Chapter 7: Financial Markets and Institutions

Deficit-budget Unit

An individual or business that spends more than it earns.

Balanced-budget Unit

An individual or business that spends exactly what it earns.

Surplus-budget Unit

An individual or business that spends less than it earns.

Broker

An individual or company that locates buyers and sellers and brings them together.

Financial Intermediary

An organization that takes funds from surplus-budget units and provides them to deficit-budget units.

Intermediation

Moving funds through financial intermediaries.

Money markets

The markets for (debt) securities with maturity of one year or less.

• Where short-term debt is traded.

Capital Markets

The markets for securities with maturity greater than one year.

• Where long-term debt and equity is traded.

Primary Financial Markets

The markets for the initial issue of securities.

• Where securities are issued for the first time.

Initial Public Offering (IPO)

The first public sale of a company’s stock.

Underwriting

Guarantees the proceeds of a security issue by purchasing the issue at an agreed-upon price.

Prospectus

A booklet of data about a company that must be given to potential investors prior to soliciting any money.

Private Placement

The sale of a new issue of securities directly to an investor.

• Sale of a security issue directly to one or a small group of investors without going through the public markets.

Shelf Registration

Advance SEC approval to make small public security issues.

Secondary Financial Markets

The markets for trading existing securities.

Listing

Arranging for a company’s securities to trade on a stock exchange.

Intrinsic Value

The true economic worth of an asset.

Exchange Traded Fund (ETF)

A collection of investments that trades on a stock exchange as if it were a single security.

Asset Allocation

The process of dividing up an investment portfolio among different categories of investments to achieve desired investment goals such as level of risk and time horizon.

Asset Class

A group of investments with similar financial characteristics and behavior in the financial markets.

Random Walk

A process in which successive changes are independent of each other.

What are the 7 functions of financial markets and institutions?

1. Payments mechanism

2. Savings vehicle

3. Credit supplier

4. Wealth storehouse

5. Liquidity source

6. Risk reducer

7. Policy vehicle

What is meant by financial markets and institutions are a payments mechanism?

Most payments for goods and services are made by checks or electronic transfers processed by the banking system.

What is meant by financial markets and institutions are a savings vehicle?

Individuals use financial markets and institutions such as banks and stock brokers to move their savings into bank deposits, notes, bonds, and stocks.

What is meant by financial markets and institutions are a credit supplier?

Financial institutions such as banks, as well as companies and individual investors operating in the financial markets, provide loans that permit companies and individuals to supplement their income and purchase assets.

What is meant by financial markets and institutions are a wealth storehouse?

Most individuals and companies that have accumulated liquid capital use financial instruments traded in the financial markets to store their wealth.

What is meant by financial markets and institutions are a liquidity source?

The many participants in the financial markets provide savers with the ability to convert most financial assets to cash if and when required.

What is meant by financial markets and institutions are a risk reducer?

Financial intermediaries such as banks and insurance companies sell a wide variety of products to reduce the risk of exposure to financial and physical damages.

What is meant by financial markets and institutions are a policy vehicle?

The federal government uses its ability to affect the financial markets to influence the stability and rate of growth in the economy.

What are the 3 ways to move funds from surplus units to deficit units?

1. Direct transfer

2. Semidirect transfer

3. Indirect transfer

What is meant by direct transfer?

The direct transfer of funds from lender to borrower.

What is meant by semidirect transfer?

Using a professional broker to locate buyers and sellers and bring them together.

What is meant by indirect transfer?

The transfer of funds from lender to borrower using a financial intermediary.

What is the primary purpose of money markets?

To help individuals and organizations manage their liquidity.

What is the primary purpose of capital markets?

To provide intermediate and long-term financing for assets of comparable maturity.

What are the three key players in the primary markets?

1. Investment Banker

2. Flotation Costs

3. Private Placement

What services does the investment banker provide?

• Analysis and advice: advise companies on the amount and timing of a new issue, the combination of features to include in the issue, how to price the issue, and the legal aspects of bringing the issue to market

• Underwriting: guarantees the proceeds of a security issue by purchasing the issue at an agreed-upon price.

• Selling: puts together a selling group who places the securities with their customers

• Market stabilization

What is a flotation cost?

The cost of issuing new securities?

What are the two components of a flotation cost?

1. Underwriting spread: investment bankers’ fees

2. Administrative costs: SEC registration fee, legal fees, printing costs, trustee’s fees, outside auditors’ fees, and taxes

Why do flotation costs vary?

They vary with the risk of placing the issue (how difficult it will be for the investment banker to sell the securities).

What is private placement?

The sale of a security issue directly to one or a small group of investors without going through the public markets.

What are the 4 advantages of private placement?

1. Speed

2. Privacy

3. Terms

4. Size

Why is speed an advantage of private placement?

There is no requirement for registration with the SEC (avoiding time on paperwork).

Why is privacy an advantage of private placement?

There is no requirement of public disclosure.

Why is terms an advantage of private placement?

