November 24, 2014

Chapter 2. Financial Markets and Institutions

 Capital allocation process
 Financial markets
 Financial institutions
 The stock market and stock returns
 Stock market efficiency
 Capital allocation process

The process of capital flows from those with surplus capital to those who need it.

Three types of transfer
(1) Direct transfer: a business sells its security directly to investors
(2) Indirect transfer through an investment banker: a business sells its security to
an investment banker, which in turn sells the same security to individual investors
(3) Indirect transfer through a financial intermediary: a financial intermediary obtains funds from investors by offering its own securities and uses funds to buy other business securities

Capital formation process

 Financial markets
Physical asset market vs. financial asset markets
Physical asset markets are markets for real (or tangible) assets
Financial asset markets are markets for financial assets - focus of this class
Money markets vs. capital markets
Money markets are markets for short-term and highly liquid debt securities (less
than one year)
Capital markets are markets for intermediate and long-term debts and stocks (one
year or longer)
Primary markets vs. secondary markets
Primary markets are markets for issuing new securities
Secondary markets are markets for trading existing securities
Spot markets vs. futures markets
Spot markets are markets for immediate delivery
Futures markets are markets for future delivery even though the deal is made
Private markets vs. public markets
In private markets: transactions are negotiated directly between two parties
Public markets: standardized contracts are traded on organized exchanges
Derivative markets: for derivative securities
A derivative security is a security whose value is derived from the value of an
underlying asset. For example, futures contracts and option contracts
Why do we need financial markets?
Bring borrowers and lenders together to exchange needs

 Financial institutions
Investment banks (investment banking houses): specialized in underwriting and distributing new securities, such as Merrill Lynch (now acquired by Bank of America) and Goldman Sachs.

The role of investment bankers: underwriters

Design securities with features that are attractive to investors
Buy these securities from the issuing firm
Resell these securities to individual investors
Public offering vs. private placement
Public offering: a security offering to all investors
Private placement: a security offering to a small number of potential investors

Commercial banks: provide basic banking and checking services, such as BOA

Financial service corporations: large conglomerates that combine different
financial institutions into a single corporation, such as Citigroup
S&Ls, credit unions
Life insurance companies
Mutual funds: sell themselves to investors and use funds to invest in securities
Exchange traded funds (ETFs): mutual funds but traded like stocks
Hedge funds: similar to mutual funds with few restrictions

 The stock market and stock returns
Organized markets vs. over-the-counter (OTC) markets
Organized markets (exchanges) have physical locations, such as NYES
OTC markets are connected by computer network with many dealers and brokers,
such as NASDAQ 10
Auction markets vs. dealer markets
Organized markets are auction markets
OTC markets are dealer markets
IPO markets: markets for initial public offerings

Stock market transactions (three types)
(1) Trading outstanding (existing) shares takes place in a secondary market
(2) Selling additional shares by a publicly owned firm takes place in a primary market (seasoned offerings)
(3) Selling shares to the public for the first time by a privately owned firm takes place in a primary market (IPOs)

Bid: someone wants to buy 4,000 shares at 29.03
Ask: someone is offering to sell 4,500 shares at 29.04

Stock market returns

Expected return: return expected to be realized, which is always positive
Realized return: actual return received, which can be either positive or negative

There is a positive relation between expected return and risk

Stock market efficiency
Efficient market: prices of securities in the market should fully and quickly reflect all available information, which means that market prices should be close to intrinsic values (market in equilibrium)

Levels of market efficiency
Weak-form efficiency - stock prices already reflect all information contained in the history of past price movements (only past prices, volumes, and returns)
Semistrong-form efficiency - stock prices already reflect all publicly available information in the market (only past publicly available information)
Strong-form efficiency - stock prices already reflect all available information in the market, including inside information (all public and private information)

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