CHAPTER 1
1. What is a Financial Market?
● A financial market is a place where people buy and sell financial
assets (also called securities) such as stocks (ownership shares of
companies) and bonds (loans to companies or governments) .
● Money (funds) moves in these markets when one person sells an
asset and another person buys it.
● These markets help households (people), businesses (companies),
and governments to either get money or invest money.
2. Role of Financial Markets
● Financial markets transfer money from those who have extra
money to those who need money.
● Example:
○ College students can get student loans.
○ Families can get home loans (mortgages).
○ Businesses can borrow money to expand.
○ Governments can borrow money to pay for expenses.
� Without financial markets, many people couldn’t study, buy homes,
companies couldn’t grow, and governments couldn’t pay for many
services.
3. Surplus Units and Deficit Units
● Surplus Units (Investors):
○ These are people or groups who have extra money (more
money than they spend).
○ They give this extra money to financial markets so it can be
lent or invested.
○ In return, they earn profit/interest/dividends (reward for
investing).
● Deficit Units (Borrowers):
○ These are people or groups who need more money than they
currently have.
○ They borrow money from the financial markets by issuing
securities (like bonds, loans, or shares).
� Example:
● Students usually are in deficit units because they borrow money
for education.
● After finishing their degree and getting a job, they become surplus
units because they earn more than they spend.
● Later, if they buy a home, they may borrow again and become
deficit units.
Sometimes, a person can be both surplus and deficit at the same time:
● For example, depositing savings in a bank (surplus role) while also
taking a home loan from the same bank (deficit role).
4. How Deficit Units Get Money
● Deficit units (like companies or governments) get money from
financial markets by issuing securities.
● Securities are simply a promise or claim made by the borrower to
the lender.
There are two main types:
1. Debt Securities (Loans/Bonds):
○ This is borrowed money.
○ The company/government borrows from investors and
promises to:
■ Pay interest (usually every 6 months).
■ Return the full borrowed money at a maturity date
(the final due date).
2. Example: A government sells a bond worth $1,000 to an investor.
○ The government promises to pay interest (say $50 every
year).
○ After 10 years (maturity date), the government will give back
the full $1,000.
✅In short:
● Financial markets move money from savers (surplus units) to
borrowers (deficit units).
● This allows students to study, families to buy houses, businesses to
grow, and governments to pay for expenses.
● Borrowers issue securities like stocks (ownership) or bonds (debt)
to raise money.
● Savers (investors) earn returns in exchange for supplying funds.
1. Securities: Debt vs Equity
● Debt securities = Loans (borrowed money). The borrower
(government or company) promises to repay with interest + give
back the borrowed money (principal) at maturity.
● Equity securities (Stocks) = Ownership. When you buy stock, you
own a small part of the company.
� Example:
● If the U.S. government needs $70 billion more than tax money it
collected, it issues Treasury securities (debt) to raise funds.
● If Google needs $40 million, it can:
○ Issue debt securities (borrow money) OR
○ Issue equity securities (sell ownership shares).
Both methods raise money, but each has different pros and cons.
2. Why Issue Securities?
● Governments and companies often spend more than they earn, so
they need extra money.
● By issuing securities, they get money from surplus units
(investors/savers).
● This is how financial markets help them spend more than their
normal income.
3. Types of Financial Markets
Different markets exist because:
● Some investors want short-term investments, some want longterm.
● Some investors are okay with high risk, others want low risk.
● Some borrowers prefer loans (debt), others prefer stocks (equity).
So, there are different financial markets to match these preferences.
4. Money Markets vs Capital Markets
● Money Markets = For short-term funds (maturity ≤ 1 year).
○ Example: Treasury bills, commercial paper.
○ Safer, more liquid.
● Capital Markets = For long-term funds (maturity > 1 year).
○ Example: Stocks, corporate bonds, Treasury bonds.
○ Riskier, but can give higher returns.
5. Primary Markets vs Secondary Markets
● Primary Market = When a company or government sells NEW
securities for the first time.
○ Example: Google issues new stock.
○ Money goes to Google (the issuer).
● Secondary Market = When investors trade existing securities with
each other.
○ Example: You sell your Google stock to another investor.
○ Money goes from one investor to another, not to Google.
� Important:
● Primary = company/government gets money.
● Secondary = investors trade among themselves.
6. Liquidity
● Liquidity = How quickly and easily you can sell a security without
losing much value.
● High liquidity = Many buyers & sellers →easy to sell at fair price.
● Low liquidity = Few buyers →you may need to sell at a discount
(lower price).
� Example:
● Big company stocks (like Apple) = very liquid (lots of buyers).
● Rare or complex securities = less liquid.
● During the 2008–2009 financial crisis, many securities became
illiquid. Investors struggled to sell them without losing huge value.
✅In short:
● Debt securities = borrowing, Equity securities = ownership.
● Governments & companies issue securities to raise money.
● Money markets = short-term, Capital markets = long-term.
● Primary markets = new securities sold, Secondary markets =
existing securities traded.
● Liquidity is key →investors prefer assets they can sell easily
without loss.
1. Problem in 2008–2009 (Credit Crisis Example)
● Investors were afraid that some debt securities (like bonds,
mortgage-backed securities) would default →meaning borrowers
wouldn’t be able to pay back interest + principal.
● Because of this fear, investors stopped buying these securities.
● As a result, the secondary market (where investors sell securities to
each other) became illiquid →investors who already held these
securities couldn’t easily sell them without losing a lot of money.
� Lesson: If investors lose confidence, financial markets can freeze up.
2. Three Segments of Finance
Finance is usually divided into 3 main parts (Exhibit 1.1 shows this):
1. Corporate Finance →How companies raise money and decide how
to use it (for operations & expansion).
2. Investment Management →How investors decide where to put
their money (which stocks, bonds, etc.).
3. Financial Markets and Institutions →The system (markets +
banks) that connects investors and corporations.
3. How Financial Markets Help Corporations
● Corporations need money to run daily operations and to expand.
● Financial markets bring money from investors (savers) to
corporations.
� Two ways corporations get money:
● Money markets = short-term borrowing (to support daily
operations, like paying workers or buying raw materials).
● Capital markets = long-term borrowing or equity (to expand
business, like building a new factory).
� The decisions of managers in public companies directly affect:
● The performance of the firm,
● The stock price,
● And the returns that investors earn.
So, good financial decisions = higher stock prices = happier investors.
4. How Financial Markets Help Investors (Investment
Management)
● Investors have many choices:
○ U.S. Treasury securities,
○ Government agency securities,
○ Corporate stocks and bonds.
● Their main job: decide which securities to buy.
� When investing in stocks, investors:
● Look for companies that are undervalued (cheap now but likely to
grow).
