Group 2 | ACCO 3063 | Financial

THE

Financial Markets
and Institutions
Management |

CHAPTER 2

ALLOCATON PROCESS

CAPITAL

 Capital allocation is a senior management teams most fundamental

responsibility. The problem is that many CEOs dont know how to allocate capital
effectively. The objective of capital allocation is to build long-term value per share.
Capital allocation is always important but is especially pertinent today because
return on invested capital is high, growth is modest, and corporate balance
sheets in the U.S. have
1

substantial cash.
Direct transfers of money
and securities occur when
a business sells its stocks
or bonds directly to savers,
without going through any

type of financial institutions.

Transfers may also go
through
bank

an

investment

(iBank)

Morgan

such

Stankey,

as

which

underwrites the issue. Primary market transaction is a transaction where new

securities are involved and the corporation receives the sale proceeds.
3 Transfers can also be
Figure 1 Diagram of the Capital Formation Process for
Business

made
financial

through

intermediary

such as an insurance company, or a mutual fund. The intermediary was the one who
obtain funds from savers in exchange of securities (shares or stocks). This
intermediary uses the money to buy and hold businesses securities, while the savers
hold the intermediarys securities.
FINANCIAL MARKETS

A market is a place where goods and where goods and services are
exchanged. A financial market is a place where individuals and organizations wanting
to borrow funds are brought together with those having a surplus of funds.
Financial markets bring together people and organizations wanting to borrow
money with those having surplus funds. There are many different financial markets in a
developed economy, each dealing with a different type of instrument serving 3 with a
different type of instrument, serving a different set of customers, or operating in a
different part of the country.
Types of Markets

1. Physical asset markets versus financial asset markets

Physical asset markets (also called "tangible" or "real" asset markets) are the
markets for such products as wheat, autos, real estate, computers, and
machinery.
Financial asset markets deal with stocks, bonds, notes, mortgages, and other
claims on real assets.
2. Spot markets versus futures markets
Spot markets are markets in which assets are bought or sold for on the
spot delivery.
Futures markets are markets in which 5 Futures markets are markets in
which participants agree today to buy or sell an asset at a future date.
3. Money markets versus capital markets
Money markets are the markets for short-term, highly liquid debt
securities, those securities that mature in less than one year.
Capital markets are the markets for long-term debt and corporate stocks.
4. Primary markets versus secondary markets
Primary markets are the markets in which corporations sell newly issued
securities to raise capital.
Secondary markets are the markets in which existing (already
outstanding) 7 which existing (already outstanding) securities are traded
among investors.
5. Private markets versus public markets
Private markets are the markets where transactions are worked out
directly between two parties.
Public markets are the markets where 9 Public markets are the markets
where standardized contracts are traded on organized exchanges.

Recent Trends
Financial markets have experienced many changes in recent years.
Technological advances in computers and telecommunications, along with the
globalization of banking and commerce, have led to deregulation, which has increased
competition throughout the world.

Globalization has exposed the need for greater cooperation among regulators at
the international level, but the task is not easy. Factors that complicate coordination
include:
(1) the different structures in nations banking and securities industries
(2) the trend toward financial services conglomerates, which obscures developments
in various market segments
(3) the reluctance of individual countries to give up control over their national
monetary policies
Another important trend in recent years has been the increased use of derivatives.
A derivative is a security with a price that is dependent upon or derived from one or
more underlying assets. The derivative itself is a contract between two or more
parties based upon the asset or assets. Its value is determined by fluctuations in the
underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies, interest rates and market indexes.
Derivatives can be used to reduce risks or to speculate.
FINANCIAL INSTITUTIONS
Usually in small businesses and individuals direct fund transfer are common. But
large businesses in developed economies generally find financial markets and
institutions more efficient in times to raise capital. So what is financial institution? A
financial institution is an establishment that conducts financial transactions such as
investments, loans and deposits. Almost everyone deals with financial institutions on a
regular basis. Everything from depositing money to taking out loans and exchanging
currencies must be done through financial institutions. Here is an overview of some of
the major categories of financial institutions and their roles in the financial system.

