Chapter 2

The Domestic and International

Financial Marketplace
Outline
1.

Overview of the U.S. financial system: financial assets

and financial markets, financial indexes

2.

International financial markets, currency securities,

and exchange rates

3.

Market efficiency

Flows of funds

Ideally, actual savings = actual investments

Surplus

spending units (net lenders) transfer funds to

deficit spending units (net borrowers)

One

firms or individuals can be both lenders and

borrowers

Savings-investment

cycle

An Overview of the U.S. Financial

System

Financial Assets
Money
Debt

Securities

Equity

Securities

Primary

vs. Derivative Securities

Financial Markets
Money

and Capital Markets

Primary

and Secondary Markets

4

An Overview of the U.S. Financial

System

Financial Assets
Money:

cant have enough cash on hand to finance

current and future operations

Need

to issue financial securities/assets to purchase

real assets, which are supposed to generate
income/cash flows to pay funds suppliers the required
returns

Financial

securities in a nutshell are nothing but a piece

of promise.
5

Securities

Securities can be classified according to the length of

their life or maturity, to whether there is an
involvement of middlemen, whether they are public
or private, whether they have a straight or derived
value.
Three types of securities according to their
maturities
1. Short-term securities
Securities having a life or maturity of one year or
less; examples, U.S. Treasury bills, Bank CDs
issued by banks, Commercial paper issued by large
corporations, etc. All these are debt securities
i.e., short-term borrowing by the issuers.
6

Securities

2. Medium-term securities
Securities having maturity between one to ten
years (examples, U.S. Treasury notes, Bank notes,
CDs, etc.)
3. Long-term securities
Securities having a maturity of ten years or more
(examples, U.S. Treasury bonds, corporate bonds,
stocks, etc.). Note that stocks do not have to be
paid back and have no maturity.

Securities

Primary security vs. derivative security

Primary

securities are issued by companies and

institutions (such as federal, state and local
governments) to raise funds examples are bonds,
notes, stocks, etc.

Derivative

securities are issued against primary

securities or assets by institutions who are
different from those who issued the primary
securities for example, stock option is a
derivative security it can be issued against a
particular stock (e.g., Google) by an investor or a
security dealer

Securities

Other examples of derivative securities include

Futures contract in precious metals or
commodities such as gold, silver, crude oil, wheat,
orange juice, etc; here gold, crude oil, wheat, etc.,
are primary assets and futures contract in each
asset is the derivative security based on that asset
Futures contracts in financial indexes such as S&P
500 (stock market index)
Forward contracts are agreements between a
financial institution and a firm to pay/deliver in the
future on a price agreed on today. (ex: currency
forward contacts.)

Securities

Private versus Public

Loans from financial institutions = private

Owed

to one or a group of institutions

Easier

to negotiate and change terms

Recovery

rates upon default are higher

Bonds = public
Owed

to millions of bondholders

Harder

to negotiate and change terms

Recovery

rates upon default are lower

10

Financial Markets

Different types of markets

Money

market vs. Capital market

Money

market:

Where

short-term securities such as U.S. TBills, or bank CDs, commercial papers are
bought and sold

Capital

market:

Where

medium and long-term securities such

as stocks, bonds and notes are bought and sold

11

Financial Markets
Primary market vs. Secondary market

Primary market:
Where

new securities are sold (for the first

time) by companies or governments who need
funds and bought by investment bankers as
serving as underwriters

Secondary market:
Where

previously issued (or old) securities

are bought and sold by individuals, and
institutions such as mutual funds, pension
funds, commercial banks, security dealers,
etc.

Note the difference between the two markets

12

Financial Markets

Relationship
markets

between

primary

and

secondary

Liquidity. Without secondary markets, primary

markets would be very illiquid. Not enough buyers and
sellers.

13

Financial Markets

Brokered, Dealer, and Auction Markets

Brokered:

in the primary market, investment

bankers who market a firms securities to the
public act as brokers. Brokers help with large
blocks (>10,000 share per block) seek other large
traders rather than bring the shares to the public
market. Examples of brokers: Merrill Lynch, A.G.
Edwards, Solomon Smith Barney, Goldman Sachs,
Bank of America Securities, J. P. Morgan Chase,
etc.

14

Financial Markets

Brokered, Dealer, and Auction Markets

Dealer: specialize in various assets. Buy these shares

for their own accounts, and later sell them for a
profit, which is the spread between bid and ask
prices. Search costs are avoided. Examples of
dealers: Merrill Lynch, A.G. Edwards, Charles
Schwab, TD Ameritrade.

Ask price = price at which dealer is willing to sell a

security

Bid price = price at which dealer is willing to buy a

security

Ask > bid. Why?

