The Financial Environment: Markets, Institutions, and Interest Rates

Ari Christianti, SE., MSM

THE FINANCIAL MARKETS

Businesses, individuals, and governments often need

to raise capital On the other hand, some individuals and firms have incomes that are greater than their current expenditures, so they have funds available to invest

THE FINANCIAL MARKETS

People and organizations wanting to borrow money

are brought together with those having surplus funds in the financial markets Each market deals with a somewhat different type of instrument in terms of the instruments maturity and the assets backing it. Also, different markets serve different types of customers, or operate in different parts of the country

TYPES OF MARKETS
Physical asset vs Financial asset markets Physical asset markets (also called tangible or real asset markets) are those for such products as wheat, autos, real estate, computers, and machinery Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, and other claims on real assets, as well as with derivative securities Spot vs Futures markets Spot markets are markets in which assets are bought or sold for on-the-spot delivery (literally, within a few days) Futures markets are markets in which participants agree today to buy or sell an asset at some future date

TYPES OF MARKETS
Money vs Capital markets Money markets are the markets for short-term, highly liquid debt securities Capital markets are the markets for intermediate- or longterm debt and corporate stocks Primary vs Secondary markets Primary markets are the markets in which corporations raise new capital Secondary markets are markets in which existing, already outstanding, securities are traded among investors

TYPES OF MARKETS
Private vs Public markets Private markets, where transactions are worked out directly between two parties Public markets, where standardized contracts are traded on organized exchanges

FINANCIAL INSTITUTIONS
Direct transfers of money and securities, as shown in the

top section, occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution Investment Banking House, An organization that underwrites and distributes new investment securities and helps businesses obtain financing Financial Intermediaries, Specialized financial firms that facilitate the transfer of funds from savers to demanders of capital.

Diagram of the Capital Formation Process

The Major Classes of Intermediaries

Commercial banks, the traditional department stores of

finance, serve a wide variety of savers and borrowers Credit unions are cooperative associations whose members are supposed to have a common bond, such as being employees of the same firm Pension funds are retirement plans funded by corporations or government agencies for their workers and administered primarily by the trust departments of commercial banks or by life insurance companies

The Major Classes of Intermediaries

Life insurance companies take savings in the form of

annual premiums; invest these funds in stocks, bonds, real estate, and mortgages; and finally make payments to the beneficiaries of the insured parties Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units

THE STOCK MARKET

The stock market, where the prices of firms stocks are established. Since the primary goal of financial management is to maximize the firms stock price, a knowledge of the stock market is important to anyone involved in managing a business Physical Location Exchanges Formal organizations having tangible physical locations that conduct auction markets in designated (listed) securities Over-the-Counter Market A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities

Market Efficiency
Efficient market, is a financial market where asset

prices rapidly reflect all available information This means that all available information is already impounded into an assets price, so investors should expect to earn a return necessary to compensate them for their anticipated risk That would seem to preclude abnormal returns

Levels of Market Efficiency (Eugene Fama)

Weak form of market efficiency, current asset prices

reflect all past prices and price movements. In other words, all worthwhile information about historical prices of the stock is already reflected in todays price; the investor cannot use that same information to predict tomorrows price and still earn abnormal profits Semi-strong form of market efficiency, the current asset prices reflect all publicly available information. The implication is that if investors employ investment strategies based on the use of publicly available information, they cannot earn abnormal profits.

Levels of Market Efficiency (Eugene Fama)

Strong form of market efficiency, asset prices reflect all

public and private information. In other words, the market (which includes all investors) knows everything about all financial assets, including information that has not been released to the public. The strong form implies that investors cannot make abnormal returns from trading on inside information (discussed earlier), information that has not yet been made public

THE COST OF MONEY

The interest rate is the price paid to borrow debt capital.

With equity capital, investors expect to receive dividends and capital gains, whose sum is the cost of equity money The four most fundamental factors affecting the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation

Factors Affecting The Cost of Money

Production Opportunities, The returns available within an

economy from investments in productive (cash-generating) assets Time Preferences for Consumption, The preferences of consumers for current consumption as opposed to saving for future consumption Risk, In a financial market context, the chance that an investment will provide a low or negative return. Inflation, The amount by which prices increase over time.

The Interest Rate Paid to Savers Depends in

on the rate of return producers expect to earn on

invested capital on savers time preferences for current versus future consumption, on the riskiness of the loan, and on the expected future rate of inflation