Chapter 1: Why Study Money, Banking, and Financial Markets?

Preview
To examine how financial markets such as bond, stock and foreign exchange markets work
To examine how financial institutions such as banks, investment and insurance companies work
To examine the role of money in the economy

Why Study Financial Markets?

Financial markets are markets in which funds are transferred from people and Firms who have an excess of
available funds to people and Firms who have a need of funds.

The Bond Market and Interest Rates

 A security (financial instrument) is a claim on the issuer’s future income or assets.
 A bond is a debt security that promises to make payments periodically for a specified period of time.
 An interest rate is the cost of borrowing or the price paid for the rental of funds.

The Stock Market

 Common stock represents a share of ownership in a corporation
 A share of stock is a claim on the residual earnings and assets of the corporation

Why Study Financial Institutions and Banking?

 Financial Intermediaries: institutions that borrow funds from people who have saved and make loans to
other people:
-Banks: accept deposits and make loans
-Other Financial Institutions: insurance companies, finance companies, pension funds, mutual funds
and investment companies
 Financial Innovation: the development of new financial products and services
-Can be an important force for good by making the financial system more efficient

Financial Crises
Financial crises are major disruptions in financial markets that are characterized by sharp declines in asset
prices and the failures of many financial and nonfinancial firms.

Why Study Money and Monetary Policy?

 Evidence suggests that money plays an important role in generating business cycles
 Recessions (unemployment) and expansions affect all of us
 Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the
price level

Money, Business Cycles and Inflation

 The aggregate price level is the average price of goods and services in an economy
 A continual rise in the price level (inflation) affects all economic players
 Data shows a connection between the money supply and the price level

Money and Interest Rates

 Interest rates are the price of money
 Prior to 1980, the rate of money growth and the interest rate on long-term Treasury bonds were closely
tied
 Since then, the relationship is less clear but the rate of money growth is still an important determinant of
interest rates

Fiscal Policy and Monetary Policy

 Monetary policy is the management of the money supply and interest rates
-Conducted in the U.S. by the Federal Reserve System (Fed)
 Fiscal policy deals with government spending
and taxation
-Budget deficit is the excess of expenditures over revenues for a particular year
-Budget surplus is the excess of revenues over expenditures for a particular year
-Any deficit must be financed by borrowing

The Foreign Exchange Market

 The foreign exchange market is where funds are converted from one currency into another
 The foreign exchange rate is the price of one currency in terms of another currency
 The foreign exchange market determines the foreign exchange rate

The International Financial System

 Financial markets have become increasingly integrated throughout the world.
 The international financial system has tremendous impact on domestic economies:
-How a country’s choice of exchange rate policy affect its monetary policy?
-How capital controls impact domestic financial systems and therefore the performance of the
economy?
-Which should be the role of international financial institutions like the IMF?

How We Will Study Money, Banking, and Financial Markets

 A simplified approach to the demand for assets
 The concept of equilibrium
 Basic supply and demand to explain behavior in financial markets
 The search for profits
 An approach to financial structure based on transaction costs and asymmetric information
 Aggregate supply and demand analysis
Chapter 2: The Financial Market Environment
Learning Goals
LG 1 Understand the role that financial institutions play in managerial finance.
LG 2 Understand the role that financial markets play in managerial finance.
LG 3 Describe the differences between the money market and the capital market.
LG 4 Understand the major regulations and regulatory bodies that affect financial institutions and markets.
LG 5 Describe the process of issuing common stock, including venture capital, going public, and the role of
the investment bank.
LG 6 Understand what is meant by financial markets in crisis, and describe some of the root causes of the
Great Recession.

2.1 Financial Institutions

• Financial institutions are intermediaries that channel the savings of individuals, businesses, and
governments into loans or investments.
• The key suppliers and demanders of funds are individuals, businesses, and governments.
• In general, individuals are net suppliers of funds, while businesses and governments are net
demanders of funds.
• Commercial Banks, Investment Banks, and the Shadow Banking System
• Commercial Banks
• Institutions that provide savers with a secure place to invest their funds offer loans to
individual and business borrowers
• Investment Banks
• 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

Matter of Fact
Consolidation in the U.S. Banking Industry
The U.S. banking industry has been going through a long period of consolidation. According to the Federal
Deposit Insurance Corporation (FDIC), the number of commercial banks in the United States declined from
14,400 in early 1984 to 4,964 by October 2017, a decline of more than 65%. The decline is concentrated
among small community banks, which larger institutions have been acquiring at a rapid pace.

2.2 Financial Markets

• The Relationship Between Institutions and Markets
– Financial markets are forums in which suppliers of funds and demanders of funds can
transact business directly
– Transactions in short-term marketable securities take place in the money market while
transactions in long-term securities take place in the capital market
– A private placement involves the sale of a new security directly to an investor or group of
investors
– Most firms, however, raise money through a public offering of securities, which is the sale
of either bonds or stocks to the general public
• The Relationship Between Institutions and Markets
– The primary market is the financial market in which securities are initially issued; the only
market in which the issuer is directly involved in the transaction
– Secondary markets are financial markets in which preowned securities (those that are not
new issues) are traded
–
Figure 2.1 Flow of Funds
• The Money Market
– A market where investors trade highly liquid securities with maturities of 1 year or less
– Most money market transactions are made in marketable securities which are short-term
debt instruments, such as:
 U.S. Treasury bills issues by the federal government
 Commercial paper issued by businesses
 Negotiable certificates of deposit issued by financial institutions
– Investors generally consider marketable securities to be among the least risky investments
available.
– Eurocurrency Market
 International equivalent of the domestic money market
 It is a market for short-term bank deposits denominated in U.S. dollars or other
marketable currencies
 The Eurocurrency market has grown rapidly mainly because it is unregulated and
because it meets the needs of international borrowers and lenders
 Nearly all Eurodollar deposits are time deposits

