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Copyright 2011 Pearson Prentice Hall. All rights reserved.

Firms and the

Financial Market

Chapter 2

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Copyright 2011 Pearson Prentice Hall. All rights reserved.2-2

Slide Contents

Learning Objectives

Principles Used in this Chapter

1.The Basic Structure of the U.S. Financial

Markets2.The Financial Marketplace Financial

Institutions

3.The Financial Marketplace Securities

Markets Key Terms

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Copyright 2011 Pearson Prentice Hall. All rights reserved.2-3

Learning Objectives

1. Describe the structure and functions offinancial markets.

2. Distinguish between commercial banks

and other financial institutions in thefinancial marketplace.

3. Describe the different securities marketsfor bonds and stock.

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Copyright 2011 Pearson Prentice Hall. All rights reserved. 2-4

Principles Used in this Chapter

Principle 2: There is a Risk-ReturnTradeoff.

Financial markets are organized to offerinvestors a wide range of investmentopportunities that have different risk anddifferent expected rates of return that reflect

those risks.

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Principles Used in this Chapter(cont.)

Principle 4: Market Prices ReflectInformation.

It is through the operations of the financialmarkets that new information is efficientlyimpounded in security prices.

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2.1 THE BASICSTRUCTURE OFTHE U.S.

FINANCIALMARKETS

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Three Players in the FinancialMarkets

There are three principal sets of players thatinteract within the financial markets:

1. Borrowers

2. Savers (or sometimes called lenders)3. Financial Institutions (or sometimes called

Financial Intermediaries)

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Three Players in the FinancialMarkets (cont.)

1. Borrowers: Individuals and businesses that needmoney to finance their purchases orinvestments.

2. Savers (Investors): Those who have money toinvest. These are principally individuals althoughfirms also save when they have excess cash.

3. Financial Institutions (Intermediaries): Thefinancial institutions and markets help bring

borrowers and savers together.

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2.2 THE FINANCIALMARKETPLACE FINANCIAL

INSTITUTIONS

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Financial Intermediaries

SAVERS Financial

Intermediaries

BORROWERS

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Financial Intermediaries

Example on Intermediaries

Johns three sons are grown up and arelooking to buy their first home.

There is no intermediation if John directly givesthem the funds they need

There is intermediation where a bank doles outthe funds and John is free to place his monies

in any bank he chooses to do so.

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Financial Intermediaries (cont.)

Financial institutions like commercialbanks, finance companies, insurancecompanies, investment banks, and

investment companies are called financialintermediaries as they help bringtogether those who have money (savers)and those who need money (borrowers).

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Money versus Capital Market

The money market refers to debtinstruments with maturity of one year orless.

Examples: Treasury bills (T-bills), Commercialpaper (CP).

The capital market refers to long-termdebt and equity instruments.

Examples: Common stock, Preferred stock,Corporate bond, Treasury bond, Municipalbond.

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Commercial Banks EveryonesFinancial Marketplace

Commercial banks collect the savings ofindividuals as well as businesses and then lendthose pooled savings to other individuals andbusinesses.

They make money by charging a rate of interestto borrowers that exceeds the rate they pay tosavers.

In the United States, banks cannot own industrialcorporations.

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Non-Bank Financial Intermediaries

These include:

Financial services corporations, like GE CapitalDivision;

Insurance companies, like Prudential; Investment banks, like Goldman Sachs;

Investment companies including mutual funds,hedge funds and private equity firms.

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Financial Services Corporations

Financial services corporation are in thelending or financing business, but they are notcommercial banks.

One well known financial service corporation is GEcapital, the finance unit of the General ElectricCorporation.

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Financial Services Corporations(cont.)

GE capital provides commercial loans, financingprograms, commercial insurance, equipmentleasing, and other services in over 35 countriesaround the world.

GE capital also provides credit services to morethan 130 million customers that range fromretailers, auto dealers, consumers offeringproducts and services from credit cards to debtconsolidation to home equity loans.

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Insurance Companies

Insurance companies sell insurance toindividuals and businesses to protect theirinvestments.

