FIN 331 Chapter 1

Financial Market

Market in which financial assets (or securities) such as stocks and bonds are traded.

Surplus Units (or Investors)

Individual, business, or government units that have excess funds that can be invested.

Deficit Units

Individual, corporate, or government units that need to borrow funds.

-Spend more than they receive

Securities

Certificates that represent a claim on the issuer.

-How Firms and government agencies access funds from financial markets

-Classified as: Money Market Securities, Capital Market Securities, or Derivative Securities

Debt Securities

Securities that represent credit provided to the initial issuer by the purchaser.

-Credit or borrowed funds

Creditors

Investors that purchase debt securities

-Receive interest

-Redeem the securities and receive the principal at the maturity date

Equity Securities (Also called Stocks)

Securities such as common stock that represent ownership in a business.

-Classified as Capital Market Securities because no maturity

-Stock prices increase as coporations grow and increase in value

Corporate Finance (Also called Financial Management)

Corporate decisions such as how much funding to obtain and which types of securities to issue when financing operations

Primary Markets

Market where securities are initially issued.

Secondary Markets

Market where securities are resold

Liquidity

Ability to sell assets easily without loss of value.

-Treasury securities are liquid

Active Secondary Market

There are many willing buyers and sellers of the secruity at a given moment in time.

Money Markets

Financial markets that facilitate the flow of short-term funds.

Money Market Securities

Debt Securities that have a maturity of less one year or less

-High Liquidity

-Low return

-Low credit default risk

-Ex: Treasury Bills by the U.S., Commercial Paper (By Corporations), Negotiable Certificates of deposit (By depository Institutions)

Capital Market

Facilities the sale of long-term securities by deficit units to surplus units

Capital Market Securities

Long-term securities, such as bonds, whose maturities are more than one year.

-Issue to purchase of capital assets like buildings, equipment, or machinery

-Bonds, Mortgages, and Stocks

Bonds

Long-term securities issued by the treasury, government agenecies, and corporations to finance their operations.

-Interest Income (Coupon Payments every 6 months)

-At maturity, the investors are paid the principal

-Maturity of 10-20 years

-Can be sold/bought on the secondary markets

Treasury Bonds

Bonds Issued by the U.S. Treasury

-Risk Free

-Lower Return due to being Risk free

Mortgages

Long-term debt obligations create to finance the purchase of real estate

Residential Mortgages

Obtained by individuals and families to purchase homes

Prime Mortgages

Offered to mortgage Borrowers who have high likely-hood of paying their mortgage due to having high enough income based on the value of the home

Subprime Mortgages

Offered to mortgage borrower who do not have a sufficient income to qualify for prime mortgages or who are unable to make a down payment

-higher risk of default

-higher interest rate

-additional up-front fees

-Subprime Mortgage led to financial crisis of 2008

Commercial Mortgages

Long-term debt obligations created to finance the purchase of commercial property

-To build shopping centers, office buildings, or other business facilities

Mortgage-Backed Securities

Debt obligations represeting claims on a package of mortgages.

Derivative Securities

Financial contracts whose values are derived from the values of underlying assets.

-Make investors to engage in speculation and risk

-Example: Say a friend has a rookie baseball card worth $100. You don't want to buy the card, but you think it'll be worth more soon. So you make a deal: "I'll pay you $5 today for the right to buy that card from you for $100 next month." If the card jumps to $150, you buy it for $100 and pocket the difference. If it flops, you walk away and just lose your $5. That side deal is a derivative — its value comes entirely from the card, but it isn't the card.

Spreculations

Derivative Securities allow and investor to speculate on movements in the value of the underlying assets without having to purchase those assets

Risk Management

Financial institutions and other firms can use derivative securities to reduce their exposure to the risk that the value of their existing investments in those assets may decline.

Efficient Market

Market in which securities are rationally priced.

-Investors will buy a undervalued stock until the price rises to its market price which creates the efficiency in the market

-Efficiency in the stock market is enhanced by the amount of information that is easily accessible

Behaviorla Finance

The application of psychology to make financial decisions.

