Chapter 2: Financial Markets and Institutions

The Capital Allocation Process

In a well-functioning economy, capital flows efficiently
from those with surplus capital to those who need it.
This transfer can take place in the three ways described
in Figure 2.1.
1. Direct transfers of money and securities, as
shown in the top section, occur when a business sells
its stocks or bonds directly to savers, without going
through any type of financial institution. The business
delivers its securities to savers, who, in turn, give the
Financial Markets
firm the money it needs. This procedure is used mainly
People and organizations wanting to borrow money are
by small firms, and relatively little capital is raised by
brought together with those who have surplus funds in
direct transfers.
the financial markets.
2. As shown in the middle section, transfers may
*Note that markets is plural; there are many different
also go through an investment bank (iBank) such as
financial markets in a developed economy such as that
Morgan Stanley, which underwrites the issue. An
of the United States.
underwriter facilitates the issuance of securities. The
company sells its stocks or bonds to the investment
Types of Markets
bank, which then sells these same securities to savers.
Different financial markets serve different types of
The businesses’ securities and the savers’ money
customers or different parts of the country. Financial
merely “pass through” the investment bank. However,
markets also vary depending on the maturity of the
because the investment bank buys and holds the
securities being traded and the types of assets used to
securities for a period of time, it is taking a risk—it
back the securities. For these reasons, it is useful to
may not be able to resell the securities to savers for as
classify markets along the following dimensions:
much as it paid. Because new securities are involved
1. Physical asset markets versus financial asset
and the corporation receives the sale proceeds, this
markets.
transaction is called a primary market transaction.
Physical asset markets (also called “tangible” or
3. Transfers can also be made through a financial
“real” asset markets) are for products such as
intermediary such as a bank, an insurance company,
wheat, autos, real estate, computers, and
or a mutual fund. Here the intermediary obtains funds
machinery. 
from savers in exchange for its securities. The
Financial asset markets, on the other hand, deal
intermediary uses this money to buy and hold
with stocks, bonds, notes, and mortgages.
businesses’ securities, and the savers hold the
*Financial markets also deal with derivative
intermediary’s securities. For example, a saver
securities whose values are derived from
deposits dollars in a bank, receiving a certificate of
changes in the prices of other assets.
deposit; then the bank lends the money to a business
2. Spot markets versus futures markets. 
in the form of a mortgage loan. Thus, intermediaries
Spot markets are markets in which assets are
literally create new forms of capital—in this case,
bought or sold for “on-the-spot” delivery
certificates of deposit, which are safer and more liquid
(literally, within a few days). 
than mortgages and thus better for most savers to
Futures markets are markets in which
hold. The existence of intermediaries greatly increases
participants agree today to buy or sell an asset
the efficiency of money and capital markets.
at some future date.
3. Money markets versus capital markets. 
In a global context, economic development is highly
Money markets are the markets for short-term,
correlated with the level and efficiency of financial
highly liquid debt securities. The New York,
markets and institutions. It is difficult, if not impossible,
London, and Tokyo money markets are among
for an economy to reach its full potential if it doesn’t
the world’s largest. 
have access to a well-functioning financial system.
Capital markets are the markets for
intermediate- or long-term debt and corporate
stocks.
 individuals and most taxes debt
4. Primary markets versus secondary markets.  institutional
Primary markets are the markets in which Corporate Capital
investors
Issued by Riskier than U.S. Up to 40 4.15% on
corporations raise new capital. bonds corporations; government years AAA bonds,
held by securities but 4.69% on
Secondary markets are markets in which individuals and less risky than BBB bonds
institutional preferred and
existing, already outstanding securities are investors common stocks;
varying degree
traded among investors. of risk within
5. Private markets versus public markets.  bonds depends
on strength of
Private markets, where transactions are Leases Capital Similar to debt
issuer
Risk similar to Generally Similar to
negotiated directly between two parties, are in that firms can corporate bonds 3 to 20 bond yields
lease assets years
differentiated from; rather than
borrow and
* Bank loans and private debt placements with insurance then buy the
companies are examples of private market transactions. assets
Preferred Capital Issued by Generally riskier Unlimited 5.75% to
public markets, where standardized contracts stocks corporations to than corporate 9.5%
individuals and bonds but less
are traded on organized exchanges. institutional risky than
* securities that are traded in public markets (for example, investors common stock
Common Capital Issued by Riskier than Unlimited NA
common stock and corporate bonds) are held by a large stocks corporations to bonds and
number of individuals. individuals and preferred stock;
institutional risk varies from
A healthy economy is dependent on efficient funds investors company to
company
transfers from people who are net savers to firms and
individuals who need capital. 
