Financial Instruments: Capital Market Securities Or Money Market Securities?

Overview

Assessment 2
Respond to five questions about financial markets, financial institutions, and interest rates.
It is necessary to be able to apply the knowledge you have gained by classifying market transactions and financial instruments and by describing how financial markets work.

By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:
• Competency 1: Evaluate the global financial environment.
o Define factors that determine the nominal interest rate on a financial security.
o Categorize financial transactions as taking place in the primary or secondary market.
o Identify financial instruments as money market securities or capital market securities.
• Competency 2: Define finance terminology and its application within the business environment.
o Define the concept of terms structure of interest rates.
o Describe services offered by each type of financial institution.

Assessment Instructions

Respond to the following five questions. Write your responses in a Word document, and number them 1–5.
1. Categorize each of the following transactions as taking place in either the primary or secondary market:
o Supercorp issues $180 million of new common stock.
o HiTech, Inc. issues $30 million of common stock in an IPO.
o Megaorg sells $10 million of HiTech preferred stock from its marketable securities portfolio.
o The XYA Fund buys $220 million of previously issued Supercorp bonds.
o A. B. Corporation sells $15 million of XYZ common stock.
2. Identify whether the following financial instruments are capital market securities or money market securities:
o U.S. Treasury bills.
o U.S. Treasury notes.
o U.S. Treasury bonds.
o Mortgages.
o Federal funds.
o Negotiable certificates of deposit.
o Common stock.
o State and government bonds.
o Corporate bonds.
3. Identify the different types of financial institutions. What are the main services each of these financial institutions offers?
4. Define the six factors that determine the nominal interest rate on a security.
5. Define the concept of term structure of interest rates. What are three theories that explain the future yield curve of interest rates?

Use references to support your answers as needed. Be sure to cite all references using correct APA style. Your responses should be free of grammar and spelling errors, demonstrating strong written communication skills.

Suggested Resources:
The following optional resources are provided to support you in completing the assessment or to provide a helpful context.

Library Resources:
Weaver, S. C., & Weston, J. F. (2001). Finance and accounting for nonfinancial managers. New York, NY: McGraw-Hill.
• Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: American Management Association.

Course Library Guide
You are encouraged to refer to the resources in the
Other Resources
• Cornett, M., Adair, T., & Nofsinger, J. (2019). M: Finance (4th ed.). New York, NY: McGraw-Hill. Available in the courseroom via the VitalSource Bookshelf link.

Financial Markets and Institutions

Question 1: Transactions Categories

Primary and secondary markets differ in the nature of their transactions. Both primary and secondary markets engage in financial transactions unique to their market, as listed below.

Supercorp issues $180 million of new common stock: The primary market supports the issuance of new securities foreign to the market, and buyers buy directly from the issuer (Işık, 2021). I believe the Supercorp transaction will most probably occur in the primary market because the seller issues new common stock and sells direct to buyers.
HiTech, Inc. issues $30 million of common stock in an IPO: According to Işık (2021), the primary market supports transactions through an Initial Public Offering (IPO). Given that HiTech will issue common stock through an IPO, the transaction will take place in the primary market.
Megaorg sells $10 million of HiTech preferred stock from its marketable securities portfolio: The secondary market works differently from the primary with the market allowing the sale of stock without involving the company issuing the stock (Işık, 2021). In this regard, Megaorg offered HiTech’s stock without involving HiTech, qualifying this transaction to take place in the secondary market.
The XYA Fund buys $220 million of previously issued Supercorp bonds: Shares previously traded in the primary market have a chance of being traded in the secondary market (Işık, 2021). In this transaction, XYA bought funds previously issued, and as a result, the transaction will take place in the secondary market.
B. Corporation sells $15 million of XYZ common stock: As noted above, the secondary market allows one company to sell another without the issuing company taking part (Işık, 2021). ABC’s sale of $15 million will occur in the secondary market.

Question 2: Financial Instruments: Capital Market Securities or Money Market Securities?

