ACC323B - FINANCIAL MANAGEMENT

S.Y. ‘24 - ‘23 | PAGE 29-60 CHAPTER 2: FINANCIAL MARKETS AND INSTITUTIONS

OVERVIEW: 2.0 FINANCIAL MARKETS

Capital Allocation Process
Financial Markets
Financial Institutions 2.1 TYPES OF MARKET
Stock Markets and Returns
Stock Market Efficiency 1. PHYSICAL ASSET MARKETS VS.
FINANCIAL ASSET MARKETS
1.0 CAPITAL ALLOCATION PROCESS 2. SPOT MARKETS VS. FUTURE MARKETS
3. MONEY MARKETS VS. CAPITAL MARKETS
People and organizations with surplus funds are 4. PRIMARY MARKETS VS. SECONDARY
saving today in order to accumulate funds for MARKETS
some future use. 5. PRIMARY MARKETS VS. PUBLIC
MARKETS
This transfer can take place in the three ways
➢ Direct transfers of money and securities
○ a business sells its stocks or PHYSICAL ASSET MARKETS VS. FINANCIAL
bonds directly to savers ASSET MARKETS
○ used mainly by small firms, and
DEFINITION EXAMPLE
relatively little capital is raised by
direct transfers. PHYSICAL are for products A share of Ford
➢ Investment Banks ASSET such as wheat, stock is a “pure
○ such as Morgan Stanley, which MARKETS autos, real financial asset
underwrites the issue (“tangible” estate,
○ the company sells its stocks or or “real” computers, and
bonds to the investment bank, asset machinery
which then sells these same markets)
securities to savers
○ Primary market transaction - FINANCIAL deal with stocks, option to buy
buying or selling of financial ASSETS bonds, notes, Ford shares is a
securities directly from the issuing MARKET and mortgages. derivative
company or entity security whose
➢ Financial Intermediaries value
○ bank, an insurance company, or a depends on the
mutual fund. price of Ford
○ intermediary obtains funds from stock
savers in exchange for its
securities
SPOT MARKETS VS. FUTURE MARKETS

DEFINITION

SPOT assets
MARKETS are bought or sold for “on-the-spot”
delivery

FUTURE participants agree today to buy or

MARKETS sell
an asset at some future date

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 ACC323B - FINANCIAL MANAGEMENT
S.Y. ‘24 - ‘23 | PAGE 29-60 CHAPTER 2: FINANCIAL MARKETS AND INSTITUTIONS

MONEY MARKETS VS. CAPITAL MARKETS 2.2 RECENT TRENDS

DEFINITION EXAMPLE
Factors that complicate coordination include
MONEY short-term, The New York, 1. the different structures in nations’ banking and
MARKETS highly liquid debt London, and securities industries
securities Tokyo 2. the trend toward financial services
money markets conglomerates, which obscures developments
in various market segments
are among the
3. the reluctance of individual countries to give
world’s largest.
up control over their national monetary
policies.
FINANCIAL Intermediate or New York
ASSETS long-term debt Stock Exchange DERIVATIVES
MARKET and corporate ➔ any security whose value is derived from the
stocks.. price of some other “underlying” asset.
➔ it is very difficult to tell how derivatives are
affecting the firm’s risk profile
PRIMARY MARKETS VS. SECONDARY MARKETS
◆ An option to buy IBM stock is a derivative,
DEFINITION EXAMPLE as is a contract to buy Japanese yen 6
months from now. The value of the IBM
PRIMARY corporations The corporation option depends on the price of IBM’s
MARKET raise new capital selling the newly stock and the value of the Japanese yen
by issuing new created stock, “future” depends on the exchange rate
securities GE, receives the between yen and dollars
proceeds from
the sale in a 3.0 FINANCIAL INSTITUTIONS
primary market
transaction
Direct funds transfers are common among
SECONDARY existing, already New York individuals and small businesses and in economies
MARKET outstanding Stock Exchange, where financial markets and institutions are less
securities are also exist for developed
traded among mortgages,
investors other types of I. Investment Banks
loans, and other ➔ An organization that underwrites and
distributes new investment securities and
financial assets.
helps businesses obtain financing
➔ traditionally help companies raise capital
◆ Help corporations design securities
PRIVATE MARKETS VS. PUBLIC MARKETS with features that are currently
attractive to investors
DEFINITION EXAMPLE ◆ Buy these securities from the
corporation
PRIVATE transactions Bank loans and ◆ Resell them to savers
MARKETS are negotiated private debt ➔ generally guarantees that the firm will raise
directly between placements with the needed capital, the investment bankers
two or more insurance are also called underwriters
parties companies
II. Commercial Banks
PUBLIC standardized securities that are ➔ The traditional department store of finance
MARKET contracts are traded in public serving a variety of savers and borrowers
traded on markets (e.g., ➔ Bank of America, Citibank, Wells Fargo, and
common stock and
organized JP Morgan Chase
corporate bonds)
exchanges
are held by a large
number of III. Financial Services Corporations
individuals ➔ A firm that offers a wide range of financial
services, including investment banking,