Auction: all traders converge at one place. NYSE is

an auction type of market

15

Financial Markets

Security Exchanges
National Exchanges
New

York Stock Exchange (NYSE), American Stock

Exchange (AMEX), and National Association of
Security Dealers Automatic Quotations (NASDAQ)
are national exchanges since national (and
international) companies are listed on these
exchanges and their shares are bought and sold
here
Regional Exchanges
Stock

exchanges in Boston, Philadelphia,

Chicago, San Francisco, etc., are regional
exchanges where smaller, regional companies are
listed and their shares are bought and sold
16

New York Stock Exchange (NYSE)

aka, Big Board, physically located on Wall Street in

NY City
Owned and operated by Intercontinental Exchange.
Previously owned by NYSE Euronext, a transAtlantic company formed by the merger of NYSE
Group, Inc. and Euronext, NV in 2007 Euronext,
NV owned several stock exchanges in Europe
including Paris, Brussels and Lisbon exchanges
which are now part of NYSE Euronext
NYSE Group owns New York Stock Exchange
(NYSE) and other stock exchanges like the
American Stock Exchange (AMEX), NYSE Arca,
etc.
17

Listing Requirements

Why requirements? Ensure frequent trading interest

For a security to be traded on an exchange, it must be

listed; listing criteria vary by the exchange and even
for the same exchange, there are multiple ways the
requirements can be met; following are some listing
criteria
Criterion

NYSE

AMEX NASDAQ

Round lot shareholders

400

800

300

Public shares (mill $)

1.1

0.50

1.0

Market value (mill $)

$100

$3

$15

Pre-tax income (mill $)

$2

$0.75

$1
18

Financial Markets

NASDAQ or the Over-the-Counter Market

NASDAQ

stands for National Association of

Security Dealers Automatic Quotations

Owned

by the security dealers (NASD)

Market

inter-connected by highly sophisticated

computer networks - it is a 24/7 market

Has

no physical location

Both

small and large companies are listed on

NASDAQ exchange

Most

technology company stocks are listed here

and hence NASDAQ is called tech heavy
19

Stock Market Averages/Indexes

Stock market activities are summarized by means of

some averages and indexes such as the following
Dow Jones Industrial Average (price weighted)

1.

Includes a sample of only 30 stocks of large,

blue chip companies listed on the NYSE, picked
by WSJ editors.

All stock prices are given an equal or price

weight in computing the average irrespective
of company size

Oldest stock market average-started in 1896

when it had only 12 stocks. GE is the longest
tenured stock in the Dow.
20

Stock Market Averages/Indexes

2. Standard & Poors (S&P) 500 index

Includes 500 stocks, mostly from the NYSE, started March

4, 1957. Referred as large-cap index, but does not include
the 500 largest companies in the U.S.

400 leading industrial firms, 20 transportation firms, 40

utilities, and 40 financial institutions.

The price of each company stock is given a weight based

on the market value of the company in computing the
index which means that bigger or larger market-valued
company prices have higher weights than smaller company
prices (hence called value-weighted)
3. NYSE Composite index
Includes all stocks listed on the NYSE
Like the S&P 500 Index, each company stock price is given a
21
weight based on its value (value-weighted index)

Stock Market Averages/Indexes

4. NASDAQ Composite index

Started

in 1971 and includes more than 3000

NASDAQ-listed companies today (technologycompany-heavy)

It

is a value-weighted index like the S&P 500 and

NYSE composite index

5. NASDAQ 100 index

Includes

only 100 of the largest stocks listed on

the NASDAQ market

It

is a value-weighted index like the S&P 500 index

and NYSE composite index
22

Stock Market Averages/Indexes

6. Russell 2000 index

Value-weighted
Consists

of 2000 stocks

7. Wilshire 5000 index

Value-weighted
Consists

index

index

of 5000 stocks

There are many other indexes based on what or

how many stocks are included in the index. For
example, Dow Jones Composite Average, S&P 100
Index, S&P 400 Midcap Index, NYSE US 100, NYSE
International 100, NASDAQ Computer Index,
NASDAQ Financial Index, etc.

23

Stock Market Averages/Indexes

Equal-weighted versus value-weighted

Equal-weighted: DJIA
Sum

of prices of 30 stock / divisor.

Divisor

was equal to 30 (in 1928) the number of stocks

Divisor

is now equal to 0.1321 to adjust for stock splits

1/.1321

= 7.57 or (rounding) 7.6. Each dollar change

in any of the 30 Dow stocks represents a 7.6 point
change in the index

Market value-weighted
Total

market value = price per share x number of

shares outstanding

Weight
Large

= market value of a firm / total market value

firms with high market value move the index24

more than small firms.

