Chapter 2 Financial Markets and Institutions Learning Objectives
After reading reading this chapter, students should be able to:
Identify the dierent types of nancial markets and nancial institutions, and explain how these markets and institutions enhance capital allocation.
Explain how the stock market operates, and list the distinctions between the dierent types of stock markets.
Explain how the stock market has performed in recent years.
iscuss the importance of market e!ciency, and explain why some markets are more e!cient than others.
e"elop a simple understanding of beha"ioral nance.
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Lecture 'uggestions
#hapter $ presents an o"er"iew of nancial markets and institutions. %tudents denitely ha"e an interest in nancial markets and institutions. &e base our lecture on the integrated case. 'he case goes systematically through the key points in the chapter, and within a context that helps students see the real world rele"ance of the material in the chapter. &e ask the students to read the chapter, and also to (look o"er) the case before class. *owe"er, our class consists of about +, students, many of whom "iew the lecture on '-, so we cannot count on them to prepare for class. or this reason, we designed our lectures to be useful to both prepared and unprepared students. %ince we ha"e easy access to computer pro/ection e0uipment, we generally use the electronic slide show as the core of our lectures. &e make the electronic slides a"ailable to our students, and we strongly suggest to our students that they print a copy of the PowerPoint slides for the chapter and bring it to class. 'his will pro"ide them with a hard copy of our lecture, and they can take notes in the space pro"ided. %tudents can then concentrate on the lecture rather than on taking notes. &e do not stick strictly to the slide show1we go to the board fre0uently to present somewhat dierent examples, to help answer 0uestions, and the like. &e like the spontaneity and change of pace trips to the board pro"ide, and, of course, use of the board pro"ides needed 2exibility. Also, if we feel that we ha"e co"ered a topic ade0uately at the board, we then click 0uickly through one or more slides. 'he lecture notes we take to class consist of our own marked3up copy of the PowerPoint slides, with notes on the comments we want to say about each slide. If we want to bring up some current e"ent, pro"ide an additional example, or the like, we use post3it notes attached at the proper spot. 'he ad"antages of this system are 4+5 that we ha"e a carefully structured lecture that is easy for us to prepare 4now that we ha"e it done5 and for students to follow, and 4$5 that both we and the students always know exactly where we are. 'he students also appreciate the fact that our lectures are closely coordinated with both the text and our exams. 'he slides contain the essence of the solution to each part of the integrated case, but we also pro"ide more in3depth solutions in this Instructor’s Manual. It is not essential, but you might nd it useful to read through the detailed solution. Also, we put a copy of the solution on reser"e in the library for interested students, but most nd that they do not need it. inally, we remind students again, at the start of the lecture on #hapter $, that they should bring a printout of the PowerPoint slides to class6 otherwise, they will nd it di!cult to take notes.
()Y' O C+),$-.: 2 OF /0 ()Y' 1/3inute periods4
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)ns"ers to -nd3o53Chapter 6uestions
237
'he prices of goods and ser"ices must co"er their costs. #osts include labor, materials, and capital. #apital costs to a borrower include a return to the sa"er who supplied the capital, plus a mark3up 4called a (spread)5 for the nancial intermediary that brings the sa"er and the borrower together. 'he more e!cient the nancial system, the lower the costs of intermediation, the lower the costs to the borrower, and, hence, the lower the prices of goods and ser"ices to consumers.
232
In a well3functioning economy, capital will 2ow e!ciently from those who supply capital to those who demand it. 'his transfer of capital can take place in three dierent ways: +. irect transfers of money and securities occur when a business sells its stocks or bonds directly to sa"ers, without going through any type of nancial institution. 'he business deli"ers its securities to sa"ers, who, in turn, gi"e the rm the money it needs. $. 'ransfers may also go through an in"estment bank that underwrites the issue. An underwriter ser"es as a middleman and facilitates the issuance of securities. 'he company sells its stocks or bonds to the in"estment bank, which then sells these same securities to sa"ers. 'he businesses7 securities and the sa"ers7 money merely (pass through) the in"estment bank. 8. 'ransfers can also be made through a nancial intermediary. *ere the intermediary obtains funds from sa"ers in exchange for its own securities. 'he intermediary uses this money to buy and hold businesses7 securities, while the sa"ers hold the intermediary7s securities. Intermediaries literally create new forms of capital. 'he existence of intermediaries greatly increases the e!ciency of money and capital markets.
238
A primary market is the market in which corporations raise capital by issuing new securities. An initial public oering 4I95 is a stock issue in which pri"ately held rms go public. 'herefore, an I9 would be an example of a primary market transaction.