Financial intermediaries consist of financial institutions, such as commercial banks,

savings institutions, insurance companies, pension funds, finance companies, and
mutual funds. These intermediaries come between ultimate borrowers and lenders by
transforming direct claims into indirect claims. Financial intermediaries purchase direct
(or primary) securities and, in turn, issue their own indirect (or secondary) securities to
the public. For example, the direct security that a savings and loan association
purchases is a mortgage; the indirect claim issued is a savings account or a certificate of
deposit. A life insurance company, on the other hand, purchases corporate bonds,
among other things, and issues life insurance policies.
1. INVESTMENT BANKS
The stock market crash of 1929 and ensuing Great Depression caused the
United States government to increase financial market regulation. The Glass-Steagall
Act of 1933 resulted in the separation of investment banking from commercial banking.
While investment banks may be called "banks," their operations are far different than
deposit-gathering commercial banks. An investment bank is a financial intermediary that
performs a variety of services for businesses and some governments. These services
include underwriting debt and equity offerings, acting as an intermediary between an
issuer of securities and the investing public, making markets, facilitating mergers and
other corporate reorganizations, and acting as a broker for institutional clients. They may
also provide research and financial advisory services to companies. As a general rule,
investment banks focus on initial public offerings (IPOs) and large public and private
share offerings. Traditionally, investment banks do not deal with the general public.
However, some of the big names in investment banking, such as JP Morgan Chase,
Bank of America and Citigroup, also operate commercial banks. Other past and present
investment banks you may have heard of include Morgan Stanley, Goldman Sachs,
Lehman Brothers and First Boston.
Generally speaking, investment banks are subject to less regulation than commercial
banks. While investment banks operate under the supervision of regulatory bodies, like
the Securities and Exchange Commission, FINRA, and the U.S. Treasury, there are
typically fewer restrictions when it comes to maintaining capital ratios or introducing new
products.
2. COMMERCIAL BANKS

Commercial banks are the most important source of funds for business firms in
the aggregate. Banks acquire demand (checking) and time (savings) deposits from
individuals, companies, and governments and, in turn, make loans and investments.
Among the loans made to business firms are seasonal and other short-term loans,
intermediate-term loans of up to five years, and mortgage loans. Besides performing a
banking function, commercial banks affect business firms through their trust
departments, which invest in corporate bonds and stocks. They also make mortgage
loans available to companies and manage pension funds. Other deposit institutions
include savings and loan associations, mutual savings banks, and credit unions. These
institutions are primarily involved with individuals, acquiring their savings and making
home and consumer loans.
3. FINANCIAL SERVICES CORPORATIONS
A financial services corporation is an institution offering a variety of banking or
other financial products and services to businesses and individuals. Financial products
and services may include checking or savings accounts, loans and leases, money
transfers, and insurance policies, as well as other types of financial services. A financial
services corporation may be organized as an insurance company, investment
bank, brokerage, credit union, or commercial bank. The specific financial services
offered by each institution usually depend on the organizational structure of the company
and the government regulations involved with each type of financial service offered to
consumers.
A commercial bank is perhaps the most traditional form of a basic financial services
corporation. These institutions offer customer services such as checking or savings
accounts, bank loans, wire transfer services, and other banking services. Commercial
banks are usually for-profit organizations owned by individuals or a conglomerate of
businesses. These institutions may also be part of the national banking system for the
country in which they reside.
An investment bank is a financial services corporation specializing in the underwriting
process corporations use when issuing equity securities. These institutions are usually
organized as broker/dealer groups with multiple agents operating in various domestic
and international stock exchanges. Investment banks may also offer services to private
investment firms, groups, or individuals looking to purchase large amounts of equity

securities and public corporations.

4. CREDIT UNIONS
Credit unions are another alternative to regular commercial banks. Credit unions
are almost always organized as not-for-profit cooperatives. Like banks and S&Ls, credit
unions can be chartered at the federal or state level. Like S&Ls, credit unions typically
offer higher rates on deposits and charge lower rates on loans in comparison to
commercial banks.
In exchange for a little added freedom, there is one particular restriction on credit unions;
membership is not open to the public, but rather restricted to a particular membership
group. In the past, this has meant that employees of certain companies, members of
certain churches, and so on, were the only ones allowed to join a credit union. In recent
years, though, these restrictions have been eased considerably, very much over the
objections of banks.

