the financial markets

1

What is a Financial Market?

A mechanism by which borrowers (those with a need for funds) and lenders (those with excess fund) get together.

The primary role of financial markets is to facilitate the flow of funds from those who have surplus funds to those who have needs for funds in excess of their current income.

2

Flow of Funds

Three financial phasesYoung adults borrow

Older working adults save

Retired adults use savings

Funds transferred from savers to borrowersDirect transfer

Investment banking house

Financial intermediary

3

Transfer of Funds

Securities (stocks or bonds)

Dollars

Borrower(Business)

Saver(Investor)

Direct Transfers

Borrower(Business)

Indirect Transfers through an Investment Banker

Saver(Investor)Investment Banker

Securities Securities

Dollars Dollars

Indirect Transfers through a Financial IntermediaryBorrower(Business)

Saver(Investor)

Financial Intermediary

BusinessSecurities

Dollars(Loans)

Dollars(Deposits)

IntermediarySecurities

4

Market Efficiency

Economic Efficiency—funds are allocated to their optimal use at the lowest costs

Informational Efficiency—investment prices are adjusted quickly to reflect current informationWeak-form—all information contained in past price

movements is reflected in current market prices

Semistrong-form—current prices reflect all publicly available information

Strong-form form—current prices reflect all pertinent information, both public and private

5

Types of Financial Markets

Money versus capital markets

Debt versus equity markets

Primary versus secondary markets

Derivatives markets

6

General Stock Market Activities

The secondary market—trading of outstanding, previously issued shares of stock

The primary market—new shares of stock sold by companies to raise funds

Initial Public Offering (IPO) market—privately/closely held firms go public for the first time

7

Stock MarketsPhysical stock exchanges NYSE, AMEX, and regional exchanges

Exchange membersFloor brokers

• House broker• Independent broker

Specialists

Listing requirements

8

Stock Markets

Over-the-Counter Markets and the NasdaqNetwork of brokers and dealers

Auction market

Organized Investment Network

Electronic Communications Networks

9

Regulation of Securities Markets

Securities and Exchange Commission (SEC)Jurisdiction over most interstate offerings of

new securities to the general public

Regulation of national securities exchanges

Power to prohibit manipulation of securities’ prices

Control over stock trades by corporate insiders

10

The Investment Banking Process

Investment BankerHelps corporations design securities

attractive to investors

Buys these securities from the corporation

Resells the securities to investors

11

The Investment Banking Process

Raising Capital: Stage I DecisionsDollars to be raised

Type of securities used

Competitive bid versus negotiated deal

Selection of an investment banker

12

The Investment Banking Process

Raising Capital: Stage II Decisions• Reevaluating the initial decisions• Best efforts or underwritten issues

• Underwritten Arrangement—investment bank guarantees the sale by purchasing the securities from the issuer

• Best Effort Arrangement—investment bank gives no guarantee that the securities will be sold

• Issuance (flotation) Costs

• Setting the offering price

13

The Investment Banking ProcessSelling ProceduresUnderwriting Syndicate—to spread riskLead Underwriter—manages the distributionSelling Group—network of brokerage firms

Shelf Registration—approved by the SEC, but held for sale at a later date

Maintenance of the Secondary Market—investment banker wants to “make a market” for the issue (especially for an IPO)

14

International Stock Markets

U.S. stock marketsLess than 40% of the total value worldwideStill dominate the international stock

markets

U.S. investors can participate in international markets by through American Depository Receipts (ADR)

15

Types of Financial Intermediaries

Commercial banks

Credit unions

Savings and loan associations

Mutual funds

Whole life insurance companies

Pension funds

16

The Roles of Financial Intermediaries

Facilitate the transfer of funds from those who have funds (savers) to those who need funds (borrowers)

Manufacture a variety of financial products

17

Benefits of Financial Intermediaries

Improved standard of living

Reduced costs

Risk/diversification

Funds divisibility/pooling

Financial flexibility

Related services

18

Financial Organizations in Other Parts of the World

U.S. financial institutions are more heavily regulated than foreign institutions

U.S. financial institutions face greater limitations on branching, services, and relationships with non-financial businesses than foreign institutions