1. Chapter 2 Financial Markets and Institutions
The Capital Allocation Process
Financial Markets
Financial Institutions
Stock Markets and Returns
Stock Market Efficiency

2. The Capital Allocation Process
Suppose..
Aljazeera Airways wants to buy a Boeing 777 aircraft costing million KD but it does not have enough cash to do so..
Your want to buy a new home costing 200,000 KD but you only have 100,000 KD in your bank account..
Where will the extra money come from?
On the other hand suppose that..
KDD accumulated 50 million KD of cash that it wants to invest..
Nasser’s salary is 1500 KD per month but he only spends 800 KD..

3. The Capital Allocation Process
In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it.
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.

4. How is capital transferred between savers and borrowers?
Examples of direct transfer
Examples of I-Banks
Examples of FIs
Economic development is highly correlated with the level & efficiency of financial markets & institutions

5. What is a market?
A market is a venue where goods and services are exchanged.
A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

6. Types of Financial Markets
Physical assets vs. Financial assets
Spot vs. Futures
How does the KPC deal with its oil sales?
Money vs. Capital
Primary vs. Secondary
Public vs. Private
Physical: (wheats, real state, computers, etc..)
Financial: stocks, bonds, notes, and morgages..
Spots: The markets in which assets are bought or sold for “on-the-spot” delivery.
Futures markets are markets in which participants agree today to buy or sell an asset at some future date.
Money markets are the markets for short term, highly liquid debt securities.
Capital markets are the markets for intermediate- or long-term debt and corporate stocks.
Primary markets are the markets in which corporations raise new capital
Secondary markets are markets in which existing, already outstanding securities are traded among investors.
Private markets, where transactions are negotiated directly between two parties
public
markets, where standardized contracts are traded on organized exchanges

7. The Importance of Financial Markets
Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.
Markets provide savers with returns on their money saved/invested, which provide them money in the future.
Markets provide users of capital with the necessary funds to finance their investment projects.
Well-functioning markets promote economic growth.
Economies with well-developed markets perform better than economies with poorly-functioning markets.

8. 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, a US 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.
Airline use of air fuel hedges
It is hard to say whether a firm is using derivatives to hedge or speculate
While derivatives help manage risks within markets, Greenspan says we don’t know how it might have affected the stability of the financial system

9. Types of Financial Institutions
Commercial banks
Investment banks
Financial services corporations
Pension funds
Life insurance companies
Mutual funds
Hedge funds
Exchange traded funds
Private equity companies
Give examples on each of these Fis
Most of these Fis are regulated to protect depositors & investors
I-Banks are there to help firms raise capital. They have been hit quite hard in the recent crisis
Mutual funds reduce risk through diversification
Many of today’s Fis are big corporations that have several of these Fis within them

10. Start this slide with this:
Stock markets are the most active
NYSE & NASDAQ are the two biggest & most important
Physical location – dealers – orders have to go through these dealers
What does it mean to be over-the-counter? Dealers who hold inventory – low liquidity – now called dealer markets

11. Physical location stock exchanges vs. dealer markets
Physical location market (ex. NYSE)
Formal organizations having tangible physical locations that conduct auction markets in designated (“listed”) securities.
Members of the exchange formerly had “seats” on the exchange, today the seats are replaced with trading licenses.
Exchange members match buyers with seller.
Dealer market: (ex. Nasdaq)
Few dealers hold inventories of securities and are said to “make a market” in these securities.
Thousands of brokers act as agents in bringing the dealers together with investors.
Computers, terminals, and electronic networks provide a link between dealers and brokers.
Over-the-Counter (OTC) markets

12. Stock Market Transactions
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?
Since new shares of stock are being issued, this is a primary 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?
Since no new shares are created, this is a secondary market transaction.

13. 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.
Give me an example of an IPO?

14. S&P 500 Index, Total Returns for the past 30 years
Stock returns are very volatile. That’s why they are risky
On the long run stocks have provided decent returns.
They much more risky when compared to a saving account, but the return is higher. Compare KFH returns for saving account and stock..

15. KSE Price Index, Total Returns: 1996-2012

16. Where can you find a stock quote, and what does one look like?
Stock quotes can be found in a variety of print sources (newspapers) and online sources (KSE’s website).
Go to KSE’s website & Bloomberg
Talk about the stock market indexes

17. What is meant by stock market efficiency?
Securities are normally in equilibrium and are “fairly priced.”
Investors cannot “beat the market” except through good luck or better information.
Efficiency continuum
Highly
Inefficient
Efficient
Small companies not followed by many analysts. Not much contact with investors.
Large companies followed by many analysts. Good communications with investors.
Stock prices will always be close to intrinsic value because investors will quickly respond to new information

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 highly efficient, can you expect to take advantage of this information by purchasing the stock?
No. If the market is efficient, this information will already have been incorporated into the company’s stock price. So, it’s probably too late for her to “capitalize” on the information.

19. Implications of Market Efficiency
A small investor has been reading about a “hot” IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this?
Probably not. The long-run track record of hot IPOs is not that great, unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading.

20. The Efficient Markets Hypothesis
The Efficient Markets Hypothesis (EMH) is made up of three progressively stronger forms:
Weak Form
Semi-strong Form
Strong Form
All historical prices and returns
All information, public and private
All public information
© P. Kulkarni& K.Pawar

21. The Weak Form
The weak form of the EMH says that past prices, volume, and other market statistics provide no information that can be used to predict future prices.
If stock price changes are random, then past prices cannot be used to forecast future prices.
Price changes should be random because it is information that drives these changes, and information arrives randomly.
This form of the EMH, if correct, repudiates technical analysis.
Most research supports the notion that the markets are weak form efficient.
© P. Kulkarni& K.Pawar

22. The Semi-strong Form
The semi-strong form says that prices fully reflect all publicly available information and expectations about the future.
This suggests that prices adjust very rapidly to new information, and that old information cannot be used to earn superior returns.
Most studies find that the markets are reasonably efficient in this sense, but the evidence is somewhat mixed.
© P. Kulkarni& K.Pawar

23. The Strong Form
The strong form says that prices fully reflect all information, whether publicly available or not.
Even the knowledge of material, non-public information cannot be used to earn superior results.
Most studies have found that the markets are not efficient in this sense.
© P. Kulkarni& K.Pawar

24. Do you think it is better to have efficient or inefficient markets?
In inefficient markets, people like us, with business knowledge might be able to get high returns and beat the market. However, many other people and institutions might not want to invest because they don’t think it is a fair game and they might be manipulated
In efficient markets, it would be hard to beat the market. More people will put their money. Better capital flow leads to what? Better economies.

25. Do you think the market for all stocks are equally efficient?