Download Financial Markets and Institutions

Chapter 2
Financial Markets and Institutions
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The Capital Allocation Process
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In a well-functioning economy, capital flows
efficiently from those who supply capital to those
who demand it.
Suppliers of capital: individuals and institutions
with “excess funds.” These groups are saving
money and looking for a rate of return on their
investment.
Demanders or users of capital: individuals and
institutions who need to raise funds to finance their
investment opportunities. These groups are willing
to pay a rate of return on the capital they borrow.
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What is a market?
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A market is a venue where goods and services are
exchanged.
A financial market is a place where individuals and
organizations wanting to borrow funds are brought
together with those having a surplus of funds.
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Types of Financial Markets
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Physical assets vs. Financial assets
Spot vs. Futures
Money vs. Capital
Primary vs. Secondary
Public vs. Private
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Types of Financial Institutions
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Commercial banks
Credit unions
Insurance companies
Investment banks
Pension funds
Mutual funds
Exchange traded funds (ETFs)
Hedge funds
Private equity companies
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The Financial System
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Financial decisions are always made within the context of a
financial system that both constrains and enables the
decision maker.
The financial system encompasses financial markets,
financial institutions and financial infrastructure.
– Financial markets: debt (fixed income instruments), equity, and
derivatives; primary and secondary
– Financial institutions: banks, insurance companies, mutual
funds, investment banks, etc.
– Financial infrastructure: rules for trading, accounting systems,
information sharing systems, exchanges, and other institutions
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Financial Decision Making in a Financial Market
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When individuals finance an investment entirely with personal funds,
the decision depends on personal preferences about the timing of
consumption.
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When the markets for borrowing and saving operate perfectly, there
is no connection between the timing of income from the investment
and the timing of the owner’s personal consumption.
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Ex: Opening a second outlet vs. buying a new sailing boat
In the perfect capital market, the interest rate at which the owner can
borrow is the same as the rate he or she could receive by lending to
others.
The conclusion about separation is important because it helps to
justify the common practice of thinking about firms, especially large
firms, as being separate entities from their owners.
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The Stock Market
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By far, the most active market and the most important
one to financial managers is the stock market.
– Because the primary goal of financial managers is to
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maximize their firms’ stock prices, knowledge of the
stock market is important to anyone involved in
managing a business.
Leading U.S. (secondary) stock markets:
– New York Stock Exchange (NYSE)
– Nasdaq
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Stock Market Transactions
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We can classify stock market transactions into three
distinct categories:
– Outstanding shares of established publicly owned
companies that are traded: the secondary market
– Additional shares sold by established publicly owned
companies: the primary market
– Initial public offerings made by privately held firms:
the IPO market
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What is an IPO?
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An initial public offering occurs when a company
issues stock in the public market for the first time
“Going public” enables a company’s owners to raise
capital from a wide variety of outside investors.
Once issued, the stock trades in the secondary
market.
Public companies are subject to additional
regulations and reporting requirements.
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Stock Market Efficiency
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Definitions:
– Market price: The current price of a stock
– Intrinsic value: The price at which the stock would sell if
all investors had all knowable information about a stock
– Equilibrium price: The price that balances buy and sell
orders at any given time. When a stock is in equilibrium,
the price remains relatively stable until new information
becomes available and causes the price to change.
– Efficient market: A market in which prices are close to
intrinsic values and stocks seem to be in equilibrium
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What is meant by stock market efficiency?
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Securities are normally in equilibrium and are
“fairly priced.”
Investors cannot “beat the market” except through
good luck or better information.
Efficiency continuum
Highly
Inefficient
Highly
Efficient
Small companies not followed by
many analysts. Not much contact
with investors.
Large companies followed by many
analysts. Good communications
with investors.
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