CHAPTER 2 Financial Markets and InstitutionsUpdated: April 19, 2023

The Capital Allocation Process Financial markets Financial institutions Stock Markets and Returns Stock Market Efficiency

The Capital Allocation Process• In a well-functioning economy, capital (credit)

flows efficiently from those who supply capital (credit) to those who demand it.

• Suppliers of capital (credit) – individuals and institutions with “excess funds.” These groups are saving money and looking for a rate of return on their investment.

• Demanders or users of capital (credit) – individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

How is capital transferred between savers (Sc) and borrowers (Dc)?

• Direct transfers – stocks and bonds, securities

• Investment banking house - Underwriting

• Financial intermediaries – banks and mutual funds

• See Figure 2-1, p. 27 Diagram of the Capital Formation Process of Business

What is a market?

• A market is a venue where goods and services are exchanged.• A financial market is a place where

individuals and organizations wanting to borrow funds/capital (Dc) are brought together with those having a surplus of funds (Sc).

Types of financial markets

• Physical assets vs. Financial assets• Money (short) vs. Capital (long)• Primary (proceeds go to firm) vs. Secondary Mkt.

for outstanding securities• Spot (cash) vs. Futures• Public (exchange-traded) vs. Private (banks)• Derivatives – Futures and options• Foreign Exchange – Currency• See Table 2-1, p. 32 – 33 for Summary of Major

Market Instruments

The importance of financial markets to economic growth

• Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.• Markets provide savers with returns on their money

saved/invested, which provides them money in the future.

• Markets provide users of capital with the necessary funds to finance their investment projects.

• Well-functioning markets promote economic growth.• Economies with well-developed markets perform better

than economies with poorly-functioning markets.

What are derivatives? How can they be used to reduce or increase risk?• A derivative security’s value is “derived” from

the price of another security (e.g., options and futures).

• Can be used to “hedge” or reduce risk. For example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens.

• Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk.

Types of financial institutions

• Commercial banks – Citizens, Chase• Investment banks – Goldman Sachs, JP

Morgan• Mutual savings banks – S&Ls• Credit unions• Pension funds• Life insurance companies• Mutual funds – Vanguard, Fidelity• Hedge funds• See Table 2-2, p. 36 and Table 2-3, p. 37

Physical location stock exchanges vs. Electronic dealer-based markets

• Auction market at a physical location (NYSE) vs. Electronic Dealer market (NASDAQ)• National Association of Securities

Dealers Automated Quotations

• NYSE: 3000 companies• NASDAQ: 2000 companies• Differences are narrowing:

Daily volume is equal

New York Stock Exchange

• NYSE is the largest stock exchange in the world-About 2,400-3,000 companies list stocks at the NYSE-Total market cap of listed companies is appx $16 trillion

and represents more than one-third of the world’s stock market value

-Daily volume is appx $150 billion-IPOs at the NYSE are huge;

LinkedIn raised $352 million in 2011• NYSE offers electronic trading

system alternatives• Direct+ automatically matches buyers

and sellers (orders <1,099) (Generally for smaller trades)

• Superdot routes orders to the floor trading post (Generally for larger trades)

Global Stock Market Capitalization

• Deal Approved:• Atlanta-based IntercontinentalExchange Inc. (ICE) agreed to buy the Big Board parent in

December in a deal currently valued at about $10.2 billion.

What Type of Market Are You Investing In?

Stock Market Transactions• Apple Computer decides to issue additional

stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction? • Since new shares of stock are being issued, this is a

primary market transaction. • What if instead an investor buys existing

shares of Apple stock in the open market – is this a primary or secondary market transaction?• Since no new shares are created, this is a

secondary market transaction.

What is an IPO?

• An initial public offering (IPO) is where a company issues stock in the public market for the first time (e.g. Google in 2004, Facebook 2012).

• “Going public” enables a company’s owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market (NYSE, NASDAQ).

• Public companies are subject to additional regulations and reporting requirements.

• Reuters: LinkedIn IPO: May 19, 2011

Linkedin IPO

Initial Public Offerings

• An initial public offering or IPO occurs when a corporation sells its shares for the very first time to the public markets. The main reason for going public is to expand possible financing sources by tapping into the huge public financial markets. In other words, the company can raise cash by allowing outsiders to become shareholders in the company.• Proceeds from an IPO would represent an increase in the Cash Asset on the

Balance sheet and an increase the Stockholders’ Equity liability.

• The going public process is complex with many tasks that generally fall into one or more of three functional categories:• Regulatory• Underwriting• Distribution

IPO Regulatory Requirements

• Securities Act of 1933, the Securities Exchange Act of 1934 and the Corporate Accountability Act of 2002 (aka Sarbannes-Oxley) • Transition from a privately-held to publicly-traded corporation

involves huge changes in regulatory responsibilities. • Once a company goes public (that is, it issues publicly traded

shares of stock), they are required to disclose a lot of information that may have been previously considered confidential.