● Monitor how managers run those companies.
● Sometimes even influence company decisions to make sure
managers try to maximize stock price.
� The stock price acts like a scorecard for how well managers are doing.
5. Role of Financial Institutions
● Financial institutions (banks, mutual funds, insurance companies,
etc.):
○ Act as middlemen (intermediaries) →they help move money
from investors to corporations.
○ They also often invest their own money directly into
corporations.
� Without financial institutions, the flow of funds in financial markets
would not work smoothly.
6. Exhibit 1.1 (Simplified Flow)
Here’s the flow in simple steps:
1. Investors (including banks, funds, etc.) put in money.
2. Money goes through Financial Markets & Institutions.
3. Corporations receive money →to run operations & expand.
4. Corporations give back returns (interest, dividends, or profits) →
flows back to investors.
So it’s a continuous cycle:
� Investors →Markets →Corporations →Back to Investors.
✅In short:
● During crises, markets can become illiquid if investors lose trust.
● Finance has 3 parts: corporate finance, investment management,
and financial markets/institutions.
● Financial markets help corporations raise money (short-term &
long-term).
● Financial markets help investors invest wisely and measure firm
performance.
● Financial institutions act as middlemen, making the flow of money
possible.
� Key Concepts You Must Understand First
● Securities = financial instruments like bonds, stocks, etc. (ways for
investors to give money to borrowers in return for some benefit
like interest or profit).
● Risk = uncertainty about how much return (profit/interest) you’ll
get.
● Return = the money you expect to earn from your investment.
● Liquidity = how easily you can sell an investment and get cash
without losing value.
1. � What Is Risk in Financial Markets?
● Risk means: You don’t know exactly how much money you’ll earn
from your investment.
● Some investments are very safe (like government securities), others
are risky (like stocks or corporate bonds).
● Example:
○ If you invest in a 1-year U.S. Treasury bill, you know exactly
how much you’ll get back. Very low risk.
○ If you invest in a company’s bond or stock, there’s a chance
the company might fail →you might lose your money. That's
a high risk.
� So, the more uncertain the return, the higher the risk.
2. � Investors Are Different
● Every investor is different. Some want:
○ Low risk (safety).
○ High liquidity (easy to sell quickly).
○ Tax benefits.
● Others are okay with taking risks if they might earn a higher
return.
� Most investors try to find a balance between:
● High return �
● Low risk ⚠️
● Enough liquidity �
3. � Types of Securities in Financial Markets
Securities are grouped into three major categories:
� A. Money Market Securities
● Definition: Short-term debt securities (maturity = 1 year or less).
● Main features:
○ Low risk.
○ Low return.
○ Highly liquid (easy to sell).
● Common examples:
○ Treasury Bills (T-bills) →issued by the government.
○ Commercial Paper →short-term loan issued by companies.
○ Certificates of Deposit (CDs) →issued by banks.
� Used by people or institutions who want to keep their money safe and
still earn a small return.
� B. Capital Market Securities
● Definition: Long-term securities (maturity = more than 1 year).
● Purpose: Companies and governments use them to raise money for
long-term things like buildings, machines, etc.
● Three common types:
1. Bonds
● Long-term debt securities issued by:
○ Companies.
○ Government agencies.
● Investors earn interest (called coupon payments) usually every 6
months.
● At maturity, the principal (original money) is paid back.
● Bonds can be sold in secondary markets before maturity.
● Risk: If the issuer fails to pay interest or principal, the investor can
lose money.
● Expected return: Higher than money market securities, but also
riskier.
2. Mortgages
● Long-term loans used to buy real estate (houses, land, buildings).
● Borrowers repay with interest + principal over time.
● Risk: Some borrowers may fail to repay →risky mortgages.
● Lenders (banks) check income and other factors to decide whether
to give a mortgage.
3. Stocks (Equity Securities)
● Represent ownership in a company.
● No fixed interest or maturity.
● Investors earn through:
○ Dividends (profit sharing).
○ Capital gains (selling stock at a higher price).
● High risk: Value depends on how well the company performs.
● High return potential, but not guaranteed.
Mortgages
● A mortgage is a loan people take to buy a home.
● There are two main types:
1. Prime mortgages →given to borrowers who have good income,
good credit history, and can make a down payment.
2. Subprime mortgages →given to people who don’t have enough
income, or can’t make a down payment.
○ These are riskier because the borrower is more likely to not
pay back (default).
○ So, lenders charge higher interest rates and extra fees to
cover this risk.
○ Subprime mortgages became famous because many people
couldn’t pay them back, which caused the 2008 financial
crisis.
Mortgage-Backed Securities (MBS)
● Mortgage-backed securities are investments that are created
from a group (package) of mortgages.
● The investors who buy these securities get the monthly payments
made by homeowners on those mortgages.
Step 1: The Bank Gives Mortgages
● Mountain Savings Bank gives out 100 mortgages (loans) to people
who want to buy houses.
● Normally, if the bank keeps these mortgages, it has to wait years
to slowly get back its money (as monthly payments).
● But the bank wants its money back sooner to make more loans
and earn more profit.
Step 2: The Bank Creates Mortgage-Backed Securities (MBS)
● Instead of holding onto the 100 mortgages, the bank packages
them together into one big financial product →Mortgage-Backed
Securities (MBS).
● It then sells these securities to 8 financial institutions (investors).
● Basically, the investors are buying the right to receive the future
payments from the homeowners.
Step 3: Monthly Payments Flow
● Homeowners pay their mortgage every month (interest +
principal) to Mountain Savings Bank.
● The bank doesn’t keep this money →it simply passes the money to
the 8 investors who bought the securities.
● So:
○ Homeowners →Bank →Investors
Step 4: Risk of Default
● If all homeowners pay on time, investors make good money.
● But if some homeowners default (stop paying), the cash inflow
drops.
● That means the investors’ returns fall.
● This is why MBS are risky: they depend on whether homeowners
keep paying their mortgages.
Step 5: If the Bank Doesn’t Know How to Make MBS
● Not every bank knows how to package mortgages into securities.
● In that case, a bigger financial institution collects mortgages
from several banks (including Mountain’s 100 mortgages).
● It then bundles all of them together into one big MBS.
● Investors who buy this bundle are indirectly financing many
mortgages from different banks.
Step 6: 2008–2009 Crisis
● Many subprime borrowers (risky borrowers) couldn’t pay back their
loans.
● As a result:
○ Cash inflows to investors dried up.
○ The value of mortgage-backed securities collapsed.
● Financial institutions that invested a lot in MBS lost billions.
● This was a key cause of the 2008 global financial crisis.
� In short:
● The bank wants quick money, so it sells mortgages as securities to
investors.
● Investors earn money from homeowners’ monthly payments.