5. PENSION FUNDS
Pension funds and other retirement funds are established to provide income to
individuals when they retire. During their working lives, employees usually contribute to
these funds, as do employers. Funds invest these contributions and either pay out the
cumulative amounts periodically to retired workers or arrange annuities. In the
accumulation phase, monies paid into a fund are not taxed. When the benefits are paid
out in retirement, taxes are paid by the recipient. Commercial banks, through their trust
departments, and insurance companies offer pension funds, as do the federal
government, local governments, and certain other noninsurance organizations. Because
of the long-term nature of their liabilities, pension funds are able to invest in longer-term
securities. As a result, they invest heavily in corporate stocks and bonds. In fact, pension
funds are the largest single institutional investors in corporate stocks.
6. LIFE INSURANCE COMPANIES
Life insurance companies insure against the loss of life. Because the mortality of
a large group of individuals is highly predictable, these companies are able to invest in
long-term securities. Also, the income of these institutions is partially exempt from taxes
owing to the buildup of reserves over time. They therefore seek taxable investments with
yields higher 2 The Business, Tax, and Financial Environments 29 Financial

intermediaries Financial institutions that accept money from savers and use those funds
to make loans and other financial investments in their own name. They include
commercial banks, savings institutions, insurance companies, pension funds, finance
companies, and mutual funds. As a result, life insurance companies invest heavily in
corporate bonds. Also important are mortgages, some of which are granted to business
firms.
7. MUTUAL FUNDS
Mutual investment funds also invest heavily in corporate stocks and bonds.
These funds accept monies contributed by individuals and invest them in specific types
of financial assets. The mutual fund is connected with a management company, to which
the fund pays a fee (frequently 0.5 percent of total assets per annum) for professional
investment management. Each individual owns a specified percentage of the mutual
fund, which depends on that persons original investment. Individuals can sell their
shares at any time, as the mutual fund is required to redeem them. Though many mutual
funds invest only in common stocks, others specialize in corporate bonds; in money
market instruments, including commercial paper issued by corporations; or in municipal
securities. Various stock funds have different investment philosophies, ranging from
investing for income and safety to a highly aggressive pursuit of growth. In all cases, the
individual obtains a diversified portfolio managed by professionals. Unfortunately
8. EXCHANGE TRADED FUNDS
An ETF, or exchange traded fund, is a marketable security that tracks an index,
a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an
ETF trades like a common stock on a stock exchange. ETFs experience price
changes throughout the day as they are bought and sold. ETFs typically have higher
daily liquidity and lower fees than mutual fund shares, making them an attractive
alternative for individual investors.
Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated
once at the end of every day like a mutual fund does.
An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much
like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades
close to its net asset value over the course of the trading day. Most ETFs track an index,
such as a stock index or bond index. ETFs may be attractive as investments because of

their low costs, tax efficiency, and stock-like features. ETFs are the most popular type
of exchange-traded product.
Only authorized participants, which are large broker-dealers that have entered into
agreements with the ETF's distributor, actually buy or sell shares of an ETF directly from
or to the ETF, and then only in creation units, which are large blocks of tens of thousands
of ETF shares, usually exchanged in-kind with baskets of the underlying securities.
Authorized participants may wish to invest in the ETF shares for the long-term, but they
usually act as market makers on the open market, using their ability to exchange creation
units with their underlying securities to provide liquidity of the ETF shares and help
ensure that their intraday market price approximates the net asset value of the
underlying assets. Other investors, such as individuals using a retail broker, trade ETF
shares on this secondary market.
An ETF combines the valuation feature of a mutual fund or unit investment trust, which
can be bought or sold at the end of each trading day for its net asset value, with the
tradability feature of a closed-end fund, which trades throughout the trading day at prices
that may be more or less than its net asset value. Closed-end funds are not considered
to be ETFs, even though they are funds and are traded on an exchange. ETFs have
been available in the US since 1993 and in Europe since 1999. ETFs traditionally have
been index funds index funds, but in 2008 the U.S. Securities and Exchange
Commission began to authorize the creation of actively managed ETFs .
9. HEDGE FUNDS
Hedge funds are alternative investments using pooled funds that may use a
number of different strategies in order to earn active return, or alpha, for their investors.
Hedge funds may be aggressively managed or make use of derivatives and leverage in
both domestic and international markets with the goal of generating high returns (either
in an absolute sense or over a specified market benchmark). Because hedge funds may
have low correlations with a traditional portfolio of stocks and bonds, allocating an
exposure to hedge funds can be a good diversifier.
10. PRIVATE EQUITY COMPANIES
A private equity firm is an investment manager that makes investments in
the private equity of operating companies through a variety of loosely affiliated

