Chapter 2: Financial Markets and Institutions

• Capital Allocation Process


  People and organizations with surplus funds are saving today in order to accumulate funds for some future use
• Capital Allocation Process


  1. Direct transfers of money and securities

  2. Investment Banks

  3. Financial Intermediaries
• Direct transfers


  A business sells its stocks or bonds directly to savers, used mainly by small firms
• Investment Banks


  Underwrite the issue, the company sells its stocks or bonds to the investment bank, which then sells these same securities to savers
• Financial Intermediaries


  Bank, an insurance company, or a mutual fund, intermediary obtains funds from savers in exchange for its securities
• Types of Financial Markets

  • Physical Asset Markets
  • Financial Asset Markets
  • Spot Markets
  • Future Markets
  • Money Markets
  • Capital Markets
  • Primary Markets
  • Secondary Markets
  • Private Markets
  • Public Markets
• Physical Asset Markets


  Markets for products such as wheat, autos, real estate, computers, and machinery
• Financial Asset Markets


  Markets that deal with stocks, bonds, notes, and mortgages
• Spot Markets


  Assets are bought or sold for "on-the-spot" delivery
• Future Markets


  Participants agree today to buy or sell an asset at some future date
• Money Markets


  Short-term, highly liquid debt securities
• Capital Markets


  Intermediate or long-term debt and corporate stocks
• Primary Markets


  Corporations raise new capital by issuing new securities
• Secondary Markets


  Existing, already outstanding securities are traded among investors
• Private Markets


  Transactions are negotiated directly between two or more parties
• Public Markets


  Standardized contracts are traded on organized exchanges
• Factors that complicate coordination in financial markets include different structures in nations' banking and securities industries, the trend toward financial services conglomerates, and the reluctance of individual countries to give up control over their national monetary policies
• Derivatives


  Any security whose value is derived from the price of some other "underlying" asset
• Derivatives


  • It is very difficult to tell how derivatives are affecting the firm's risk profile
• Investment Banks


  An organization that underwrites and distributes new investment securities and helps businesses obtain financing
• Investment Banks


  • Traditionally help companies raise capital by helping them design securities with features that are currently attractive to investors, buy these securities from the corporation, and resell them to savers
• Commercial Banks


  The traditional department store of finance serving a variety of savers and borrowers
• Financial Services Corporations


  A firm that offers a wide range of financial services, including investment banking, brokerage operations, insurance and commercial banking
• Credit Unions


  Cooperative associations whose members are supposed to have a common bond, cheapest source of funds available to individual borrowers
• Pension Funds


  Retirement plans funded by corporations or government agencies for their workers and administered primarily by the trust departments of commercial banks or by life insurance companies, invest primarily in bonds, stocks, mortgages, and real estate
• Life Insurance Companies


  Take savings in the form of annual premiums, invest these funds in stocks, bonds, real estate, and mortgages, and make payments to the beneficiaries of the insured parties
• Mutual Funds


  Organizations that pool investor funds to purchase financial instruments and thus reduce risks through diversification, buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units
• Money Market Funds


  Mutual funds that invest in short-term, low-risk securities and allow investors to write checks against their accounts
• Actively Managed Funds


  Mutual funds that try to outperform the overall markets
• Indexed Funds


  Mutual funds designed to simply replicate the performance of a specific market index
• Exchange-Traded Funds


  Similar to regular mutual funds and are often operated by mutual fund companies
• Hedge Funds


  Accept money from savers and use the funds to buy various securities but are largely unregulated, have large minimum investments, and take on risks that are considerably higher than that of an average individual stock or mutual fund
• Private Equity Companies


  Buy and then manage entire firms
• Physical Location Exchanges


  Formal organizations having tangible physical locations that conduct auction markets in designated ("listed") securities
• Over-the-Counter (OTC) Market


  A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities
• Dealer Markets


  Include all facilities that are needed to conduct security transactions not conducted on the physical location exchanges, the relatively few dealers who hold inventories of these securities and who are said to "make a market" in these securities, the thousands of brokers who act as agents in bringing the dealers together with investors, and the computers, terminals, and electronic networks that provide a communication link between dealers and brokers
• Bid Price


  The price at which dealers will pay for the stock
• Ask Price


  The price at which dealers will sell shares
• Bid-Ask Spread


  The dealer's markup, or profit
• Financial Industry Regulatory Authority (FINRA)


  The self-regulatory body which licenses brokers and oversees trading practices, including the National Association of Securities Dealers Automated Quotations (NASDAQ) - the computerized network used by FINRA