Chapter 2 - Financial Markets and Institutions

Why financial markets matter?

• the big picture

• connecting savers and users

• two channels of flow

What is the big picture?

• the core function: move money from people who have it (savers) to people who need it (users of capital) — efficiently, safely, and at scale

What problems do the financial systems solve?

• How do I find companies that need money?

• How do I know they’re legitimate?

• What if I need my money back suddenly?

• What if they need millions but I only have thousands?

What are the two ways money flows?

• financial markets

• financial intermediaries

How does money flow through financial markets?

• you invest directly in companies by buying their securities (stocks and bonds) on exchanges

How does money flow through financial intermediaries?

• an institution (bank, mutual fund) collects money from many investors and invests on your behalf

What is the example that has to do with financial markets and financial intermediaries?

Think about buying groceries, you could drive to farms and buy directly (like financial markets) or you could go to a grocery store that buys from farms and sells to you (like intermediaries)

• both get food to your table — just through different routes

How money flows?

• Savers: people with money to invest —→ financial markets (stock exchanges, bond markets, direct investment) OR intermediaries (bands, mutual funds, invest on your behalf) ——> users of capital (companies, governments, families)

What do companies need at different stages?

• different financing during stages like startup, growing, mature, and cash-rich

What happens in the startup stage?

• situation: unproven idea, very risky

• where they get money: founders, friends/family, VCs

What happens in the growing stage?

• situation: proven product, needs to scale

• where they get money: IPO, bank loans

What happens in the mature stage?

• situation: established, predictable cash flows

• where they get money: bonds, stock sales, reinvested profits

What happens in the cash-rich stage?

• situation: more money than investment ideas

• where they get money: returns cash to shareholders

What is true about private (closely held) companies?

• stock NOT traded publicly

• only founders, employees, early investors own shares

• you can’t just buy stocks— you need an invitation

• examples: chick-fil-A, Mars candy, most startups

What is true about public companies?

• stock IS traded on exchanges

• anyone can buy shares

• company has disclosed financials, met regulatory requirements

• examples: Apple, Walmart, any company on NYSE/NASDAQ

What is an IPO?

• initial public offering

• when a company sells stock to the public for the first time

• it’s how a company “goes public”

• before: only insiders own stock

• after: anyone can buy shares on the exchange, the company gets cash to fund growth, and early investors can sell holdings

What is one example of an IPO?

• Facebook’s 2012 IPO

• Raised $16 billion for the company to fund growth

• Made early investors and employees wealthy

• anyone could then buy FB shares on NASDAQ

What are stocks? (equity)

• you own a piece of the company

• share in profits through dividends or price increases

• if company fails, you could lose everything

• you’re last in line to get paid

• higher risk, higher potential return

What are bonds? (debit)

• you’re lending money to the company

• they promise to pay back with interest

• you get paid before stockholders

• safer, but upside limited to interest rate

• lower risk, lower return

What are primary markets?

• new securities are issued

• company RECEIVES the money

• examples: IPOs, new bond issues

• company gets funds to invest

What are secondary markets?

• existing securities trade

• company gets NOTHING

• money moves between investors

• most daily stock trading

Why do secondary markets matter?

• when you buy Apple stock today, Apple gets nothing

• But secondary markets still mater

• If you couldn’t sell later, would you buy in the first place? Liquidity in secondary markets makes people willing to invest in primary markets

What are the different types of financial markets?

• stock markets, bond markets, money markets, foreign exchange, commodities markets, derivatives markets

Which is the stock market?

• trade ownership in companies

• NYSE, NASDAQ are major US exchanges

What is the bond market?

• trade debt

• companies and governments borrow by issuing bonds

What are money markets?

• trade short-term debt (<1 year)

• used for temporary cash needs

What is foreign exchange?

• trade currencies

• essential for international business

What are commodities markets?

• trade raw materials — oil, wheat, gold, copper

What are derivatives markets?

• trade contracts based on other assets (options, futures)

What are spot markets?