An Overview of the U.S. Financial

System

Financial Intermediaries = depository vs. non-depository

Commercial
Thrift

Banks

Institutions

Investment
Pension

Funds

Insurance
Finance

Companies

Companies

Companies

25

An Overview of the U.S. Financial

System

Commercial Banks
Accept

demand deposits (checking a/cs) and time

deposits (savings a/cs)

Make

loans to businesses, governments, individuals

Thrift institutions
Savings

and loan associations, credit unions

Accept

demand deposits (checking a/cs) and time

deposits (savings a/cs)

Loans
They

to consumers, mortgage loans

have been bought out by commercial banks

26

An Overview of the U.S. Financial

System

Investment Banks
Goldman

Sachs, Merrill Lynch, Credit Swiss First Boston,

Bank of America Securities, Salomon Smith Barney, J.
P. Morgan Chase, etc.

Buy

primary and sell secondary securities

27

An Overview of the U.S. Financial

System

Investment companies

Mutual funds, real estate investment trusts (REITs)

Invest funds pooled from savers in different types of

securities

Big mutual funds: Fidelity, Vanguard, T. Row Price

Pension funds

Insurance companies

Life

Property and casualty

Premiums collected in advance are invested

28

An Overview of the U.S. Financial

System

Finance companies

GE Capital, CITIGroup, IBM Global Financing

Using their own debt securities and loans from commercial banks

Make loans to individuals and businesses

29

The Structure and Operation of U.S.

Security Markets

Regulation of the Security Markets

Need regulations?

Blue

Sky Laws

Securities

and Exchange Commission (SEC)

10-K:

Annual Report

10-Q:

Quarterly Report

14-A:

Proxy Statements

Insider

FINRA:

Trading

Financial Industry Regulatory Authority

30

Dodd-Frank Act 2010

Enacted in 2010 after the great recession of 2008 some important features of the Act are:
Created

an SEC Office of Credit Ratings to oversee

rating firms

Created

Consumer Financial Protection Bureau

Created

Financial Stability Oversight Council to spot

systemic risk

31

Dodd-Frank Act - Summarized

Require

hedge funds and private-equity funds to

register with the SEC

Require

exchange-trading and clearing of some

derivative securities

Make

sellers of mortgage backed securities keep 5%

of credit risk

Make

mortgage lenders sure that borrowers can

repay

32

The Structure and Operation of U.S.

Security Markets

Regulation of the Security Markets

Sarbanes-Oxley

Act

Top

management is directly responsible for the

accuracy of the firms financial statements

Strengthened

the independence and accountability

of the audit committee

Created

the Public Company Accounting Standards

Board
Requires

that auditors now certify a firms financial

control system

Ensures

independence of financial analysts

33

Stock Market Regulators

FINRA is the largest independent regulator for all

securities firms (i.e., dealers) doing business in the
United States. Its mission is to protect Americas
investors by making sure the securities industry
operates fairly and honestly. It oversees nearly 4,500
brokerage firms, about 163,470 branch offices and
approximately
634,385
registered
securities
representatives (or brokers).

34

The Global Economy and Multinational

Enterprises

Merchandise Trade Balance

Balance of Payments (BOP): national statement of

cash flows

BOP = Curr Acc + Capital Acc + Fin Acc

+ Res. +
Error
(mainly) = (X-M) + (CI CO) + ( FI FO) + FXB

X-M: exports minus imports

CI-CO: capital inflows minus capital outflows
FI-FO: financial inflows minus financial outflows
FXB: Foreign exchange reserves
35

The Global Economy and Multinational

Enterprises

Balance of Trades (BOT):

36

Foreign Currency Markets and Exchange

Rates

Foreign exchange market

The Eurocurrency Market

Eurodollars,

Euroyen, Eurosterling: currency deposited

outside the country of origin

LIBOR:

London Interbank Offer Rate = the interest rate at

which banks in the Eurocurrency market lend each other

FIBOR,

SIBOR, etc.

The Euro: A Common European Currency

37

Foreign Currency Markets and Exchange

Rates
Foreign

exchange (forex) market

Allows for the exchange of one currency for another.
Exchange rate specifies the rate at which one currency can be exchanged for
another. It is the price of one currency expressed in terms of another currency
Functions:

Transfer of purchasing power: intl trade & cap txns involve parties living in
different countries with different national currencies. One party must deal in a
foreign currency

Movement of goods btw countries take time and inventory in transit must
be financed. FX mkt provides a source of credit (bankers acceptance,
letters of credit)
FX mkt provides hedging facilities for transferring FX risk to someone else
more willing to carry risk.

