McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Financial Markets

Financing Decision

Source of Funds (Capital)

Capital Structure

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The Flow of Capital: Closely Held Corporations

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The Flow of Capital: Public Corporations

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The Flow of Capital: Public Corporations

Financial Market: Market where securities are issued and traded.

Primary Market:Market for the sale of new securities by corporations.

Secondary Market:Market in which previously issued securities are traded among investors.

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Financial Markets

Initial Public Offering (IPO):First offering of stock to the general public.

Fixed-Income Market:Market for debt securities

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Financial Markets:Markets for Debt

Capital Markets are used for long-term financing

Example of long-term debt: Bonds

Money Markets are used for short-term financing.

Example of short-term debt: Commercial Paper

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Information Provided by Financial Markets:

• Commodity Prices

• Interest Rates

• Company Value

• Cost of Capital

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Financial Intermediaries• Mutual Fund•An investment company that pools the savings of many investors and invests in a portfolio of securities

• Hedge Fund•A private investment pool, open to wealthy or institutional

investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds

• Pension Fund•Fund set up by an employer to provide for employees’ retirement

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Flow of Cash Example:Mutual Fund$ $

Sells shares

Issues shares

Bank of America

InvestorsExplorer

Fund

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A Closer Look:Financial Institutions

Commercial Bank

Investment Bank

Insurance Company

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Company

Intermediaries

Banks

Insurance Companies

Brokerage Firms

Obligations Funds

Companies and Intermediaries

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Intermediaries and Investors

Intermediaries

Investors

Depositors

Policyholders

Investors

Obligations Funds

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Cash Flow Example:Banks

Banks

Depositors

$2.5 mil

Cash

Loan

Deposits

Company

Intermediary

Investor

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Cash Flow Example:Insurance Company

Insurance Company

Policyholders

$2.5 mil

Cash

Issue Debt

Sell Policies

Company

Intermediary

Investor

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Function of Financial Markets and Intermediaries

Transport cash across time

Risk transfer and diversification

Liquidity

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Function of Financial Markets and Intermediaries

Payment mechanism

Provide information

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Homebuyers overextended

Financial Crisis 2007-2009:Causes

Federal Reserve Easy-Money

Policy

The U.S. Government encouraged

expansion of credit to low-income

housing

Bankers aggressively

promoted subprime mortgagesCredit Rating

Agencies gave many AAA ratings to MBS that shortly went into

default

A Perfect Storm:

•Falling Housing Prices

•Bankruptcy

•Credit Freeze

•International Effect

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Government Bailouts

Government Response: TARP

Financial Crisis 2007-2009:The Response

Government Bailout (or arranged acquisition)

No Government Bailout

Bear Stearns (JP Morgan Chase) Lehman Brothers

Fannie Mae

Freddie Mac

Merrill Lynch (Bank of America)

AIG

Did this response effectively decrease the uncertainty in the market?

What was the rationale behind TARP?

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Appendix A:Total U.S. Equity Financing

Holdings of Corporate Equities, 3rd Quarter 2010

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Appendix B:Total U.S. Debt Financing

Holdings of Corporate & Foreign Bonds, 3rd Quarter 2010