-Explain why markets are not always efficient

-Explain why security’s price moved abruptly even if information hasn’t changed

Asymmetric Information

Information about a firm’s financial condition that is not available to investors.

-Public information of a firm can be interpreted in different ways

Securities Act of 1933

The Securities Act of 1933 was intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities.

Securities Exchange Act of 1934

Expanded disclosure rules to secondary-market securities. Made deceptive practices illegal, including misleading financial statements and market manipulation.

-Created the SEC to regulate and oversee securities markets.

-Securities laws aim to ensure full disclosure and prevent fraud, but they do not protect investors from making bad investment decisions.

Sarbanes-Oxley Act of 2002

Created stricter auditing and board oversight requirements. Top executives must sign off on financial statements and can face penalties if fraud is discovered.

-Reduce asymmetric information and financial fraud in publicly traded companies.

International Financial Markets

-Countries that require more financial disclosure tend to have more liquid financial markets

-Investors are more willing to participate in the financial market of countries that allow the right of a lawsuit against a local firm that engage in fraud

-Investors willing to participate more if the security laws are enforced strictly

Foreign Exchange Market

The financial market that facilitates the exchange of currencies.

Imperfect

Markets where securities buyers and sellers do not have full access to information.

Depository institutions

Accept deposits from surplus units and provide credit to deficit units through loans and purchase of securities

-They bare the risk

-Without them Surplus units are less likely to invest

Commercial Banks

Most dominant type of depository institution

-They offer deposit accounts, and transfer funds to deficit units

-Serve as both private and public sectors

-The Federal Reserve serves as a regulator of banks

-Must have minimum level of capital relative to their size for cushon

Federal Funds Market

Market that facilitates the flow of funds from banks that have excess funds to banks that are in need of funds.

Savings Institutions (or Thrift Institutions)

Another type of depository institutions that include savings and loan associations (S&Ls) and saving banks.

-Take deposits from surplus units and then channel these deposits to deficit units.

-More diversified usess of funds

-Owned by shareholders

-Rely on the federal funds market to lend their excess funds or to borrow funds on a short-term basis

Credit Unions

Differ from Commercial banks and saving institutions because they are nonprofit enterprises and restrict their business to credit union members who share a common bond such as a common employer or union.

-Smaller than other depository institutions

Nondepository Financial Institutions

Generates funds from sources other than deposits but also play a major role in financial intermediation

Finance Companies

Obtain funds by issuing securities and then lend those funds to individual and small businesses

Mutual Funds

Sell shares to surplus units and use the funds received to purchase a portfolio of securities

-dominant nondepository financial institution

-invest in capital market securities such as stocks or bonds

Money Market Mutual Funds

Mutual funds that concentrate their investment in money market securities.

Securities Firms

Some Act as broker: Executing Securities transaction between two parties for commission

Some act as dealer: Making a market in specific securities by maintaining an inventory of Securities

Provide Underwriting and advising servies: Investment Banking

Broker

One who executes securities transactions between two parties.

Dealers

Securities firms that make a market in specific securities by adjusting their inventories.

Underwrite

Act of guaranteeing a specific price to the initial issuer of securities.

Insurance Companies

Provide individuals and firms with insurance policies that reduce the financial burden associated with death, illness, and damage to property

-Charge fees (premiums) in exchange for the insurance that they provide

-They invest premiums into the financial market until its time for payout

Pension Funds

-Employee and sometimes employer contribution to a fund for retirement purposes

-The pension fund is invested in the financial market

Global Consolidation of Financial Institutions

Commercial banks, insurance companies, and securities firms have all expanded through international mergers.

-If a U.S. company merge with a European company, both their skills can be used to service the other country.

Systemic Risk

The spread of financial problems, among financial institutions and across financial markets, that could cause a collapse in the financial system.

-Financial institutions invest their funds in similar types of securities and therefore have similar exposure to large declines in the prices of these securities

-One institution loan to another

Fintech

Multitude of innovative products and services offered in the financial sector to improve or replace the traditional methods of doing financial intermediation and provide financial services