Capital Markets

(ACFN 615)
Chapter Two
Financial Markets and
Institutions
Nature and Functions of FM
Where do you get a financial market?

Generally speaking, there is no specific place or

location to indicate a financial market.

FM are pervasive in nature since, financial trs are

themselves very pervasive throughout the economic
system.

But, they can be referred to as those centers and

arrangements which facilitate buying and selling of FA,
claims and services.
Functions of FM
◼ Financial markets provide the following three major
economic functions:
❑ Price discovery
❑ Liquidity
❑ Reduced transaction costs

◼ Price discovery:
◼ Since the interactions of buyers and sellers in a financial market
determine the price of the traded asset, they determine the required
return that participants in a financial market demand in order to buy
a financial instrument.

◼ This required return of investors in financial markets signals how the

funds available from those who want to lend or invest funds.
Functions …
◼ Liquidity:
◼ Liquidity is an appealing feature when circumstances
arise that either force or motivate an investor to sell a
financial instrument.
◼ Otherwise, an investor would be compelled to hold on a
financial instrument until either conditions arise that allow
for the disposal of the financial instrument or the issuer is
contractually obligated to pay it off.
◼ For a debt instrument, that is when it matures, whereas
for an equity instrument that is until the company is
either voluntarily or involuntarily liquidated.
Functions …
◼ Liquidity:
◼ All financial markets provide some form of liquidity.
However, the degree of liquidity is one of the factors that
characterize different financial markets.
◼ The more actively that instruments trade in the market,
the greater their liquidity. Moreover, the lower the
market’s trading costs, the greater trading volumes are
likely to be.
◼ Thus a market in which it is cheap and easy to find
counterparties is also likely to be a market in which the
assets exchanged are relatively liquid
Functions …
◼ Reduced Transaction Costs:
◼ This is performed when FM participants are charged and
/or bear the costs of trading a financial instruments.
◼ Key attributes that determine trs costs are:
❑ Asset specificity (organization & execution)
◼ Assets put to alternative use, can be deployed for different tasks without
significant costs
❑ Uncertainty (due to external forces or internal forces)
◼ External: is it readily verifiable or not?
◼ Internal: opportunistic behavior of contracting parties
❑ Frequency of occurrence
◼ A one-time trs reduces costs than frequent trs.
◼ Frequent trs require detailed contracting and should take place within a firm in
order to reduce costs
Functions…
◼ Asset specificity is the degree to which an asset can have use
across multiple situations and purposes.
◼ An asset with a high level of specificity has use in only certain
situations or for certain purposes.
◼ An asset with low specificity has multiple uses and purposes.
◼ Assets specificity applies to capital designed to have a single
function, or labor trained to perform a single task, and has its limited
uses because of some inherent restriction on other possible uses.
◼ The more specific an asset, the lower its potential resale value or
redeployability.
◼ Customized computer software is an example of a highly specific
asset.
Functions …
◼ In general, there are three classes of costs: search and
information costs, contracting and monitoring costs, and costs
of incentive problems.
◼ Search and information costs:
◼ Search costs fall into two categories: explicit costs and implicit
costs. Explicit costs include expenses that may be needed to
advertise one’s intention to sell or purchase a financial
instrument; implicit costs include the value of time spent in
locating a counterparty to the transaction. The presence of
some form of organized financial market reduces search costs.
◼ Information costs are costs associated with assessing a
financial instrument’s investment attributes. In a price efficient
market, prices reflect the aggregate information collected by
all market participants.
Functions …
◼ Cost of contracting and monitoring:
◼ These costs are related to the costs necessary to resolve
information asymmetry problems, when the two parties
entering into the trs possesses limited information on each
other and seek to ensure that the trs obligations are fulfilled.

◼ Costs of incentive problems:

◼ These are costs incurred when there are problems related to
conflict of interest between buyers and sellers having different
incentives for the trs involving financial assets.
FM Classifications:
FM Classifications…
◼ Market performance is usually assessed in terms of
market efficiency, liquidity, and information
production.
◼ Market places are ordinarily organized in attempts to
enhance these performance characteristics, and
examining the principal capabilities of different
market types shows how combinations of
performance characteristics are used.
◼ In this regard, markets may be classified as: private
vs public, primary vs secondary, dealer vs broker,
wholesale vs retail, all display different combinations
of capabilities, and as a result align cost-effectively
with classes of deals presenting different attribute
combinations.
Public Vs Private Markets
❑ Public market
❑ refers to any member of a class of securities
markets in which issues are both initially sold to
and subsequently traded by the public at large.