Money markets differ from capital markets, with each trading unique instruments. The money markets represent a type of market whereby financial institutions, brokers, and money dealers trade short-term debt instruments. Some of the most common instruments traded in money markets include T bills, certificates of deposit, trade credit, and commercial paper (Wall Street Mojo, n.d.). Capital markets trade differently, and as a result, trade instruments foreign to the money markets. Majorly, capital markets focus on stocks, bonds, debentures, and shares (Wall Street Mojo, n.d.). Capital markets also divide into primary markets and secondary markets, dividing their instruments into two. According to capital market securities and money market securities descriptions, the following instruments belong to different categories as highlighted:

S. Treasury Bills: Money Markets
S. Treasury Notes: Money Markets
S. Treasury Bonds: Capital Markets
Mortgages: Capital Markets
Federal Funds: Money Markets
Negotiable Certificates of Deposit: Money Markets
Common Stock: Capital Markets
State and Government Bonds: Capital Markets
Corporate Bonds: Capital Markets

Question 3: Types of Financial Institutions and their Services

Four types of financial institutions exist, and they include commercial banks, savings banks, credit unions, and saving and loan associations. Commercial banks, the most common financial institution, accept deposits from the public and with these deposits sit guarantees safety to these deposits (Wall Street Mojo, Financial Institutions, n.d.). Commercial banks allow individuals and institutions not to store vast sums of money away from the banks. According to the Wall Street Mojo analysis of financial institutions, commercial banks allow transactions through checks and cards. Saving banks also allow deposits but function differently from commercial banks. Saving banks accept deposits from individuals and groups and lend their clients to improve their financial health (Wall Street Mojo, Financial Institutions, n.d.). Credit unions function as associations rather than institutions. Focusing on voluntary participation, credit unions operate as not-for-profit organizations that lend money to their members who own them (Wall Street Mojo, Financial Institutions, n.d.). Saving and loan associations qualify as financial institutions under the depository category. The saving and loan associations collect funds from savers and use theses to help members acquire assets (Wall Street Mojo, Financial Institutions, n.d.). Mostly, saving and loan associations deal with mortgages.

Question 4: Factors Influencing Nominal Interest Rate on a Security

Factors influencing nominal interest rate on a security include real-risk free rate, default risk, maturity risk, liquidity risk, premium expected inflation, and quoted rate on risk-free security.

Real-risk free rate: Expected risk over a period of time
Default risk: Risk determining chance that a borrower fails to oblige to payments
Maturity risk: Expected return/risk on a long-term investment
Liquidity risk: Failure to meet short-term obligations
Premium for expected inflation: Compensation for expected increases in price
Quoted rate on a risk-free security: Minimum rate on zero investment risk

Question 5: Term Structure of Interest Rates

Term structure of interest rates determines the relationship between bond yields, maturities, and interest rates. Three theories explaining the yield curve of interest rates include the rational pure expectations hypothesis, the market segmentation theory, and the liquidity preference theory. According to Schultz (2016), the rational expectations theory holds that fixed-income investors do not show a preference for specific maturity bonds, while the market segmentation theory underlines the segmentation of maturity bonds. On its part, the liquidity preference theory focuses on bonds. The theory claims that bonds can replace each other perfectly, and as a result, no particular preference for a single one exists (Schultz, 2016). Instead, it outlines the rational liquidity premium expectation.

References

Işık, G. G. (2021, January 16). Financial markets, primary and secondary: What does it mean?

Business & Leaders. https://businessandleaders.it/2018/08/01/financial-markets-primary-secondary/.

Schultz, G. M. (2016). Theories of the term structure of interest rates. Chapter 2. DOI:

https://doi.org/10.1002/9781118949108.ch2.

Wall Street Mojo. (n.d.). Difference between money market and capital market.

https://www.wallstreetmojo.com/money-market-vs-capital-market/.

Wall Street Mojo. (n.d.). Financial institutions. https://www.wallstreetmojo.com/financial-