Chapter 2

Financial Markets and Institutions

The Capital Allocation Process

Financial Markets
Financial Institutions
Stock Markets and Returns
Stock Market Efficiency
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 Chapter 2 Objectives

• Identify the different types of financial markets and

financial institutions, and explain how these
markets enhance capital allocation.
• Explain how the stock markets operates, and list the
distinction between the different types of stock
markets.
• Explain how the stock market has performed in
recent years.
• Discuss the importance of market efficiency, and
explain why some markets are more efficient than
others.
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 What is a market?

• A market is a venue where goods and services are

exchanged.
• A financial market is a place where individuals and
organizations wanting to borrow funds are brought
together with those having a surplus of funds.

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 Types of Financial Markets

• Physical assets vs. Financial assets

- Physical assets markets are markets for products (e.g. machinery and
computers). Financial markets are markets for bonds and stocks
• Spot vs. Futures
- Spot markets are markets in which assets are bought or sold for ‘on- ---the-
spot’ delivery. Future markets are markets in which participants agree to
buy or sell an asset at some future date.
• Money vs. Capital
- Money markets are the markets for short-term debt securities. Capital
markets are markets for long-term debt and corporate bonds.
• Primary vs. Secondary
• Public vs. Private
- Public markets are markets where standardized contracts are traded on
organized exchanges. Private markets are markets where transaction are
negotiated directly between two parties.

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 Types of Financial Institutions

• Commercial banks: the traditional departmental

store of finance serving a variety of savers and
borrowers.

• Investment banks: an organization that

underwrites and distributes new investment
securities and help businesses obtain financing.

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 The Capital Allocation Process

• In a well-functioning economy, capital flows

efficiently from those who supply capital to those
who demand it.
• Suppliers of capital: individuals and institutions
with “excess funds.” These groups are saving
money and looking for a rate of return on their
investment.
• Demanders or users of capital: individuals and
institutions who need to raise funds to finance their
investment opportunities. These groups are willing
to pay a rate of return on the capital they borrow.
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 How is capital transferred between savers and
borrowers?

• Direct transfers: occurs when a business sells its

stock or bonds directly to savers, without going
through any type of financial institution.
• Investment banks: buys stocks or bonds from
companies and sell these same securities to savers.
• Financial intermediaries: Financial intermediary
(e.g. banks, insurance companies and mutual funds)
obtain funds from savers in exchange for its
securities. The intermediary uses this money to buy
and hold securities, while the savers hold the
intermediary’s securities.
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 Securitization and Its Importance to a Bank

• Solution to banks’ limited funds and local market

conditions
• Help banks to diversify their risks
• An agent bank buy a large no. of loans from other
banks
• Issue securities backed by these loan payments

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 Leading U.S. Stock Exchanges

• New York Stock Exchange

• Nasdaq

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 East Asian Stock Markets

• Japan
– Tokyo Stock Exchange / Japan Exchange Group
– Nikkei Stock Average and TOPIX
• Mainland China
– Shanghai (SSE) and Shenzhen (SZSE) stock exchanges
– “A” shares in RMB
– “B” shares in USD (SSE) and HKD (SZSE)
– QFII program: under the Qualified Foreign Institutional
Investor (QFII) program, foreign investors are allowed
(with limitations) to trade in “A” shares.
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 East Asian Stock Markets (continued)

• Hong Kong
– Hong Kong Securities Exchange / HKEx
– Hang Seng Index
• Taiwan
– Taiwan Stock Exchange Corporation (TSEC)
– Taiwan Stock Index (TAIEX)

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 What is an IPO?

• An initial public offering occurs when a company

issues stock in the public market for the first time
• “Going public” enables a company’s owners to raise
capital from a wide variety of outside investors.
• Once issued, the stock trades in the secondary
market
• Public companies are subject to additional
regulations and reporting requirements.

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 S&P 500 Index, Total Returns: Dividend Yield +
Capital Gain or Loss, 1968-2010

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 Where can you find a stock quote, and what does one
look like? new slide 10

• Stock quotes can be found in a variety of print sources

(The Wall Street Journal or the local newspaper) and
online sources (Yahoo!Finance, CNNMoney, or MSN
MoneyCentral).
Stock Quote for GlaxoSmithKline, July 11, 2011

Source: GlaxoSmithKline (GSK), finance.yahoo.com.

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 Stock Market Transactions

• Applesauce Computer decides to issue additional

common stock. An investor purchases some of the
newly issued shares from the underwriter. Is this a
primary market transaction or a secondary market
transaction?
– Since new shares of stock are being issued, this is a
primary market transaction.

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 Types of Financial Institutions

• Pension funds: retirement plans funded by corporations or

government agencies administered by trust department of commercial
banks.
• Mutual funds: are corporations that accept money from savers and
then use these funds to buy stocks, long-term bonds, or short-term
debt instruments issued by businesses or government
• Exchange traded funds (ETFs): are corporations that buy a) and then
sell their own shares to the public. portfolio of stocks of a certain type
(e.g. S&P 500 or media companies
• Hedge funds: are similar to mutual funds because they accept money
from savers and use the funds to buy various securities. The main
difference between them is that while mutual funds are registered and
regulated by the Securities and Exchange Commission (SEC), hedge
funds are largely unregulated.
• Private equity companies: are organizations that buy and manage
entire firms.

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 What is meant by stock market efficiency?

• Securities are normally in equilibrium and are

“fairly priced.”
• Investors cannot “beat the market” except through
good luck or better information.
• Efficiency continuum
Highly Highly
Inefficient Efficient

Small companies not followed by Large companies followed by

many analysts. Not much contact many analysts. Good
with investors. communications with investors.

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 What are derivatives? How can they be used to
reduce or increase risk?

• A derivative security’s value is “derived” from the

price of another security (e.g., options and futures).
• Can be used to “hedge” or reduce risk. For
example, an importer, whose profit falls when the
dollar loses value, could purchase currency futures
that do well when the dollar weakens.
• Also, speculators can use derivatives to bet on the
direction of future stock prices, interest rates,
exchange rates, and commodity prices. In many
cases, these transactions produce high returns if
you guess right, but large losses if you guess wrong.
Here, derivatives can increase risk.
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