• The Capital Market
– A market that enables suppliers and demanders of long-term funds to make transactions
– Key Securities Traded: Bonds and Stocks
 Securities traded in the capital market fall into two broad categories: debt and equity
 Bonds
• Long-term debt instruments used by businesses and government to raise large
sums of money, generally from a diverse group of lenders
– Key Securities Traded: Bonds and Stocks
 Common Stock
• Units of ownership interest or equity in a corporation
 Preferred Stock
• A special form of ownership that has features of both a bond and common
stock
– Broker Markets and Dealer Markets
 Securities Exchanges
• Organizations that provide the marketplace in which firms can raise funds
through the sale of new securities and in which purchasers can resell securities
 Broker Markets
• Securities exchanges in which the two sides of a transaction, the buyer and the
seller, are brought together to trade securities
• Trading takes place on centralized trading floors of national exchanges, such
as NYSE Euronext, as well as regional exchanges
 – Broker Markets and Dealer Markets
 Dealer Markets
– Markets, like the NASDAQ, in which the buyer and seller are not brought
together directly but instead have their orders executed by securities dealers
that “make markets” in the given security
– The dealer market has no centralized trading floors
• It is made up of a large number of market makers who are linked
together via a mass-telecommunications network
– Broker Markets and Dealer Markets
 Dealer Markets
– As compensation for executing orders, market makers make money on the
bid/ask spread (ask price – bid price)
• Ask Price: The lowest price a seller is willing to accept for a security
• Bid Price: The highest price a buyer is willing to pay for a security
Example 2.1
Mark instructs his broker to submit a market order to buy 100 shares of Facebook common stock. At the
time, the ask price for Facebook is $138.79, and the bid price is $138.71. Remember, the ask price is the
lowest price offered in the market to sell Facebook to a potential buyer. Since Mark is trying to buy
Facebook stock, and he wants to buy at the lowest possible price, he will pay $138.79, plus whatever
commissions his broker charges. If, however, Mark already owned Facebook stock and wanted to sell it, he
would be looking for the market’s best offer to buy, the bid price. In that case, Mark would sell his shares
for $138.71, less commissions charged by the broker.

Personal Finance Example 2.2

Assume that the current bid price for Merck & Co. stock is $63.25 and the ask price is $63.45. Suppose you
have an E*TRADE brokerage account that charges a $6.95 commission for online equity trades. What is the
current bid/ask spread for Merck?
Bid/Ask Spread  Ask Price  Bid Price (2.1)
Bid/Ask Spread  $63.45 – $63.25  $0.20
Inserting the current bid and ask prices into Equation 2.1, you find that the bid/ask spread for Merck is
$0.20. What would your total transaction costs be if you purchased 100 shares of Merck by submitting a
market order via your E*TRADE account? Assume the trade is sent to a broker market for execution, and
the market maker matches your order with a 100-share sell order for Merck from another investor. In this
case your order will be executed at the midpoint of the bid/ask spread ($63.35), so you will pay only the
brokerage commission.
Total Transaction Costs  Brokerage Commission = $6.95
Now what would your total transaction costs be if you purchased 100 shares of Merck by submitting a
market order via your E*TRADE account, and it is routed to a dealer market for execution?
Total Transaction Costs   Number of Shares 1/2 the Bid/Ask Spread 
 Brokerage Commission
  100  1/2  $0.20   $6.95
 $10  $6.95  $16.95

Depending on where your brokerage routes your order, you find that your total transaction costs are either
$6.95 in a broker market or $16.95 in a dealer market.

• The Capital Market

– International Capital Markets
 Eurobond Market
 – The market where corporations and governments typically issue bonds
denominated in dollars and sell them to investors located outside the United
States.
 Foreign Bond Market
– A market for bonds issued by a foreign corporation or government that is
denominated in the investor’s home currency and sold in the investor’s home
market
 International Equity Market
– Allows corporations to sell blocks of shares to investors in a number of
different countries simultaneously

• The Role of Capital Markets

– The Efficient-Market Hypothesis
 Securities are typically in equilibrium, which means they are fairly priced and their
expected returns equal their required returns
 At any point in time, security prices fully reflect all information available about the
firm and its securities, and these prices react swiftly to new information
 Because stocks are fully and fairly priced, investors need not waste their time trying
to find mispriced (undervalued or overvalued) securities

• The Role of Capital Markets

– Behavioral Finance
 Argues that stock prices and prices of other securities can deviate from their true
values for extended periods and that these deviations may lead to predictable patterns
in stock prices

2.3 Regulation of Financial Markets and Institutions

• Regulations Governing Financial Institutions
– Glass-Steagall Act
 Prohibited institutions that took deposits from engaging in activities such as securities
underwriting and trading, thereby effectively separating commercial banks from
investment banks
– 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

• Regulations Governing Financial Institutions

– Gramm-Leach-Bliley Act
 Allows 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
– Dodd-Frank Wall Street Reform and Consumer Protection Act
 Realigns the duties of several existing agencies and requires existing and new
agencies to report to Congress regularly
 Nearly a decade after Dodd-Frank became law, the various agencies affected or
created by the new law were still writing rules specifying how the new law’s
provisions would be implemented