239
A money market transaction occurs in the nancial market in which funds are borrowed or loaned for short periods 4less than one year5. A capital market transaction occurs in the nancial market in which stocks and intermediate1or long3term debt 4one year or longer51are issued. a# A ;.%. 'reasury bill is an example of a money market security. b#
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If people lost faith in the safety of nancial institutions, it would be di!cult for rms to raise capital. 'hus, capital in"estment would slow down, unemployment would rise, the output of goods and ser"ices would fall, and, in general, our standard of li"ing would decline.
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230
inancial markets ha"e experienced many changes during the last two decades. 'echnological ad"ances in computers and telecommunications, along with the globali=ation of banking and commerce, ha"e led to deregulation, which has increased competition throughout the world. As a result, there are more e!cient, internationally linked markets, which are far more complex than what existed a few years ago. &hile these de"elopments ha"e been largely positi"e, they ha"e also created problems for policy makers. &ith these concerns in mind, #ongress and regulators ha"e mo"ed to reregulate parts of the nancial sector following the recent nancial crisis. >lobali=ation has exposed the need for greater cooperation among regulators at the international le"el. actors that complicate coordination include 4+5 the dierent structures in nations7 banking and securities industries6 4$5 the trend toward nancial ser"ices conglomerates, which obscures de"elopments in "arious market segments6 and 485 the reluctance of indi"idual countries to gi"e up control o"er their national monetary policies. %till, regulators are unanimous about the need to close the gaps in the super"ision of worldwide markets. Another important trend in recent years has been the increased use of deri"ati"es. 'he market for deri"ati"es has grown faster than any other market in recent years, pro"iding in"estors with new opportunities but also exposing them to new risks. eri"ati"es can be used either to reduce risks or to speculate. eri"ati"es should allow companies to better manage risk but it7s not clear whether recent inno"ations ha"e (increased or decreased the inherent stability of the nancial system.)
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'he physical location exchanges are tangible entities. Each of the larger ones occupies its own building, allows a limited number of people to trade on its 2oor, and has an elected go"erning body. A dealer market includes all facilities that are needed to conduct security transactions not conducted on the physical location exchanges. 'he dealer market system consists of 4+5 the relati"ely few dealers who hold in"entories of these securities and who are said to (make a market) in these securities6 4$5 the thousands of brokers who act as agents in bringing the dealers together with in"estors6 and 485 the computers, terminals, and electronic networks that pro"ide a communication link between dealers and brokers.
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'he two leading stock markets today are the ?ew @ork %tock Exchange 4?@%E5 and the ?asda0 stock market. 'he ?@%E is a physical location exchange, while the ?asda0 is an electronic dealer3based market.
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'here is an (e!ciency continuum,) with the market for some companies7 stocks being highly e!cient and the market for other stocks being highly ine!cient. 'he key factor is the si=e of the company1the larger the rm, the more analysts tend to follow it and thus the faster new information is likely to be re2ected in the stock7s price. Also, dierent companies communicate better with analysts and in"estors6 and the better the communications, the more e!cient the market for the stock. Highly Inefficient
Highly Efficient
Small companies not followed by many analysts. Not much contact with investors. Large companies followed by many analysts. Good communications with investors.
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Answers and Solutions
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237
a# alse6 deri"ati"es can be used either to reduce risks or to speculate. b# 'rue6 hedge funds ha"e large minimum in"estments and are marketed to institutions and indi"iduals with high net worths. *edge funds take on risks that are considerably higher than that of an a"erage indi"idual stock or mutual fund. c# alse6 hedge funds are largely unregulated because hedge funds target sophisticated in"estors. d# 'rue6 the ?@%E is a physical location exchange with a tangible physical location that conducts auction markets in designated securities. e# alse6 a larger bid3ask spread means the dealer will reali=e a higher prot.
