Chapter 2

Financial Markets and Institutions

Learning Objectives
After reading this chapter, students should be able to:
Identify the different types of financial markets and financial institutions and realize how these markets
and institutions enhance capital allocation.
Explain how the stock market operates and list the distinctions between the different types of stock
markets.
Explain how the stock market has performed in recent years.
Discuss the importance of market efficiency and explain why some markets are more efficient than
others.
Chapter 2: Financial Markets and Institutions Learning Objectives 7
Lecture Suggestions
hapter ! presents an o"er"iew of financial markets and institutions and it leads right into the next chapter.
Additionally, students ha"e an interest in financial markets and institutions.
#e base our lecture on the integrated case. $he case goes systematically through the key points in
the chapter, and within a context that helps students see the real world rele"ance of the material in the
chapter. #e ask the students to read the chapter, and also to %look o"er& the case before class. 'owe"er,
our class consists of about (,))) students, many of whom "iew the lecture on $*, so we cannot count on
them to prepare for class. +or this reason, we designed our lectures to be useful to both prepared and
unprepared students.
,ince we ha"e easy access to computer pro-ection e.uipment, we generally use the electronic slide
show as the core of our lectures. #e strongly suggest to our students that they print a copy of the
PowerPoint slides for the chapter from the web site and bring it to class. $his will pro"ide them with a hard
copy of our lecture, and they can take notes in the space pro"ided. ,tudents can then concentrate on the
lecture rather than on taking notes.
#e do not stick strictly to the slide show/we go to the board fre.uently to present somewhat
different examples, to help answer .uestions, and the like. #e like the spontaneity and change of pace trips
to the board pro"ide, and, of course, use of the board pro"ides needed flexibility. Also, if we feel that we
ha"e co"ered a topic ade.uately at the board, we then click .uickly through one or more slides.
$he lecture notes we take to class consist of our own marked0up copy of the PowerPoint slides,
with notes on the comments we want to say about each slide. If we want to bring up some current e"ent,
pro"ide an additional example, or the like, we use post0it notes attached at the proper spot. $he ad"antages
of this system are 1(2 that we ha"e a carefully structured lecture that is easy for us to prepare 1now that we
ha"e it done2 and for students to follow, and 1!2 that both we and the students always know exactly where
we are. $he students also appreciate the fact that our lectures are closely coordinated with both the text
and our exams.
$he slides contain the essence of the solution to each part of the integrated case, but we also
pro"ide more in0depth solutions in this Instructors Manual. It is not essential, but you might find it useful to
read through the detailed solution. Also, we put a copy of the solution on reser"e in the library for interested
students, but most find that they do not need it.
+inally, we remind students again, at the start of the lecture on hapter !, that they should bring a
printout of the PowerPoint slides to class, for otherwise they will find it difficult to take notes
D!S O" C#$%&': ( OF )* D!S +),-.inute periods/
* Lecture Suggestions Chapter 2: Financial Markets and Institutions
ns0ers to &nd-o1-Chapter 2uestions
2-( $he prices of goods and ser"ices must co"er their costs. osts include labor, materials, and
capital. apital costs to a borrower include a return to the sa"er who supplied the capital, plus a
mark0up 1called a %spread&2 for the financial intermediary that brings the sa"er and the borrower
together. $he more efficient the financial system, the lower the costs of intermediation, the lower
the costs to the borrower, and, hence, the lower the prices of goods and ser"ices to consumers.
2-2 In a well0functioning economy, capital will flow efficiently from those who supply capital to those who
demand it. $his transfer of capital can take place in three different ways:
(. Direct transfers of money and securities occur when a business sells its stocks or bonds directly
to sa"ers, without going through any type of financial institution. $he business deli"ers its
securities to sa"ers, who in turn gi"e the firm the money it needs.
!. $ransfers may also go through an in"estment banking house which underwrites the issue. An
underwriter ser"es as a middleman and facilitates the issuance of securities. $he company
sells its stocks or bonds to the in"estment bank, which in turn sells these same securities to
sa"ers. $he businesses3 securities and the sa"ers3 money merely %pass through& the
in"estment banking house.
4. $ransfers can also be made through a financial intermediary. 'ere the intermediary obtains
funds from sa"ers in exchange for its own securities. $he intermediary uses this money to buy
and hold businesses3 securities. Intermediaries literally create new forms of capital. $he
existence of intermediaries greatly increases the efficiency of money and capital markets.