• Regulations Governing Financial Markets

– Securities Act of 1933
 Regulates the sale of securities to the public via the primary market
 Requires sellers of new securities to provide extensive disclosures to the potential
buyers of those securities
 – Securities Exchange Act of 1934
 Regulates the trading of securities in the secondary market
 Created the Securities Exchange Commission
 Requires ongoing disclosure by companies whose securities trade in secondary
markets (e.g., 10-Q, 10-K)
 Imposes limits on the extent to which “insiders” can trade in their firm’s securities

• Regulations Governing Financial Markets
– Securities and Exchange Commission
 The primary government agency responsible for enforcing federal securities laws

2.4 The Securities Issuing Process

• Issuing Common Stock
– Private Equity
 External equity financing that is raised via a private placement, typically by private
early-stage firms with attractive growth prospects
 Angel Investors (Angels)
– Wealthy individual investors who make their own investment decisions and
are willing to invest in promising startups in exchange for a portion of the
firm’s equity

• Issuing Common Stock

– Private Equity
 Venture Capitalists (VCs)
– Formal business entities that take in private equity capital from many
individual investors, often institutional investors such as endowments and
pension funds or individuals of high net worth, and make private equity
investment decisions on their behalf
– Organization and Investment Stages
 VC Limited Partnership is the most common structure

• Issuing Common Stock

– Private Equity
 Venture Capitalists (VCs)
– Formal business entities that take in private equity capital from many
individual investors, often institutional investors such as endowments and
pension funds or individuals of high net worth, and make private equity
investment decisions on their behalf
– Organization and Investment Stages
 VC Limited Partnership is the most common structure

• Issuing Common Stock

– Deal Structure and Pricing
 The deal structure allocates responsibilities and ownership interests between the
existing owners (typically the founders) and the venture capitalist, and its terms
depend on numerous factors related to the founders; the business structure, stage of
development, and outlook; and other market and timing issues
 Venture capitalists will require more equity ownership and pay less for it the riskier
and less developed the business

Table 2.1 Organization of Venture Capital Investors

Organization Description
Small business Corporations chartered by the federal government that can borrow at attractive
investment companies rates from the U.S. Treasury and use the funds to make venture capital
(SBICs) investments in private companies.

Financial VC funds
Subsidiaries of financial institutions, particularly banks, set up to help young
firms grow and, it is hoped, become major customers of the institution.

Corporate VC funds
Firms, sometimes subsidiaries, established by nonfinancial firms, typically to
gain access to new technologies that the corporation can access to further its
own growth.

VC limited partnerships
Limited partnerships organized by professional VC firms, which serve as the
general partner and organize, invest, and manage the partnership using the
limited partners’ funds; the professional VCs ultimately liquidate the
partnership and distribute the proceeds to all partners.

• Issuing Common Stock

– Going Public
 Private Placement
– The firm sells new securities directly to an investor or group of investors
 Rights Offering
– The firm sells new shares to existing stockholders
 Public Offering
– The firm sells new shares to the general public

• Issuing Common Stock

– Going Public
 Initial Public Offering (IPO)
– The first public sale of a firm’s stock, typically made by small, rapidly
growing companies that either require additional capital to continue growing
or have met a milestone for going public that was established in an earlier
agreement to obtain VC funding
 Prospectus
– A portion of a security registration statement that describes the key aspects of
the issue, the issuer, and its management and financial position

• Issuing Common Stock

– Going Public
 Red Herring
– A preliminary prospectus made available to prospective investors during the
waiting period between the registration statement’s filing with the SEC and its
approval
 Quiet Period
– Period during which the law places restrictions on what company officials
may say about the company
 • Issuing Common Stock
– Going Public
 Roadshow
– A series of presentations to potential investors around the country, providing
investors with information about the new issue
– Sessions help investment banks gauge demand for the offering and set a
preliminary offer price range

• Issuing Common Stock

– The Investment Bank’s Role
 Investment Bank
– Financial intermediary that specializes in selling new security issues and
advising firms with regard to major financial transactions
 Underwriting
– The role of the investment bank in bearing the risk of reselling, at a profit, the
securities purchased from an issuing corporation at an agreed-on price
 IPO Offer Price
– The price at which the issuing firm sells its securities

• Issuing Common Stock

– The Investment Bank’s Role
 Originating Investment Bank
– The investment bank initially hired by the issuing firm, it brings other
investment banks in as partners to form an underwriting syndicate
 Underwriting Syndicate
– A group of other banks formed by the originating investment bank to share the
financial risk associated with underwriting new securities

• Issuing Common Stock

– The Investment Bank’s Role
 Tombstone
– The list of underwriting syndicate banks, presented in such a way to indicate a
syndicate member’s level of involvement, located at the bottom of the IPO
prospectus cover page
 Selling Group
– A large number of brokerage firms that join the originating investment
bank(s); each accepts responsibility for selling a certain portion of a new
security issue on a commission basis

Figure 2.3 The Selling Process for a Large Security Issue

 • Issuing Common Stock
– The Investment Bank’s Role
 Total Proceeds
– The total amount of proceeds for all shares sold in the IPO
– Total Proceeds = (IPO Offer Price × # of IPO Shares Issued)
 Market Price
– The price of the firm’s shares as determined by the interaction of buyers and
sellers in the secondary market
 Market Capitalization
– The total market value of a publicly traded firm’s outstanding stock
– Market Capitalization = (Market Price of Stock × # of Shares of Stock
Outstanding)

