FIN303 Vicentiu Covrig 1 Financial Markets and Institutions (chapter 5)

FIN303 Vicentiu Covrig 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.

FIN303 Vicentiu Covrig 3 How is capital transferred between savers and borrowers? Direct transfers Investment banking house Financial intermediaries

FIN303 Vicentiu Covrig 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.

FIN303 Vicentiu Covrig 5 Types of financial markets Money vs. Capital Primary vs. Secondary Spot vs. Futures (Derivatives instruments) Public vs. Private

FIN303 Vicentiu Covrig 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?

FIN303 Vicentiu Covrig 7 What are derivatives? How can they be used to reduce or increase risk? A derivative security’s 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.

FIN303 Vicentiu Covrig 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 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.

FIN303 Vicentiu Covrig 9 Types of financial institutions Commercial banks Investment banks Mutual savings banks Credit unions Pension funds Life insurance companies Mutual funds Hedge funds

FIN303 Vicentiu Covrig 10 Physical location stock exchanges vs. Electronic dealer-based markets Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq

FIN303 Vicentiu Covrig 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)

FIN303 Vicentiu Covrig 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.

FIN303 Vicentiu Covrig 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.

FIN303 Vicentiu Covrig 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

FIN303 Vicentiu Covrig 15 Weak-form efficiency Can’t 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.

FIN303 Vicentiu Covrig 16 Semistrong-form efficiency All publicly available information is reflected in stock prices, so it doesn’t pay to over analyze annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information.

FIN303 Vicentiu Covrig 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 that’s illegal.

FIN303 Vicentiu Covrig 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 company’s stock price. So, it’s probably too late …

FIN303 Vicentiu Covrig 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. *

FIN303 Vicentiu Covrig 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 ) 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