The Financial Markets

Key instruments of the financial markets are:

• Equities or shares (termed "stocks" in the US). Stocks are ownership shares in a company. Here's a common-sense introduction .
• Mutual funds. A mutual fund, otherwise known as an investment company, is a corporation which pools together investor's money generally to purchase stocks and bonds. Investors participate in the mutual fund by purchasing shares of the entire pool of assets, thus diversifying their investment. The pooled assets are invested by professional managers who buy and sell securities on behalf of the investors.

Because mutual funds pass all gains, losses and tax obligations/benefits through to investors, mutual funds receive preferential tax treatment under the U.S. Internal Revenue Code.

A closed-end fund has a fixed number of shares outstanding and is traded just like other stocks on an exchange or over the counter. The more common open-end funds sell and redeem shares at any time directly to shareholders. Sales and redemption prices of open-end funds are fixed by the sponsor based on the fund's net asset value; closed-end funds may trade a discount (usually) or premium to net asset value.

Much more information here.

• Bonds of various different varieties (e.g., they may be Eurobonds, domestic bonds, fixed interest / floating rate notes, etc.). Bonds are medium to long-term negotiable debt securities issued by governments, government agencies, federal bodies (states), supra-national organisations such as the World Bank, and companies. Negotiable means that they may be freely traded without reference to the issuer of the security. That they are debt securities means that in the event that the company goes bankrupt. bond-holders will be repaid their debt in full before the holders of unsecuritised debt get any of their principal back.
• Short term ("money market") negotiable debt securities such as T-Bills (issued by governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are much like bonds, differing mainly in their maturity "Short" term is usually defined as being up to 1 year in maturity. "Medium term" is commonly taken to mean form 1 to 5 years in maturity, and "long term" anything above that.
• Over the Counter ("OTC") money market products such as loans / deposits. These products are based upon borrowing or lending. They are known as "over the counter" because each trade is an individual contract between the 2 counterparties making the trade. They are neither negotiable nor securitised. Hence if I lend your company money, I cannot trade that loan contract to someone else without your prior consent. Additionally if you default, I will not get paid until holders of your company's debt securities are repaid in full. I will however, be paid in full before the equity holders see a penny.
• Spot Foreign Exchange. This is the buying and selling of foreign currency at the exchange rates that you see quoted on the news. As these rates change relative to your "home currency" (dollars if you are in the US), so you make or lose money.
• Commodities. These include grain, pork bellies, coffee beans, orange juice, etc.

The core of the US financial markets is the market for debt issued by the US government, which issues US Treasury bills, notes and bonds.

US Treasuries

The US Treasury Department periodically borrows money and issues IOUs in the form of bills, notes, or bonds ("Treasuries"). The differences are in their maturities and denominations:

	Bill	Note	Bond
Maturity	up to 1 year	1 - 10 years	10 - 30/40 years
Denomination	$1,000	$1,000	$1,000
Minimum	$10,000	$1,000	$1,000

Treasuries are auctioned. Short term T-bills are auctioned every Monday, and longer term bills, notes, and bonds are auctioned at other intervals. A recording maintained by the Kansas City Federal Reserve will tell you the purchase price, auction date, issue date, series number, coupon rate and effective annualized yield for each of the most recent treasury auctions. To find out the results of the latest auction, dial the KC Fed information line at (800) 333-2919 using a touch-tone phone. Press "1", then "4", then "1". You don't have to wait for the recordings to complete before entering each digit. Unfortunately, this number is not reachable from all areas of the country.

T-Notes and Bonds pay a stated interest rate semi-annually, and are redeemed at face value at maturity. Exception: Some 30 year and longer bonds may be called (redeemed) at 25 years.

T-bills work a bit differently. They are sold on a "discounted basis." This means you pay, say, $9,700 for a 1-year T-bill. At maturity the Treasury will pay you (via electronic transfer to your designated bank checking account) $10,000. The $300 discount is the "interest." In this example, you receive a return of $300 on a $9,700 investment, which is a simple rate of slightly more than 3%.

Treasuries can be bought through a bank or broker, but you will usually have to pay a fee or commission to do this. They can also be bought with no fee using the Treasury Direct program, which is described elsewhere in the FAQ.

In practice, the first T-bill purchase requires you to send a certified or cashiers check for the full face value, and within a week or so, after the auction sets the interest rate, the Treasury will return the discount ($300 in the example above) to your checking account. For some reason, you can purchase notes and bonds with a personal check.

Treasuries are negotiable. If you own Treasuries you can sell them at any time and there is a ready market. The sale price depends on market interest rates. Since they are fully negotiable, you may also pledge them as collateral for loans.

Treasury bills, notes, and bonds are the standard for safety. By definition, everything is relative to Treasuries; there is no safer investment in the U.S. They are backed by the "Full Faith and Credit" of the United States.

Interest on Treasuries is taxable by the Federal Government in the year paid. States and local municipalities do not tax Treasury interest income. T-bill interest is recognized at maturity, so they offer a way to move income from one year to the next.

The US Treasury also issues Zero Coupon Bonds. The ``Separate Trading of Registered Interest and Principal of Securities'' (a.k.a. STRIPS) program was introduced in February 1986. All new T-Bonds and T-notes with maturities greater than 10 years are eligible. As of 1987, the securities clear through the Federal Reserve's books entry system. As of December 1988, 65% of the ZERO-COUPON Treasury market consisted of those created under the STRIPS program.

However, the US Treasury did not always issue Zero Coupon Bonds. Between 1982 and 1986, a number of enterprising companies and funds purchased Treasuries, stripped off the ``coupon'' (an anachronism from the days when new bonds had coupons attached to them) and sold the coupons for income and the non-coupon portion (TIGeRs or Strips) as zeroes. Merrill Lynch was the first when it introduced TIGR's and Solomon introduced the CATS. Once the US Treasury started its program, the origination of trademarks and generics ended. There are still TIGRs out there, but no new ones are being issued.

Agencies

Other US government debt obligations include US Savings Bonds (Series E/EE and H/HH) and bonds from various US Government agencies, including the ones that are known by cutesy names like Freddie Mac, as well as the Mae sisters, Fannie, Ginnie and Sallie. US Government Agency Bonds, in general, pay slightly more interest but are somewhat less predictible than Treasuries. For example, mortgage-backed-bond returns will vary if mortgages are redeemed early. Some agency bonds, technically, are not general obligations of the United States, so may not be purchased by certain institutions and local governments. The "common sense" of many people, however, is that the Congress will never allow any of those bonds to default.

Munis

US municipal bonds are free of Federal income taxes. The taxable equivalent yield is equal to the tax free yield divided by the sum of 100 minus the current tax bracket. For example the taxable equivalent yield of a 6.50% tax free bond for someone in the 32% tax bracket would be: 6.5/(100-32) = 0.0955882 or 9.56%