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Integrated Case
237
'yth =arry > Copany Financial Markets and Institutions )ssue that you recently graduated "ith a degree in ?nance and have just reported to "ork as an investent adviser at the brokerage ?r o5 'yth =arry > Co# Your ?rst assignent is to e@plain the nature o5 the %#'# ?nancial arkets to Michelle AargaB a pro5essional tennis player "ho recently cae to the %nited 'tates 5ro Me@ico# Aarga is a highly ranked tennis player "ho e@pects to invest substantial aounts o5 oney through 'yth =arry# 'he is very bright there5oreB she "ould like to understand in general ters "hat "ill happen to her oney# Your boss has developed the 5ollo"ing Duestions that you ust use to e@plain the %#'# ?nancial syste to Aarga# )#
!hat are the three priary "ays in "hich capital is trans5erred bet"een savers and borro"ersE (escribe each one#
)ns"er: 'ho" '237 through '238 here#G $rans5ers o5 capital can be ade 174 by direct trans5er o5 oney and securitiesB 124 through an investent bankB or 184 through a ?nancial interediary# In a direct trans5erB a business sells its stocks or bonds directly to investors 1savers4B "ithout going through any type o5 institution# $he business borro"er receives dollars 5ro the saversB and the savers receive securities 1bonds or stock4 in return# I5 the trans5er is ade through an investent bankB the investent bank serves as a iddlean# $he business sells 0
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its securities to the investent bankB "hich in turn sells the to the savers# )lthough the securities are sold t"iceB the t"o sales constitute one coplete transaction in the priary arket# I5 the trans5er is ade through a ?nancial interediaryB savers invest 5unds "ith the interediaryB "hich then issues its o"n securities in e@change# =anks are one type o5 interediaryB receiving dollars 5ro any sall savers and then lending these dollars to borro"ers to purchase hoesB autoobilesB vacationsB and so onB and also to businesses and governent units# $he savers receive a certi?cate o5 deposit or soe other instruent in e@change 5or the 5unds deposited "ith the bank# Mutual 5undsB insurance copaniesB and pension 5unds are other types o5 interediaries# =#
!hat is a arketE (iHerentiate bet"een the 5ollo"ing types o5 arkets: physical asset arkets versus ?nancial asset arketsB spot arkets versus 5utures arketsB oney arkets versus capital arketsB priary arkets versus secondary arketsB and public arkets versus private arkets#
)ns"er: 'ho" '239 and '23/ here#G ) arket is a venue "here assets are bought and sold# $here are any diHerent types o5 ?nancial arketsB each one dealing "ith a diHerent type o5 ?nancial assetB serving a diHerent set o5 custoersB or operating in a diHerent part o5 the country# Financial arkets diHer 5ro physical asset arkets in that realB or tangibleB assets such as achineryB real estateB and agricultural products are traded in the physical asset arketsB but Chapter 2: Financial Markets and Institutions *You
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?nancial securities representing clais on assets are traded in the ?nancial arkets# 'pot arkets are arkets in "hich assets are bought or sold 5or on3the3spotJ deliveryB "hile 5utures arkets are arkets in "hich participants agree today to buy or sell an asset at soe 5uture date# Money arkets are the arkets in "hich debt securities "ith aturities o5 less than one year are traded# e" YorkB LondonB and $okyo are ajor oney arket centers# Longer3 ter securitiesB including stocks and bondsB are traded in the capital arkets# $he e" York 'tock -@change is an e@aple o5 a capital arketB "hile the e" York coercial paper and $reasury bill arkets are oney arkets# ,riary arkets are arkets in "hich corporations raise capital by issuing ne" securitiesB "hile secondary arkets are arkets in "hich securities and other ?nancial assets are traded aong investors a5ter they have been issued by corporations# ,rivate arketsB "here transactions are "orked out directly bet"een t"o partiesB are diHerentiated 5ro public arketsB "here standardiKed contracts are traded on organiKed e@changes# C#
!hy are ?nancial arkets essential 5or a healthy econoy and econoic gro"thE
)ns"er: 'ho" '230 here#G In a global conte@tB econoic developent is highly correlated "ith the level and eciency o5 ?nancial arkets and institutions# It is dicultB i5 not ipossibleB 5or an econoy to reach its 5ull potential i5 it doesnt have access to a "ell35unctioning ?nancial syste#
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) healthy econoy is dependent on ecient 5unds trans5ers 5ro people "ho are net savers to ?rs and individuals "ho need capital# !ithout ecient trans5ersB the econoy siply could not 5unction# ObviouslyB the level o5 eployent and productivityB hence our standard o5 livingB "ould be uch lo"er# $here5oreB it is absolutely essential that our ?nancial arkets 5unction ecientlyNnot only DuicklyB but also at a lo" cost# (#
!hat are derivativesE +o" can derivatives be used to reduce riskE Can derivatives be used to increase riskE -@plain#