2-3 A primary market is the market in which corporations raise capital by issuing new securities. An
initial public offering is a stock issue in which pri"ately held firms go public. $herefore, an I56
would be an example of a primary market transaction.
2-4 A money market transaction occurs in the financial market in which funds are borrowed or loaned
for short periods 1less than one year2. A capital market transaction occurs in the financial market in
which stocks and intermediate/or long0term debt 1one year or longer2/are issued.
a5 A 7.,. $reasury bill is an example of a money market transaction.
b5 8ong0term corporate bonds are examples of capital market transactions.
c5 ommon stocks are examples of capital market transactions.
d5 5referred stocks are examples of capital market transactions.
e5 Dealer commercial paper is an example of a money market transaction.
2-) It would be difficult for firms to raise capital. $hus, capital in"estment would slow down,
unemployment would rise, the output of goods and ser"ices would fall, and, in general, our standard
of li"ing would decline.
Chapter 2: Financial Markets and Institutions Answers and Solutions 6
2-7 +inancial markets ha"e experienced many changes during the last two decades. $echnological
ad"ances in computers and telecommunications, along with the globalization of banking and
commerce, ha"e led to deregulation, and this has increased competition throughout the world. $he
result is a much more efficient, internationally linked market, but one that is far more complex than
existed a few years ago. #hile these de"elopments ha"e been largely positi"e, they ha"e also
created problems for policy makers. 8arge amounts of capital mo"e .uickly around the world in
response to changes in interest and exchange rates, and these mo"ements can disrupt local
institutions and economies. $he sub0prime mortgage crisis illustrates how problems in one country
.uickly affect the economies of other nations.
9lobalization has exposed the need for greater cooperation among regulators at the
international le"el. +actors that complicate coordination include 1(2 the differing structures among
nations3 banking and securities industries, 1!2 the trend in Europe toward financial ser"ices
conglomerates, and 142 reluctance on the part of indi"idual countries to gi"e up control o"er their
national monetary policies. :egulators are unanimous about the need to close the gaps in the
super"ision of worldwide markets.
Another important trend in recent years has been the increased use of deri"ati"es. $he market
for deri"ati"es has grown faster than any other market in recent years, pro"iding corporations with
new opportunities but also exposing them to new risks. Deri"ati"es can be used either to reduce
risks or to speculate. It3s not clear whether recent inno"ations ha"e %increased or decreased the
inherent stability of the financial system.&
2-7 $he physical location exchanges are tangible physical entities. Each of the larger ones occupies its
own building, has a limited number of members, and has an elected go"erning body. A dealer
market is defined to include all facilities that are needed to conduct security transactions not made
on the physical location exchanges. $hese facilities include 1(2 the relati"ely few dealers who hold
in"entories of these securities and who are said to %make a market& in these securities; 1!2 the
thousands of brokers who act as agents in bringing the dealers together with in"estors; and 142 the
computers, terminals, and electronic networks that pro"ide a communication link between dealers
and brokers.
2-* $he two leading stock markets today are the <ew =ork ,tock Exchange 1<=,E2 and the <asda.
stock market. $he <=,E is a physical location exchange, while the <asda. is an electronic dealer0
based market.
2-6 $he three forms, or le"els, of market efficiency are: weak0form efficiency, semistrong0form
efficiency, and strong0form efficiency. $he weak form of the E>' states that all information
contained in past stock price mo"ements is fully reflected in current market prices. $he semistrong
form of the E>' states that current market prices reflect all publicly a"ailable information. $he
strong form of the E>' states that current market prices reflect all pertinent information, whether
publicly a"ailable or pri"ately held.
2-(, If the market is semistrong0form efficient and the company announces a (? increase when
in"estors had expected it to announce a ()? earnings increase, you would expect the stock3s price
to fall because the earnings increase was less than expected, which is ,tatement b. In fact, if the
assumption were made that weak0form efficiency existed then you would expect the stock3s price to
increase slightly because the company had a slight increase in earnings, which is ,tatement a. If
the assumption were made that strong0form efficiency existed then you would expect the stock3s
price to remain the same because earnings announcements ha"e no effect because all information,
whether publicly a"ailable or pri"ately held, is already reflected in the stock price.
