companies (SPACs) are publicly traded companies created solely to acquire or merge with an existing private company, thereby taking it public. They are also known as 'blank check companies' because they do not have any commercial operations at the time of their IPO.
Standard & Poor's: Standard & Poor's (S&P) is a leading provider of credit ratings, research, and analytics that assess the creditworthiness of organizations and investment products. It is one of the most influential financial information and analysis companies in the world, serving as a crucial resource for investors, lenders, and policymakers in the context of the US financial markets.
Standard and Poor’s: Standard and Poor’s (S&P) is a financial services company known for its stock market indices, such as the S&P 500. It also provides credit ratings for companies and government entities, helping investors assess risk.
Stop Orders: A stop order, also known as a stop-loss order, is a type of order placed with a broker to buy or sell a security once the price of the security reaches a specified price, known as the stop price. The purpose of a stop order is to limit an investor's loss on a position in a security.
Treasury Bills: Treasury bills (T-bills) are short-term debt securities issued by the U.S. government with maturities of one year or less. They are considered one of the safest investments due to the full faith and credit backing of the U.S. government, and they play a crucial role in the functioning of financial markets and the broader economy.
Treasury bills (T-bills): Treasury bills (T-bills) are short-term debt securities issued by the U.S. Department of the Treasury with maturities ranging from a few days to 52 weeks. They are sold at a discount to their face value and do not pay periodic interest.
Treasury bonds: Treasury bonds (T-bonds) are long-term debt securities issued by the U.S. Department of the Treasury to support government spending. They have maturities greater than 10 years and pay periodic interest until maturity, at which point the principal is repaid.
Treasury Bonds: Treasury bonds are debt securities issued by the U.S. government to finance its operations and borrowing needs. They are considered one of the safest investments due to the full faith and credit backing of the U.S. government, and they play a crucial role in the U.S. financial markets and the historical returns of bonds.
Treasury Inflation-Protected Securities: Treasury Inflation-Protected Securities (TIPS) are a type of U.S. government bond that provides protection against inflation by adjusting the principal value of the bond based on changes in the Consumer Price Index (CPI). The interest payments and the final payout at maturity are then calculated based on this adjusted principal amount, ensuring that the real value of the investment is preserved despite rising prices.
Treasury notes: Treasury notes are U.S. government debt securities with maturities ranging from 2 to 10 years. They pay interest every six months until maturity, at which point the face value is returned to the holder.
Treasury Notes: Treasury notes are debt securities issued by the U.S. government with maturities ranging from 2 to 10 years. They are considered low-risk investments and are commonly used to finance the federal government's operations and borrowing needs.
Treasury notes (T-notes): Treasury notes (T-notes) are U.S. government debt securities with maturities ranging from 2 to 10 years. They pay interest semi-annually and are considered low-risk investments.
US Securities and Exchange Commission (SEC): The US Securities and Exchange Commission (SEC) is a federal agency responsible for regulating the securities industry and enforcing securities laws. It aims to protect investors, maintain fair and efficient markets, and facilitate capital formation.
Vanguard: Vanguard is an investment management company known for its low-cost mutual funds and ETFs. It is a key player in the US financial markets, emphasizing long-term investment strategies and passive management.
Volatility: Volatility refers to the degree of variation in the price or value of a financial asset, economic indicator, or market over time. It is a measure of the uncertainty or risk associated with the size of changes in a variable's value. Volatility is a crucial concept in finance, economics, and risk management, as it helps understand the stability and predictability of various financial and economic phenomena.
Walmart: Walmart is a multinational retail corporation that operates a chain of hypermarkets, discount department stores, and grocery stores. It is one of the largest companies in the world by revenue and a significant player in the US financial markets.
World Bank: The World Bank is an international financial institution that provides loans and grants to the governments of low and middle-income countries for the purpose of pursuing capital projects. It aims to reduce poverty by providing funding for development programs that can boost economic growth.