❑ Information about the nature of public market

securities is usually widely and relatively evenly
distributed, and

❑ Regulations attempt to ensure that agents

potentially have access to new or evolving
information.
Public Vs Private Markets
❖ Private market
❖ refers to any member of a class of markets in
which instruments are traded among a small
number of parties on a negotiated basis.

❖ Information about private market transactions is

usually less widely distributed than it is for public
market transactions.

What is the difference between Public and Private

? markets?
 Primary vs Secondary
involve selling new issues of securities.

Primary public market issues of securities are sold to large numbers

of purchasers who have potentially equal access to public information
Primary

regarding an issuing firm

Primary Private market issues are sold to a smaller number of

possible investors. Information produced for analyzing and selling
private issues is not usually required to be released to the public at
large, because the issue is intended to be sold to a relatively small
number of sophisticated parties.

Primary market agents are concerned mainly with raising new funds, and
depend on an effective distribution network to do successfully. Firms that can
successfully capture the business of floating primary issues are also usually
skilled ar reselling the securities to investors
 Trades in outstanding secondary trs

Secondary trs are used both to invest surplus funds and to

raise cash, and are usually finalized in the stock markets,
the bond markets, or the money markets.

Use: stock markets exchange (national, regional &

Secondary international), over the counter and independent trading
systems as trading locations

Secondary market agents are concerned mainly with

carrying out trades at or near existing market prices.

Secondary trs help evaluate new information about firms that

issue publicly traded securities and also improve the liquidity of
primary securities issues, in the latter case by making it easier to
trade outstanding securities.
P BUYERS SELLERS
R
I
M S
A E
C
R
O
Y N
D
A
R
LENDERS
Y
BORROWERS
Dealer Vs Broker Market

Dealer
• Takes instruments into inventory i.e. they do
trade their own account with a profit motive
from trading than holding.
Broker
• Act as agents for public investors and motivated by
remuneration they received for their services.
• Arrange trs between counterparties without taking a
position themselves. i.e. trade for others not for their
own account
Wholesale Vs Retail Markets
• Securities are traded in large volumes.
• Large volumes in these wholesale markets may not
takes place at the ruling market price due to
Wholesale • The counterparty to a large trade may be
concerned about possible adverse selection (why
the seller is willing to dispose of a large amount of
securities)
• Large trades can affect the price (price inelasticity)

• Are usually completed at or near the current

market price (after allowing for agents’ fees
such as commissions and bid-ask spreads.
• Are not usually thought to be subject to a
Retail
significant degree of adverse selection,
partly because they occur much more
frequently than wholesale trades
• Do have large number of agents
Money markets Vs Capital markets

◼ Money markets:
◼ Deal with financial assets and securities
which have a maturity period of up to one
year (for short-term funds)
◼ Capital markets:
◼ Deal with long-term financial assets: debt
(fixed income i.e. >1 yr maturity) and equity
Foreign Exchange Markets
◼ The term Forex refers to the process of converting home
currency into foreign currencies and vice versa.
◼ The market where Forex takes place is called Forex
market.
◼ Where do you get it?
◼ It doesn’t refer to a market place in the physical sense of
the term.
◼ It consists of: dealers, banks and brokers engaged in the
business of buying and selling Forex. Also central bank
of each country.
◼ Functions of Forex Market (Reading assignment)
Foreign Exchange Markets
◼ There are five market participants in Forex:
◼ End Users: firms, individuals and governments who need foreign
currency in order to acquire goods and services from abroad
◼ Market-makers: large international banks who hold stocks of
currencies to allow the market to operate and who make their
profits through the spread (difference between buying and selling
rates of exchange).
◼ Speculators: banks, that make profits from buying in on market
at the same time as selling in another, taking advantage of small
inconsistencies that develop between markets;
◼ Central banks, which enter the market to attempt to influence
the international value of their currency-perhaps to protect a fixed
rate of exchange, or to influence an allegedly market-determined
rate.
 Market Efficiency
and
Efficient Market Hypothesis
Market Prices and Value

◼ Is the value of an asset equal to its market price? Y/N

If not, why are they different?

No matter how markets are structured, the market price of

an asset is an estimate of its value, which is a function of

[Information, Expectation, and Prices]

Perfect Markets and Efficient Markets
◼ A perfect market is an ideal market where its existence is
full of doubt due to the following characteristics:
❑ Absence of factors inhibiting buying and selling, such
as taxes or transaction costs;
❑ All participants have the same expectations regarding

asset prices, interest rates and other economic factors

❑ Entry to and exist from the market is free

❑ Information has no cost and is freely available to all

market participants
❑ A large number of buyers and sellers, none of whom

dominates the market.