• Issuing Common Stock

– The Investment Bank’s Role
 IPO Market Price
– The final trading price on the first day in the secondary market
 IPO Underpricing
– The percentage change from the final IPO offer price to the IPO market price,
which is the final trading price on the first day in the secondary market; this is
also called the IPO initial return
– IPO Underpricing = (Market Price − Offer Price) ÷ Offer Price

Example 2.3
With baby boomers retiring and hitting the open roads of America in droves, the largest U.S. recreational
vehicle dealer, Camping World, decided it was time to go public. Its IPO took place on October 7, 2016, at
which time the company sold 11.4 million shares at an IPO offer price of $22 per share. Checking prices for
Camping World on Yahoo! Finance, you can find that the IPO market price at the close of secondary market
trading on October 7 was $22.50. With this information you can calculate the IPO underpricing using
Equation 2.4.
IPO Underpricing   Market Price – Offer Price   Offer Price (2.4)
  $22.50 – $22   $22  0.0227 or 2.27%

Camping World’s IPO underpricing of 2.27% is considerably less than the 44% underpricing for Snap Inc.
This demonstrates another interesting fact about IPOs, specifically, that the degree to which IPOs are
underpriced varies tremendously from one deal to another and one time to another. Usually, smaller IPOs
are underpriced more than larger ones, but that was not the case here. Camping World raised $250.8 million
in its offering, which is a small fraction of the $3.4 billion raised in Snap’s IPO.

2.5 Financial Markets in Crisis

• Financial Institutions and Real Estate Finance
– Securitization
 The process of pooling mortgages or other types of loans and then selling claims or
securities against that pool in the secondary market
– Mortgage-Backed Securities
 Securities that represent claims on the cash flows generated by a pool of mortgages
 A primary risk associated with mortgage-backed securities is that homeowners may
not be able to, or may choose not to, repay their loans

• Financial Institutions and Real Estate Finance

– Falling Home Prices and Delinquent Mortgages
 Rising home prices between 1987 and 2006 kept mortgage default rates low
 Lenders relaxed standards for borrowers and created subprime mortgages
 As housing prices fell from 2006 to 2009, many borrowers had trouble making
payments, but were unable to refinance
 As a result, there was a sharp increase in the number of delinquencies and
foreclosures
 Subprime Mortgages
– Mortgage loans made to borrowers with lower incomes and poorer credit
histories as compared to “prime” borrowers

Figure 2.5 House Prices Soar and Then Crash

• Financial Institutions and Real Estate Finance

– Crisis of Confidence in Banks
 With delinquency rates rising, the value of mortgage-backed securities began to fall
and so did the fortunes of financial institutions that had invested heavily in real estate
assets
 Only 3 banks failed in 2007, but 25 failed in 2008, 140 failed in 2009, peaking at 157
bank failures in 2010
  It was not until 2015 that bank failures fell back into the single digits

Figure 2.6 Bank Stocks Plummet During Financial Crisis

• Spillover Effects and Recovery from the Great Recession

– As banks came under intense financial pressure in 2008, they tightened their lending
standards and dramatically reduced the quantity of loans they made
– Corporations found that they could no longer raise money in the money market, or could only
do so at extraordinarily high rates
– As a consequence, businesses began to hoard cash and cut back on expenditures, and
economic activity contracted