investment strategies including leveraged buyout, venture capital, and growth capital.
Often described as a financial sponsor, each firm will raise funds that will be invested in
accordance with one or more specific investment strategies.
Typically, a private equity firm will raise pools of capital, or private equity funds that
supply the equity contributions for these transactions. Private equity firms will receive a
periodic management fee as well as a share in the profits earned (carried interest) from
each private equity fund managed.
Private equity firms, with their investors, will acquire a controlling or substantial minority
position in a company and then look to maximize the value of that investment. Private
equity firms generally receive a return on their investments through one of the following
avenues:
an initial public offering (IPO) shares of the company are offered to the public,
typically providing a partial immediate realization to the financial sponsor as well as a
public market into which it can later sell additional shares;
a merger or acquisition the company is sold for either cash or shares in another
company;
a recapitalization cash is distributed to the shareholders (in this case the financial
sponsor) and its private equity funds either from cash flow generated by the company or
through raising debt or other securities to fund the distribution.
Private equity firms characteristically make longer-hold investments in target industry
sectors or specific investment areas where they have expertise.
Private equity firms and investment funds should not be confused with hedge fund
firms which typically make shorter-term investments in securities and other more liquid
assets within an industry sector but with less direct influence or control over the
operations of a specific company. Where private equity firms take on operational roles to
manage risks and achieve growth through long term investments, hedge funds more
frequently act as short-term traders of securities betting on both the up and down sides
of a business or of an industry sector's financial health.
THE STOCK MARKET

What is a stock market? Lets find out thru its allied word, market
a place where people trade their goods. And at this point, the resource there in
trading are stocks. Stocks are companys part of equity. In this market, the initial
price of a stock is being determined and recognized. Thats why a sufficient
knowledge in stock trading is important to run an equity market.
The NYSE (New York Stock Exchange) and the Nasdaq stock
markets are the primary leaders in stock exchange. Stocks are being traded in two
basic options: (a) Physical location exchange (NYSE and AMEX)

and (b)

Electronic-based markets or Over-the-counter market like Nasdaq. Lets begin to

find out their difference.
(a) These are formal organizations having tangible physical locations that conduct
auction markets. Meaning, they have their own building, that allows people to
enter and join the stock auction. It has also a governing body, called the governors
to ensure the control and management in the entire market place. The building is
also equipped with electronic communications devices (with the leveling to the
internet-based exchanges to communicate to buyers and sellers). There is also a
broker department, which is someone who arranges a sell order (to a specific
stocks) to a buy order (to the same stock) and the management of these
transaction.
(b) The Over-the-counter is entirely different to physical location exchange. While
in (a), there is in need of great listed security, here, it is more likely to not. Thus,
the trade is easy, claiming is easy, and the transfer is easy. No hard feelings. We
can compare it to purchasing a medicine. Over-the-counter, means that you buy a
medicine in your own decision, with no specific consultation and prescription of a
specialist, resulting to lesser possibility to be cured. Likewise, in OTC market,
there is a lesser security, thus, higher risk. Also, it does not involved a building or
a tangible location. There is a presence of a more widely collection of ECNs to
communicate to sellers and buyers.
In this time, it is more referred to as a dealer market. Why? Because of the more
widely connection to brokers. That is, these brokers buy and sell stocks and store
them as inventories. It is there solution to infrequent stocks and the disagreement
of the buyer and seller. And the bid-ask spreads represents the mark-up or the
profit of a dealer.

In short, (a) has more security, guarantee, and formality than of (b), and in the
stock market, your greatest enemy is the risk. Even if the prices of stocks changes
over time, and the risk also changes overtime, still, there is a risk.
NYSE and Nasdaq becomes Go Global!
Because of the threat of ECNs (that bring buyer and seller
connected easily by an electronic connection), the primary leaders take action in
it.
They became open to public. Experts say, that in time, these traditional
exchanges may dissolve, and bypass by the ECNs exchanges, but of course,
these two wont and dont. Abide from internet-trading, they decide to take in
action, become better, bolder, and fiercer.
THE COMMON STOCK
There are basically two major types of firms (based on stock
activeness and ownership).
1. Privately owned / Closely held corporations owned by relatively few people.
2. Publicly owned corporations owned by thousands of investors.
Types of Stock Market Transactions:
1. Outstanding shares of established publicly owned companies that are traded:
the secondary market.
For outstanding shares or used shares which are being sold from a previous
owner, called the secondary market.
2. Additional shares sold by established publicly owned companies: the primary
market.
Issuance of additional and new shares of stocks, called the primary market.
3. Initial public offerings made by privately held firms: the IPO Market.