They collect premium and hold the premium inreserves until there is an insured loss and then payout claims to the holders of the insurancecontracts. Later, these reserves are deployed invarious types of investments including loans toindividuals, businesses and the government.

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Investment Banks

Investment banks are specializedfinancial intermediaries that:

help companies and governments raise money

provide advisory services to client firms onmajor transactions such as mergers

Firms that provide investment bankingservices include Bank of America, Goldman

Sachs, Morgan Stanley and JP MorganChase.

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Investment Companies

Investment companies are financialinstitutions that pool the savings ofindividual savers and invest the money in

the securities issued by other companiespurely for investment purposes.

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Mutual Funds and Exchange TradedFunds (ETFs)

Mutual funds are professionally managedaccording to a stated investment objective.

Individuals can invest in mutual funds by

buying shares in the mutual fund at thenet asset value (NAV). NAV is calculateddaily based on the total value of the funddivided by the number of mutual fund

shares outstanding.

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Mutual Funds and Exchange TradedFunds (ETFs) (cont.)

Mutual funds can either be load or no-loadfunds. The term load refers to the salescommission that you pay when acquiring

ownership shares in the fund. Thesecommissions typically range between 4.0to 6.0%.

A mutual fund that does not charge a

commission is referred to as a no-loadfund.

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An exchange-traded fund (ETF) issimilar to a mutual fund except that theownership shares in the ETF can be bought

and sold on the stock exchange. Most ETFs track an index, such as the Dow

Jones Industrial Average or the S&P 500,and generally have relatively low

expenses.

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Mutual funds and ETFs provide a cost-effectiveway to diversify and reduce risk.

If you had only $10,000 to invest, it would bedifficult to diversify since you will have to pay

commission for each individual stock. However,by buying a mutual fund that invests in S&P500,you can indirectly purchase a portfolio thattracks 500 stocks with just one transaction.

Alternatively, you might purchase an ETF, such asSPDR S&P 500 (SPY), which tracks S&P 500.

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Hedge Funds

Hedge funds are similar to mutual fundsbut they tend to take more risk and aregenerally open only to high net worth

investors. Management fees also tends to be higher

for hedge funds and most funds include anincentive fee based on the funds overall

performance, which typically runs at 20%of profits.

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Private Equity Firms

Private equity firms include two majorgroups: Venture capital (VC) firms andLeveraged buyout firms (LBOs).

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Private Equity Firms (cont.)

Venture capital firms raise money frominvestors (wealthy individuals and otherfinancial institutions) that they then use to

provide financing for private start-upcompanies when they are first founded.

For example, Venture capital firm, KleinerPerkins Caufield & Byers (KPCB) was

involved in the initial financing of Google.

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Private Equity Firms (cont.)

Leveraged buyout firms acquire establishedfirms that typically have not been performing verywell with the objective of making them profitableagain and selling them. An LBO typically uses debt

to fund the purchase of a firm. LBO transactionsgrew from $7.5 billion in 1991 to $500 billion in2006.

Prominent LBO private equity firms include

Cerberus Capital Management, L.P., TPG (formerlyTexas Pacific Group), and KKR (Kohlberg, Kravis,and Roberts).

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2.3 THEFINANCIALMARKETPLACE SECURITIESMARKET

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Security

A security is a negotiable instrument thatrepresents a financial claim and can takethe form of ownership (such as stocks) or

debt agreement (such as bonds).

The securities market allow businesses andindividual investors to trade the securitiesissued by public corporations.

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Primary versus Secondary Market

A primary market is a market in whichsecurities are bought and sold for the firsttime. In this market, the firm selling

securities actually receives the moneyraised. For example, securities sold by acorporation to investment bank.

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Primary versus Secondary Market(cont.)

A secondary market is where allsubsequent trading of previously issuedsecurities takes place. In this market, the

issuing firm does not receive any newfinancing. The securities are simplytransferred from one investor to another.Thus secondary markets provide liquidity

to the investor. For example, the New YorkStock Exchange.

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How Securities Markets BringCorporation and Investors Together

Figure 2-2 describes the role of securitiesmarket in bringing investors together withbusinesses looking for financing.

