The Financial Markets and the Investment
Banking Process
What are financial markets and what role do they play in
improving the standard of living in an economy?
Why is it important for financial markets to be somewhat
efficient?
Why are there so many different types of financial markets?
What is an investment banking house?
What is a financial intermediary?
How do financial markets in the U.S. differ from financial
markets in other parts of the world?
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What is a Financial Market?
A mechanism by which borrowers (those
with a need for funds) and lenders (those
with excess fund) get together.
The primary role of financial markets is to
facilitate the flow of funds from those who
have surplus funds to those who have
needs for funds in excess of their current
income.
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Flow of Funds
Three financial phases
 Young adults borrow
 Older working adults save
 Retired adults use savings
Funds transferred from savers to borrowers
 Direct transfer
 Investment banking house
 Financial intermediary
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Transfer of Funds
Direct Transfers
Borrower
(Business)
Securities (stocks or bonds)
Saver
(Investor)
Dollars
Indirect Transfers through an Investment Banker
Borrower Securities
(Business) Dollars
Securities
Investment Banker
Dollars
Saver
(Investor)
Indirect Transfers through a Financial Intermediary
Borrower
(Business)
Business
Securities
Dollars
(Loans)
Financial
Intermediary
Intermediary
Securities
Dollars
(Deposits)
Saver
(Investor)
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Market Efficiency
Economic Efficiency—funds are allocated to their
optimal use at the lowest costs
Informational Efficiency—investment prices are
adjusted quickly to reflect current information
 Weak-form—all information contained in past price
movements is reflected in current market prices
 Semistrong-form—current prices reflect all publicly available
information
 Strong-form form—current prices reflect all pertinent
information, both public and private
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Types of Financial Markets
Money versus capital markets
Debt versus equity markets
Primary versus secondary markets
Derivatives markets
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General Stock Market Activities
The secondary market—trading of
outstanding, previously issued shares of
stock
The primary market—new shares of
stock sold by companies to raise funds
Initial Public Offering (IPO) market—
privately/closely held firms go public for
the first time
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Stock Markets
Physical stock exchanges
 NYSE, AMEX, and regional exchanges
Exchange members
 Floor brokers
• House broker
• Independent broker
 Specialists
Listing requirements
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Stock Markets
Over-the-Counter Markets and the Nasdaq
 Network of brokers and dealers
 Auction market
 Organized Investment Network
 Electronic Communications Networks
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Regulation of Securities Markets
Securities and Exchange Commission (SEC)
 Jurisdiction over most interstate offerings of new
securities to the general public
 Regulation of national securities exchanges
 Power to prohibit manipulation of securities’ prices
 Control over stock trades by corporate insiders
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The Investment Banking Process
Investment Banker
 Helps corporations design securities
attractive to investors
 Buys these securities from the corporation
 Resells the securities to investors
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The Investment Banking Process
Raising Capital: Stage I Decisions
 Dollars to be raised
 Type of securities used
 Competitive bid versus negotiated deal
 Selection of an investment banker
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The Investment Banking Process
Raising Capital: Stage II Decisions
•
•
Reevaluating the initial decisions
Best efforts or underwritten issues
•
•
•
•
Underwritten Arrangement—investment bank
guarantees the sale by purchasing the securities from
the issuer
Best Effort Arrangement—investment bank gives no
guarantee that the securities will be sold
Issuance (flotation) Costs
Setting the offering price
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The Investment Banking Process
Selling Procedures
 Underwriting Syndicate—to spread risk
 Lead Underwriter—manages the distribution
 Selling Group—network of brokerage firms
Shelf Registration—approved by the SEC, but
held for sale at a later date
Maintenance of the Secondary Market—
investment banker wants to “make a market”
for the issue (especially for an IPO)
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International Stock Markets
U.S. stock markets
 Less than 40% of the total value worldwide
 Still dominate the international stock markets
U.S. investors can participate in international
markets by through American Depository
Receipts (ADR)
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Types of Financial Intermediaries
Commercial banks
Credit unions
Savings and loan associations
Mutual funds
Whole life insurance companies
Pension funds
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The Roles of Financial Intermediaries
Facilitate the transfer of funds from
those who have funds (savers) to those
who need funds (borrowers)
Manufacture a variety of financial
products
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Benefits of Financial Intermediaries
Improved standard of living
Reduced costs
Risk/diversification
Funds divisibility/pooling
Financial flexibility
Related services
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Financial Organizations in Other Parts of
the World
U.S. financial institutions are more
heavily regulated than foreign
institutions
U.S. financial institutions face greater
limitations on branching, services, and
relationships with non-financial
businesses than foreign institutions
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The Financial Markets and the Investment
Banking Process
What are financial markets?
 The mechanisms by which borrowers and lenders are
brought together.
Why is it important for financial markets to be
somewhat efficient?
 If we can borrow at the lowest cost and invest at the
highest returns, the use of money is efficient and the
standard of living is higher than it otherwise would be.
Why are there so many different types of financial
markets?
 Savers and borrowers have different needs.
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The Financial Markets and the Investment
Banking Process
What is an investment banking house?
 An organization that acts as a middleman to help firms and
governments raise funds by issuing financial instruments
What is a financial intermediary?
 An organization that takes “deposits” and uses the money to
generate returns by creating loans or other investments
How do financial markets in the U.S. differ from financial
markets in other parts of the world?
 U.S. financial markets/intermediaries face greater
restrictions.
 More participants in U.S. markets.
 U.S. financial markets are more efficient.
 More independent financial intermediaries in U.S.
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