● If homeowners don’t pay, investors lose money.
● In 2008, too many people defaulted →investors + banks lost huge
amounts.
Real-Life Example (No Finance Words)
1. You lend money to friends
○ Imagine you lend money to 100 of your friends so they can
buy something (like houses).
○ Each friend promises: “I’ll give you back a little money every
month.”
2. You don’t want to wait
○ But you don’t want to wait years to get your money back.
○ You want money right now to use for yourself.
3. You sell the promise
○ So you go to 8 other people and say:
“Hey, if you give me money right now, you can collect the
monthly payments from my 100 friends.”
○ Those 8 people agree.
○ Now they get the money your friends pay each month.
4. How the money moves
○ Friends (borrowers) →pay you every month.
○ You →just pass the money to the 8 new people (investors).
○ You already got your money back quickly, so you’re happy.
5. The risk
○ If all 100 friends pay on time, the 8 people (investors) are
happy.
○ But if many friends stop paying (default), the 8 investors get
less money →they lose.
6. Big problem in 2008
○ In real life, lots of risky borrowers couldn’t pay their loans.
○ So the investors who bought those “promises” lost huge
amounts of money.
○ That’s what caused the 2008 financial crisis.
� In one line:
It’s like you lend money to friends, but then you sell the “right to collect
that money” to someone else. If your friends stop paying, the new
person who bought the right loses.
Stocks (Equity Securities)
● Stocks = partial ownership in a company.
● They are capital market securities (long-term) because they have
no maturity date.
● Companies may:
1. Pay dividends →give part of their profits to shareholders
every quarter.
2. Reinvest profits →keep money in the business to grow
bigger.
How stocks work:
● Owning stock means you are a part-owner of the company.
● If the company grows and becomes more valuable, the stock price
goes up →you can sell it for a profit (capital gain).
● Investors earn in 2 ways:
○ Dividends (if the company pays them).
○ Capital gain (if they sell stock at a higher price).
● But stocks are risky:
○ If the company does poorly, stock prices fall.
○ Investors can lose money.
� Compared to long-term debt (like bonds), stocks usually have a higher
expected return but also higher risk.
Using the Wall Street Journal to Check Stock Performance
● The Wall Street Journal (WSJ) shows information about how stocks
have recently performed.
● It has charts for different stock indexes.
● Example: The Dow Jones Industrial Average (DJIA) →this index
shows the performance of 30 big, famous U.S. companies.
● In the chart, you can see the range of prices (high and low) over
time.
○ This helps you understand how volatile (how much the price
moves up and down) the index is.
● The WSJ also shows the daily trading volume →how many shares
were traded on the New York Stock Exchange (NYSE), measured in
billions of shares.
� What are Derivative Securities?
● A derivative is like a side deal (contract).
● Its value depends on something else →like a stock, a bond, or even
gold, oil, or the dollar.
● You don’t directly own that thing; instead, you make an
agreement about how its price will move.
� Example: Instead of buying Apple stock, you make a contract that
says “I’ll win money if Apple’s stock goes up (or down).”
� Why Do People Use Derivatives?
1. Speculation (Betting / Trying to Make Profit)
● Derivatives let you bet on price changes without owning the real
thing.
● You can profit if the price:
○ Goes up (some derivatives work this way).
○ Goes down (other derivatives work this way).
● You can make more money faster than if you just bought the stock
or bond.
● BUT ⚠️ if your guess is wrong →you can also lose money very fast.
� Example:
Imagine mangoes cost $10 per kilo today.
You don’t buy mangoes, but you make a deal:
● If mango prices go up next week, you’ll earn money.
● If mango prices go down, you’ll lose money.
That’s speculation with derivatives.
2. Risk Management (Protection / Insurance)
● Derivatives can also be used like insurance for investments.
● If the value of something you own falls, the derivative can give you
money to reduce the loss.
� Example:
● You own $1,000 worth of bonds.
● You’re worried bond prices might fall.
● So, you buy a derivative that pays you if bond prices drop.
● If bonds really fall, you lose money on your bonds but gain money
on the derivative, so your loss is smaller.
It’s just like buying insurance for your car:
● If the car crashes, insurance pays you.
● If nothing happens, you lose the small insurance fee — but you had
peace of mind.
Derivative Securities
● Besides money market securities and capital market securities,
there are also derivative securities.
● A derivative security is a financial contract whose value depends
on (is “derived” from) another asset.
○ Example: A derivative might be linked to a stock or a bond.
● Derivatives are used mainly for two purposes: speculation and risk
management.
1. Speculation
● Derivatives let investors bet on the movement of the underlying
asset’s value without owning it.
● Some derivatives let you profit if the asset’s value goes up.
● Other derivatives let you profit if the asset’s value goes down.
● Using derivatives for speculation can give higher returns than
directly investing in the asset.
● But: they also carry higher risk (because if your bet is wrong, you
lose).
2. Risk Management
● Derivatives can also be used for protection.
● They can give profits if the value of the underlying asset drops,
which helps cover losses.
● Example: A financial institution that owns a lot of bonds might use
derivatives to protect itself.
● If bond prices fall, the derivative could give them gains to balance
out the loss.
● This way, derivatives can help companies adjust the level of risk in
their investments.
� Explanation in Super Easy Way (with Examples)
1. Stock Information in WSJ
● Think of the Dow Jones index like a report card of 30 top
companies.
● If the index goes up →those companies are doing well.
● If it goes down →they are doing badly.
● WSJ shows:
○ High and low prices →to see how much stocks are jumping
around.
○ Volume →how many people are buying/selling stocks daily.
� Example: If 2 billion shares were traded yesterday, it means people
were very active in buying/selling.
2. Derivative Securities
● A derivative is like a side bet about another asset.
● You don’t own the asset, but you’re betting on whether its price will
go up or down.
Speculation Example:
● Imagine a stock is at $100.
● You don’t buy the stock, but you buy a derivative contract that
says:
○ If the stock goes to $110, you earn money.
○ If the stock goes to $90, you lose money.
● If you’re right, you can make more profit than if you just owned
the stock.
● But if you’re wrong, you can lose faster and bigger.
Risk Management Example:
● Suppose you already own bonds worth $1,000,000.
● You’re scared that bond prices might go down.
● So, you buy a derivative that will give you money if bond prices
fall.
● If bonds drop in value, you lose money on the bonds, but you gain
money from the derivative, so your total loss is smaller.
� That’s like buying insurance for your investments.
Example: Using Derivatives to Reduce Risk
● A company may own a lot of bonds.
● If bond prices go down, the company will lose money.
● To protect itself, the company can take a position in derivative
securities that will make money if bond prices fall.
● This way:
○ Loss on bonds →is covered by gains on derivatives.
