CHAPTER 2
Financial Markets and
Institutions
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Capital Allocation Process
Types of Market
Recent Trends
Financial Institutions
Stock Markets
Market Efficiency
2-1
Capital Allocation Process
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Businesses, individuals, and governments
often need to raise capital.
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Some individuals and firms have incomes that
exceed their current expenditure.
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The surplus fund they have are accumulated as
savings for some future use.
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Transfer of Funds
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In a well-functioning economy, capital flows
efficiently from those with surplus capital to
those who need it.
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Three ways the capital is transferred:
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Direct transfer
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Indirect transfers through investment bankers
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Indirect transfers through financial intermediary.
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Transfer of Funds
2-4
Types of Markets
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Physical asset Markets VS Financial
asset Markets
Spot Markets VS Futures Markets
Money Markets VS Capital Markets
Primary Markets VS Secondary Markets
Private Markets VS Public Markets
2-5
Physical Asset Markets VS
Financial Asset Markets
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Physical asset Markets are for products that has
physical substance (size, shape). For example:
wheat, cars, real estate, computers, machineries etc.
Thus it is also called “tangible” or “real” assets
market
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Financial asset Markets deal with financial securities
like stocks, bonds, notes, mortgage, derivative.
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Spot Markets VS Futures
Markets
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Spot Markets are markets in which assets are bought
or sold for “on-the-spot” delivery. Spot market prices
are the current prices of the asset.
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Futures Markets are markets in which participants
agree today to buy or sell an asset at some future
date at a particular price. Prices at the futures market
are estimated.
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Transactions in the futures market can reduce risk. This is
called hedging.
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Money Markets VS Capital
Markets
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Money Markets are the markets for short-term, highly
liquid debt securities. NY, London and Tokyo money
markets are the largest in the world.
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Capital Markets are the markets for intermediate or
long-term debt and equity securities. All the stock
exchanges in the world are examples of Capital
Market.
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Primary Markets VS Secondary
Markets
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Primary Markets are the markets in which
corporations raise new capital. When securities are
sold for the first time directly from the issuer it is a
transaction in the primary market.
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Secondary Markets are markets in which existing,
already outstanding, securities are traded among
investors. It is the place where securities are sold
“second-hand”
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Types of Transactions
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Outstanding shares of established publicly owned
companies that are traded in the secondary market
(second-hand stocks trading).
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Additional new shares issued and sold by established
publicly owned companies in the primary market.
This is called “seasoned offerings”
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Initial Public Offerings (IPO) made by companies who
are selling shares for the first time in the stock
exchange. This is called “going public”.
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Private Markets VS Public
Markets
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Private Markets are markets where transactions are
negotiated directly between buyer and seller. These
deals are very customized. Example: bank loans,
insurance etc.
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Public Market are markets in which standardized
contracts are traded on organized exchanges. Large
number of buyers and sellers hold similar securities in
public markets
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Recent Trends
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Some recent trends in financial markets
are:
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Use of technology
Globalization of banking and commerce
Deregulation
Increased Competition
Increased use of derivative securities
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Financial Institutions
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These are companies who act as an
intermediary in between the investors and
borrowers.
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Not involved in direct fund transfers.
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Most of them earns through either
commissions or underwriting
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Financial Institutions
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Commercial banks
Investment banks
Financial services
corporations
Mutual Funds
Credit Unions
Pension Funds
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Insurance Companies
Exchange Traded
Funds
Hedge Funds
Private Equity
Companies
2-15
Investment Banks
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Investment banks are an organization that
underwrites and distributes new investment
securities and helps business obtain funds.
Sometimes they also participate in investment
with their own share of funds along with their
client investors.
They sometimes help the corporations to
design the securities with features that are
currently attractive to investors.
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Commercial Banks
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Commercial banks are the traditional
“departmental store” of finance serving a
variety of savers (deposits) and borrowers
(loans).
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Securitization: The process of pooling
mortgages or other types of loans and then selling
claims or securities against that pool in the
secondary market. Example: MBS
In every country there is a central bank who
monitors and guides all the other commercial
banks. Example: Bangladesh Bank, Federal
Reserve of USA.
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Financial Services Corporation
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Financial Services Corporation are large
conglomerates that combine many
different financial institutions within a
single corporation.
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For example Citigroup owns Citibank
(commercial bank), Smith Barney
(investment bank & brokerage house),
insurance companies, and leasing
companies.
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Mutual Funds
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Mutual Funds are organizations that
pool investor funds to purchase
financial securities and thus divides the
risk and achieve economies of scale in
security analysis and trading costs.
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Money market funds are mutual funds
invested only in instruments traded in
money market.
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Insurance Companies
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Insurance Companies take savings in
the form of annual premiums against a
particular asset. They invest these
funds in stocks, bonds, real estate,
mortgages etc and make payments to
the insured parties in case of the asset
being stolen or broken.
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Stock Market
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The most active secondary market and
most important to financial managers is
the stock market.
There are two basic types of Stock
Markets:
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Physical Location Stock Exchange
Over-the-counter (OTC) Market/Dealer
Market
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Physical Location Exchange
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Physical Location Exchange: Formal Organizations
having tangible physical locations that conduct trades
of designated (listed) securities. Example: New York
Stock Exchange (NYSE), Dhaka Stock Exchange
(DSE).
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Sells trading license or “seats” to brokers which gives
them the right to trade for the investors.
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Over-the-Counter Markets
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Over-the-counter (OTC) markets are a large
collection of brokers and dealers, connected
electronically by telephones and computers, that
provides for trading in unlisted securities. Example:
National Association of Securities Dealers Automated
Quotations (NASDAQ), Central Depository
Bangladesh Limited (CDBL).
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Dealers state the bid price (buying price) of the stocks and
the ask price (selling price). The difference between the two
is the dealer’s profit, known as bid-ask spread.
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Stock Market Efficiency
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When the prices of all the stocks are at
equilibrium most of the time then that market
is said to be efficient.
A market in which prices are close to the
intrinsic values is efficient.
Intrinsic Values are calculated using
information related to the security.
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The more information available in a market about
all the securities the more efficient that market is
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