 Perfect Market and Efficient Market
◼ companies and investors do not need capital
markets to be perfect; rather, they need capital
markets to be efficient and to offer fair prices so
they can make reasoned investment and
financing decisions.
◼ An efficient capital market can have the
following features:
❑ Operational efficiency: low trs cost
❑ Price efficiency: inclusive of all information
❑ Allocational efficiency: best allocation of funds
Market Efficiency

The Concept of Market Efficiency

◼ The concept of efficiency is central to finance. Primarily,
the term efficiency is used to describe a market in which
relevant information is impounded into the price of
financial assets.

It is an “informationally efficient” market, as opposed to a

“transactionally efficient” market.
 How much & how
long prices deviate

Market
Efficiency
 Market Efficiency [ME]
1◼ How much and for how long prices deviate from
true price.
❑ The smaller and less persistent the deviations are, the
more efficient a market is.
❑ ME :
◼ does not require the mkt price be equal to true value
at every point in time.
◼ It requires it is that errors in the market price be
unbiased - i.e., prices can be greater than or to less
than true value, as long as these deviations are
random.
 Market Efficiency [ME]
2 How quickly and how well markets react to new
information
The value of an asset should change when new information
that affects any of the input value reaches the market.

Price

Over reaction to “GN”

Delayed response to
“GN”

Efficient Mkt response

to “GN”

Time
Good News is revealed
Market Efficiency [ME]

◼ To examine whether some investors in financial

3
markets are able consistently earn higher
returns than the rest of the market.

If so, this would suggest that

deviations from the market
price were not random and that
markets were not efficient.
 Efficient Market
Hypothesis /EMH/
EMH-Background
◼ The term “efficient market” was first introduced by E.F. Fama
(1965) in his article “The Behavior of stock Prices”. He said –
“in an efficient market, on average, competition will cause the
full effects of new information on intrinsic values to be
reflected “instantaneously” in actual prices”.
◼ EMH is popularly known as Random Walk Theory.
◼ It [EMH] is the proposition that current stock prices fully
reflect available information about the value of the firm,
and there is no way to earn excess profits, (more than the
market overall), by using this information.
◼ The theory of random walks in stock prices actually involves
two separate hypotheses:
❑ Successive price changes are independent, and
❑ The price changes confirm to some probability distribution.
EMH- Background
◼ Arguably, there is no theory in economics or finance
generates more passionate discussion between
challengers and proponents.
◼ Michale Jensen (Harvard Financial Analyst) writes:
❑ “ there is no other proposition in economics which has
more solid empirical evidence supporting it than the
EMH,”
◼ while investment expert Peter Lynch claims
❑ “ Efficient Markets? That is a bunch of junk, crazy

stuff”
EMH- Background
◼ EMH suggests that profiting from predicting price
movements is very difficult and unlikely.
◼ The main engine behind price changes is the
arrival of new information.
◼ A market is said to be “efficient” if prices adjust
quickly and , on average , without bias, to new
information.
◼ So, current prices of securities reflect all
available information at any given time.
◼ Hence, there is no reason to believe that prices
are too high or too low.
Implications of the EMH
◼ The EFM Slogan is: “Trust Market Prices!”
◼ At any point in time, prices of securities in EM reflect all
known information available to investors.
◼ There is no room for fooling investors, as a result, all
investments in EM are fairly priced, i.e. on average investors
get exactly what they pay for.
◼ Fair pricing of all securities does not mean that they will all
perform similarly, or that even the likelihood of rising or falling
in prices is the same for all securities.
◼ As per Capital market theory, the expected return from a
security is primarily a function of its risk.
◼ Price of a security reflects the present value of its expected
future cash flows, which incorporates many factors such as
volatility, liquidity, and risk of bankruptcy.
Implications of the EMH for investors

◼ Paying for investment research will not produce above-

average returns.
◼ Studying published accounts and investment tips will not
produce above-average returns.
◼ There are no bargains (underpriced shares) to be found
on the stock market.
Implications of the EMH for companies
and their managers
◼ The share price of a company fairly reflects its value
and market expectations about its future
performance and returns. Hence, financial manager
should therefore focus on making ‘good’ financial
decisions which increase shareholder wealth
◼ Cosmetic manipulation of accounting information
(window dressing or massaging EPS) will not
mislead the market.
◼ The timing of new issues of shares is not important
since shares are never underpriced.
THREE VERSIONS OF EMH
Three Versions…
◼ EMH predicts that market prices should incorporate all
available information at any point in time.
◼ As there are different kinds of information that influences
security values, financial researchers distinguish among
three versions of EMH depending on what is meant by
the term “all available information”
◼ These are:
◼ Weak Form Efficiency
◼ Semi-strong Form Efficiency
◼ Strong Form Efficiency
The Weak Form
◼ The Weak form of EMH asserts that the Current price
fully incorporates information contained in the past
history of prices only.