)ns"er: 'ho" '23 here#G (erivatives are any ?nancial asset "hose value is derived 5ro the value o5 soe other underlyingJ asset# (erivatives can be used either to reduce risks or to speculate# For an e@aple o5 risk reductionB suppose an iporters costs rise and its net incoe 5alls "hen the dollar 5alls relative to the yen# $he copany could reduce its risk by purchasing derivatives "hose values increase "hen the dollar declines# $his is a hedging operationB and its purpose is to reduce risk e@posure# 'peculationB on the other handB is done in the hope o5 high returnsB but it raises risk e@posure# -#
=riey describe each o5 the 5ollo"ing ?nancial institutions: investent banksB coercial banksB ?nancial services corporationsB pension 5undsB utual 5undsB e@change traded 5undsB hedge 5undsB and private eDuity copanies#
)ns"er: 'ho" '23; here#G Investent banks are organiKations that under"rite and distribute ne" investent securities and help businesses obtain ?nancing#
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Coercial banks are the traditional departent stores o5 ?nance serving a variety o5 savers and borro"ers# +istoricallyB they "ere the ajor institutions that handled checking accounts and through "hich the Federal .eserve 'yste e@panded or contracted the oney supply# $odayB ho"everB several other institutions also provide checking services and signi?cantly inuence the oney supply# ConverselyB coercial banks are providing an ever3"idening range o5 servicesB including stock brokerage services and insurance# Financial services corporations are large congloerates that cobine any diHerent ?nancial institutions "ithin a single corporation# Most ?nancial services corporations started in one area but have no" diversi?ed to cover ost o5 the ?nancial spectru# ,ension 5unds are retireent plans 5unded by corporations or governent agencies 5or their "orkers and are adinistered priarily by the trust departents o5 coercial banks or by li5e insurance copanies# ,ension 5unds invest priarily in bondsB stocksB ortgagesB and real estate# Mutual 5unds are corporations that accept oney 5ro savers and then use these 5unds to buy stocksB long3ter bondsB or short3ter debt instruents issued by businesses or governent units# $hese organiKations pool 5unds and thus reduce risks by diversi?cation# -@change traded 5unds 1-$Fs4 are siilar to regular utual 5unds and are o5ten operated by utual 5und copanies# -$Fs buy a port5olio o5 stocks o5 a certain typeN
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5or e@aple '>, /Nand then sell their o"n shares to the public# +edge 5unds are siilar to utual 5unds because they accept oney 5ro savers and use the 5unds to buy various securitiesB but there are soe iportant diHerences# !hile utual 5unds are registered and regulated by the '-CB hedge 5unds are largely unregulated# $his diHerence in regulation stes 5ro the 5act that utual 5unds typically target sall investorsB "hereas hedge 5unds typically have large iniu investents 1o5ten e@ceeding P7 illion4 that are arketed priarily to institutions and individuals "ith high net "orths# $hese 5unds received their nae because they traditionally "ere used "hen an individual "as trying to hedge risks# ,rivate eDuity copanies are organiKations that operate uch like hedge 5undsB but rather than buying soe o5 the stock o5 a ?rB private eDuity players buy and then anage entire ?rs# Most o5 the oney used to buy the target copanies is borro"ed# F#
!hat are the t"o leading stock arketsE (escribe the t"o basic types o5 stock arkets#
)ns"er: 'ho" '23< here#G $he t"o leading stock arkets today are the e" York 'tock -@change and the asdaD stock arket# $here are just t"o basic types o5 stock arkets: 174 physical location e@changesB "hich include the e" York 'tock -@change 1Y'-4B and 124 electronic dealer3based arkets that include the asdaD stock arketB the less 5oral over3 the3counter arketB and the recently developed electronic counications net"orks 1-Cs4#
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$he physical location e@changes are 5oral organiKations having tangibleB physical locations and trading in designated securities# $here are e@changes 5or stocksB bondsB cooditiesB 5uturesB and options# $he physical location e@changes are conducted as auction arkets "ith securities going to the highest bidder# =uyers and sellers place orders "ith their brokers "ho then e@ecute those orders by atching buyers and sellersB although specialists assist in providing continuity to the arkets# $he electronic dealer3based arket is ade up o5 hundreds o5 brokers and dealers around the country "ho are connected electronically by telephones and coputers# $he dealer3based arket 5acilitates trading o5 securities that are not listed on a physical location e@change# ) dealer arket is de?ned to include all 5acilities that are needed to conduct security transactions not ade on the physical location e@changes# $hese 5acilities include 174 the relatively 5e" dealers "ho hold inventories o5 these securities and "ho are said to ake a arket in these securities 124 the thousands o5 brokers "ho act as agents in bringing the dealers together "ith investors and 184 the coputersB terinalsB and electronic net"orks that provide a counication link bet"een dealers and brokers# (ealers continuously post a price at "hich they are "illing to buy the stock 1the bid price4 and a price at "hich they are "illing to sell the stock 1the ask price4# $he ask price is al"ays higher than the bid priceB and the diHerence 1or bid3ask spreadJ4 represents the dealers arkupB or pro?t#