Review of Learning Goals

• LG 1
– Understand the role that financial institutions play in managerial finance.
 Financial institutions bring net suppliers of funds and net demanders together to help
translate the savings of individuals, businesses, and governments into loans and other
types of investments
 The net suppliers of funds are generally individuals or households who save more
money than they borrow
 Businesses and governments are generally net demanders of funds, meaning they
borrow more money than they save
• LG 2
– Understand the role that financial markets play in managerial finance.
 Like financial institutions, financial markets help businesses raise the external
financing they need to fund new investments for growth
 Financial markets provide a forum in which savers and borrowers can transact
business directly
 Businesses and governments issue debt and equity securities directly to the public in
the primary market
 Subsequent trading of these securities between investors occurs in the secondary
market
• LG 3
 – Describe the differences between the money market and the capital market.
 In the money market, savers who want a temporary place to deposit funds where they
can earn interest interact with borrowers who have a short-term need for funds
 Marketable securities, including Treasury bills, commercial paper, and other
instruments, are the main securities traded in the money market
 The Eurocurrency market is the international equivalent of the domestic money
market.
 In contrast, the capital market is the forum in which savers and borrowers interact on
a long-term basis
• LG 3 (Cont.)
– Describe the differences between the money market and the capital market.
 Firms issue either debt (bonds) or equity (stock) securities in the capital market
 Once issued, these securities trade on secondary markets that are either broker
markets or dealer markets
 An important function of the capital market is to determine the underlying value of
the securities issued by businesses
 In an efficient market, the price of a security is an unbiased estimate of its true value
• LG 4
– Understand the major regulations and regulatory bodies that affect financial institutions and
markets.
 The Glass-Steagall Act created the FDIC and imposed a separation between
commercial and investment banks
 The act was designed to limit the risks that banks could take and to protect depositors
 More recently, the Gramm-Leach-Bliley Act essentially repealed the elements of
Glass-Steagall pertaining to the separation of commercial and investment banks.
 After the recent financial crisis, much debate has occurred regarding the proper
regulation of large financial institutions
• LG 4 (Cont.)
– Understand the major regulations and regulatory bodies that affect financial institutions and
markets.
 The Dodd-Frank Act was passed in 2010 and contained a host of new regulatory
requirements, the effects of which are yet to be determined
 The Securities Act of 1933 and the Securities Exchange Act of 1934 are the major
pieces of legislation shaping the regulation of financial markets
– Understand the major regulations and regulatory bodies that affect financial institutions and
markets.
 The 1933 act focuses on regulating the sale of securities in the primary market,
whereas the 1934 act deals with regulations governing transactions in the secondary
market
 The 1934 act also created the Securities and Exchange Commission, the primary body
responsible for enforcing federal securities laws
• LG 5
– Describe the process of issuing common stock, including venture capital, going public, and
the investment bank.
 The initial external financing for business startups with attractive growth prospects
typically comes in the form of private equity raised via a private equity placement
 These investors can be either angel investors or venture capitalists (VCs). VCs usually
invest in both early-stage and later-stage companies that they hope to take public to
cash out their investments
 The first public issue of a firm’s stock is called an initial public offering (IPO).
• LG 5 (Cont.)
 – Describe the process of issuing common stock, including venture capital, going public, and
the investment bank.
 The company selects an investment bank to advise it and to sell the securities
 The lead investment bank may form a selling syndicate with other investment banks
 The IPO process includes getting SEC approval, promoting the offering to investors,
and pricing the issue
• LG 6
– Understand what is meant by financial markets in crisis, and describe some of the root causes
of the Great Recession.
 The financial crisis was caused by several factors related to investments in real estate
 Financial institutions lowered their standards for lending to prospective homeowners,
and institutions also invested heavily in mortgage-backed securities
 When home prices fell and mortgage delinquencies rose, the value of the mortgage-
backed securities held by banks plummeted, causing some banks to fail and many
others to restrict the flow of credit to business
 That, in turn, contributed to a severe recession in the United States that became
known as the Great Recession
Chapter 2: An Overview of the Financial System
Function of Financial Markets
• Perform the essential function of channeling funds from economic players that have saved surplus
funds to those that have a shortage of funds
• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them
securities

Function of Financial Markets (cont’d)

• Promotes economic efficiency by producing an efficient allocation of capital, which increases
production
• Directly improve the well-being of consumers by allowing them to time purchases better

Figure 1 Flows of Funds Through the Financial System

Structure of Financial Markets

• Debt and Equity Markets
– Debt instruments (maturity)
– Equities (dividends)
• Primary and Secondary Markets
– Investment Banks underwrite securities in primary markets
– Brokers and dealers work in secondary markets

Structure of Financial Markets (cont’d)

• Exchanges and Over-the-Counter (OTC) Markets
– Exchanges: NYSE, Chicago Board of Trade
– OTC Markets: Foreign exchange, Federal funds
• Money and Capital Markets
– Money markets deal in short-term debt instruments
– Capital markets deal in longer-term debt and
equity instruments

Structure of Financial Markets (cont’d)

• Exchanges and Over-the-Counter (OTC) Markets
– Exchanges: NYSE, Chicago Board of Trade
 – OTC Markets: Foreign exchange, Federal funds
• Money and Capital Markets
– Money markets deal in short-term debt instruments
– Capital markets deal in longer-term debt and
equity instruments

Table 1 Principal Money Market Instruments

Table 2 Principal Capital Market Instruments

Internationalization of Financial Markets

• Foreign Bonds: sold in a foreign country and denominated in that country’s currency
• Eurobond: bond denominated in a currency other than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited in banks outside the home country
– Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of
U.S. banks
• World Stock Markets
– Also help finance the federal government

Function of Financial Intermediaries: Indirect Finance

• Lower transaction costs (time and money spent in carrying out financial transactions)
– Economies of scale
– Liquidity services
• Reduce the exposure of investors to risk
– Risk Sharing (Asset Transformation)
 – Diversification

Function of Financial Intermediaries: Indirect Finance (cont’d)

Deal with asymmetric information problems
(before the transaction) Adverse Selection: try to avoid selecting the risky borrower.
Gather information about potential borrower.
(after the transaction) Moral Hazard: ensure borrower will not engage in activities that will prevent
him/her to repay the loan.
Sign a contract with restrictive covenants.

Function of Financial Intermediaries: Indirect Finance (cont’d)

• Conclusion:
– Financial intermediaries allow “small” savers and borrowers to benefit from the existence of
financial markets.

Table 3 Primary Assets and Liabilities of Financial Intermediaries

 Table 4 Principal Financial Intermediaries and Value of Their Assets

Regulation of the Financial System

• To increase the information available to investors:
– Reduce adverse selection and moral hazard problems
– Reduce insider trading (SEC).

