Ch. 2 – Financial Markets and Institutions
Pg. 25
 A strong financial system is a necessary ingredient for a growing and prosperous economy.
 Companies need money (i.e. – to raise capital) in order to grow and they go to the financial markets
and institutions in order to be matched with the savings from households, firms and governments.
 The hard lessons from 2008 stemmed from the exorbitant losses that were experienced by investors
(both intuitional & individual) who had purchased mortgage backed securities.
o Assignment: Create a drawing that visually depicts what a mortgage backed security is and
how it works. 5 points.
Pg. 26
 By the end of 2008, the leading financial institutions in our country were in financial trouble.
 The U.S. Government, through its Troubled Asset Relief Program (TARP), allocated $700 Billion to
purchase or insure the troubled assets of many of the surviving institutions.
 During the time, the financial markets became illiquid. The flow of capital dried up, even for individuals
and companies with the highest credit rating. How did this affect the economy?
 Waiting for the recession to subside, many investors either put their money into banks or purchased
U.S. Treasury Securities. Why?
 Stock prices are determined in the financial markets.
Pg. 27
 The Capital Allocation Process (i.e. – how does capital flow from savers to demanders of capital).
Savers can be households, companies or governments. Demanders can also be these same three
entities.
 Why do savers save? Simply put, they expect to earn a return on their investment. The demanders for
capital must pay this return on investment.
 The Capital Formation Process for Companies
o Direct Transfers – the business sells its stocks or bonds directly to the savers. No financial
institutions are used.
o Indirect Transfers through Investment Banks - an investment bank underwrites (i.e. – serves
as the middleman) and facilitates the issuance of the securities. The company sells its stocks or
bonds to the underwriter, which then sells these same securities to the savers.
 The first time that securities are sold, they are sold in the PRIMARY MARKET.
o Indirect Transfers through a Financial Intermediary – a financial intermediary, such as a bank,
mutual fund company, pension fund, or insurance company, sells its investment to the savers.
With the capital from the savers in hand, the intermediary then purchases the stocks or bonds
of the business who need capital.
 The presence of the intermediaries greatly increase the efficiency of money flowing
through the economy.
Pg. 28
 If the economy does not have a well-functioning financial system, it will be difficult for it to reach its
full potential.
Pg. 29
 TYPES OF FINANCIAL MARKETS
o Physical Asset Markets – are for products such as wheat, autos, real estate, computers and
machinery.
o Financial Asset Markets – Stocks, bonds, and derivative securities.
 Derivatives – any investment whose value is dependent on some other investment.
For example, mortgage backed securities, stock options, call & put options and mutual
funds.
o Spot Markets – markets in which assets are bought on the spot.
o Futures Markets – markets in which the participants agree today to buy or sell an asset at
some future date. Commodities are traded in futures markets and can serve as a Hedge for the
purchasing company. What does this mean?
o Money Markets – markets for short-term, highly liquid debt securities. What are some
examples of instruments traded in the money market? See page 31.
o Capital Markets – markets for intermediate and long-term debt and stocks. See pages 31 & 32.
o Primary Markets – markets in which companies raise new capital.
o Secondary Markets – markets in which existing securities, those that are already outstanding,
are traded.
o Private Markets – markets where transactions are conducted directly between two parties.
Bank loans are an example.
o Public Markets – markets where there are standardized contracts, the contracts are always the
same so that market participants will always know what to expect. Standardization increases
the efficiency of the market because all traders know what to expect when it comes to what is
being bought and sold.
Pg. 30
 It is essential that the financial markets function efficiently, meaning that they must function quickly
and also inexpensively.
 Recent Trends:
o Technological innovation, along with the globalization of banking and international trade, has
led to deregulation in many markets, increasing competition throughout the world.
o Increased use of derivatives throughout the world. Caution: this can be dangerous when
individuals and firms are purchasing investments that they do not fully understand.
Pg. 33
 Derivatives can be used to reduce risk. For example, a delivery company like FedEx can purchase Oil
Futures, a contract that allows them to purchase oil at a set price effectively allowing the company to
lock in their operating costs with regard to oil. If the price of oil rises in the future, FedEx is not hurt b/c
they will have already locked in their costs. This example illustrates how a company can use derivative
securities (a futures contract in this example) to HEDGE away their risk.
 Derivatives can also be used for speculative purposes. For example, you could purpose oil futures
today that are to be delivered in 6 months. You do not wish to take possession of the actual oil.
Instead, you are banking that the price per barrel will rise in the future and as your contract date
nears, you’ll be able to sell your oil futures contract for more than you paid for it.
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 Major Categories of Financial Institutions
o Investment Banks – help corporations (1) design securities, (2) buy securities from the
corporations, (3) and resell these securities to savers.