(, Answers and Solutions Chapter 2: Financial Markets and Institutions
2-(( $here is an %efficiency continuum,& with the market for some companies3 stocks being highly
efficient and the market for other stocks being highly inefficient. $he key factor is the size of the
company/the larger the firm, the more analysts tend to follow it and thus the faster new information
is likely to be reflected in the stock3s price. Also, different companies communicate better with
analysts and in"estors; and the better the communications, the more efficient the market for the
stock.
2-(2 a5 +alse; deri"ati"es can be used either to reduce risks or to speculate.
b5 $rue; hedge funds ha"e large minimum in"estments and are marketed to institutions and
indi"iduals with high net worths. 'edge funds take on risks that are considerably higher than
that of an a"erage indi"idual stock or mutual fund.
c5 +alse; hedge funds are largely unregulated because hedge funds target sophisticated
in"estors.
d5 $rue; the <=,E is a physical location exchange with a tangible physical location that conducts
auction markets in designated securities.
e5 +alse; a larger bid0ask spread means the dealer will realize a higher profit.
15 +alse; the E>' does not assume that all in"estors are rational.
Chapter 2: Financial Markets and Institutions Answers and Solutions ((
'ighly Inefficient 'ighly Efficient
,mall companies not
followed by many analysts.
<ot much contact with
in"estors.
8arge companies followed
by many analysts. 9ood
communications with
in"estors.
Integrated Case
2-(
S.8th 9arr8 : Co.pan8
Financial Markets and Institutions
ssu.e that 8ou recentl8 graduated 0ith a degree in 1inance and have just reported
to 0ork as an invest.ent adviser at the brokerage 1ir. o1 S.8th 9arr8 : Co5 !our
1irst assign.ent is to e;plain the nature o1 the <5S5 1inancial .arkets to Michelle
=arga> a pro1essional tennis pla8er 0ho recentl8 ca.e to the <nited States 1ro.
Me;ico5 =arga is a highl8 ranked tennis pla8er 0ho e;pects to invest substantial
a.ounts o1 .one8 through S.8th 9arr85 She is ver8 bright? there1ore> she 0ould like
to understand in general ter.s 0hat 0ill happen to her .one85 !our boss has
developed the 1ollo0ing @uestions that 8ou .ust use to e;plain the <5S5 1inancial
s8ste. to =arga5
5 Ahat are the three pri.ar8 0a8s in 0hich capital is trans1erred bet0een
savers and borro0ersB Describe each one5
ns0er: CSho0 S2-( through S2-3 here5D %rans1ers o1 capital can be .ade +(/ b8
direct trans1er o1 .one8 and securities> +2/ through an invest.ent banking
house> or +3/ through a 1inancial inter.ediar85 In a direct trans1er> a
business sells its stocks or bonds directl8 to investors +savers/> 0ithout
going through an8 t8pe o1 institution5 %he business borro0er receives
dollars 1ro. the savers> and the savers receive securities +bonds or stock/
in return5
I1 the trans1er is .ade through an invest.ent banking house> the
invest.ent bank serves as a .iddle.an5 %he business sells its securities
to the invest.ent bank> 0hich in turn sells the. to the savers5 lthough
the securities are sold t0ice> the t0o sales constitute one co.plete
transaction in the pri.ar8 .arket5
(2 Integrated Case Chapter 2: Financial Markets and Institutions
I1 the trans1er is .ade through a 1inancial inter.ediar8> savers invest
1unds 0ith the inter.ediar8> 0hich then issues its o0n securities in
e;change5 9anks are one t8pe o1 inter.ediar8> receiving dollars 1ro.
