Chapter 3

The Financial
Markets and the
Investment
Banking Process
What is a Financial Market?

 A system consisting of individuals and institutions,

instruments, and procedures that brings together
borrowers and savers.
 A mechanism by which borrowers (those with a need
for funds) and lenders (those with excess fund) get
together.
 Financial market is a mechanism of interaction between
SSUs and DSUs
 In Financial Markets financial instruments are traded and
financial transactions are taking place.

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Importance of Financial Markets

 The primary role of financial markets is to facilitate the

flow of funds from individuals and businesses that have
surplus funds to individuals, businesses, and
governments that have needs for funds in excess of their
incomes.
 In developed economies, financial markets help efficiently
allocate excess funds of savers to individuals and
organizations in need of funds for investment or
consumption
– The more efficient the process of funds flow, the
more productive the economy.
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Flow of Funds

 When we borrow, for example, we sacrifice future

income to increase current income; when we save, or
invest, we sacrifice current income in exchange for
greater expected income in the future.
Three financial phases:  Funds transferred
– Young adults borrow from savers to
borrowers:
– Older working adults save
 Direct transfer
– Retired adults use savings  Investment banking
house
 Financial intermediary
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Transfer of Funds
Direct Transfers
Business’s Securities (stocks or bonds)
Business Saver
(Borrower) Funds (Investors)

Indirect Transfers through an Investment Banker

Business Securities Investment Banking
Securities
Saver
(Borrower) Funds House Funds (Investors)

Indirect Transfers through a Financial Intermediary

Business’s Intermediary’s
Business Securities Financial Securities Saver
(Borrower) Funds Intermediary Funds (Investors)
(Loans) (Deposits)

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Market Efficiency

When we speak about market efficiency (financial markets

responds quickly and at a low cost), we generally mean
either economic or informational Efficiency:
 Economic Efficiency: funds are allocated to their optimal use
at the lowest costs in the financial markets
 Transaction costs: Costs associated with buying and
selling investments, including commissions, search costs,
taxes, and so on. If transaction costs are very high
investment will not be attractive
 Informational Efficiency: The prices of investment reflect
existing information and adjust quickly when new information
enters the market.
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Market Efficiency (Cont’d)

 Informational efficiency generally is classified into

one of the following three categories:
1. Weak-form efficiency:
• all information contained in past price movements is
fully reflected in current market prices. Therefore,
information about recent, or past, trends in investment
prices is of no use in selecting ‘‘winning’’ investments.
 an investment has risen for the past three days,
gives us no clues as to what it will do today or
tomorrow.
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Market Efficiency (Cont’d)

2. Semistrong-form efficiency:
 current market prices reflect all publicly available
information
 even under semistrong-form efficiency, insiders (for
example, the executives of companies) can still earn
abnormal returns (returns that exceed those that are
justified by the risks associated with the investments) on
their own companies' investments (Stocks).
3. Strong-form efficiency:
 current prices reflect all pertinent information, both public
and private

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Types of Financial Markets

Money versus Capital markets

• Money markets: the segments of the financial markets in
which the instruments that are traded have maturities equal to
one year or less. Money markets include only debt
instruments (short term; for example, short-term bank loans,
treasury bills, commercial paper and so forth) because equity
instruments (that is, stocks) have no specific maturities.
• Capital markets: The segments of the financial markets in
which the instruments that are traded have maturities greater
than one year. Capital markets include both equity instrument
and such long term debt instruments (example: stocks, bonds,
debentures and so forth).
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Types of Financial Markets (Cont’d)

Debt versus Equity markets

• Debt Markets: Financial markets in which loans are
traded. A debt instrument is a contract that specifies
the amounts as well as the dates, a borrower must
repay a lender.
• Equity Markets: Financial markets in which
corporate stocks are traded. Equity represents
‘ownership’ in a corporation; it entitles the
stockholders to share in future cash distributions
generated from income and from liquidation of firm.
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Types of Financial Markets
(Cont’d)
Primary versus Secondary markets
• Primary Markets: Markets in which various
organizations raise funds by issuing new securities. If
Beximco were to sell a new issue of common stock to
raise capital, this activity would be a primary market
transaction.
• Secondary Markets: Markets in which financial assets
that have previously been issued by various
organizations are traded among investors. if someone
decides to buy 1000 shares of existing Beximco stocks
the purchase would occur in the secondary market.
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Types of General Stock Market
Activities
 Stock Market: It is a place where shares of pubic
listed companies are traded.
We can classify general stock market activities into three distinct
categories:
1. Trading in the outstanding, previously issued shares of
established, publicly owned companies: the secondary
market. The company receive no new money when sales occur.
2. Additional shares sold by established, publicly owned
companies: If Beximco decides to sell (or issue) additional
shares to raise funds for expansion, this transaction is said to
occur in the primary market. The company receive funds.

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Types of General Stock Market
Activities (Cont’d)
3. New public offerings by privately held firms: the
initial public offering (IPO) market; the primary market.
When a privately held company decides to sell some
stock to raise capital needed to grow and expand into new
products, it took its stock public. The company receive
funds.
– Going public: The act of selling stock to the general
public for the first time by a corporation or its principal
stockholders.
– Initial public offering (IPO) market: The market
consisting of stocks of companies that have just gone
public.
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Physical Security Exchanges

• Formal organizations with physical locations that facilitate

trading in designated (" listed") securities. The two major U.S.
stock exchanges are the New York Stock Exchange (NYSE)
and the American Stock Exchange (AMEX).
• In Bangladesh two stock exchanges are there: Dhaka Stock Exchange
(DSE) & Chittagong Stock Exchange (CSE)

• Exchange Members:
– Floor Brokers: House Brokers (agents of investors, for
example, Merrill Lynch and IDLC securities) and
Independent brokers (freelance brokers).
– Specialists: bring buyers and sellers together and
charged with ensuring fair and efficient auction process.
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Securities and Exchange
Commission
• Securities and Exchange Commission: The government
agency that regulates the issuance and trading of stocks and
bonds. The primary elements of SEC regulations include:
– 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 (officers,
directors, major stockholders, or others who might have inside
information about a company's operations).
• BSEC: it was established on 1993 as the regulator of the country’s
capital market through enactment of the SEC Act 1993.
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The Investment Banking
Process
• Investment Banker: An organization that underwrites and
distributes new issue of securities; it helps business and
other entities obtained needed financing. For example;
Morgan Stanley, Goldman Sachs, IDLC investment,
LankaBangla investment.
• Investment Bankers perform three types of tasks:
i. They help corporations design securities with the
features that are most attractive to investors given
existing market conditions;
ii. They buy these securities from the corporation; and
iii. They resells the securities to investors (savers).
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Shelf Registration

• Shelf Registration: Securities registered with the

SEC for sale at a later date; the securities are held
“on the shelf” until the sale.
• Shelf registration is a method for publicly traded
companies to register new stock offerings without
having to issue them immediately. Instead, the
securities can be issued at any time within a two-year
period, allowing a company to adjust the timing of the
sales to take advantage of more favorable market
conditions.

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Financial Intermediaries

• Financial Intermediaries: Specialized

financial firms that facilitate the transfer of
funds from savers to borrowers.

– Types of Financial Intermediaries includes:

Commercial banks, Credit unions, Savings and
loan associations, Mutual funds, Whole life
insurance companies, Pension funds etc.

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Financial Intermediation
Process
• Financial intermediation: The process by
which financial intermediaries transform funds
provided by savers into funds used by
borrowers.

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