 Underwriters – since investment banks guarantee to help a firm raise capital, they are
called underwriters.
o Commercial Banks – Bank of America, SunTrust, Citibank, Chase Bank, & Wells Fargo are all
examples. They are the one-stop shopping experience for financial services much like a
department store like Macy’s or Dillards. Historically, they are the major checkable depository
agencies within the country, although credit unions today have infringed somewhat on this
territory.
o Financial Services Corporations – Large conglomerates that combine many different financial
institutions within one company. For example, Citigroup owns Citibank (commercial bank),
Smith Barney (investment bank and securities brokerage), insurance companies, and leasing
companies.
o Credit Unions – Owned by their members, CUs are often the cheapest source of funds
available to borrowers.
o Pension Funds – are retirement plans funded by corporations or government agencies for their
workers.
o Life Insurance Companies – take savings in the form of annual premiums and invest this capital
into stocks, bonds, real estate and mortgages and to make payouts to their policy holders’
beneficiaries when there is a death of one of their customers.
o Mutual Funds – accept money from savers through the sale of their own company’s securities.
Then, with the money from the savers, they use these funds to buy stocks, long-term bonds, or
short-term debt instruments issued by business and government units.
 Primary advantage = instant diversification as mutual funds own over a 100 different
securities.
 Are the cornerstone of most families’ retirement plans as companies have transitioned
to Defined Contribution Plans for their employees.
 Investors buy and sell directly with the company; there is no secondary market.
o Exchange Traded Funds – similar to mutual funds but instead of being offered for sale through
a mutual fund company, they are offered for sale by the actual stock exchanges themselves.
 Are traded in the secondary market
 Examples include Spiders (S&P 500), Diamonds (Dow) and Cubes (Nasdaq).
o Hedge Funds – Similar to mutual funds and ETFs. However, unlike ETFs and mutual funds,
hedge funds are not registered with the SEC. They are essentially large pools of money for
wealthy investors to participate in. Minimum investments to participate in such a fund often
exceed $1 million. Hedge Funds are marketed to institutional investors and to individual
investors with high net worths.
o Private Equity Companies – similar to hedge funds, however, instead of buying stock in a
company, private equity firms actually buy the entire firm and then manage it. Such companies
as Albertson’s, Hertz, and Clear Channel Communications ( the parent company of XL106.7 &
WJRR 104.1) have been purchased by private equity firms in recent years.
 With the exception of Hedge Funds and Private Equity Funds, financial institutions are regulated to
ensure the safety of these institutions and to protect investors.
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 9 of the top investment banks in the world are also listed as commercial banks.
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 Commercial banking used to be simple… A bank would only loan out the funds that it had received
from depositors. A bank held the loan until it matured. The downside to this was that the banks had
limited funding to make new loans as well as the fact that most of their loans were made to businesses
and individuals in their local market. This meant that if the local economy struggled, the bank would be
hurt; in other words, the bank could spread out its risks.
 To address these concerns, the financial system came up with the idea of “securitizing” the loans.
Here’s how the process works:
o An investment bank creates a company that buys a large # of loans from banks from around
the country.
o The investment bank then creates and sells a security that is backed by the loan payments.
o Such investments began to surface in the 1970s.
o Advantages to the banks:
 Banks no longer have to hold their own loans.
 Banks can generate larger revenues annually b/c they can create new loans quicker.
o Mortgage backed securities:
 Traded in the open market
 Reality Hits… What Happened?
o An investment bank purchases $100 million of mortgages and then creates $100 million in new
securities. The securities are divided into 3 classes (tranches). The investment bank gets a
credit ratings company to rate their security, earning the new security instant credit in the
eyes of investors. The 3 classes are separated into Class A, B & C shares. The credit rating of
the Class A shares is the highest so the interest rate to investors is the lowest. As the credit
rating goes down, the interest rate on the Class B & C shares increases.
o Because the economy was buoyed by the mistaken belief that housing prices would never fall,
many people viewed these securities as solid investments. The high credit ratings from such
firms as Moody’s and Standard & Poor’s only exacerbated the future problem.
o When the housing market collapsed, the value of these securities plummeted, destroying the
balance sheets of many financial institutions.
Pg. 39
o
The Stock Market
 The most active secondary market and most important one to financial managers is
the stock market.
 2 types of stock markets
 Physical Exchanges (NYSE)
 Electronic Dealer-Based Markets (Nasdaq, OTC, and ECN markets)
 Physical Location Stock Exchanges
 The NYSE limits the number of people/companies that are allowed to trade on
its floor.
 Trading licenses are auctioned to member organizations and cost about
$50,000 per year.
 The trading platform is an “auction” market where “open outcry” between
buyers and sellers determines each security’s price.
Pg. 40
 OTC Markets & the Nasdaq
o OTC (over the counter) Markets


When a stock is thinly traded, because it may be a new company, small company, or
struggling company, there are few buy and sell orders. The companies, as a result, are
not listed on one of the major exchanges.
To provide liquidity in such instances, the OTC market is a collection of brokers and
dealers connected electronically by telephones and computers, that provides for
trading in the unlisted securities.
 Dealers buy and sell stocks from individual investors from their company’s
own account. The dealers are thus called “market makers” b/c they make a
market for investors when one otherwise might not exist.
 Dealers quote the price that they will pay (BID price) for a stock and the price
at which they will sell (ASK price) their shares at.
 The difference between the bid and the ask is called the BID-ASK SPREAD and
represents the dealer’s mark-up.