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Process of Raising Money in theSecurities Market (Figure 2-2)

1. The firms sells securities (debt or equity)to investors in the primary market.

2. The firm invests the funds it raises in its

business.3. The firm distributes the cash earned from

its investments.

4. Security continues to trade in thesecondary market.

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Types of Securities

Debt Securities: Firms borrow money byselling debt securities in the debt market.

If the debt has a maturity of less than one

year, it is typically called notes, and istraded in the money market.

If the debt has a maturity of more thanone year, it is called bond and is traded in

the capital market.

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Types of Securities (cont.)

Most bonds pay a fixed interest rate on theface or par value of bond.

For example, a bond with a face value of

$1,000 and semi-annual coupon rate of9% will pay an interest of $45 every 6months or $90 per year, which is 9% of$1,000. When the bond matures, the

owner of the bond will receive $1,000.

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Equity securities represent ownership ofthe corporation.

There are two major types of equitysecurities: common stock and preferredstock.

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Common stock is a security that representsequity ownership in a corporation, provides votingrights, and entitles the holder to a share of thecompanys success in the form ofdividends and

any capital appreciation in the value of thesecurity.

Common stockholders are residual owners of thefirm i.e. they earn a return only after all other

security holder claims (debt and preferred equity)have been satisfied in full.

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Dividend on common stock are neitherfixed nor guaranteed. Thus a company canchoose to reinvest all of the profits in a

new project and pay no dividends.

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Preferred stock is an equity security.However, preferred stockholders havepreference with regard to:

Dividends: They are paid before the commonstockholders.

Claim on assets: They are paid before commonstockholders if the firm goes bankrupt and sells

or liquidates its assets.

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Preferred stock is also referred to as ahybrid security as it has features of bothcommon stock and bonds.

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Preferred stock is similar to common stocksin that:

It has no fixed maturity date,

The nonpayment of dividends does not result inbankruptcy of the firm, and

The dividends are not deductible for taxpurposes.

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Preferred stock is similar to corporate bondsin that:

The dividends are typically a fixed amount, and

There are no voting rights.

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Stock Markets

A stock market is a public market in whichthe stocks of companies is traded.

Stock markets are classified as eitherorganized security exchanges or over-the-counter (OTC) market.

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Stock Markets (cont.)

Organized security exchanges aretangible entities; that is, they physicallyoccupy space and financial instruments are

traded on their premises. For example, theNew York Stock Exchange (NYSE) islocated at 11 Wall Street in Manhattan,NY. The total value of stocks listed on the

NYSE fell from $18 trillion in 2007 to justover $10 trillion at the beginning of 2009.

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Stock Markets (cont.)

The over-the-counter markets includeall security market except the organizedexchanges.

NASDAQ (National Association ofSecurities Dealers Automated Quotations)is an over-the-counter market anddescribes itself as a screen-based,

floorless market. In 2009, nearly 3,900companies were listed on NASDAQ,including Starbucks, Google, Intel.

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Reading Stock Price Quotes

Figure 2-3 illustrates how to read stockprice quotes fromwww.google.com/finance.

Similar information is available athttp://finance.yahoo.com
http://www.google.com/financehttp://finance.yahoo.com/http://finance.yahoo.com/http://www.google.com/finance

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Other Financial Instruments

Table 2-2 provides a list of differentfinancial instruments used by firms to raisemoney beginning with the shortest

maturity instruments that are traded inthe money market and moving through tothe longest maturity instruments that aretraded in the capital market.

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Key Terms

Accredited investor

Bond

Capital market

Commercial bank

Common stock

Coupon rate

Credit default swaps

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Key Terms (cont.)

Debt securities

Equity securities

Exchange-traded funds (ETFs)

Face or par value

Financial intermediaries

Hedge fund

Investment bank

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Key Terms (cont.)

Investment companies

Leveraged buyout fund

Load funds

Maturity

Money market

Mutual fund

Net asset value

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Key Terms (cont.)

Notes

No-load fund

Organized security exchanges

Over-the-counter markets Preferred stock

Primary market

Secondary market

Security

Venture Capital firm

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