1. The Financial Markets
Financial markets represent a system that includes individuals and institutions, instruments, and procedures that bring together borrowers and savers, no matter the location.
The primary role of financial markets is to facilitate the flow of funds from individuals and businesses that have surplus funds to individuals, businesses, and governments that need funds in excess of their incomes.
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2. Flow of Funds Three financial phases Young adults borrow
Older working adults save
Retired adults use savings
Funds transferred from savers to borrowers
Direct transfer
Investment banking house
Financial intermediary
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3. Financial Intermediary
Business’s Securities (Stocks or Bonds)
Funds less
issuing costs
Securities
(Stocks/Bonds)
Investment Banker
Helps corporations issue securities (stocks or bonds)
Receives fees from the issue
Business
(Borrower)
Funds
Financial Intermediary
Uses funds to buy/create loans and other financial instruments
Pays a return/interest to attract funds from savers
Intermediary’s Liability
(Account at intermediary)
Borrower’s Liability
(Debt owed to intermediary)
Savers
(Investors)
Firm’s Stocks or Bonds
Diagram of the Capital Formation Process
1. Direct Transfers
Indirect Transfers through an Investment Banker
Indirect Transfers through a Financial Intermediary
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4. Market Efficiency
Economic Efficiency - Funds are allocated to their optimal use at the lowest costs.
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5. Market Efficiency (cont.)
Informational Efficiency—investment prices are adjusted quickly to reflect current information.
Weak-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—current prices reflect all pertinent information, both public and private.
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6. Types of Financial Markets
Money markets versus capital markets
Debt markets versus equity markets
Primary markets versus secondary markets
Derivatives markets
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7. General Stock Market Activities
The secondary market—trading in the outstanding, previously issued shares of investment instruments.
The primary market—additional shares sold by established, publicly owned companies.
IPO market—new offerings by privately held firms that are “going public” with their shares.
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8. Stock Markets Physical stock exchanges Exchange members
NYSE, AMEX, and regional exchanges
Exchange members
Floor brokers
Designated market makers (specialists)
Supplemental liquidity providers (SLPs)
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9. Stock Markets (cont.) To have a stock listed Apply to the exchange
Pay a relatively small fee
Meet the exchange’s minimum requirements
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10. Stock Markets Over-the-Counter Markets and the NASDAQ
Network of brokers and dealers
Auction market
Organized Investment Network
Electronic Communications Networks (ECNs)
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11. 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
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12. The Investment Banking Process
Investment Banker
Helps corporations design securities attractive to investors
Buys these securities from the corporation
Resells the securities to investors
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13. The Investment Banking Process
Raising Capital: Stage I Decisions
Dollars to be raised
Type of securities used to raise funds
Selection of an investment banker
Competitive bid versus negotiated deal
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14. The Investment Banking Process
Raising Capital: Stage II Decisions
Reevaluate 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
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15. The Investment Banking Process
NP = Net proceeds
F = flotation costs as a decimal
Example: A firm needs $470,000; flotation costs are 6 percent of total issue.
If $500,000 is issued, $30,000 = $500,000(0.06) in flotation costs will be paid, which leaves $470,000 for the firm to use
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16. The Investment Banking Process
Selling Procedures
Underwriting Syndicate—a group of investment firms formed to spread the risk associated with the distribution of a new security issue
Lead or Managing Underwriter—the member of an underwriting syndicate who manages the distribution and sale of a new security offering
Selling Group—a network of brokerage firms formed for the purpose of distributing a new issuance of securities
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17. The Investment Banking Process
Shelf Registrations
Securities registered with the SEC for sale at a later date
Held “on the shelf” until the sale
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18. The Investment Banking Process
Maintenance of a Secondary Market
When a company is going public for the first time, the investment banker is obligated to maintain a market for the shares after the issue has been completed.
The lead underwriter agrees to “make a market” in the stock and keep it reasonably liquid.
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19. Types of Financial Intermediaries
Commercial banks
Credit unions
Savings and loan associations (thrifts)
Mutual funds
Whole life insurance companies
Pension funds
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20. The Role 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 that take the form of either loans or savings instruments
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21. Benefits of Financial Intermediaries
Reduced costs
Risk/diversification
Funds divisibility/pooling
Financial flexibility
Related services
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22. International Financial Markets
U.S. stock markets represent 35% - 40% of the total value worldwide
U.S. markets dominate the stock markets in other countries
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23. Financial Organizations in Other Parts of the World
U.S. financial institutions are more heavily regulated.
Historically, U.S. financial institutions have faced greater limitations on branching, services offered, and relationships with non- financial businesses.
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24. Legislation of Financial Markets
When financial markets perform poorly, Congress tends to regulate financial activities more than normal.
When financial markets are performing efficiently and producing above-normal returns, Congress tends to deregulate financial activities.
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