● So, derivatives can help reduce risk.
Valuation of Securities in Financial Markets
● Every type of security (stocks, bonds, etc.) gives investors some
cash flows (payments).
● Each security also has a different level of uncertainty (risk) about
those cash flows.
● To find the value of a security:
○ You calculate the present value of its expected future cash
flows.
○ You use a discount rate that reflects the level of risk
(uncertainty).
● Since each security has different cash flows and risks, each security
has a unique value.
Example: Nike Stock
● If you buy Nike stock, you can get cash flows in two ways:
○ Quarterly dividends (if Nike pays them).
○ The price of the stock when you sell it in the future.
● The problem: both the future dividends and the future stock price
are uncertain.
● Investors try to estimate future cash flows by looking at:
○ Reports about the athletic shoe industry.
○ Announcements from Nike about sales.
○ Opinions about Nike’s management ability.
Impact of Information on Valuations
● All investors use valuation to decide whether to invest.
● But: different investors may look at information differently.
○ Some focus more on economic/industry conditions.
○ Others focus more on management quality or news about
the company.
● When new information comes in (like better sales reports or
reduced risks), investors update their valuations.
○ If the new info shows higher expected cash flows or less risk,
the valuation of the security will increase.
Exhibit 1.2 (Explained in Words)
To decide whether to buy a security, investors use 3 kinds of
information:
1. Economic conditions (overall economy health).
2. Industry conditions (how the company’s industry is doing).
3. Firm-specific information (details about the company, like:
○ Information provided by the company itself.
○ Information from other sources, like analysts or news
reports).
� They combine all this info →to make a valuation of the security →
then decide whether to buy or not.
� Super Easy Explanation with Example
Imagine you want to buy shares of Nike:
● You’ll get money from:
1. Dividends Nike might pay.
2. The price you sell the stock for later.
But the future is uncertain — maybe Nike sells more shoes, maybe less.
● If Nike announces strong sales, investors think: “Okay, I’ll get
more cash flows in the future.” →Valuation goes up.
● If Nike faces bad news (like a scandal or drop in sales), investors
think: “Future cash flows will be lower.” →Valuation goes down.
� That’s why the value of securities changes all the time — it depends on
future cash flows and how risky they are.
Example: How Information Affects Security Prices
When investors get good news about a security (like a stock), they
expect higher future cash flows or a lower discount rate. This makes the
security look more valuable. At the old price, it now seems undervalued,
so more people want to buy it (demand goes up), while fewer want to sell
it (supply goes down). Because of this, the price rises until it reaches a
new equilibrium (balance).
On the other hand, when investors get bad news, they expect lower cash
flows or use a higher discount rate. This makes the security less valuable.
Investors lower their valuations, which shifts demand and supply, and
the price of the security falls to a new equilibrium.
If an announcement doesn’t contain any new information, it won’t
affect prices. Sometimes investors expect certain announcements in
advance and already adjust prices before the announcement happens. In
that case, when the announcement comes, the market shows no reaction
because it was already “priced in.”
Impact of the Internet on Valuation
The Internet has improved how securities are valued:
● Prices of securities are available online anytime, so investors can
check them instantly.
● For some securities, investors can even track the exact order of
transactions in real time.
● More information about companies is available online, which helps
securities be priced more accurately.
● Investors can now buy or sell securities online, making price
adjustments happen faster when new information comes out.
Market Efficiency
Because securities have market-based prices, their good or bad qualities
(as investors see them) are already reflected in those prices.
When security prices reflect all available information, we call this an
efficient market.
● In an efficient market, securities are fairly priced.
● If a stock is clearly undervalued based on public information, some
investors will quickly buy it. Their strong demand will push the price
up until the undervaluation disappears.
● These investors make higher returns, but once the price adjusts, the
opportunity is gone.
● This process motivates investors to always watch market prices.
Their actions usually make sure securities stay properly priced,
based on the available information.
Even in efficient markets, there is still uncertainty. Prices can change a
lot over time because investors don’t have perfect information about a
company, its industry, or the whole economy.
Example: Google’s IPO
When Google first issued stock on August 18, 2004, there was huge
uncertainty about its value. Investors knew that Google’s stock price
would depend on:
● its management,
● industry conditions (like competition), and
● economic conditions.
But no one knew exactly how these would play out. Some investors
thought the starting price of $85 per share was too high, while others
bought as many shares as they could.
Within the first year, as more information became available about
Google’s business plans and performance, its stock price tripled. So, if
someone invested $1,000 at the IPO, their investment was worth over
$3,000 within a year.
Role of Information from Firms
Much of the information investors use to value a company’s securities
comes from the managers of those companies. Investors also depend on
accounting reports (revenue, expenses, profits) to estimate future cash
flows.
Firms that are publicly traded (listed on stock exchanges) are required
by law to share this financial information with investors.
Asymmetric Information
Even though firms disclose information through reports and accounting
statements, managers often know more about the company’s real
financial condition than outside investors. When managers have
information that investors do not, it is called asymmetric information.
Sometimes, even if managers share information, it can be misleading. In
that case, asymmetric information problems still exist.
Behavioral Finance
Sometimes, securities are not priced correctly because investors’
decisions are influenced by psychology rather than facts. This area is
called behavioral finance, which applies psychology to financial
decision-making. It explains why markets are not always efficient.
Example: Nadal Company
● A positive earnings report increased demand for Nadal’s stock, and
the price went up by 2% — this was justified by the news.
● Later, as the media repeated the story, more investors bought the
stock, and the price rose by another 4%.
● The next day, even more media hype pushed the price up another
3%.
● So, the stock price increased much more than it should have, not
because of the actual news, but because of investor psychology
and media attention.
● Eventually, when the hype faded, the price dropped back down.
This shows that behavioral finance can sometimes explain why prices of
a single stock—or even the whole market—move in ways that are not
justified by real information.
Financial Market Regulation
Securities markets are regulated to make sure all participants are
treated fairly. Many rules were created after fraudulent practices
contributed to the Great Depression.
1. Disclosure Rules
● Incorrect or hidden information can lead investors to make bad
decisions.
● Regulations try to ensure that businesses share accurate
information.
● If information is given only to a small group of investors, those
people get an unfair advantage.
● Regulations therefore aim to provide equal access to information
for all investors.
Key laws:
● Securities Act of 1933 →Ensured full disclosure of relevant
financial info on newly offered (public) securities and prevented
fraud in selling securities.
● Securities Exchange Act of 1934 →Extended disclosure
requirements to the secondary market (where existing securities
are traded). It also:
○ Made misleading financial statements illegal.
○ Banned strategies designed to manipulate prices.
○ Created the Securities and Exchange Commission (SEC) to
oversee securities markets.