Recent Trends
Summary of Major Market Instruments, Market Financial markets have experienced many
Participants, and Security Characteristics changes in recent years. Technological advances in
Instrument Market Major Riskiness (4) Original Interest computers and telecommunications, along with the
(1) (2) Participants (3) Maturity Rate on
(5) 6/3/14 (6) globalization of banking and commerce, have led to
U.S. Treasury
bills
Money Sold by U.S.
Treasury to
Default-free,
close to riskless
91 days to
1 year
0.035%
deregulation, which has increased competition
finance federal
expenditures
throughout the world. As a result, there are more
Bankers’ Money A firm’s note, Low degree of Up to 180 0.23% efficient, internationally linked markets, which are far
acceptances but one risk if days
guaranteed by a guaranteed by a more complex than what existed a few years ago. While
bank strong bank
Commercial Money Issued by Low default risk Up to 270 0.09% these developments have been largely positive, they
paper financially
secure firms to
days
have also created problems for policy makers.
Negotiable Money
large investors
Issued by major Default risk Up to 1 0.25%
Globalization has exposed the need for greater
certificates money-center depends on the year cooperation among regulators at the international level,
of deposit commercial strength of the
(CDs) banks to large issuing bank but the task is not easy. Factors that complicate
investors
Money Money Invest in Low degree of No 0.40% coordination include
market Treasury bills, risk specific
mutual funds CDs, and maturity
1. the different structures in nations’ banking and
commercial
paper; held by
(instant
liquidity)
securities industries;
individuals and 2. the trend toward financial services
businesses
Eurodollar Money Issued by banks Default risk Up to 1 0.15% conglomerates, which obscures developments
market time outside the depends on the year
deposits United States strength of the in various market segments; and
issuing bank
Consumer Money Issued by banks, Risk is variable Variable Variable,
3. the reluctance of individual countries to give up
credit,
including
credit unions,
and finance
but
average
control over their national monetary policies.
credit card companies to APR is Still, regulators are unanimous about the need to close
debt individuals 11.05%–
16.35% the gaps in the supervision of worldwide markets.
U.S. Treasury Capital Issued by U.S. No default risk, 2 to 30 0.403% on
notes and government but price will years 2-year to Another important trend in recent years has been the
bonds decline if 3.437% on
interest rates 30-year increased use of derivatives. A derivative is any security
rise; hence,
there is some
bonds
whose value is derived from the price of some other
risk “underlying” asset.
Mortgages Capital Loans to Risk is variable; Up to 30 3.52%
individuals and risk is high in the years adjustable
businesses case of 5-year rate,
secured by real subprime loans 4.22% 30- Financial Institutions
estate; bought year fixed
by banks and rate Direct funds transfers are common among individuals
other
institutions
and small businesses and in economies where financial
State and
local
Capital Issued by state
and local
Riskier than U.S.
government
Up to 30
years
4.26% 20-
year bonds,
markets and institutions are less developed. But large
government governments; securities but mixed businesses in developed economies generally find it
bonds held by exempt from quality
more efficient to enlist the services of a financial types of savers. Hence, there are bond funds for
institution when it comes time to raise capital. those who prefer safety, stock funds for savers
1. Investment banks traditionally help companies who are willing to accept significant risks in the
raise capital. They: hope of higher returns, and money market
(1) help corporations design securities with funds that are used as interest-bearing checking
features that are currently attractive to accounts.
investors; *Another important distinction exists between
(2) buy these securities from the corporation, actively managed funds and indexed
and; funds. Actively managed funds try to
(3) resell them to savers. Because the outperform the overall markets,
investment bank generally guarantees that the whereas indexed funds are designed to simply
firm will raise the needed capital, the replicate the performance of a specific market
investment bankers are also index.
called underwriters. 8. Exchange Traded Funds (ETFs) are similar to
2. Commercial banks are the traditional regular mutual funds and are often operated by
“department stores of finance” because they mutual fund companies. ETFs buy a portfolio of
serve a variety of savers and borrowers. stocks of a certain type—for example, the S&P
Historically, commercial banks were the major 500 or media companies or Chinese companies
institutions that handled checking accounts —and then sell their own shares to the public.
and through which the Federal Reserve System ETF shares are generally traded in the public
expanded or contracted the money supply. markets, so an investor who wants to invest in
3. Financial services corporations are large the Chinese market, for example, can buy
conglomerates that combine many different shares in an ETF that holds stocks in that
financial institutions within a single corporation. particular market.
Most financial services corporations started in 9. Hedge funds are also similar to mutual funds
one area but have now diversified to cover most because they accept money from savers and
of the financial spectrum. use the funds to buy various securities, but
4. Credit unions are cooperative associations there are some important differences. While
whose members are supposed to have a mutual funds (and ETFs) are registered and
common bond, such as being employees of the regulated by the Securities and Exchange
same firm. Commission (SEC), hedge funds are largely
5. Pension funds are retirement plans funded by unregulated. This difference in regulation stems
corporations or government agencies for their from the fact that mutual funds typically target
workers and administered primarily by the trust small investors, whereas hedge funds typically
departments of commercial banks or by life have large minimum investments (often
insurance companies. Pension funds invest exceeding  million) and are marketed primarily
primarily in bonds, stocks, mortgages, and real to institutions and individuals with high net
estate. worths.