.an8 s.all savers and then lending these dollars to borro0ers to
purchase ho.es> auto.obiles> vacations> and so on> and also to
businesses and govern.ent units5 %he savers receive a certi1icate o1
deposit or so.e other instru.ent in e;change 1or the 1unds deposited
0ith the bank5 Mutual 1unds> insurance co.panies> and pension 1unds are
other t8pes o1 inter.ediaries5
95 Ahat is a .arketB Di11erentiate bet0een the 1ollo0ing t8pes o1 .arkets:
ph8sical asset .arkets versus 1inancial asset .arkets> spot .arkets
versus 1utures .arkets> .one8 .arkets versus capital .arkets> pri.ar8
.arkets versus secondar8 .arkets> and public .arkets versus private
.arkets5
ns0er: CSho0 S2-4 and S2-) here5D .arket is a venue 0here assets are bought
and sold5 %here are .an8 di11erent t8pes o1 1inancial .arkets> each one
dealing 0ith a di11erent t8pe o1 1inancial asset> serving a di11erent set o1
custo.ers> or operating in a di11erent part o1 the countr85 Financial
.arkets di11er 1ro. ph8sical asset .arkets in that real> or tangible> assets
such as .achiner8> real estate> and agricultural products are traded in the
ph8sical asset .arkets> but 1inancial securities representing clai.s on
assets are traded in the 1inancial .arkets5 Spot .arkets are .arkets in
0hich assets are bought or sold 1or Eon-the-spotF deliver8> 0hile 1utures
.arkets are .arkets in 0hich participants agree toda8 to bu8 or sell an
asset at so.e 1uture date5
Mone8 .arkets are the .arkets in 0hich debt securities 0ith
.aturities o1 less than one 8ear are traded5 "e0 !ork> London> and %ok8o
are .ajor .one8 .arket centers5 Longer-ter. securities> including stocks
and bonds> are traded in the capital .arkets5 %he "e0 !ork Stock
Chapter 2: Financial Markets and Institutions Integrated Case (3
&;change is an e;a.ple o1 a capital .arket> 0hile the "e0 !ork co..ercial
paper and %reasur8 bill .arkets are .one8 .arkets5
$ri.ar8 .arkets are .arkets in 0hich corporations raise capital b8
issuing ne0 securities> 0hile secondar8 .arkets are .arkets in 0hich
securities and other 1inancial assets are traded a.ong investors a1ter the8
have been issued b8 corporations5 $rivate .arkets> 0here transactions
are 0orked out directl8 bet0een t0o parties> are di11erentiated 1ro. public
.arkets> 0here standardiGed contracts are traded on organiGed
e;changes5
C5 Ah8 are 1inancial .arkets essential 1or a health8 econo.8 and econo.ic
gro0thB
ns0er: CSho0 S2-7 here5D In a global conte;t> econo.ic develop.ent is highl8
correlated 0ith the level and e11icienc8 o1 1inancial .arkets and
institutions5 It is di11icult> i1 not i.possible> 1or an econo.8 to reach its 1ull
potential i1 it doesnHt have access to a 0ell-1unctioning 1inancial s8ste.5
health8 econo.8 is dependent on e11icient 1unds trans1ers 1ro.
people 0ho are net savers to 1ir.s and individuals 0ho need capital5
Aithout e11icient trans1ers> the econo.8 si.pl8 could not 1unction5
Obviousl8> the level o1 e.plo8.ent and productivit8> hence our standard
o1 living> 0ould be .uch lo0er5 %here1ore> it is absolutel8 essential that
our 1inancial .arkets 1unction e11icientl8Inot onl8 @uickl8> but also at a
lo0 cost5
D5 Ahat are derivativesB #o0 can derivatives be used to reduce riskB Can
derivatives be used to increase riskB &;plain5
ns0er: CSho0 S2-7 here5D Derivatives are an8 1inancial asset 0hose value is
derived 1ro. the value o1 so.e other Eunderl8ingF asset5 Derivatives can
be used either to reduce risks or to speculate5 For an e;a.ple o1 risk
(4 Integrated Case Chapter 2: Financial Markets and Institutions
reduction> suppose an i.porterHs costs rise and its net inco.e 1alls 0hen
the dollar 1alls relative to the 8en5 %he co.pan8 could reduce its risk b8
purchasing derivatives 0hose values increase 0hen the dollar declines5
%his is a hedging operation> and its purpose is to reduce risk e;posure5
Speculation> on the other hand> is done in the hope o1 high returns> but it
raises risk e;posure5
&5 9rie1l8 describe each o1 the 1ollo0ing 1inancial institutions: co..ercial
banks> invest.ent banks> .utual 1unds> hedge 1unds> and private e@uit8
co.panies5
ns0er: CSho0 S2-* here5D Co..ercial banks are the traditional depart.ent stores
o1 1inance serving a variet8 o1 savers and borro0ers5 #istoricall8> the8
0ere the .ajor institutions that handled checking accounts and through
0hich the Federal 'eserve S8ste. e;panded or contracted the .one8
suppl85 %oda8> ho0ever> several other institutions also provide checking
services and signi1icantl8 in1luence the .one8 suppl85 Conversel8>
co..ercial banks are providing an ever-0idening range o1 services>
including stock brokerage services and insurance5
Invest.ent banks are organiGations that under0rite and distribute
ne0 invest.ent securities and help businesses obtain 1inancing5
Mutual 1unds are organiGations that pool investor 1unds to purchase
1inancial instru.ents and thus reduce risks through diversi1ication5
#edge 1unds are si.ilar to .utual 1unds because the8 accept .one8
1ro. savers and use the 1unds to bu8 various securities> but there are
so.e i.portant di11erences5 Ahile .utual 1unds are registered and
regulated b8 the S&C> hedge 1unds are largel8 unregulated5 %his
di11erence in regulation ste.s 1ro. the 1act that .utual 1unds t8picall8
target s.all investors> 0hereas hedge 1unds t8picall8 have large .ini.u.