• buy now, get it now

• transaction happens immediately

• settlement in 1-2 days

• most stock and bond trading

What are future markets?

• agree now, exchange later

• lock in price today for future transaction

• farmers use wheat futures to lock prices before harvest

• airlines use oil futures to lock in fuel costs

What are financial intermediaries??

• institutions that collect money from many investors and invest on their behalf

• most people don’t pick individual stocks — they invest through intermediaries

What are mutual funds?

• pool money to buy diversified portfolios (from thousands of investors)

• even small investors get diversification (buy diversified portfolios)

• you own fund shares; fund owns securities

• professional management

• higher fees for active management

What are pension funds?

• invest retirement savings

• employer/employee contribute; fund invests

What are insurance companies?

• collect premiums, play claims later, invest in between

What are hedge funds?

• like mutual funds for wealthy investors, complex strategies, high fees

What is an index fund?

• type of mutual fund

• tracks a market index (S&P 500)

• no active stock pricing

• very low fees

• often outperforms active funds

What are the two types of pension plans?

• defined-contribution - 401K

• defined- benefit - pension

What is defined-contribution (401K)?

• you and employer contribute money

• its gets invested in stocks/bonds

• whatever it grows to is what you get

• YOU bear the investment risk

• market crash = your retirement suffers

• most common today

What is defined-benefit? (pension)

• employers promises specific payment

• based on salary and years worked

• EMPLOYER bears the risk

• they owe you regardless of market

• increasingly rare

• still common in government jobs

What is a commercial bank?

• what you think of as a ‘bank’

• takes deposits (checking/savings)

• makes loans (mortgages, business)

• profits from interest rate spread

• FDIC insured up to 250,000

• examples: chase, bank of america, wells fargo

What is an investment bank?

• NOT what you think of as a bank

• does NOT take deposits

• helps companies issue securities (IPOS)

• advises on mergers and acquisitions

• trades securities

• examples: goldman sachs, morgan stanley

How does trading actually work?

• the bid-ask spread

• types of orders

• where trading happens

What is the bid-ask spread?

• the spread= ask-bid

• at any moment there are 2 prices for every stock: bid price and ask price

• example: apple bid 150,000 ask 150.02, spread is 0.02 (very liquid)

• small illiquid stock might have 0.50 spread

• the spread is the market maker’s profit and YOUR transaction cost

• market makers provide liquidity — they’re always willing to buy and sell so you can trade instantly

What is the bid price?

• higher price a buyer is willing to PAY

• if you want to sell NOW, this is what you get

What is the ask price?

• lowest price a seller is willing to accept

• if you want to buy NOW, this is what you pay

What are the types of orders?

• market order

• limit order

• stop order

What is market order?

• guarantees execution, not price

• best for liquid stocks when speed matters

• buy/sell RIGHT NOW at current price

What is limit order?

• guarantees price, not execution

• best when you have a specific target

• buy only at/below $X, sell only at/above $X

What is stop order?

• used to limit losses (‘if stock drops to $45, sell’)

• also for entering on breakouts

• if price hits $X, trigger a market order

Where does trading happen?

• stock exchanges

• ECNS

• Dark pools

What is the stock exchange?

• traditional venues

• companies ‘list’ here after meeting requirements

• NYSE has trading floor, NASDAQ always electronic

What is ECNS?

• alternative systems matching buyers/sellers electronically

• often lower fees, faster execution

• compete with exchanges

• electronic communication networks

What are dark pools?

• larger institutions trade anonymously

• if a pension fund sells $500 M, doing it publicly would move the price, dark pools hide intentions

• private exchanges

What to remember about primary and secondary markets?

• primary: NEW securities issued; company gets money

• secondary: existing securities trade; company gets $0

What to remember about stocks (equity) and bonds (debt)?

• stocks: ownership share; higher risk; higher return

• bonds: loan to company; lower risk; fixed return

What to remember about bid price and ask price?

• bid price: what buyer pay (lower)

• ask price: what sellers accept (higher)