Financial Market Instruments

Here we examine the securities (instruments) traded in financial markets. We first focus on the instruments traded in the money market and then turn to those traded in the capital market.

Money Market Because of their short terms to maturity, the debt instruments traded in the money

Instruments market undergo the least price fluctuations and so are the least risky investments. The money market has undergone great changes in the past three decades, with the amount of some financial instruments growing at a far more rapid rate than others.

The principal money market instruments are listed in Table 1 along with the amount outstanding at the end of 1970, 1980, 1990, and 2002.

United States Treasury Bills. These short-term debt instruments of the U.S. government are issued in 3-, 6-, and 12-month maturities to finance the federal government. They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount, that is, at a price lower than the set amount paid at maturity. For instance, you might pay $9,000 in May 2004 for a one-year Treasury Bill that can be redeemed in May 2005 for $10,000.

U.S. Treasury bills are the most liquid of all the money market instruments, because they are the most actively traded. They are also the safest of all money market instruments, because there is almost no possibility of default, a situation in which the party issuing the debt instrument (the federal government, in this case) is unable to make interest payments or pay off the amount owed when the instrument matures. The federal government is always able to meet its debt obligations, because it can raise taxes or issue currency (paper money or coins) to pay off its debts. Treasury bills are held mainly by banks, although small amounts are held by households, corporations, and other financial intermediaries.

Negotiable Bank Certificates of Deposit. A certificate of deposit (CD) is a debt instrument, sold by a bank to depositors, that pays annual interest of a given amount and at maturity, pays back the original purchase price. Before 1961, CDs were nonnegotiable; that is, they could not be sold to someone else and could not be redeemed from the bank before maturity without paying a substantial penalty. In 1961, to make CDs more liquid and more attractive to investors, Citibank introduced the first negotiable CD in large denominations (over $100,000) that could be resold in a secondary market. This instrument is now issued by almost all the major commercial banks and has been extremely successful, with the amount outstanding currently around $1.2 trillion. CDs

Table 1 Principal Money Market Instruments

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