● Over time, the SEC has added more rules.
● Important note: Securities laws do not stop investors from making
bad decisions. Instead, they just make sure information is
complete and not fraudulent.
2. Response to Financial Scandals
The scandals of 2001–2002 (like Enron and WorldCom) showed that old
regulations were not strong enough.
● These companies exaggerated their earnings and hid negative
information, misleading investors.
● Companies that sell stock and debt must hire independent
auditors to check that their reports are accurate.
● However, in some cases, auditors failed to do their job properly,
which allowed fraud to continue.
Sarbanes-Oxley Act (SOX)
After the financial scandals, the Sarbanes-Oxley Act (SOX) was passed.
● It required companies to provide more complete and accurate
financial information.
● It placed restrictions to ensure proper auditing by auditors.
● It also required better oversight by the company’s board of
directors.
● The main goal was to regain investor trust, since investors provide
the funds that flow into financial markets.
● These measures were designed to reduce or eliminate asymmetric
information (where managers know more than investors).
Cycle of Scandals and Regulations
● Because there is so much money to gain, some people will always
try to cheat the system.
● This means new scandals will always happen, followed by new
regulations, and then new types of scandals that find ways around
the latest rules.
● The most harmed are usually the naive investors (those with the
least knowledge).
Example: 2008 Crisis
● Financial institutions like Bear Stearns, Lehman Brothers, and AIG
had major financial problems.
● Many investors were caught by surprise.
● This raised concerns that firms were not providing enough
information.
● Limited financial disclosure creates uncertainty about how to
properly value a company.
Global Financial Markets
Financial markets are being developed all over the world to help move
money from surplus units (savers) to deficit units (borrowers).
● But markets are more advanced in some countries than others.
● They differ in:
1. The total amount of funds being transferred.
2. The types of funding available (loans, stocks, etc.).
Development in Developing Countries
● Since the early 1990s, many private businesses have been created
in developing countries.
● Governments allowed privatization (selling government-owned
firms to individuals).
● Some businesses began issuing stock, letting outside investors
become part-owners.
● Financial markets were created in these countries so businesses
could get funding from surplus units.
● As a result:
○ Private businesses can now raise money by borrowing or
selling stock.
○ Individuals can now lend money or buy shares in companies.
International Corporate Governance
Financial markets only work if surplus units (investors) are willing to
provide funds. For this to happen, there must be:
● enough information about securities, and
● safeguards to make sure investors are treated fairly.
If these don’t exist, investors will not participate, and the market will
not have enough liquidity (ease of trading).
Why Some Developing Countries Have Weak Markets
Financial markets have grown slowly in some countries because of
several problems:
1. Issuers of debt securities do not give enough financial information
to show how they will repay investors.
2. Regulatory agencies do little enforcement to ensure information is
accurate.
3. Businesses that fail to repay investors are rarely punished.
4. Courts are inefficient, so investors can’t easily recover the money
they are owed.
Global Integration
Many financial markets are now connected globally, which means
investors can easily move their money from one country’s markets to
another’s.
● Foreign investors play a big role in the U.S. by buying U.S.
Treasury securities and securities issued by U.S. businesses.
● Similarly, U.S. investors often buy securities from foreign
corporations and foreign government agencies, becoming surplus
units (lenders) for those countries.
Investors compare the risk and return of securities in different countries
and invest where the balance matches their preferences.
Because markets are so connected, movements in the U.S. markets
affect foreign markets, and foreign markets also affect the U.S.
● Interest rates, which depend on the supply and demand for funds,
are now more sensitive to foreign borrowing and lending.
Europe’s Progress
● Europe has made the most progress in integrating financial
markets.
● Many regulations were removed, so surplus and deficit units in one
European country can use financial markets throughout Europe.
● Some European stock exchanges merged, making it easier for
investors to trade in one place.
● In 1999, 16 European countries adopted the euro as their currency
(called the eurozone).
○ Now, transactions between these countries are all in euros.
○ Securities are also issued in euros.
○ This means investors and consumers don’t need to convert
currencies when trading within the eurozone.
Role of the Foreign Exchange Market
For most international financial transactions (except those inside the
eurozone), currencies must be exchanged.
● The foreign exchange market helps make this exchange possible.
● Commercial banks and other financial institutions act as
intermediaries by matching people who want to buy one currency
with those who want to sell it.
● Some financial institutions also act as dealers, taking positions in
currencies to handle foreign exchange requests.
Like securities, currencies also have a market-determined price, called
the exchange rate, which changes based on supply and demand.
● If corporations, governments, or individuals suddenly demand
more of a certain currency, or if more supply of that currency
becomes available, its price (exchange rate) will change.
Role of Financial Institutions
If financial markets were perfect, things would look like this:
● All information about securities (including how creditworthy issuers
are) would be free and always available.
● Investors who want to buy and sell securities would easily find each
other.
● Securities could be broken into any size an investor wanted.
● Transaction costs would not exist.
● In such a case, there would be no need for financial
intermediaries (like banks).
But in reality, markets are imperfect:
● Buyers and sellers of securities do not have complete information.
● People with extra money (surplus units) don’t always know how to
find creditworthy borrowers (deficit units) to lend their funds to.
Part 1: Overview of the Financial Environment
Sometimes, individual people or businesses (called surplus units) who
have extra money do not have the knowledge or ability to check if
borrowers (called deficit units) are trustworthy. Because of this,
financial institutions are needed to solve such problems.
These institutions take money from surplus units (those with extra funds)
and lend or invest it with deficit units (those who need money). Without
financial institutions, the cost of finding borrowers and handling
transactions would be too high.
Financial institutions are divided into two groups:
1. Depository institutions
2. Non-depository institutions
Role of Depository Institutions
Depository institutions are banks and similar organizations that help
money flow smoothly in the economy.
They do two main jobs:
1. Take deposits →from people or businesses who have extra money
(called surplus units).
2. Give loans or invest →to people or businesses who need money
(called deficit units).
✅Why are they so useful?
● They let people keep money safely in deposit accounts (and you
can take out cash whenever needed).
● They give out loans of different sizes and time periods depending
on what borrowers need.
● They take on the risk if borrowers don’t pay back.
● They are better at checking borrowers’ reliability than ordinary
people.
● They lend to many people at once, so if one person doesn’t pay
back, the bank can still manage.
� What if banks didn’t exist?
Without depository institutions:
● Every saver would need to find a borrower by themselves.
● The saver would need to check if the borrower is trustworthy.
● The saver would carry all the risk if the borrower doesn’t pay back.
� This would make lending so difficult that most people would just hold
on to their money instead of lending. That means the flow of money in
the economy would stop.
� How Loans Work
When a bank gives you a loan, it acts like a creditor (someone who lends
money).