38

Foreign exchange market

Participants in FX market

Foreign exchange dealers serve as intermediaries in the foreign

exchange market

Operate in both interbank and client markets

Also operate as market makers: 1/willing to buy and sell at all

times currencies they specialize in, 2/ maintain an inventory
position in those currencies

FX departments are profit centers and individual dealers are

compensated on a profit incentive basis

39

Foreign Exchange Transactions

Other participants:

Individuals and firms conducting commercial and investment

transactions.

Speculators and arbitragers: seek to profit from trading in the

mkt: profit from EX rate changes. (simultaneous EX rate
differences in different markets)

Central banks and Treasuries: to acquire or spend their

countrys FX reserves to influence the trading price of their own
currency. Willing to take a loss, which is different from other
participants
40

How are foreign exchange rates

quoted?

41

Foreign Currency Markets and Exchange

Rates

Direct Quote
Home

currency price of one unit of foreign currency

$1.42/

Indirect Quote
Foreign

currency price of one unit of home currency

0.7042/$

Direct quote = 1 / Indirect quote

.0001 = 1 pip (finance jargon)

42

Foreign Currency Markets and Exchange

Rates

43

Foreign Currency Markets and Exchange

Rates

Spot Rates

Forward Rates
Premium
Discount

Annualized forward rate: p = (F-S)/S x 360/N x 100%

44

Foreign Currency Markets and Exchange

Rates

45

Foreign Currency Markets and Exchange Rates

Example from a WSJ report on currencies
IN US$
Country/curre
ncy

US$ VS. % CHG

Thurs

Wed

PER US$

1-Day

YTD

Thurs

Wed

Australian dollar

0.8560

0.8594

0.40

4.2

1.1683

1.1636

1-mos forward

0.8541

0.8575

0.39

4.0

1.1708

1.1662

3-mos forward

0.8503

0.8537

0.40

4.1

1.1760

1.1714

6-mos forward

0.8448

0.8482

0.40

4.1

1.1837

1.1790

China yuan

0.1637

0.1636

-0.08

0.9

6.1087

6.1136

Hong Kong dollar

0.1290

0.1290

unch

unch

7.7529

7.7517

0.01625

0.01629

0.24

-0.5

61.52995

61.37995

0.0000821

0.0000821

unch

0.2

12179

12185

0.00868

0.00872

0.48

9.4

115.21

114.66

1-mos forward

0.00868

0.00872

0.48

8.6

115.19

114.63

3-mos forward

0.00869

0.00873

0.48

8.5

115.09

114.53

6-mos forward

0.00870

0.00874

0.49

8.5

114.98

114.42

India rupee
Indonesia rupiah
Japan yen

46

Foreign Currency Markets and Exchange

Rates

Foreign Currency Futures

Forward
Futures

Contract

Contract

Differences

between the two contracts. Futures contracts

have the following features than forward contracts do not
Exchange

traded

Standardized

amount

Standardized

maturity date

Marked-to-market
47

Foreign Currency Markets and Exchange

Rates

Foreign Currency Options

Call

Option: right, but not obligation, to buy (from the

option holders perspective)

Put

Option: right, but not obligation, to sell (from the

option holders perspective)

European

Option: exercise only at expiration

American

Option: exercise any time before expiration

48

Market Efficiency

Efficient Capital Markets

Stock

prices:

Provide

an unbiased estimate of the true value of an

enterprise

Reflect

a present value estimate of the firms

expected cash flows, evaluated at an appropriate
required rate of return

49

Market Efficiency

Information and Capital Market Efficiency

Capital

markets are efficient if security prices

instantaneously reflect in an unbiased manner all
economically relevant information about a securitys
prospective returns and the risk of those returns

50

Market Efficiency

Degrees of Market Efficiency

Weak-Form

Efficiency

Semistrong-Form
Strong-Form

Efficiency

Efficiency

51

Market Efficiency

Implications of Market Efficiency for Financial Managers

Timing
An

or Gambling

Expected NPV of Zero

Expensive
Security

and Unnecessary Corporate Diversification

Price Adjustments

52

Market Efficiency

Behavioral Finance
Marketplace
Psychological

Perspectives

on

the

Financial

considerations may lead to market

inefficiencies
E.g.,

investors refusal to sell a losing stock

53

Holding Period Returns

Holding Period Return

Also called

Holding Period Yield

Realized Rate of Return

Realized/Ex-Post

Expected/Ex-Ante

54

Holding Period Returns

Holding Period Return (HPR) example:

Bought a share for $40 last year. Received $.50 in dividends per share during the
year. Sold the stock for $42. What is the return over the year?

HPR = (42 40 + .5) / 40 = 6.25%

Do it yourself: if this investor bought 100 shares instead of 1 share. Calculate the
HPR.

55

Questions?
Dont forget to practice as many end-ofchapter problems as possible

56