invest.ents +o1ten e;ceeding J( .illion/ that are e11ectivel8 .arketed to
institutions and individuals 0ith high net 0orths5
Chapter 2: Financial Markets and Institutions Integrated Case ()
$rivate e@uit8 co.panies are organiGations that operate .uch like
hedge 1unds> but rather than bu8ing so.e o1 the stock o1 a 1ir.> private
e@uit8 pla8ers bu8 and then .anage entire 1ir.s5
F5 Ahat are the t0o leading stock .arketsB Describe the t0o basic t8pes o1
stock .arkets5
ns0er: CSho0 S2-6 here5D %he t0o leading stock .arkets toda8 are the "e0 !ork
Stock &;change and the "asda@ stock .arket5 %here are just t0o basic
t8pes o1 stock .arkets: +(/ ph8sical location e;changes> 0hich include
the "e0 !ork Stock &;change +"!S&/> the .erican Stock &;change
+M&K/> and several regional stock e;changes> and +2/ electronic dealer-
based .arkets that include the "asda@ stock .arket> the less 1or.al over-
the-counter .arket> and the recentl8 developed electronic
co..unications net0orks +&C"s/5
%he ph8sical location e;changes are 1or.al organiGations having
tangible> ph8sical locations and trading in designated securities5 %here are
e;changes 1or stocks> bonds> co..odities> 1utures> and options5 %he
ph8sical location e;changes are conducted as auction .arkets 0ith
securities going to the highest bidder5 9u8ers and sellers place orders
0ith their brokers 0ho then e;ecute those orders b8 .atching bu8ers and
sellers> although specialists assist in providing continuit8 to the .arkets5
%he electronic dealer-based .arket is .ade up o1 hundreds o1 brokers
and dealers around the countr8 0ho are connected electronicall8 b8
telephones and co.puters5 %he dealer-based .arket 1acilitates trading o1
securities that are not listed on a ph8sical location e;change5 dealer
.arket is de1ined to include all 1acilities that are needed to conduct securit8
transactions not .ade on the ph8sical location e;changes5 %hese 1acilities
include +(/ the relativel8 1e0 dealers 0ho hold inventories o1 these
securities and 0ho are said to .ake a .arket in these securities? +2/ the
thousands o1 brokers 0ho act as agents in bringing the dealers together
(7 Integrated Case Chapter 2: Financial Markets and Institutions
0ith investors? and +3/ the co.puters> ter.inals> and electronic net0orks
that provide a co..unication link bet0een dealers and brokers5 Dealers
continuousl8 post a price at 0hich the8 are 0illing to bu8 the stock +the bid
price/ and a price at 0hich the8 are 0illing to sell the stock +the ask price/5
%he ask price is al0a8s higher than the bid price> and the di11erence +or
Ebid-ask spreadF/ represents the dealerHs .arkup> or pro1it5
L5 I1 pple Co.puter decided to issue additional co..on stock and =arga
purchased (,, shares o1 this stock 1ro. S.8th 9arr8> the under0riter>
0ould this transaction be a pri.ar8 or a secondar8 .arket transactionB
Aould it .ake a di11erence i1 =arga purchased previousl8 outstanding
pple stock in the dealer .arketB &;plain5
ns0er: CSho0 S2-(, here5D I1 =arga purchased ne0l8 issued pple stock> this
0ould constitute a pri.ar8 .arket transaction> 0ith S.8th 9arr8 acting as
an invest.ent banker in the transaction5 I1 =arga purchased EusedF stock>
then the transaction 0ould be in the secondar8 .arket5
#5 Ahat is an initial public o11ering +I$O/B
