Financial Markets and Instruments: Structure, Pricing, and Yield Spreads
Market structure
Primary markets issue new securities (IPOs, Treasury auctions); secondary markets trade existing claims, providing liquidity and price discovery. Money markets trade debt maturing in one year or less: Treasury bills, negotiable CDs, commercial paper, repurchase agreements, banker's acceptances, Eurodollars. Capital markets trade longer debt and equity: notes, bonds, mortgages, common and preferred stock.
Prices, yields, and the Fisher effect
Bond prices and yields move inversely. Yield to maturity equates the present value of promised payments to the price paid. A coupon bond sells at par when coupon equals market yield, at a discount when market rates rise above the coupon, at a premium when they fall below. Fisher equation: nominal rate ≈ real rate + expected inflation; exactly, (1+r)(1+π) − 1. Nominal rates rise roughly one-for-one with anticipated inflation.
Risk structure and term structure
Default risk, liquidity, and tax treatment create yield spreads. Treasuries are the benchmark because they carry no default risk. Municipal bonds yield less pre-tax because interest is federally tax-exempt: equivalent taxable yield = municipal yield ÷ (1 − marginal tax rate). The yield curve is explained by expectations theory (long rates average expected short rates), liquidity premium theory (long bonds carry a premium), and segmented markets theory (maturity niches have separate supply and demand). Inverted curves have historically preceded recessions.
Worked example
A 3% municipal bond versus a taxable corporate bond for an investor in the 32% bracket: 0.03 ÷ (1 − 0.32) = 4.41%. Any taxable bond yielding less than 4.41% leaves the investor worse off after tax, so the muni wins. Show the arithmetic, not just the intuition.
Traps
Using face value instead of price when computing returns; forgetting that a price rise means a yield fall; applying the tax adjustment to the wrong bond; assuming a flat curve reflects expectations alone; ignoring that money market instruments are quoted on a bank discount basis, which understates the true return relative to a bond-equivalent yield.