Regulation of the Financial System (cont’d)

• To ensure the soundness of financial intermediaries:

– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control holding of risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates

Table 5 Principal Regulatory Agencies of the U.S. Financial System

 Chapter 7: The Stock Market, the Theory of
Rational Expectations, and the Efficient Market Hypothesis

Computing the Price of Common Stock

The One-Period Valuation Model:

Div1 P1
P0  
(1  ke ) (1  ke )
P0 = the current price of the stock
Div1 = the dividend paid at the end of year 1
ke = the required return on investment in equity
P1 = the sale price of the stock at the end of the first period

The Generalized Dividend Valuation Model

The value of stock today is the present value of all future cash flows
D1 D2 Dn Pn
P0    ...  
(1  ke ) (1  ke )
1 2
(1  ke ) (1  ke ) n
n

If Pn is far in the future, it will not affect P0


Dt
P0  
t 1 (1  ke )t
The price of the stock is determined only by the present value of
the future dividend stream

The Gordon Growth Model

 D0 (1 g) D1
P0  
(ke  g) (ke  g)
D0 = the most recent dividend paid
g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate forever
The growth rate is assumed to be less than the required return on equity
How the Market Sets Prices
 The price is set by the buyer willing to pay the highest price
 The market price will be set by the buyer who can take best advantage of the asset
 Superior information about an asset can increase its value by reducing its perceived risk
How the Market Sets Prices (cont’d)
 Information is important for individuals to value each asset.
 When new information is released about a firm, expectations and prices change.
 Market participants constantly receive information and revise their expectations, so stock prices change
frequently.

Application: The Global Financial Crisis and the Stock Market

 Financial crisis that started in August 2007 led to one of the worst bear markets in 50 years.
 Downward revision of growth prospects: ↓g.
 Increased uncertainty: ↑ke
 Gordon model predicts a drop in stock prices.

The Theory of Rational Expectations

 Adaptive expectations:
 Expectations are formed from past experience only.
 Changes in expectations will occur slowly over time as data changes.
 However, people use more than just past data to form their expectations and sometimes change their
expectations quickly.

The Theory of Rational Expectations (cont’d)

 Expectations will be identical to optimal forecasts using all available information
 Even though a rational expectation equals the optimal forecast using all available information, a
prediction based on it may not always be perfectly accurate
 It takes too much effort to make the expectation the best guess possible
 Best guess will not be accurate because predictor is unaware of some relevant information

Formal Statement of the Theory

X e  X of
X e  expectation of the variable that is being forecast
X of = optimal forecast using all available information
Rationale Behind the Theory
 The incentives for equating expectations with optimal forecasts are especially strong in financial
markets. In these markets, people with better forecasts of the future get rich.
 The application of the theory of rational expectations to financial markets (where it is called the
efficient market hypothesis or the theory of efficient capital markets) is thus particularly useful
Implications of the Theory
 If there is a change in the way a variable moves, the way in which expectations of the variable are
formed will change as well
-Changes in the conduct of monetary policy (e.g. target the federal funds rate)
 The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time.
The Efficient Market Hypothesis: Rational Expectations in Financial Markets

Recall
The rate of return from holding a security equals the sum of the capital
gain on the security, plus any cash payments divided by the
initial purchase price of the security.
Pt 1  Pt  C
R
Pt
R = the rate of return on the security
Pt 1 = price of the security at time t + 1, the end of the holding period
Pt = price of the security at time t , the beginning of the holding period
C = cash payment (coupon or dividend) made during the holding period

The Efficient Market Hypothesis: Rational Expectations in Financial Markets (cont’d)

At the beginning of the period, we know Pt and C.

Pt+1 is unknown and we must form an expectation of it.
The expected return then is
Pt e1  Pt  C
R e

Pt

Expectations of future prices are equal to optimal forecasts using all currently available information so
Pt e1  Pt of1  R e  R of
Supply and Demand analysis states Re will equal the equilibrium return R*, so Rof = R*

The Efficient Market Hypothesis: Rational Expectations in Financial Markets (cont’d)

 Current prices in a financial market will be set so that the optimal forecast of a security’s return using all
available information equals the security’s equilibrium return
 In an efficient market, a security’s price fully reflects all available information
Rationale Behind the Hypothesis
R of  R*  Pt  R of 
R of  R*  Pt  R of 
until
R of  R*
In an efficient market, all unexploited profit opportunities will
be eliminated
How Valuable are Published Reports by Investment Advisors?
 Information in newspapers and in the published reports of investment advisers is readily available to
many market participants and is already reflected in market prices
 So acting on this information will not yield abnormally high returns, on average
 The empirical evidence for the most part confirms that recommendations from investment advisers
cannot help us outperform the general market

Efficient Market Prescription for the Investor

 Recommendations from investment advisors cannot help us outperform the market
 A hot tip is probably information already contained in the price of the stock
 Stock prices respond to announcements only when the information is new and unexpected
 A “buy and hold” strategy is the most sensible strategy for the small investor

Why the Efficient Market Hypothesis Does Not Imply that Financial Markets are Efficient
 Some financial economists believe all prices are always correct and reflect market fundamentals (items
that have a direct impact on future income streams of the securities) and so financial markets are
efficient
 However, prices in markets like the stock market are unpredictable- This casts serious doubt on the
stronger view that financial markets are efficient

Behavioral Finance
 The lack of short selling (causing over-priced stocks) may be explained by loss aversion
 The large trading volume may be explained by investor overconfidence
 Stock market bubbles may be explained by overconfidence and social contagion
Chapter 2: An Overview of the Financial System

Function of Financial Markets

• Perform the essential function of channeling funds from economic players that have saved surplus
funds to those that have a shortage of funds

• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them
securities
BA 42 QUIZ Ch 2 The Financial Market Environment
2.1 Financial institutions

_T_1) A financial institution is an intermediary that channels the savings of individuals, businesses, and
governments into loans or investments.

_T_2) Commercial banks advise firms on major transactions such as mergers or financial restructurings.

_B_3) Government is typically a ________.