● It’s a bit like when investors buy debt securities (like bonds).
● But here’s the difference:
○ Loans are harder to sell later because each loan has many
specific rules and terms (interest rate, repayment time,
conditions, etc.), which are different for each borrower.
○ If another investor wanted to buy a loan from the bank, they
would have to read all the loan details carefully before
agreeing.
That’s why loans are less “liquid” (less easy to trade) than securities like
bonds.
� In super simple terms:
Banks make life easier by connecting savers and borrowers, taking the
risk, and making the process smooth. Without them, lending would be
messy and risky.
How Loans Work
When a depository institution gives a loan, it acts like a creditor (similar
to buying a debt security). But loans are less marketable (harder to sell
later) than debt securities. This is because loan agreements are very
detailed and vary a lot between borrowers. If another investor wanted
to buy such a loan, they would have to carefully review all terms before
purchasing.
Types of Depository Institutions
1. Commercial Banks
● These are the most important and common banks.
● They help surplus units (people or businesses with extra money) by
offering different deposit accounts (like savings accounts, current
accounts, etc.).
● They use the money deposited to:
○ Give loans directly to borrowers.
○ Buy debt securities (like government bonds).
● They serve everyone →households, businesses, and even
government agencies.
● Some commercial banks are huge, holding more than $100 billion
in assets.
� Examples: Bank of America, J.P. Morgan Chase, Citigroup,
SunTrust Banks.
2. Federal Funds Market
● Not all banks have the same money situation:
○ Some banks get more deposits than they need.
○ Others get less deposits than they need to meet customer
loan demands.
● To fix this imbalance, the federal funds market exists.
● In this system:
○ Banks with extra funds lend money to banks that need more
funds.
○ These loans are very short-term, usually lasting 1 to 5 days.
● This keeps the banking system balanced and ensures money flows
smoothly between banks.
� Simple Example:
● Imagine Bank A has a lot of extra deposits, but Bank B doesn’t
have enough to give loans to its customers.
● Bank A lends money to Bank B for a few days through the federal
funds market.
● Later, Bank B returns the money with a little interest.
● This way, banks help each other, and the whole financial system
runs smoothly.
Chapter 1: Role of Financial Markets and Institutions
Savings Institutions
Savings institutions, also called thrift institutions, are another type of
depository institution (like banks that take deposits). These include:
● Savings and Loan Associations (S&Ls)
● Savings Banks
S&Ls accept deposits from people and then lend that money to others,
just like commercial banks. But while commercial banks usually focus on
giving business loans, S&Ls mostly focus on giving residential mortgage
loans (home loans).
Because of this difference, the financial performance of commercial
banks and S&Ls has often been different. In recent decades, however,
government deregulation has allowed S&Ls more freedom in how they
use their funds. Now, their activities look more similar to commercial
banks.
S&Ls can be owned by shareholders, but most are mutual
organizations—meaning they are owned by their depositors.
Savings Banks are similar to S&Ls, but they have usually invested their
funds in a wider range of things. Over time, the differences between
savings banks and S&Ls have become very small. Like S&Ls, most savings
banks are also mutual (owned by depositors).
Like commercial banks, savings institutions also use the federal funds
market. They lend their extra funds there or borrow short-term funds if
they need them.
Credit Unions
Credit unions are different from commercial banks and savings
institutions in two main ways:
1. They are nonprofit organizations.
2. They only provide services to their members, who must share a
common bond (like working for the same employer or being part of
the same union).
Because of this common bond, credit unions are usually much smaller
than other depository institutions. Most of their funds are used to give
loans to their members.
Some of the biggest credit unions are:
● Navy Federal Credit Union
● State Employees Credit Union of North Carolina
● Pentagon Federal Credit Union
Each of these has assets of more than $5 billion.
Role of Nondepository Financial Institutions
Nondepository institutions do not rely on deposits to get funds. Instead,
they use other sources, but they still play an important role in
connecting borrowers and lenders (financial intermediation). These
include:
Finance Companies
● They collect money by selling securities (like bonds).
● Then, they lend this money to people and small businesses.
● Similar to banks, but they only focus on specific types of loans or
markets.
● Big companies like American Express and General Electric own
many finance companies.
� Think of them as special lenders who don’t take deposits like banks but
still give loans.
Mutual Funds
● They sell shares to people who want to invest.
● The money collected from all investors is used to buy a basket of
investments (stocks, bonds, etc.).
● They are the largest non-bank financial institution.
Types:
1. Capital Market Mutual Funds →invest in stocks & bonds (longterm).
2. Money Market Mutual Funds →invest in short-term, safer
investments.
● Mutual funds usually buy in big amounts, more than what one small
saver can afford.
● By joining a mutual fund, small investors pool their money and get
a diversified portfolio (many different investments, which reduces
risk).
� Think of them as investment clubs where everyone puts money
together to buy big investments and share the returns.
Securities Firms
● These companies help in buying and selling financial products (like
stocks & bonds).
● Often act as brokers (middlemen between buyer and seller).
● Transactions are standardized for simplicity.
○ Example: Stock trades usually happen in multiples of 100
shares.
● The delivery process (transfer of securities) is also made standard
to make trading faster and easier.
� Think of them as market helpers who make sure buying and selling of
stocks happens smoothly and quickly.
Part 1: Overview of the Financial Environment
Brokers
Brokers charge a fee for helping people buy and sell financial assets .
This fee is usually included in the difference between the price they are
willing to buy at (bid) and the price they are asking for (ask). The fee is
often higher for unusual transactions because it takes more time to find
a buyer or seller. Small transactions also usually have higher fees so
brokers are fairly compensated for their time.
Securities firms don’t just help people buy and sell stocks or bonds—they
also provide investment banking services. This means they help
companies and governments sell new stocks or bonds to raise money.
This process happens in the primary market, which is where securities
are sold for the first time.
When a securities firm underwrites new securities, it basically promises
to help sell them. They might either:
1. Guarantee a price – the company is sure to get a certain amount
of money no matter what.
2. Sell at the best price – the firm tries to get the highest possible
price but doesn’t guarantee it.
Securities firms can also work as dealers. This means they buy securities
themselves and keep them in their own inventory, then sell them to
others.
● A broker mainly makes money from fees by helping people trade
securities.
● A dealer makes money depending on how well the securities they
own increase in value.
Some firms do both—they act as brokers and dealers—so they can earn
money in two ways.
Another service that securities firms offer is advising companies on
mergers and corporate restructuring. They help a company plan
changes in its structure and may also help sell the company’s securities.
Big firms like Morgan Stanley and Goldman Sachs are involved in
brokerage, underwriting, and advisory services.