ns0er: CSho0 S2-(( here5D n initial public o11ering +I$O/ is 0here a co.pan8
issues stock in the public .arket 1or the 1irst ti.e5 ELoing publicF enables
a co.pan8Hs o0ners to raise capital 1ro. a 0ide variet8 o1 outside
investors5 Once issued> the stock trades in the secondar8 .arket5
CSho0 S2-(2 and S2-(3 here5 <se these slides to sho0 .arket
per1or.ance in recent 8ears and ho0 to read a stock @uote5D
I5 Ahat does it .ean 1or a .arket to be e11icientB &;plain 0h8 so.e stock
prices .a8 be .ore e11icient than others5
ns0er: CSho0 S2-(4 here5D I1 .arkets are e11icient> investors can bu8 and sell
stocks and be con1ident that the8 are getting good prices5 I1 .arkets are
Chapter 2: Financial Markets and Institutions Integrated Case (7
ine11icient> then investors 0ill be a1raid to invest> and this 0ill lead to a
poor allocation o1 capital and econo.ic stagnation5 So 1ro. an econo.ic
standpoint> .arket e11icienc8 is clearl8 good5
%here is an Ee11icienc8 continuu.>F 0ith the .arket 1or so.e
co.paniesH stocks being highl8 e11icient and that 1or other stocks highl8
ine11icient5 %he ke8 1actor is the siGe o1 the co.pan8Ithe larger the 1ir.>
the .ore anal8sts tend to 1ollo0 it> and thus the 1aster ne0 in1or.ation is
likel8 to be re1lected in the stockHs price5 lso> di11erent co.panies
co..unicate better 0ith anal8sts and investors generall8> and the better
the co..unications> the .ore e11icient the .arket 1or the stock5
M5 1ter the consultation 0ith Michelle> she asks to discuss these t0o
scenarios 0ith 8ou:
+(/ Ahile in the 0aiting roo. o1 8our o11ice> she overheard an anal8st on a
1inancial %= net0ork sa8 that a particular .edical research co.pan8 just
received FD approval 1or one o1 its products5 On the basis o1 this EhotF
in1or.ation> Michelle 0ants to bu8 .an8 shares o1 that co.pan8Hs stock5
ssu.ing the stock .arket is se.i-strong 1or. e11icient> 0hat advice
0ould 8ou give herB
ns0er: CSho0 S2-() here5D %he se.istrong 1or. o1 the &M# suggests that this
stockHs .arket price re1lects all publicl8 available in1or.ation> so there
0ould be no gains to be .ade on this stock based on the recent FD
approval5 Its price alread8 re1lects this in1or.ation5
M5 +2/ She has read a nu.ber o1 ne0spaper articles about a huge I$O being
carried out b8 a leading technolog8 co.pan85 She 0ants to get as .an8
shares in the I$O as possible and 0ould even be 0illing to bu8 the shares
in the open .arket i..ediatel8 a1ter the issue5 Ahat advice do 8ou have
1or herB
(* Integrated Case Chapter 2: Financial Markets and Institutions
ns0er: CSho0 S2-(7 here5D "ot all I$Os are 0ell received5 nd> even i1 8ou are
able to identi18 a EhotF issue> it is o1ten di11icult to purchase shares in the
initial o11ering5 %hese deals are generall8 oversubscribed> 0hich .eans
that the de.and 1or shares at the o11ering price e;ceeds the nu.ber o1
shares issued5 In such instances> invest.ent bankers 1avor large
institutional investors +0ho are their best custo.ers/> and s.all investors
1ind it hard> i1 not i.possible> to get in on the ground 1loor5 She can bu8
the stock in the a1ter-.arket> but evidence suggests that i1 8ou do not get
in on the ground 1loor the average I$O underper1or.s the overall .arket
over the long run5
Chapter 2: Financial Markets and Institutions Integrated Case (6