If a privately owned corporation decides to sell their stocks to public, they are
known to be going publicthat is there is a change from private going to public.
And the offered market to stocks is called the initial public offering (IPO) market.
The Biggest IPOs
1. Agricultural Bank of China (China) with +21.9% change.
2. AIA Group (Hong Kong) with +11.00%.
3. General Motors (US) with 11.70%

STOCK MARKETS and RETURNS

Anyone who has invested in a stock market knows that there are large differences
between expected and realized price returns for they estimate expected returns before
they do so. As logic would suggest, a stock's expected as estimated by investors at the
margin will always be positive; otherwise, investors would not buy the stock.
Stock Market Reporting
Up through years ago, the best stock market quotations was the business section of
daily newspapers such as The Wall Street Journal. However, newspapers report
yesterday's prices. While now it is possible to obtain quotes throughout the day from a
wide variety of Internet sources. One of the best quotes provider was Yahoo!'s
finance.yahoo.com. It provides a great deal of information in its detailed quote and even
more details are available than a classical newspaper quote.
Stock Market Returns
This topic will be broadly discussed in Chapters 8 & 9 but it is useful at this point to give
you an idea of how stocks have performed in recent years. In the Figure 2.2 (p.44)
shows how the returns on large U.S. stocks have varied over the past years. The market
trend has been strongly up since 1968, but it doesn't mean that it go up every year. In
the Figure we can see that the overall market was down for 10 of 43 years including the

three consecutive years of 2000-2002. The stock prices of individual companies have
likewise gone up and down. Of course even in bad years some other companies do well
so "the name game" for the security analysis is to pick the winners. Financial managers
attempt to do this, but they don't always succeed. In subsequent chapters there will be
discussed the desicions managers make to increase the odds that their firm will perform
well in the marketplace.
STOCK MARKET EFFICIENCY

To begin this topic, consider the ff. def'n:

* Market price- The current price of a stock.
* Intrinsic value- The price which the stock would sell if all investors had knowable
information about a stock.
* Equilibrium price- The price that balances buy and sell orders at any given time.
* Efficient market- A market in which prices are close to intrinsic values and stocks
seems to be in equilibrium.
Stock market indexes are designed to show the performance of stock market but there
are so many types of stock markets. There are those market indexes that represents
market as a whole, market indexes that tracks certain industry sectors, and market
indexes that tracks small-cap, mid-cap, or large cap stocks.
Dow Jones Industrial Average
Unveiled in 1896 by Charles H. Dow, the DJIA began with just 10 stocks, was expanded
in 1916 to 20 stocks, and then was increased to 30 stocks in 1928. Up until today, DJIA
still includes 30 companies. They represent almost the fifth of the U.S. market stocks and
are all leading companies in their industries and widely held by individual and
institutional investors.
S&P 500 Index
Created in 1926, the S&P 500 Index is widely regarded as the standard of measuring
large-cap U.S. stock market performance. It's stocks are selected by Standard & Poor's
Index Committee, and they are the leading companes in the leading industries. It is
weighted by each stock's market value so the largest companies have the greatest

influence.
Nasdaq Composite Index
The Nasdaq Composite Index measures the performance of all stocks listed in Nasdaq.
Currently, it includes approximately 3200 companies and because many companies in
the technology sector are traded on computer-based Nasdaq exchange, this index is
generally regarded as an economic indicator in the high-tech industry. Microsoft, Apple,
Google, Cisco System, and Oracle are the 5 largest Nasdaq companies and they make
up a high percentage of the index's value weighted capitalization and for this reason, a
movement in the same direction by these comanies can move the entire index.
Conclusions About Market Efficiency
As noted previously, if the stock market is efficient, it is a waste of time for most people to
seek bargains by analyzing published data on stocks. That follows because if stock
prices are already reflect all publicly available information, they will be fairly priced; and a
person can beat the market only with luck or inside information. So rather than spending
time and money trying to find undervalued stocks, it would be better to buy an index with
fund designed to match overall market as reflected in an index such as S&P 500.
However, even if markets are efficient and all stocks and companies are fairly priced, an
investor should still need to be careful always when selecting stocks for his and her
portfolio. Most importantly, the portfolio should be diversified, with a mix of stocks with
some bonds and other fixed income securities.