• Companies going public must submit a detailed registration statement and a preliminary prospectus to the SEC (Securities and Exchange Commission). • No public shares may be issued until SEC approval is granted.

• The company will eventually distribute the prospectus to potential investors. The prospectus contains information about the company, its mission and management, and other financial information considered important for analyzing and valuing the company.

IPO Underwriting Process

• Companies going public hire an investment banker to advise and assist the company in issuing the IPO. One of the more important roles of the investment banker is the underwriting process.

• Underwriting by an investment banker is the analysis of new security issuances in order to properly assign prices and collect fees.

• Several investment bankers may join together to form an “underwriting syndicate” to aid in the distribution of relatively large offerings.

• Two extreme fee structures exist for underwriting:• Firm commitment• Best efforts

Underwriting Process: Firm Commitment Contracts• In a firm commitment contract the investment banker

purchases the security from the issuing company for a mutually agreeable price.

• The issuing company receives a specified sum of money and the underwriter receives the security and bears the risk of selling the security in the primary market.

• The underwriter’s income depends on the spread between the price paid to the issuing company and the price received upon re-sell.

• In this type of arrangement, the underwriter is exposed to a substantial amount of risk because they may be unable to sell all of the shares.

• The company, on the other hand, bears no risk because the underwriter (the investment bank or syndicate) has provided a guaranteed price for the IPO.

Underwriting Process: Best Efforts Contracts

• In a best efforts contract, the investment banker receives a mutually agreeable fee from the issuing company and sells the security for them in the primary market at the best possible price.

• The underwriter has no risk exposure with a best efforts contract because they never take ownership of the stock.

• The issuing company bears all of the risk because they are not guaranteed a minimum price or that all of the shares will sell. • As a result, the company may be unable to raise as much capital as

was desired.

IPO Distribution

• Perhaps the most difficult task is setting the offer price for issuing stocks in the primary market. The underwriter compares existing public companies to the IPO company and sets a preliminary price range for the new issue. They then gauge potential investor interest by conducting pre-market activities:• Roadshows inform institutional investors about the company.• Order books fill with tentative purchase agreements.• Allocation agreements stipulate which underwriters, brokers, and customers

get the IPO stocks.

• Underwriters set the final offer price the day before shares begin trading.

• Once trading commences, shares flow out of the primary market and begin trading in the secondary market. The stock price moves up or down in response to supply and demand forces.

How do companies perform after their IPO?

• Huge Initial Returns in the Secondary Marker

• However, these stocks also exhibit below-average returns in the long-run (2 to 3 yrs after the offering) in the secondary market.

Huge Initial Returns and Long-run Underperformance

Historical stock market performance, S&P 500 (1926-2011)

Cap Gains Yield and Dividend Yield

Suppose:• You buy a stock today for $50 • In one year, you receive DIV = $1• Stock sells for $55 in one year

• Dividend Yield (%) = • $1 / $50 = 2%

• Cap Gain Yield (%) = • $5 Gain / $50 = 10%

• Total Return = • 2% + 10% = 12%

Historical Stock Returns

• SP 500 Return (%):• 1/22/1968: 94 (PV)• 1/22/2007: 1425 (FV)• N = 39• Solve for I = __________

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

• Stock quotes can be found in a variety of print sources (Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, MSN MoneyCentral, or Bloomberg Terminal).

What is the Efficient Market Hypothesis (EMH)?

• Securities are normally in equilibrium and are “fairly priced.”

• Investors cannot “beat the market” except through good luck or better information.

• Levels of market efficiency• Weak-form efficiency• Semistrong-form efficiency• Strong-form efficiency

Weak-form efficiency

• Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Stocks follow a “random walk.”

• Evidence supports weak-form EMH, but “technical analysis” is still used by “chartists.”

Semistrong-form efficiency

• All publicly available information is reflected in stock prices, so it doesn’t pay to over-analyze annual reports looking for undervalued stocks.

• Largely true, but superior analysts can still profit by finding and using new information.

Strong-form efficiency

• All information, even inside information, is embedded in stock prices.

• Generally considered to be not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

Conclusions about market efficiency• Empirical studies suggest the stock market is:• Highly efficient in the weak form.• Reasonably efficient in the semistrong form.• More information available for large firms (i.e. greater analyst

coverage

• Not efficient in the strong form. Insiders have made abnormal (and sometimes illegal) profits.

• Behavioral finance• Incorporates elements of cognitive psychology to better

understand how individuals and markets respond to different situations.

Implications of market efficiency

• You hear in the news that a medical research company received FDA approval for one of its products. If the market is semi-strong efficient, can you expect to take advantage of this information by purchasing the stock?• No – if the market is semi-strong efficient,

this information will already have been incorporated into the company’s stock price. So, it’s probably too late …

Implications of market efficiency• A small investor has been reading about a “hot” IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this?• Probably not. The long-run track record of hot IPOs

is not that great, unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. • It is usually hard for small investors to receive shares of

hot IPOs before the stock begins trading.