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CHAPTER 2 Financial Markets and Institutions: Financial markets Financial institutions The stock market 4-1 The Capital Flow Process 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(interest) on the capital they borrow. 4-2 2-2 Three ways capital flow from savers to borrowers? Direct transfer Investment Bank Securities pass through the investment bank Financial intermediary Intermediary create new securities for savers. 4-3 What is a market Market: A place/venue where goods and services are exchanged FM: A place where funds/financial assets are traded. 4-4 Types of financial markets Money vs. Capital Primary vs. Secondary Spot vs. Futures Public vs. Private 4-5 FM F Asset /F instruments: contracts specifying borrowing/lending terms, claims on real assets i. Money M (borrowed for less than 1 Y) and Capital M (1 Y or longer) ii. Primary M and secondary M 1. PM: Corporations raise capital by issuing new securites 2. SM: outstanding issues traded among investors iii. Private M vs. Public 1. Private: transactions between two parties 2. Public: standardized contracts traded on exchanges. iv. Spot M vs. Future M 1. SM: transaction “on-the-spot” 2. FM: Contract specifying terms of future trading 4-6 Types of Financial Institutions Banks Commercial banks Investment banks Middleman between savers and borrowers An organization that helps to sell new investment securities (bonds, stocks). Financial services corporations A firm that offers a wide range of financial services, including investment banking, commercial banking, brokerage and insurances. Citi, B of A, JPM 4-7 2-7 Types of Financial Institutions Funds-pool money to invest Mutual funds Pension funds-retirement plans Hedge funds; largely unregulated, target high net worth, might hedge risk or have even higher risk Exchange traded funds-ETF Private equity: borrows money to invest/mange the whole company 4-8 2-8 Types of Financial Institutions Life Insurance companies: Collect premiums and invest. Now offers taxdeferred saving and investing plans Tax benefits Return & Risk Flexibility High initial cost 4-9 The stock market Types of stock market transactions The secondary market The primary market: IPO market: Initial Public Offering additional new shares 4-10 Where can you find a stock quote, and what does one look like? Stock quotes can be found in a variety of print sources (The Wall Street Journal and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral). Stock Quote for Twitter, Inc., June 3, 2014 Source: Twiter, Inc. (TWTR), finance.yahoo.com. 2-11 4-11 S&P 500 Index, Total Returns: Dividend Yield + Capital Gain or Loss, 1968-2013 Source: Data taken from various issues of The Wall Street Journal “Investment Scoreboard” section. 2-12 4-12 Returns of the stock market Historical average return about 10% Real return (adjusted for inflation) about 6-7% Real value double every 10 years Future might not look like the past Stocks for the Long Run by Jeremy Siegel 4-13 Stock market efficiency The Efficient Market Hypothesis(EMH): Stock price has reflected all available information Market prices are close to intrinsic values Why: competitions in the market, inefficiency (undervaluation or overvaluation) will be traded away Implication: buy the market(index) 4-14 Behavioral finance Misprices can not be all traded away Investors are irrational Too much risk Short sell restrictions and risk Overconfidence Loss aversion Evidence Obviously overvalued or undervalued market and individual stock, from hindsight. 4-15