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I5 )pple Coputer decided to issue additional coon stock and Aarga purchased 7 shares o5 this stock 5ro 'yth =arryB the under"riterB "ould this transaction be a priary or a secondary arket transactionE !ould it ake a diHerence i5 Aarga purchased previously outstanding )pple stock in the dealer arketE -@plain#
)ns"er: 'ho" '237 here#G I5 Aarga purchased ne"ly issued )pple stockB this "ould constitute a priary arket transactionB "ith 'yth =arry acting as an investent banker in the transaction# I5 Aarga purchased usedJ stockB then the transaction "ould be in the secondary arket# +#
!hat is an initial public oHering 1I,O4E
)ns"er: 'ho" '2377 here#G )n initial public oHering 1I,O4 occurs "hen a copany issues stock in the public arket 5or the ?rst tie# Qoing publicJ enables a copanys o"ners to raise capital 5ro a "ide variety o5 outside investors# Once issuedB the stock trades in the secondary arket# 'ho" '2372 and '2378 here# %se these slides to sho" arket per5orance in recent years and ho" to read a stock Duote#G I#
!hat does it ean 5or a arket to be ecientE -@plain "hy soe stock prices ay be ore ecient than others#
)ns"er: 'ho" '2379 here#G I5 arkets are ecientB investors can buy and sell stocks and be con?dent that they are getting good prices# I5 arkets are inecientB then investors "ill be a5raid to investB and this "ill lead to a poor allocation o5 capital and
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econoic stagnation# 'o 5ro an econoic standpointB arket eciency is clearly good# $here is an eciency continuuBJ "ith the arket 5or soe copanies stocks being highly ecient and that 5or other stocks highly inecient# $he key 5actor is the siKe o5 the copanyNthe larger the ?rB the ore analysts tend to 5ollo" itB and thus the 5aster ne" in5oration is likely to be reected in the stocks price# )lsoB diHerent copanies counicate better "ith analysts and investors generallyB and the better the counicationsB the ore ecient the arket 5or the stock# R#
)5ter your consultation "ith MichelleB she "ants to discuss these t"o possible stock purchases: 174 !hile in the "aiting roo o5 your oceB she overheard an analyst on a ?nancial $A net"ork say that a particular edical research copany just received F() approval 5or one o5 its products# On the basis o5 this hotJ in5orationB Michelle "ants to buy any shares o5 that copanys stock# )ssuing the stock arket is highly ecientB "hat advice "ould you give herE
)ns"er: 'ho" '237/ here#G I5 the arket is highly ecientB this stocks arket price "ill have already incorporated this in5oration# 'o its probably too late 5or her to capitaliKeJ on the in5oration# $here "ould be no gains to be ade on this stock on the basis o5 the recent F() approval because its price already reects this in5oration#
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124 'he has read a nuber o5 ne"spaper articles about a huge I,O being carried out by a leading technology copany# 'he "ants to purchase as any shares in the I,O as possible and "ould even be "illing to buy the shares in the open arket iediately a5ter the issue# !hat advice do you have 5or herE
)ns"er: 'ho" '2370 here#G ot all I,Os are "ell received# )ndB even i5 you are able to identi5y a hotJ issueB it is o5ten dicult to purchase shares in the initial oHering# $hese deals are generally oversubscribedB "hich eans that the deand 5or shares at the oHering price e@ceeds the nuber o5 shares issued# In such instancesB investent bankers 5avor large institutional investors 1"ho are their best custoers4B and sall investors ?nd it hardB i5 not ipossibleB to get in on the ground oor# 'he can purchase the stock in the a5ter3arketB but evidence suggests that i5 you do not get in on the ground oor the average I,O underper5ors the overall arket over the long run# S#
+o" does behavioral ?nance e@plain the real "orld inconsistencies o5 the ecient arkets hypothesis 1-M+4E
)ns"er: 'ho" '237 here#G =ehavioral ?nance borro"s insights 5ro psychology to better understand ho" irrational behavior can be sustained over tie# It is o5ten dicult 5or traders to take advantage o5 ispriced assets# In additionB e@perients indicate that investors and anagers behave diHerently in do"n arkets than they do in up arkets# )lsoB individuals tend to overestiate their true abilities# $his overcon?dence ay ste 5ro t"o other biases: sel53attribution bias and Chapter 2: Financial Markets and Institutions *You
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hindsight bias# 'el53attribution bias re5ers to peoples tendency to ascribe any success they have in an activity to their o"n talentsB "hile blaing 5ailure on bad luck rather than on their ineptitude# +indsight bias is the tendency o5 people to believeB a5ter an event has occurredB that they predicted it be5ore it actually happened#
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