6. Life insurance companies take savings in the 10. Private equity companies are organizations that
form of annual premiums; invest these funds in operate much like hedge funds; but rather than
stocks, bonds, real estate, and mortgages; and purchasing some of the stock of a firm, private
make payments to the beneficiaries of the equity players buy and then manage entire
insured parties. firms. Most of the money used to buy the target
7. Mutual funds are corporations that accept companies is borrowed. 
money from savers and then use these funds to
buy stocks, long-term bonds, or short-term debt The Stock Market
instruments issued by businesses or The most active secondary market—and the most
government units. These organizations pool important one to financial managers—is the stock
funds and thus reduce risks by diversification. market, where the prices of firms’ stocks are
They also achieve economies of scale in established. Because the primary goal of financial
analyzing securities, managing portfolios, and managers is to maximize their firms’ stock prices,
buying and selling securities. Different funds are knowledge of the stock market is important to anyone
designed to meet the objectives of different involved in managing a business.
 2. Additional shares sold by established publicly
Stocks are traded using a variety of market procedures, owned companies: the primary market. If Allied
but there are two basic types: Food decides to sell (or issue) an
1. physical location exchanges – formal additional  million shares to raise new equity
organizations having tangible physical locations capital, this transaction is said to occur in the
that conduct auction markets in designated primary market.
(“listed”) securities; includes the NYSE and 3. Initial public offerings made by privately held
several regional stock exchanges firms: the IPO market. Whenever stock in a
2. electronic dealer-based  markets - includes the closely held corporation is offered to the public
NASDAQ, the less formal over-the-counter for the first time, the company is said to
market(A large collection of brokers and be going public. The market for stock that is just
dealers, connected electronically by telephones being offered to the public is called the initial
and computers, that provides for trading in public offering (IPO) market.
unlisted securities.), and the recently developed
electronic communications networks (ECNs). Stock Markets and Returns
A dealer market includes all facilities that are needed to Anyone who has invested in the stock market knows
conduct security transactions, but the transactions are that there can be (and generally are) large differences
not made on the physical location exchanges. The between expected and realized prices and returns.
dealer market system consists of
1. the relatively few dealers who hold inventories Stock Market Efficiency
of these securities and who are said to “make a To begin this section, consider the following definitions:
market” in these securities; 1. Market price: The current price of a stock.
2. the thousands of brokers who act as agents in 2. Intrinsic value: The price at which the stock
bringing the dealers together with investors; would sell if all investors had all knowable
and information about a stock.
3. the computers, terminals, and electronic 3. Equilibrium price: The price that balances buy
networks that provide a communication link and sell orders at any given time. When a stock
between dealers and brokers. is in equilibrium, the price remains relatively
stable until new information becomes available
The Market for Common Stock and causes the price to change.
Some companies are so small that their common stocks 4. Efficient market: A market in which prices are
are not actively traded; they are owned by relatively close to intrinsic values and stocks seem to be in
few people, usually the companies’ managers. These equilibrium.
firms are said to be privately owned, or closely held, *When markets are efficient, investors can buy and
corporations; and their stock is called closely held stock. sell stocks and be confident that they are getting
In contrast, the stocks of most large companies are good prices. When markets are inefficient, investors
owned by thousands of investors, most of whom are may be afraid to invest and may put their money
not active in management. These companies are “under the pillow,” which will lead to a poor
called publicly owned corporations, and their stock is allocation of capital and economic stagnation. From
called publicly held stock. an economic standpoint, market efficiency is good.

Types of Stock Market Transactions Behavioral Finance Theory

We can classify stock market transactions into three The efficient markets hypothesis (EMH) remains one of
distinct categories: the cornerstones of modern finance theory. It implies
1. Outstanding shares of established publicly that, on average, asset prices are about equal to their
owned companies that are traded: the intrinsic values.
secondary market. Although the logic behind the EMH is compelling, many
*If the owner of  shares sells his or her stock, events in the real world seem inconsistent with the
the trade is said to have occurred in hypothesis, which has spurred a growing field
the secondary market. Thus, the market for called behavioral finance. Rather than assuming that
outstanding shares, or used shares, is the investors are rational, behavioral finance theorists
secondary market. The company receives no borrow insights from psychology to better understand
new money when sales occur in this market. how irrational behavior can be sustained over time.
Pioneers in this field include psychologists Daniel
Kahneman, Amos Tversky, and Richard Thaler. Their
work has encouraged a growing number of scholars to
work in this promising area of research.