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CHAPTER 5Financial Markets and InstitutionsUpdated: July 21, 2013

The Capital Allocation Process

Financial markets

Financial institutions

Stock Markets and Returns

Stock Market Efficiency

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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 moneyand looking for a rate of return on their investment.

Demanders or users of capital (credit) individuals andinstitutions who need to raise funds to finance theirinvestment opportunities. These groups are willing topay a rate of return on the capital they borrow.

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How is capital transferred between

savers (Sc) and borrowers (Dc)? Direct transfers stocks

and bonds, securities

Investment bankinghouse - Underwriting

Financial intermediariesbanks and mutual funds

See Figure 5-1, p. 144Supply and Demand forCredit

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What is a market?A market is a venue where goods and

services are exchanged.

A financial market is a place whereindividuals and organizations wanting toborrow funds/capital (Dc) are brought

together with those having a surplus offunds (Sc).

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Types of financial markets

Physical assets vs. Financial assets

Money (short) vs. Capital (long)

Primary (proceeds go to firm) vs. Secondary Mkt. foroutstanding securities

Spot (cash) vs. Futures

Public (exchange-traded) vs. Private (banks)

Derivatives Futures and options Foreign Exchange Currency

See Table 5-1, p. 148 - 149

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

Markets provide users of capital with the necessary fundsto finance their investment projects.

Well-functioning markets promote economic

growth. Economies with well-developed markets perform

better than economies with poorly-functioningmarkets.

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What are derivatives? How can they be

used to reduce or increase risk? A derivative securitys 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 thedollar loses value, could purchase currency futuresthat 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 manycases, these transactions produce high returns ifyou guess right, but large losses if you guesswrong. Here, derivatives can increase risk.

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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 5-2, p. 153

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Physical location stock exchanges

vs. Electronic dealer-based markets

Auction market at aphysical location (NYSE) vs.Electronic Dealer market(NASDAQ)

NYSE: 3000 companies

NASDAQ: 2000 companies Differences are narrowing:

Daily volume is equal

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Stock Market Transactions Apple Computer decides to issue additional stock

with the assistance of its investment banker. Aninvestor purchases some of the newly issued

shares. Is this a primary market transaction or asecondary 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 primaryor secondary market transaction? Since no new shares are created, this is a secondary

market transaction.

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What is an IPO? An initial public offering (IPO) is where a

company issues stock in the public marketfor the first time (e.g. Google in 2004). See

Table 5-3 on p. 159. Going public enables a companys owners

to raise capital from a wide variety ofoutside investors. Once issued, the stock

trades in the secondary market (NYSE,NASDAQ). Public companies are subject to additional

regulations and reporting requirements.

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Historical stock market performance,

S&P 500 (1968-2004)

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Historical Stock Returns SP 500 Return (%):

1/22/1968: -94 (PV)

1/22/2007: 1425 (FV)

N = 39

Solve for I = __________

See Measuring the Market p. 164-165

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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 Journalor the local newspaper) and online sources(Yahoo!Finance, CNNMoney, or MSN MoneyCentral).

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What is the Efficient Market

Hypothesis (EMH)? Securities are normally in equilibrium

and are fairly priced.

Investors cannot beat the marketexcept through good luck or betterinformation.

Levels of market efficiency Weak-form efficiency

Semistrong-form efficiency

Strong-form efficiency

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Weak-form efficiency Cant profit by looking at past trends. A

recent decline is no reason to think

stocks will go up (or down) in thefuture. Stocks follow a random walk.

Evidence supports weak-form EMH, but

technical analysis is still used bychartists.

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Semistrong-form efficiencyAll publicly available information is

reflected in stock prices, so it doesnt

pay to over-analyze annual reportslooking for undervalued stocks.

Largely true, but superior analysts

can still profit by finding and usingnew information.

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Strong-form efficiencyAll 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, butthats illegal.

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Conclusions about market efficiency Empirical studies suggest the stock market

is: Highly efficient in the weak form.

Reasonably efficient in the semistrong form.

Not efficient in the strong form. Insiders havemade abnormal (and sometimes illegal) profits.

Behavioral finance Incorporates elements of cognitive psychology to

better understand how individuals and marketsrespond to different situations.

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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-strongefficient, can you expect to take advantage ofthis information by purchasing the stock?

No if the market is semi-strong efficient, this

information will already have been incorporatedinto the companys stock price. So, its probablytoo late

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Implications of market efficiency A small investor has been reading about a hot IPO

that is scheduled to go public later this week. Shewants to buy as many shares as she can get her

hands on, and is planning on buying a lot of sharesthe first day once the stock begins trading. Wouldyou 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 floorand receive an allocation of shares before the stock beginstrading. It is usually hard for small investors to receiveshares of hot IPOs before the stock begins trading.