There are no standardized terms; the terms can be directly negotiated with the borrower and lender.

Why is size an advantage of private placement?

Small issues can be sold without excessive flotation costs; the firm can raise funds in an amount too small to warrant a public offering.

What is a “tombstone” in finance?

An announcement of a stock issue.

What are the 5 functions of the secondary markets?

1. Permit trading

2. Provide information

3. Create continuity

4. Protect participants

5. Improve capital distribution

Why is permit trading a function of the secondary markets?

A large number of buyers and sellers come together.

Why is provide information a function of the secondary markets?

Trading activities are public and highly visible.

Why is create continuity a function of the secondary markets?

Guarantees securities are highly liquid and marketable.

Why is protect participants a function of the secondary markets?

Regulation by the SEC creates a set of publicly known and accepted ground rules for trading activities.

Why is improve capital distribution a function of the secondary markets?

An active secondary market makes investors more willing to purchase securities in the primary market.

What are the security exchanges?

The places where buyers and sellers come together.

What are the 2 types of security exchanges?

1. Physical exchanges

2. NASDAQ

What are the 4 types of physical exchanges?

1. New York Stock Exchange

2. Regional exchanges (ex: Chicago Stock Exchange)

3. Local exchanges (ex: Boston Stock Exchange)

4. International exchanges: security exchanges in each major financial center, on which the securities of companies headquartered in that country trade (ex: London, Tokyo, Frankfurt, Paris, etc.)

What is the NASDAQ?

A computerized network of some 500 securities dealers who offer to buy and sell securities.

What are the 2 types of other trading mechanisms?

1. Institutional Block Trading

2. Electronic Communications Networks (ECNs)

What is Institutional Block Trading?

Large blocks of securities are often traded directly through stockbrokers, usually by large institutional investors.

What are Electronic Communications Networks (ECNs)?

Companies trading through their own computer systems. Trades are cheap, fast, and anonymous.

What is the purpose of financial market indexes?

To attempt to capture the performance of a group of securities or of a financial market as a whole.

What are some examples of financial market indexes?

• Dow Jones indexes

• Standard and Poor’s indexes

• Composite indexes

• Multimarket indexes

• Foreign indexes

What is the characteristic of the Dow Jones indexes?

They are based on the sum of the prices of a select number of New York Stock Exchange stocks representing sectors of the economy.

What is the characteristic of the Standard and Poor’s (S&P) indexes?

They are based on the market value of a large number of New York Stock Exchange stocks representing sectors of the economy.

What is the characteristic of the Composite indexes?

They are a measure of the market value of all stocks traded on an exchange. (Ex: New York Stock Exchange Composite Index and NASDAQ Composite Index)

What is the characteristic of the Multimarket indexes?

They span several exchanges and markets.

What is the characteristic of Foreign indexes?

They measure the activity on major stock exchanges. (Ex: FTSE 100 in London, Nikkei 225 in Tokyo)

What are the 3 investment philosophies?

1. Active investors

2. Passive investors

3. Algorithmic traders

What are Active Investors?

They believe they can find securities that can be purchased at a bargain price and/or sold at an inflated price.

What are Passive Investors?

They believe they cannot consistently find securities that can be purchased at a bargain price.

What are Algorithmic Traders?

They are not interested in the underlying value of a security but care only about the next change in price.

• Trades are done automatically by computers that have been programmed to buy and sell based on a set of formulas that the traders believe will correctly predict the next price move more often than not.

What are the 3 classes of intermediaries?

1. Deposit intermediaries

2. Contractual intermediaries

3. Investment intermediaries

What is a Deposit Intermediary?

They take deposits from lenders and make loans to borrowers. In return they collect interest and principal repayments from the borrowers and return the lender’s deposits with interest earned.

• Commercial banks, savings and loans associations, mutual savings banks, and credit unions

What is a Contractual Intermediary?

They take premiums and contributions from their customers and contributors and invest the proceeds, making loans to governments and corporations. In return the earnings and principal of their investment portfolio are used to pay insurance claims, pay retirement funds, or support the endowed institution.

• Insurance companies, pension funds, and endowment funds.

What is an Investment Intermediary?

They aggregate money from investors and purchase many kinds of investment portfolios, providing each investor the ability to own a piece of a broadly diversified portfolio. They manage the portfolios for their investors and return the money when requested.

• Mutual funds

What are the 5 types of intermediation?

1. Amount intermediation

2. Risk intermediation

3. Maturity intermediation

4. Portfolio mix intermediation

5. Information intermediation

What is Amount Intermediation?

Intermediaries serve lenders and borrowers who have and need different amounts of money.

What is Risk Intermediation?

Intermediaries serve lenders and borrowers with different attitudes toward and perceptions of risk.

What is Maturity Intermediation?

Intermediaries serve lenders and borrowers with different maturity needs.

What is Portfolio Mix Intermediation?

Intermediaries serve lenders and borrowers who desire to change the combination of investments they are holding.

What is Information Intermediation?

Intermediaries serve borrowers and lenders with different access to information.