A) net provider of funds because it borrows more than it saves
B) net demander of funds because it borrows more than it saves
C) net provider of funds because it can print money at will
D) net demander of funds because it saves more than it borrows

_D_4) Government can obtain funds ________.

A) by trading in the equity market
B) by issuing financial instruments such as futures and options
C) through the foreign exchange market
D) by selling debt securities

_A_5) Firms that require funds from external sources can obtain them ________.
A) through financial institutions B) from central bank directly
C) through the foreign exchange market D) by issuing T-bills

_C_6) Investment banks are institutions that ________.

A) perform all activities of commercial banks and retail banks
B) are exempted from Securities and Exchange Commission regulations
C) engage in trading and market making activities
D) are only limited to capital market activities

_A_7) Which of the following serves as an intermediary channeling the savings of individuals, businesses,
and governments into loans and investments?
A) financial institutions B) financial markets
C) Securities and Exchange Commission D) OTC market

_T_8) The shadow banking system describes a group of institutions that engage in lending activities, much
like traditional banks.

_D_9) Which of the following provides savers with a secure place to invest funds and offer both individuals
and companies loans to finance investments?

A) investment banks B) securities exchanges C) mutual funds D) commercial banks

_A_10) Which of the following assists companies in raising capital, advise firms on major transactions such
as mergers or financial restructuring, and engage in trading and market making activities?

A) investment banks B) securities exchanges C) mutual funds D) commercial banks

2.2 Financial markets

_F_11) Primary and secondary markets are markets for short-term and long-term securities, respectively.

_T_12) The over-the-counter (OTC) market is a market for trading smaller and unlisted securities.

_T_13) In the Eurobond market, corporations and governments typically issue bonds denominated in
dollars and sell them to investors located outside the United States.

_F_14) Money markets are markets for long-term funds such as bonds and equity.

_T_15) An efficient market is a market that establishes correct prices for the securities that firms sell and
allocates funds to their most productive use as a result of the intense competition among investors.

_T_16) Money markets involve the trading of securities with maturities of one year or less.
_T_17) Eurocurrency deposits arise when a corporation or individual makes a deposit in a bank in a
currency other than the local currency of the country where the bank is located.

_T_18) The Eurocurrency market is a market for short-term bank deposits denominated in U.S. dollars or
other easily convertible currencies.

_F_19) The money market is a financial relationship created by a number of institutions and arrangements
that allows suppliers and demanders of long-term funds to make transactions.

_D_20) The over-the-counter (OTC) market is ________.

A) a highly liquid market as compared to NASDAQ
B) a market in which low risk-high return securities are traded
C) an organized market in which all financial derivatives are traded
D) a market where smaller, unlisted securities are traded

_D_21) Which of the following is true of a primary market?

A) It is an organized market in which all financial derivatives are traded.
B) It is regulated by The Sarbanes-Oxley Act.
C) It is a market where smaller, unlisted securities are traded.
D) It is the only market in which the issuer is directly involved in the transaction.

_D_22) Which of the following is true of a secondary market?

A) It is a market for an unlisted company to raise equity capital.
B) It is a market where securities are issued through private placement.
C) It is a market in which short-term money market instruments such as Treasury bills are traded.
D) It is a market in which preowned securities are traded.

_A_23) Which of the following is true of preferred stock?

A) It has features of bonds and a common stock.
B) It has a claim on assets prior to creditors in the event of liquidation.
C) Its dividends can be paid only after paying dividends to the common stockholders.
D) It usually has a maturity of thirty years.

_C_24) The key securities traded in the capital markets are ________.
A) commercial papers and Treasury bills B) Treasury bills and certificates of deposit
C) stocks and bonds D) bills of exchange and commercial papers

_A_25) Which of the following is true of a dealer market?

A) Buyers and sellers are never brought together directly.
B) Brokers execute the buy or sell orders in a dealer market.
C) It has centralized trading floors.
D) It is a part of the broker market.

_D_26) Which of the following is true of a securities exchange?

A) It serves as an intermediary by channeling the savings of individuals, businesses, and
governments into loans or investments.
B) It borrows funds directly from the financial institutions.
C) It is an association of banks who meet to buy and sell stocks and bonds.
D) It provides a marketplace in which firms can raise funds through the sale of new securities and
purchasers can resell securities.

_C_27) A market that establishes correct prices for the securities that firms sell and allocates funds to their
most productive uses is called a(n) ________.
A) future market B) forex market C) efficient market D) weak-form market

_D_28) The ________ is created by a financial relationship between suppliers and demanders of short-
term funds.
A) stock market B) capital market C) forex market D) money market
_B_29) By definition, the money market involves the buying and selling of ________.
A) stocks and bonds B) short-term securities
C) all financial instruments except derivatives D) secured premium notes

_B_30) Most money market transactions are made in ________.

A) common stock B) marketable securities
C) commodities market D) preferred stock

_B_31) The ________ is created by a number of institutions and arrangements that allow the suppliers and
demanders of long-term funds to make transactions.
A) forex market B) capital market C) money market D) commodities market
_C_32) Long-term debt instruments used by both government and business are known as ___.
A) preferred stocks B) T-bills C) bonds D) equities

_A_33) Which of the following is an example of marketable securities?

A) U.S.Treasury bills B) treasury stock
C) mortgage backed securities D) loans

_C_34) In a ________ market, the buyer and seller are brought together to trade securities in an
organization called ________.
A) dealer; securities market B) broker; over-the -counter market
C) broker; securities market D) dealer; over-the-counter market

_F_35) A primary market is a financial market in which pre-owned securities are traded.