◼ The weak form of the hypothesis got its name for a

reason – security prices are arguably the most public as
well as the most easily available pieces of information.

◼ Thus, one should not be able to profit from using

something that “everybody else knows”.

◼ In other words, nobody can detect mis-priced securities

and “beat” the market by analyzing past prices.
The Weak Form
◼ If this form holds, technical analysis (see next slide)
is of no value.
◼ Usually this form is represented as:
Pt = Pt-1 + Expected return + random errort
◼ Prices should change very quickly and to the correct
level when new information arrives and hence they are
said to follow a random walk.
◼ On the other hand, many financial analysist attempt to
generate profits by studying exactly what this hypothesis
asserts is of no value – past stock price series and
trading volume data.
 Technical analysis

cycles and waves candle stick chart

43
Semi-strong Form
◼ The semi-strong form suggests that the current security
prices fully reflect all publicly available information and
expectations about the future.
◼ Publicly available information includes:
❑ Historical price and volume information

❑ Published accounting statements

❑ Information found in annual reports (including earnings and

dividend announcements, annual merger plans)
❑ The financial situation of company’s competitors,

❑ Expectations regarding macroeconomic factors (inflation,

unemployment, GDP growth rates, etc.)
◼ This suggests that prices adjust very rapidly to new
information, and that old information cannot be used to earn
superior returns.
◼ The semi-strong form, if correct, rejects fundamental analysis.
Strong Form

◼ The strong form says that prices fully reflect

all information, whether publicly available or
not.
◼ Even the knowledge of material, non-public
information cannot be used to earn superior
results.
◼ Most studies have found that the markets are
not efficient in this sense.
The EMH Graphically
All historical prices & returns

▪ In this diagram, the

circles represent the Strong Form
amount of information
that each form of the Semi-Strong
EMH includes.
Weak Form
• Note that each
successive form
includes the previous
ones.

All information: public & private

All public information
Implications for Corporate Finance
◼ The EMH has 3 implications for corporate
finance:
❑ The price of a company’s stock cannot be affected
by a change in accounting
❑ Financial managers cannot “time” issues of stocks
and bonds using publicly available information
❑ A firm can sell as many as shares of stocks or
bonds as it desires without depressing prices.

There is conflicting empirical evidence on all three points

 Anomalies

In standard finance theory, anomalies happen when

the performance of a stock or group of stocks deviate
from the assumptions of EMH.

For simplicity, market anomalies can be categorized

into three:
▪ Firm characteristics
▪ Calendar or seasonal anomalies
Firm Characteristics
◼ The Size Effect
❖ Since early 1980’s a number of studies found that the
stocks of small firms (in terms of market value of equity)
typically outperform the stocks of large firms.
❖ It indicates that the small firms are relatively much
riskier, so the investors require more returns due to the
more risk they bear.
❖ Also:
❑ as the companies’ size is small, they can have more
chance to growth their business, and instead the big
company has less room for growing.
❑ the small firm has a lower stock price comparing to the big
firm, and the lower price can make more opportunities to
increase.
Firm Characteristics
◼ The P/E Effect
◼ It has been found that portfolios of “low P/E”
stocks generally outperform portfolios of “high
P/E” stocks.
◼ This may be related to the size effect since
there is a high correlation between the stock
price and the P/E.
◼ It may be that buying low P/E stocks is
essentially the same as buying small
company stocks.
Calendar or seasonal anomalies
◼ Also called temporal anomalies.
◼ Are difficult to rationalize and also suggestive for
inefficiencies.
◼ Include:
❑ The January Effect or year end effect
o Studies of returns in financial markets indicate that the returns in
January are significantly higher than in any other month of the year.
❑ The weekend effect
◼ Refers the differences in returns between Mondays and other days of the
week.
◼ The returns on Mondays are significantly negative, whereas the returns on
every day of the week are not.
Summary of the EMH
◼ Weak form is supported, so technical analysis
cannot consistently outperform the market.
◼ Semi-strong form is mostly supported , so
fundamental analysis cannot consistently
outperform the market.
◼ Strong form is generally not supported. If you
have secret (“insider”) information, you CAN use
it to earn excess returns on a consistent basis.
◼ Ultimately, most believe that the market is very
efficient, though not perfectly efficient. It is
unlikely that any system of analysis could
consistently and significantly beat the market
(adjusted for costs and risk) over the long run.
Financial Institutions - Roles
◼ Financial institutions permit the flow of
funds between borrowers and lenders by
facilitating financial transactions

