Financial Markets and Institutions

1

• Financial Markets and Institutions
• (chapter 5)

2
The Capital Allocation Process

• 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.

3
How is capital transferred between savers and
borrowers?

• Direct transfers
• Investment banking house
• Financial intermediaries

4
Why financial markets are important?

• What is a financial market?
• Well-functioning financial markets facilitate the
  flow of capital from investors to the users of
  capital.
• Well-functioning markets promote economic growth.

5
Types of financial markets

• Money vs. Capital
• Primary vs. Secondary
• Spot vs. Futures (Derivatives instruments)
• Public vs. Private

6
Exam type questions

• Apple Computer decides to issue additional stock
  with the assistance of its investment banker. An
  investor purchases some of the newly issued
  shares. Is this a primary market transaction or
  a secondary market transaction?
• What if instead an investor buys existing shares
  of Apple stock in the open market is this a
  primary or secondary market transaction?

7
What are derivatives? How can they be used to
reduce or increase risk?

• A derivative securitys value is derived from
  the price of another security (e.g., options and
  futures).
• Can be used to hedge or reduce risk. For
  example, an importer, whose profit falls when the
  dollar loses value, could purchase currency
  futures that do well when the dollar weakens.
• Also, speculators can use derivatives to bet on
  the direction of future stock prices, interest
  rates, exchange rates, and commodity prices. In
  many cases, these transactions produce high
  returns if you guess right, but large losses if
  you guess wrong. Here, derivatives can increase
  risk.

8
What is an IPO?

• An initial public offering (IPO) is where a
  company issues stock in the public market for the
  first time.
• Going public enables a companys 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.

9
Types of financial institutions

• Commercial banks
• Investment banks
• Mutual savings banks
• Credit unions
• Pension funds
• Life insurance companies
• Mutual funds
• Hedge funds

10
Physical location stock exchanges vs. Electronic
dealer-based markets

• Auction market vs. Dealer market (Exchanges vs.
  OTC)
• NYSE vs. Nasdaq

11
Dealer markets

• Example Nasdaq
• Dealers make money from the bid-ask spread
• Ex a dealer can buy Microsoft at 27/share (bid)
  and sell at 27.2/share (ask)

12
Exam type question
Which of the following statements is most
correct? a. While the distinctions are blurring,
investment banks generally specialize in lending
money, whereas commercial banks generally help
companies raise capital from other
parties. b. Money market mutual funds usually
invest their money in a well-diversified
portfolio of liquid common stocks. c. The NYSE
operates as an auction market, whereas NASDAQ is
an example of a dealer market. d. Statements
b and c are correct.
13
Exam type question

• Which of the following statements is most
  correct?
• a. If a company has two classes of common stock,
  Class A and Class B, the stocks may pay different
  dividends, but the two classes must have the same
  voting rights.
• b. An IPO occurs whenever a company buys back its
  stock on the open market.
• c. The preemptive right is a provision in the
  corporate charter that gives common stockholders
  the right to purchase (on a pro rata basis) new
  issues of common stock.
• d. Statements a and b are correct.

14
What is the Efficient Market Hypothesis (EMH)?

• Securities are normally in equilibrium and are
  fairly priced.
• Investors cannot beat the market except through
  good luck or better information.
• Levels of market efficiency
• Weak-form efficiency
• Semistrong-form efficiency
• Strong-form efficiency

15
Weak-form efficiency

• Cant profit by looking at past trends. A recent
  decline is no reason to think stocks will go up
  (or down) in the future.
• Evidence supports weak-form EMH, but technical
  analysis is still used.

16
Semistrong-form efficiency

• All publicly available information is reflected
  in stock prices, so it doesnt pay to over
  analyze annual reports looking for undervalued
  stocks.
• Largely true, but superior analysts can still
  profit by finding and using new information.

17
Strong-form efficiency

• All information, even inside information, is
  embedded in stock prices.
• Not true--insiders can gain by trading on the
  basis of insider information, but thats illegal.

18
Implications of market efficiency

• You hear in the news that a medical research
  company received FDA approval for one of its
  products. If the market is semi-strong
  efficient, can you expect to take advantage of
  this information by purchasing the stock?
• No if the market is semi-strong efficient, this
  information will already have been incorporated
  into the companys stock price. So, its
  probably too late

19
Exam type question

• Which of the following statements is most
  correct?
• a. If the stock market is weak-form efficient,
  then information about recent trends in stock
  prices would be very useful when it comes to
  selecting stocks.
• b. If the stock market is semistrong-form
  efficient, stocks and bonds should have the same
  expected return.
• c. If the stock market is semistrong-form
  efficient, all stocks should have the same
  expected return.
• d. None of the statements above is correct.

20
Learning objectives

• Identify three different ways capital is
  transferred between savers and borrowers. (see
  slide )
• Know what is a financial market its role.
• Know the spot and futures markets money and
  capital markets primary and secondary markets
  IPO market private and public markets a little
  about derivatives
• Know the types of financial intermediaries (text
  pages 148-152)
• Physical location stock exchanges vs over-the
  counter (NYSE vs NASDAQ)
• Dealer markets
• Know the three forms of market efficiency
• Problems 5-1 to 5-5, 5-7, 5-9, 5-10