Insurance Companies
Insurance companies provide policies to protect individuals and
businesses against financial loss from death, illness, or damage to
property. They charge a premium for this service. The money they
collect is invested until it is needed to pay insurance claims.
Insurance companies usually invest in stocks or bonds from companies or
government bonds. By doing this, they help provide funds to businesses
or governments that need money, making them important financial
intermediaries. Their success depends on how well the stocks and bonds
they invest in perform. Big insurance companies include State Farm,
Allstate, Travelers, CNA, and Liberty Mutual.
Pension Funds
Many companies and government agencies offer pension plans to their
employees. Employees, employers, or both put money into these plans
regularly. Pension funds are a good way for people to save for
retirement.
Pension funds manage these contributions until employees retire and
withdraw the money. The funds are often invested in company stocks or
bonds, or government bonds. Like insurance companies, pension funds
provide money to those who need it and act as important financial
intermediaries.
Comparison of Financial Institutions
Financial institutions help move money from people who have extra
funds (surplus units) to those who need funds (deficit units).
1. Depository institutions take deposits from surplus units and give
loans to deficit units.
2. Finance companies sell securities, like commercial paper, to
investors and use that money to lend to deficit units.
3. Securities firms, insurance companies, and pension funds also
collect funds from investors and provide them to those who need
financing.
This way, financial institutions play a key role in moving money
efficiently between those who have it and those who need it.
Exhibit 1.3: Comparison of Roles among Financial Institutions
Depository Institutions (like Commercial Banks, Savings Institutions,
Credit Unions)
● Surplus units (people or entities with extra money) deposit their
funds in these institutions.
● These institutions then provide loans to deficit units (firms,
government agencies, or some individuals who need funds).
Finance Companies
● They get money from surplus units by issuing securities (like
bonds).
● Then, they lend this money to deficit units.
Mutual Funds
● Surplus units buy shares from mutual funds.
● Mutual funds use this money to purchase debt and equity securities
from deficit units.
Insurance Companies
● Surplus units pay premiums.
● The insurance companies use this money to invest in stocks and
bonds of deficit units.
Pension Funds
● Employers and employees make contributions.
● Pension funds invest these contributions in securities issued by
deficit units.
Key Point:
● Deficit units get funding from finance companies, mutual funds,
insurance companies, and pension funds.
● Because insurance companies and pension funds buy large amounts
of stocks and bonds, they provide a lot of funding to big deficit
units like corporations and government agencies.
● Financial institutions that invest money from surplus units are
called institutional investors.
Securities Firms
● Though not shown in Exhibit 1.3, securities firms are important.
● They help move money between financial institutions and deficit
units by acting as brokers.
● Sometimes, funds go directly from surplus units to deficit units
through securities transactions, with securities firms helping in the
process.
Role as Monitors of Publicly Traded Firms
● Financial institutions also watch over publicly traded firms.
● Insurance companies, pension funds, and some mutual funds are
big investors in stocks, so they can influence how these firms are
managed.
● Recently, large institutional investors have criticized management
in certain firms, which has led to corporate changes or even firing
of executives.
Institutional Investors and Corporate Control
● Institutional investors don’t just provide money to companies;
they can also influence how companies are run.
● By acting as activist shareholders, they make sure that managers
of publicly traded companies make decisions in the best interest of
the shareholders.
Relative Importance of Financial Institutions
● Exhibit 1.4 shows the sizes of different financial institutions based
on their total assets.
● The percentages show each type’s share of the total assets held by
all financial institutions, which together total about $46 trillion.
Key Figures from Exhibit 1.4:
● Commercial Banks: $11.2 trillion (24%) – largest among depository
institutions.
● Mutual Funds: $11.2 trillion (24%) – largest among nondepository
institutions.
● Pension Funds: $10.2 trillion (22%).
● Insurance Companies: $6.3 trillion (14%).
● Securities Firms: $3.1 trillion (7%).
● Savings Institutions: $1.8 trillion (4%).
● Finance Companies: $1.46 trillion (3%).
● Credit Unions: $758 billion (2%).
Sources and Uses of Funds (Exhibit 1.5)
● Depository institutions serve households with savings.
● Each type of financial institution collects funds from certain
sources (like deposits, premiums, or contributions) and then uses
those funds to provide loans or invest in assets.
Exhibit 1.5: Summary of Sources and Uses of Funds by Financial
Institutions
Financial
Main Sources of Funds
Main Uses of Funds
Institution
Commercia Deposits from
Loans to businesses and
l Banks
households, businesses,
households; purchase of
and government
government and corporate
agencies
securities
Savings
Deposits from
Mortgages and other loans to
Institution
households, businesses,
households; some business
s
and government
loans; purchase of government
agencies
and corporate securities
Credit
Deposits from credit
Loans to credit union members
Unions
union members
Finance
Securities sold to
Loans to households and
Companies
households and
businesses
businesses
Mutual
Shares sold to
Purchase of long-term
Funds
households, businesses,
government and corporate
and government
securities
agencies
Money
Shares sold to
Purchase of short-term
Market
households, businesses,
government and corporate
Funds
and government
securities
agencies
Insurance
Insurance premiums and
Purchase of long-term
Companies
earnings from
government and corporate
investments
securities
Pension
Employer/employee
Purchase of long-term
Funds
contributions
government and corporate
securities
Key Points:
● Households with savings use depository institutions and finance
companies.
● Large corporations and governments that issue securities get
financing from all types of financial institutions.
● Different regulations apply to different financial institutions, which
can give some an advantage over others.
Consolidation of Financial Institutions
● Many financial institutions have merged in recent years to reduce
costs and serve more customers efficiently.
● Commercial banks acquire other banks to handle more business
with the same infrastructure, lowering average costs.
● Savings institutions consolidate to save costs in mortgage
lending.
● Insurance companies merge to reduce the average cost of
providing insurance services.
● From the 1980s to 2000s, regulations became less strict, allowing
financial institutions to offer more types of services (economies of
scope).
● Commercial banks have merged with savings institutions, securities
firms, finance companies, mutual funds, and insurance companies.
● Financial conglomerates allow customers to get all financial
services from one place and reduce risk because they are more
diversified.
Example:
● Wells Fargo started as a commercial bank but now offers
mortgages, small business loans, consumer loans, real estate,
brokerage, investment banking, online financial services, and
insurance.
Wells Fargo Example – Diversified Financial Services
● Wells Fargo emphasizes that it is more than a traditional bank; it
is a diversified financial services company.
● Being diversified allows it to handle downturns better because
different parts of the financial industry are affected differently at
any given time.
Typical Structure of a Financial Conglomerate
● A financial conglomerate is a company that owns multiple types of
financial services, such as banking, mortgages, brokerage, and
insurance.
● In the past, each type of financial service had high barriers to
entry, so only a few firms competed in each area.
