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Chapter 2 Financial Markets and Institutions 2-1 The Capital Allocation 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 on the capital they borrow. 2-2 What is a market? • • 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. 2-3 Types of Financial Markets • • • • • Physical assets vs. Financial assets Spot vs. Futures Money vs. Capital Primary vs. Secondary Public vs. Private 2-4 Types of Financial Institutions • • • • • • • • • Commercial banks Credit unions Insurance companies Investment banks Pension funds Mutual funds Exchange traded funds (ETFs) Hedge funds Private equity companies 2-5 The Financial System • • 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 6 Financial Decision Making in a Financial Market • • When individuals finance an investment entirely with personal funds, the decision depends on personal preferences about the timing of consumption. – 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. – • 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. 7 The Stock Market • 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 • 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 2-8 Stock Market Transactions • 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 2-9 What is an IPO? • • • • 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. 2-10 Stock Market Efficiency • 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 2-11 What is meant by stock market efficiency? • • • 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. 2-12