Chapter Two

The Financial Market Environment

Resume by Cecillia Cung

Financial Institution

• An intermediary that channels the savings of individuals, businesses, and governments into
loans or investments.
• Major types of financial institutions include commercial banks, investment banks,
investment funds, insurance companies, and pension funds. Financial institutions offer a
wide range of products and services for individual, business, and government clients.

Commercial Banks, Investment Banks, and the Shadow Banking System

• Commercial Banks, Institutions that provide savers with a secure place to invest their funds
and that offer loans to individual and business borrowers. Glass-Steagall Act An act of
Congress in 1933 that created the Federal Deposit Insurance Corporation (FDIC) and
separated the activities of commercial and investment banks.
• Investment banks, Institutions that assist companies in raising capital, advise firms on
major transactions such as mergers or financial restructurings, and engage in trading and
market-making activities.
• Shadow Banking System, A group of institutions that engage in lending activities, much
like traditional banks, but that do not accept deposits and therefore are not subject to the
same regulations as traditional banks.
The Relationship Between Institutions and Market

The Money Market

• The money market is a market where investors trade highly liquid securities with
maturities of 1 year or less.
• Marketable Securities, Short-term debt instruments, such as U.S. Treasury bills,
commercial paper, and negotiable certificates of deposit issued by government, business,
and financial institutions, respectively.
• Eurocurrency market International equivalent of the domestic money market.

The Capital Market

• Capital Market, A market that enables suppliers and demanders of long-term funds to
make transactions
• Key Securities Traded: Bonds and Stocks (common stock and preferred stock)
• Broker Markets and Dealer Markets
- liquidity the ability to quickly buy or sell a security without having an impact on the
security’s price. (A desirable feature of secondary markets for traders)
- broker market, the securities exchanges on which the two sides of a transaction, the
buyer and seller, are brought together to trade securities.
 - dealer market, the market in which the buyer and seller are not brought together
directly but instead have their orders executed by securities dealers who “make
markets” in the given security.

The Role of Capital Markets

• A capital market should be an efficient market that establishes correct prices for the
securities that firms sell and allocates funds to their most productive uses.
• The Efficient-Market Hypothesis, which is the basic theory describing the behavior of
such a market

Regulations Governing Financial Institutions

• Federal Deposit Insurance Corporation (FDIC) An agency created by the Glass-Steagall

Act that provides insurance for deposits at banks and monitors banks to ensure their
safety and soundness.
• Gramm-Leach-Bliley Act An act that allows business combinations (i.e., mergers)
between commercial banks, investment banks, and insurance companies and thus permits
these institutions to compete in markets that prior regulations prohibited them from
entering.

Regulations Governing Financial Markets

• Securities Act of 1933 An act that regulates the sale of securities to the public via the
primary market.
• Securities Exchange Act of 1934 An act that regulates the trading of securities such as
stocks and bonds in the secondary market.
• Securities and Exchange Commission (SEC) The primary government agency
responsible for enforcing federal securities laws.

Issuing Common Stock

• Private equity is equity financing that is raised via a private placement, typically by early-
stage firms with attractive growth prospects
• Going Public When a firm wishes to sell its stock in the primary market, it has three
alternatives. It can make (1) a private placement, in which the firm sells new securities
directly to an investor or group of investors; (2) a rights offering, in which the firm sells
new shares to existing stockholders; or (3) a public offering, in which it offers its shares
for sale to the general public. Here we focus on public offerings, particularly the initial
public offering (IPO), which is the first public sale of a firm’s stock.
• An investment bank (such as Morgan Stanley or Goldman Sachs) is a financial
intermediary that specializes in selling new security issues and advising firms with regard
to major financial transactions.