● Today, these barriers are lower, allowing specialized firms to
expand into other financial services, often by acquiring other
companies.
● Many financial conglomerates now consist of originally
independent institutions that have become subsidiaries of the
larger conglomerate.
Impact of Consolidation on Competition
● As financial institutions expand into new services, competition
increases.
● This often leads to lower prices for customers.
● Consolidation also improves convenience:
○ Individual customers can get life/health insurance,
brokerage services, mutual funds, investment advice, bank
deposits, and personal loans from one conglomerate.
○ Corporate customers can get property/casualty insurance,
employee health plans, business loans, restructuring advice,
help issuing debt/equity securities, and pension plan
management.
Exhibit 1.6: Organizational Structure of a Financial Conglomerate
● Holding Company of a Financial Conglomerate
○ Commercial Bank Operations: Commercial loans, other
corporate services
○ Thrift Operations: Mortgages
○ Consumer Finance Operations: Consumer loans, small
business loans
○ Mutual Fund Operations: Stock funds, bond funds, money
market funds
○ Securities Operations: Brokerage, investment banking
○ Insurance Operations: Insurance for individuals, insurance
for firms
Impact of the Internet on Financial Institutions
● The Internet has increased competition among financial
institutions.
● Some banks operate entirely online, which lowers costs. This allows
them to:
○ Offer higher interest rates on deposits
○ Offer lower rates on loans
● Other banks also provide online services to reduce costs and
improve efficiency.
● Insurance companies use the Internet to conduct business online,
lowering costs and forcing competitors to price services more
competitively.
● Brokerage firms also operate online, reducing fees and increasing
competition among brokers.
● Corporations and municipal governments can now issue securities
online and sell directly to investors, bypassing traditional securities
firms. This forces securities firms to compete more effectively for
business.
Global Expansion by Financial Institutions
● Many financial institutions have expanded internationally to use
their expertise in new markets.
● International mergers allow two institutions from different
countries to offer each other’s services to both customer bases.
○ Example: A U.S. bank specializes in lending, while a European
securities firm specializes in underwriting. After merging, the
U.S. bank can serve European clients, and the European firm
can serve U.S. clients.
● Mergers combine skills and customer bases, enabling financial
institutions to provide more services internationally.
● The adoption of the euro by 16 European countries increased
cross-border business, creating more competition among European
financial institutions.
● Many institutions also target emerging markets, offering:
○ Underwriting services for newly privatized companies and
government agencies
○ Loans through expanded commercial banking operations
Impact of the Credit Crisis on Financial Institutions
● During 2004–2006, home prices increased rapidly. Many financial
institutions increased their holdings of mortgages and mortgagebacked securities.
● Some institutions, especially commercial banks and savings
institutions, used loose standards when giving mortgages and did
not carefully check the risk of default.
● Other institutions, including banks, savings institutions, insurance
companies, securities firms, and pension funds, bought large
bundles of mortgages in the secondary market without properly
assessing their risk.
● By 2007–2008, this risky behavior contributed to the mortgage and
credit crisis.
Impact of Mortgage Defaults and the Credit Crisis
● Between 2007–2008, homeowners started defaulting on their
mortgages, and home values fell sharply.
● By January 2009, about 10% of American homeowners were behind
on payments or had defaulted.
● Mortgage defaults caused the credit crisis, which affected financial
institutions in several ways:
1. Mortgages and mortgage-backed securities lost a lot of
value.
2. Some institutions lost business because customers feared
they might fail.
● Financial institutions rely on funds from surplus units (investors
who trust the institutions). During the crisis, investors became
extremely cautious, even avoiding financially stable institutions,
because limited information about risk was available.
Government Intervention
● On October 3, 2008, Congress passed the Emergency Economic
Stabilization Act of 2008 (the bailout act) to resolve liquidity
problems and restore investor confidence.
● The Treasury injected $700 billion into the financial system, mainly
by buying preferred stock in banks.
● This capital helped large commercial banks cushion losses and
reduced the chance of failure.
● The crisis highlighted the need for better regulations to ensure
financial institutions remain safe.
Summary of Key Points from Chapter 1
1. Role of Financial Markets
○ Financial markets transfer funds from surplus units (those
with extra money) to deficit units (those needing funds).
○ Primary markets issue new securities; secondary markets
allow trading of existing securities.
2. Types of Securities
○ Money market securities: Short-term (less than 1 year).
○ Capital market securities: Long-term, such as bonds,
mortgages, mortgage-backed securities, and stocks.
○ Security prices reflect the present value of expected future
cash flows. Prices change when expectations or risks change.
3. Role of Financial Institutions
○ Depository institutions (commercial banks, savings
institutions, credit unions) provide loans, assess
creditworthiness, and repackage funds to match borrower
needs.
○ Nondepository institutions (finance companies, mutual
funds, pension funds, insurance companies) are major buyers
of securities and fund deficit units.
4. Consolidation and Financial Conglomerates
○ Many financial institutions have merged into conglomerates,
where specialized subsidiaries provide a wide range of
services.
○ Consolidation allows for economies of scale and scope,
improving efficiency, cash flows, and the institution’s overall
value.
○ Conglomerates can offer multiple financial services under one
organization, providing convenience to customers and
reducing risk through diversification.
✨In short:
● Derivatives can protect companies from losses.
● Valuation of securities = Present value of expected cash flows
(adjusted for risk).
● Example: Nike stock’s value depends on dividends + stock price
when sold, but both are uncertain.
● New information (economy, industry, company news) changes how
investors value securities.
✨In short:
● WSJ shows stock performance (prices, highs/lows, volumes).
● Derivatives = contracts linked to another asset.
○ Used for speculation (betting to make profit).
○ Used for risk management (protection/insurance).
✨In short:
● Mortgages = loans for homes (prime = safe, subprime = risky).
● Mortgage-backed securities = investments made from a bunch of
mortgages, risky if many people don’t pay.
● Stocks = ownership in companies, can bring dividends + profit but
also come with higher risk.
� Summary Table (Very Simple)
Type
Examples
Risk
Return
Maturi
Liquidity
ty
Money
T-bills,
Market
Commercial
Low
Low
≤1
High (easy to
year
sell)
Paper, CDs
Capital
Bonds,
Medium
Medium
>1
Varies (bonds:
Market
Mortgages,
–High
–High
year
medium,
Stocks
✅In Short:
stocks: high)
● Money Market Securities = short-term, low risk, low return, very
liquid.
● Capital Market Securities = long-term, higher risk, higher return.
○ Bonds = long-term debt.
○ Mortgages = long-term real estate loans.
○ Stocks = ownership (high risk, high return).
● Investors choose based on how much risk, return, and liquidity they
want.