Financial Markets and Institutions: Chapter 2 Key Concepts

What is the capital allocation process?

It is the process by which capital flows efficiently from those who supply capital to those who demand it.

Who are the suppliers of capital?

Individuals and institutions with excess funds looking for a rate of return on their investment.

Who are the demanders of capital?

Individuals and institutions that need to raise funds to finance their investment opportunities.

What are direct transfers in capital allocation?

Transfers that occur directly from firms to investors or savers.

What are indirect transfers in capital allocation?

Transfers that occur via investment banks.

What role do financial intermediaries play?

They facilitate capital transfer through financial institutions like banks, insurance companies, and mutual funds.

What is a financial market?

A venue where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

Why are well-functioning financial markets important?

They facilitate the flow of capital, provide returns to savers, and promote economic growth.

What are physical assets?

Real or tangible assets such as property, plant, and equipment.

What are financial assets?

Legal contracts such as stock ownership or derivatives, and contractual debt obligations.

What is the difference between spot and futures markets?

Spot markets involve assets bought/sold for delivery today, while futures markets involve assets bought/sold for delivery in the future.

What distinguishes money markets from capital markets?

Money markets involve short-term borrowing (one year or less), while capital markets involve long-term capital issuance (over one year).

What are primary markets?

Markets where firms raise new capital.

What are secondary markets?

Markets where existing equity or debt issuance trades.

What is the difference between public and private markets?

Public markets have standardized contracts traded on organized exchanges, while private markets involve transactions negotiated privately.

What are derivatives?

Securities whose value is derived from the price of another security, such as options and futures.

How can derivatives be used to hedge risk?

They can be used to reduce risk, such as purchasing currency futures to protect against currency fluctuations.

How can derivatives increase risk?

Speculators can use derivatives to bet on future price movements, which can lead to high returns or large losses.

What are investment banks?

Organizations that underwrite and distribute new investment securities and help businesses obtain financing.

What role do commercial banks play?

They serve as traditional 'department stores of finance' for a variety of savers and borrowers.

What are credit unions?

Cooperative associations whose members share a common bond, such as being employees of the same firm.

What are pension funds?

Retirement plans funded by corporations or government agencies for their workers.

What do life insurance companies do?

They take savings in the form of premiums, invest these funds, and make payments to beneficiaries.

What are mutual funds?

Investment companies that accept money from savers to buy stocks, long-term bonds, or short-term debt instruments.

What are exchange-traded funds (ETFs)?

Similar to mutual funds, ETFs buy a portfolio of stocks and sell their shares to the public.

What are hedge funds?

Investment funds that employ various strategies to earn high returns for their investors.

What are private equity companies?

Firms that invest directly in private companies or buy out public companies to delist them from stock exchanges.

What do ETFs do?

ETFs buy a portfolio of stocks of a certain type and sell their own shares to the public.

How are hedge funds different from mutual funds?

Hedge funds are lightly regulated and cater to high net-worth individuals and institutions.

What is the primary function of private equity companies?

Private equity companies buy and take public companies private.

What is the difference between an auction market and a dealer market?

An auction market involves direct transactions between buyers and sellers (like NYSE), while a dealer market involves intermediaries (like Nasdaq).

What type of transaction occurs when a company issues new stock?

This is a primary market transaction.

What type of transaction occurs when an investor buys existing shares of stock?

This is a secondary market transaction.

What is an IPO?

An initial public offering (IPO) occurs when a company issues stock in the public market for the first time.

What is a seasoned equity offering (SEO)?

A seasoned equity offering (SEO) is when a company with existing stock issues additional stock.

What does the S&P 500 Index represent?

The S&P 500 Index represents the total returns from dividend yield and capital gain or loss.

Where can you find stock quotes?

Stock quotes can be found in print sources like The Wall Street Journal and online sources like Yahoo! Finance.

What is meant by stock market efficiency?

Stock market efficiency means that securities are normally in equilibrium and are 'fairly priced.'

Can investors consistently beat the market in an efficient market?

No, investors cannot consistently beat the market except through good luck or better information.

What happens if a medical research company receives FDA approval in an efficient market?

The information will already have been incorporated into the company's stock price, making it too late to capitalize on it.

What should a small investor consider before buying shares of a 'hot' IPO?

The long-run track record of hot IPOs is not great, and small investors usually have difficulty getting shares before trading begins.

What are some reasons markets may not be efficient?

Costs and risks of trading mispriced assets, and cognitive biases causing systematic mistakes.

What is behavioral finance?

Behavioral finance studies how psychological factors influence investor behavior and market inefficiencies.

What is a key cognitive bias that affects investors?

Overconfidence, which can lead to self-attribution bias and hindsight bias.

What is the role of investment bankers in stock issuance?

Investment bankers assist companies in issuing additional stock.

What is the implication of market efficiency for investors?

Investors cannot expect to take advantage of new information to gain an edge in an efficient market.

What is the primary market?

The primary market is where new securities are issued and sold for the first time.

What is the secondary market?

The secondary market is where existing securities are traded among investors.

What is the significance of 'going public' for a company?

'Going public' allows a company to raise capital from a wide variety of outside investors.

What are public companies subject to after an IPO?

Public companies are subject to additional regulations and reporting requirements.

What is the difference between NYSE and Nasdaq?

NYSE is an auction market, while Nasdaq operates as a dealer market.

What does it mean if a market is highly efficient?

It means that securities are fairly priced and reflect all available information.

What is a common misconception about investing in hot IPOs?

Many believe they can profit significantly, but the long-term performance is often poor.