Pg. 41 & 42
o


Brokers and dealers who participate in the OTC market are members of a self-regulatory body
known as the National Association of Securities Dealers (NASD), which licenses brokers and
oversees trading.
o The computerized network used by the brokers and dealers is known as the NASDAQ (National
Association of Securities Dealers & Automated Quotations).
o The NASDAQ has grown through the years and has become an organized securities market
that has its own listing requirements.
The Market for Common Stock
o Privately owned companies are called Closely Held Corporations.
o Publicly owned companies – are owned by thousands of investors and can be purchased and
sold in the secondary market.
Types of Stock Market Transactions
o Outstanding Shares traded in the secondary market
o Additional shares sold in the primary market (New Seasoned Issue)
o IPOs made by privately held companies
 The number of new IPOs rises and falls with the stock market. When the market is
strong, many companies go public to bring in new capital and to give their founders
the opportunity to cash out some of their shares. When the economy is contracting,
the number of IPOs fall.
 When the public really wants to buy an IPO b/c it’s a HOT ISSUE, investment banks
often favor selling to large institutional investors, leaving the small individual investors
stuck out in the cold; not being able to buy the new IPO shares.
 Dutch Auction – Google’s stock was sold in a different approach with regard to its IPO.
Investors were allowed to place bids on what they’d pay on a per share basis. Then,
shares were sold to those who had bid the highest, and then to everyone else in a topdown approach until all of the shares were sold. Google’s IPO price turned out to be
$85 per share.
o Companies can go public without raising additional capital. Ford Motor Company did this.
When Henry Ford died, he left a large block of stock to the Ford Foundation. When the
foundation sold the stock to raise funds for charitable purposes, Ford became a publicly traded
company, even though there was no additional capital that was raised.
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 STOCK MARKETS AND RETURNS – Items you must know:
o Last Trade (price of last trade)
o Trade Time (time of last trade)
o Change (% change from previous price)
o Prev Close (the closing price on the previous day)
o Open (the opening price today)
o Bid (the price that investors are bidding to buy at)
o Ask (the price that investors are selling at)
o Day’s Range (the range of prices for that day)
o 52 wk Range (the range of prices for the last 52 weeks)
o Volume (the number of shares that were traded that day)
o Avg Vol (3m) (the average daily volume for the past 3 months)
o Market Cap (market capitalization = # of shares outstanding x current price)
o P/E (price earnings ratio = current price divided by EPS)
o EPS (earnings per share – net income – preferred dividends divided by total # of outstanding
shares)
o Div & Yield (most recent dividend & the most recent dividend divided by the current price)
RESEARCH: WHY DOES A STOCK’S OPENING PRICE OFTEN DIFFER FROM ITS PREVIOUS DAYS’ CLOSING PRICE?
This material is not in the text in this chapter but is needed with regard to stocks. Investors can place one of
two types of orders. They can place a market order or a limit order.
 Market orders are executed at the current market price when the order is received.
 Limit orders place constraints on the order. For instance, if the current price is $20 per share, an
investor who owns the shares could place a limit order to sell his or her stock at $20.50. If the price
rises to $20.50, then the order would be executed. If the price doesn’t reach this limit price, the order
is cancelled. On the flip side, a prospective buyer could place a limit order to buy 100 shares at a price
of $19.30. If the price declines from its current $20 per share price down to $19.30, the buyer’s order
would be executed. If the price doesn’t drop this low, then the order is cancelled.
Pg. 46
 Measuring the Market
o Indexes are designed to show the performance of either the total stock market, a single
industry, or the markets for such securities as small caps, mid caps and large caps.
o The DJIA
 Developed in 1896 by Charles Dow
 Originally included only 10 stocks
 Today, there are 30 stocks included within the index.
 These 30 companies represent almost 20% of the market value of all U.S.
Stocks and all are leading companies in their industries and widely held by U.S.
investors.
o S&P 500
 Created in 1926 by Standard & Poors
 Measures large cap U.S. stock market performance
 It is a weighted index so the largest companies have the greatest influence
 Used by 97% of all money managers and pension plan sponsors.
 Approx. $915 billion is held in index mutual funds designed to mirror this index.
o NASDAQ Composite Index
 Measure the performance of all of the stocks listed on the NASDAQ.
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Includes approx. 3200 companies
Many companies are in the technology sector
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 Stock Market Efficiency
o Market Price – the current price of a stock
o Intrinsic Value – The price at which the stock would sell if all investors had all knowable
information about the company.
o Equilibrium Price – the price that balances buy and sell orders at any given time. The price
remains relatively stable until new information becomes available and causes the price to
change.
o Efficient Market – A market in which the equilibrium price is close to the intrinsic value of the
stock.
 When markets are efficient, investors trade stocks in a confident manner knowing that
they are getting a good price.
Pg. 50
RESEACH “EFFICIENT MARKET HYPOTHESIS

EMH implies that, on average, asset prices are about = to their intrinsic values. If a stock’s price is too
low, rational traders will quickly buy, driving up the price to its intrinsic value. If a stock’s price is too
high, investors will sell the stock, once again, driving it back toward its more realistic, intrinsic value.