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 ACC323B - FINANCIAL MANAGEMENT
S.Y. ‘24 - ‘23 | PAGE 29-60 CHAPTER 2: FINANCIAL MARKETS AND INSTITUTIONS

brokerage operations, insurance and X. Private Equity Companies

commercial banking ➔ Private equity players buy and then manage
➔ large conglomerates that combine many entire firms.
different financial institutions within a single
corporation 4.0 STOCK MARKET & RETURNS
➔ Citigroup owns Citibank (a commercial bank),
an investment bank, a securities brokerage
organization, insurance companies, and Physical Location Exchanges
leasing companies Formal organizations having tangible physical
locations that conduct auction markets in designated
IV. Credit Unions (“listed”) securities.
➔ cooperative associations whose members are Over-the-Counter (OTC) Market
supposed to have a common bond A large collection of brokers and dealers, connected
➔ cheapest source of funds available to electronically by telephones and computers, that
individual borrowers. provides for trading in unlisted securities.

V. Pension Funds Dealer Markets

➔ retirement plans funded by corporations or Include all facilities that are needed to conduct
government agencies for their workers and security transactions not conducted on the physical
administered primarily by the trust location exchanges
departments of commercial banks or by life ❖ The relatively few dealers who hold
insurance companies inventories of these securities and who are
➔ invest primarily in bonds, stocks, mortgages, said to “make a market” in these securities,
and real estate. ❖ The thousands of brokers who act as agents
in bringing the dealers together with investors
VI. Life Insurance Companies ❖ The computers, terminals, and electronic
➔ take savings in the form of annual premiums; networks that provide a communication link
invest these funds in stocks, bonds, real between dealers and brokers
estate, and mortgages; and make payments
to the beneficiaries of the insured parties Bid Price - price at which they will pay for the stock
Ask Price - which they will sell shares
VII. Mutual Funds Bid-Ask Spread - dealer’s markup, or profit.
➔ Organizations that pool investor funds to
purchase financial instruments and thus Financial Industry Regulatory Authority (FINRA)
reduce risks through diversification Brokers and dealers who participate in the OTC
➔ buy stocks, long-term bonds, or short-term market are members of this self-regulatory body which
debt instruments issued by businesses or licenses brokers and oversees trading practices
government units ❖ National Association of Securities Dealers
➔ Money Market Funds - Mutual funds that Automated Quotations (NASDAQ) - The
invest in short-term, low-risk securities and computerized network used by FINRA
allow investors to write checks against their
accounts. Closely Held Corporation
➔ Actively managed funds try to outperform A corporation that is owned by a few individuals who
the overall markets are typically associated with the firm’s management.
➔ Indexed funds are designed to simply
replicate the performance of a specific market Publicly Owned Corporation
index A corporation that is owned by a relatively large
number of individuals who are not actively involved in
VIII. Exchange-Traded Funds the firm’s management.
➔ similar to regular mutual funds and are often
operated by mutual fund companies
4.1 TYPES OF STOCK MARKET
IX. Hedge Funds TRANSACTIONS
➔ accept money from savers and use the funds
to buy various securities but largely
unregulated 1. Outstanding shares of established publicly
➔ have large minimum investments owned companies that are traded: the
➔ take on risks that are considerably higher than that secondary market.
of an average individual stock or mutual fund 2. Additional shares sold by established publicly
owned companies: the primary market

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S.Y. ‘24 - ‘23 | PAGE 29-60 CHAPTER 2: FINANCIAL MARKETS AND INSTITUTIONS

3. Initial public offerings made by privately held

firms: the IPO market. - when a company is
going public

5.0 STOCK MARKET EFFICIENCY

➢ Market price: The current price of a stock

➢ Intrinsic value: The price at which the stock

would sell if all investors had all 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 seem
to be in equilibrium

5.1 BEHAVIORAL FINANCE THEORY

Efficient Markets Hypothesis (EMH)

asset prices are about equal to their intrinsic values

Behavioral Finance
insights from psychology to better understand how
irrational behavior can be sustained over time
➔ First, it is often difficult or risky for traders to
take advantage of mispriced assets.
➔ Why mispricings can occur in the first place.

Rather than spending time and money trying to find

undervalued stocks, it would be better to buy an index
fund designed to match the overall market

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