_A_36) Most businesses raise money by selling their securities in a ________.

A) public offering B) forex market C) futures market D) commodities market

_B_37) Which of the following is a means of selling bonds or stocks to the public?
A) private placement B) public offering
C) organized selling D) direct placement

_B_38) Which of the following is a forum in which suppliers and demanders of funds can transact business
directly?
A) shadow banking system B) financial markets
C) commercial banks D) financial institutions

_D_39) The sale of a new security directly to an investor or a group of investors is called _____.
A) arbitraging B) short selling
C) a capital market transaction D) a private placement

_T_40) The money market is a market where investors trade highly liquid securities with maturities of 1
year or less.

_B_41) The market for short-term bank deposits denominated in dollars and other currencies is the
________.
A) money marketB) Eurocurrency market C) primary market D) broker market

_F_42) The Eurocurrency market is a market where investors can exchange currencies, for example by
trading dollars for euros.

_A_43) The ________ market is where securities are initially issued and the ________ market is where
pre-owned securities (not new issues) are traded.
A) primary; secondary B) money; capital C) secondary; primary D) primary; money

_D_44) An efficient market is one where ________.

A) prices of stocks move up and down widely without apparent reason
 B) prices of stocks remain low for long periods of time
C) prices of stocks are unaffected by market news
D) the price of a security is an unbiased estimate of its true value

_C_45) The ________ represents income to a market maker who helps facilitate securities trading.
A) commission B) IPO underpricing C) bid/ask spread D) cost of doing business

_F_46) You submit an order to buy 100 shares of stock. The price that you pay for the stock is more likely
to be the ask price rather than the bid price.

_B_47) The money market is a market ________.

A) that enables suppliers and demanders of long-term funds to make transactions
B) which brings together suppliers and demanders of short-term funds
C) where smaller, unlisted securities are traded
D) where all derivatives are traded

_F_48) In a securities market, the bid price is typically higher than the ask price.

_A_49) A ________ is someone who helps facilitate securities trading by offering to buy or sell them at
stated bid/ask prices.
A) market maker B) stockbroker C) day trader D) middle man
_C_50) Apex Inc. issues a bond of $1,000 which pays interest semiannually at a coupon interest rate of
8%. The maturity of the bond is 15 years. Where should this bond be traded?
A) forex market B) money market C) capital marketD) commodities market

_T_51) One sign that the stock market is efficient is that prices in the market move seemingly at random,
display almost no predictable, repeating patterns.

2.3 Regulation of financial markets and institutions

_C_52) The Glass-Steagall Act ________.

A) was intended to regulate the activities in the secondary market
B) created the Securities Exchange Commission
C) separated the activities of commercial and investment banks
D) was intended to regulate the activities in the primary market

_T_53) The Securities Act of 1933 focuses on regulating the sale of securities in the primary market,
whereas the 1934 Act deals with the regulations governing the transactions in the secondary market.

_C_54) Which of the following acts regulates the secondary market?

A) The Securities Act of 1933 B) The Gramm-Leach-Bliley Act
C) The Securities Exchange Act of 1934 D) The Glass-Steagall Act

_A_55) Which of the following acts regulates the primary market in which securities are originally issued to
the public?
A) The Securities Act of 1933 B) The Gramm-Leach-Bliley Act
C) The Securities Exchange Act of 1934 D) The Glass-Steagall Act

2.4 The securities issuing process

_A_56) A firm conducting an IPO of common stock sold 1 million new shares in the offering at an offer price
of $10 per share. After the offering, the firm had 5 million shares outstanding, and the price of those shares
in the secondary market was $12. The firm's market capitalization is ____
A) $60 million B) $50 million C) $12 million D) $10 million

_C_57) A firm conducting an IPO of common stock sold 1 million new shares in the offering at an offer price
of $10 per share. After the offering, the firm had 5 million shares outstanding, and the price of those shares
in the secondary market was $12. The firm's IPO was underpriced by __.
 A) 0% B) 100% C) 20% D) 16.7%

_B_58) Which of the following is an attribute of investment bankers?

A) They make long-term investments for banking institutions.
B) They bear the risk of selling a security issue.
C) They act as middlemen between the issuer and the banker.
D) They provide the issuer with advice relating to the amounts of dividend to be paid.

_D_59) A(n)________ is hired by a firm to find prospective buyers for its new stock or bond issue.
A) securities analyst B) trust officer
C) commercial loan officer D) investment banker

_B_60) When an investment bank buys new securities from a firm and takes on the responsibility of
reselling those securities to the public it is engaged in ________.
A) market manipulation B) underwriting
C) the road show D) underpricing the security offering

_A_62) ________ is a financial intermediary that specializes in selling new security issues.
A) An investment bankB) A commercial bank
C) A securities dealer D) A stock exchange

_A_62) A group formed by an investment banker to share the financial risk associated with underwriting
new securities is called a(n) ________.
A) underwriting syndicate B) selling group
C) investment banking consortium D) broker pool

_C_63) The document that a company conducting an initial public offering produces to describe the key
aspects of the securities offered for sale is called the ________.
A) annual report to stockholders B) term sheet
C) prospectus D) tombstone

_A_64) When a firm sells stock to the public for the first time the transaction is called ________.
A) an initial public offering B) a seasoned equity offering
C) a private placement D) a secondary market offering

_T_65) When venture capitalists invest money in a firm, they are making a private equity investment.