◼ Why Do FI Exist?
Fact 1 – Stocks are not the most important
source of external financing for businesses

◼ Because so much attention in the media is

focused on the stock market, many people
have the impression that stocks are the most
important sources of financing.
◼ But in US, the stock markets accounted for only
11% of the external financing of US firms (1970-
2000).
◼ Q: Why is the stock market less important
than other sources of financing in the United
States and other countries?
Fact 2 – Issuing marketable securities (debt
and equity) is not the primary way
◼ In US, bonds are far more important sources of
financing than stocks (32% vs 11%).
◼ But , stocks and bonds combined (43%), which
make up the total share of marketable securities,
still supply less than one-half of the external funds
corporations need to finance their activities.
◼ Q: Why don’t businesses use marketable securities
more extensively to finance their activities?
Fact – 3 Indirect finance is many times
more important than
◼ Direct finance involves the sale to households of
marketable securities (such as stocks and bonds).
◼ The 43% share of these marketable securities as a
source of external financing for US businesses actually
greatly overstates the importance of direct finance in
our financial system.
◼ Since 1970, less than 5% of newly issued corporate
bonds and commercial paper and less than one-third
of stocks have been sold directly to US households.
◼ The rest of these securities have been bought primarily
by financial intermediaries (such as insurance
companies, pension funds, and mutual funds.)
Fact – 3 Cont’d
◼ These figures indicate that direct finance is used in
less than 10% of the external funding of American
business.

◼ Because in most countries marketable securities are

an even less important source of finance than in the
US, direct finance is also far less important than
indirect finance in the rest of the world.

◼ Q: Why is this happening?

Fact – 4 Financial intermediaries are the most
important source of external funds.
◼ Empirical studies indicate that, 56% in the United
States, but more than 70% in Germany, Japan, and
Canada banks and other FI are found the primary
source of external funds for businesses.
◼ Such findings suggest that banks in these countries
have the most important role in financing business
activities.
◼ In developing countries, banks play an even more
important role in the financial system than they do
in the industrialized countries.

◼ Q: What is driving this decline?

Fact – 5 The financial system is among the
most heavily regulated sectors
of the economy
◼ The financial system is heavily regulated in
the many developed nations.

◼ Governments regulate financial markets

primarily to promote the provision of
information, and to ensure the soundness
(stability) of the financial system.

◼ Q: Why are financial markets so extensively regulated

throughout the world?
Fact – 6 Limited access to securities market

◼ Individuals and smaller businesses are less likely

to raise funds by issuing marketable securities.
◼ Instead, they most often obtain their financing
from banks.
◼ Only large, well-established corporations have
easy access to securities markets to finance
their activities.

◼ Q: Why do only large, well-known corporations

find it easier to raise funds in securities markets?
Fact – 7 Collateral is a prevalent feature of debt
contracts
◼ Collateral is property that is pledged to a lender to
guarantee payment in the event that the borrower is
unable to make debt payments.
◼ Collateralized debt (also known as secured debt) is
the predominant form of household debt and is
widely used in business borrowing as well.
◼ The majority of household debt consists of
collateralized loans: Your automobile is collateral for
your auto loan, and your house is collateral for your
mortgage.

◼ Q: Why is collateral such an important feature of debt

contracts?
Fact – 8 Debt contracts typically are extremely
complicated legal documents that place substantial
restrictions on the behavior of the borrower.
◼ In all countries, bond or loan contracts typically are
long legal documents with provisions (called
restrictive covenants) that restrict and specify
certain activities that the borrower can engage in.
◼ Restrictive covenants are not just a feature of debt
contracts for businesses; for example, personal
automobile loan and home mortgage contracts
have covenants that require the borrower to
maintain sufficient insurance on the automobile or
house purchased with the loan.
◼ Q: Why are debt contracts so complex and
restrictive?
End of Chapter Two