Chapter 2
Dealer markets
A dealer market includes all facilities that are needed to conduct security transactions, but the transactions are not made on the physical location exchanges. The dealer market system consists of (1) the relatively few dealers who hold inventories of these securities and who are said to "make a market" in these securities; (2) the thousands of brokers who act as agents in bringing the dealers together with investors; and (3) the computers, terminals, and electronic networks that provide a communication link between dealers and brokers. The dealers who make a market in a particular stock quote the price at which they will pay for the stock (the bid price) and the price at which they will sell shares (the ask price). Each dealer's prices, which are adjusted as supply and demand conditions change, can be seen on computer screens across the world. The bid-ask spread, which is the difference between bid and ask prices, represents the dealer's markup, or profit. The dealer's risk increases when the stock is more volatile or when the stock trades infrequently. Generally, we would expect volatile, infrequently traded stocks to have wider spreads in order to compensate the dealers for assuming the risk of holding them in inventory
Derivative
A derivative is any security whose value is derived from the price of some other "underlying" asset. An option to buy IBM stock is a derivative, as is a contract to buy Japanese yen six months from now. The value of the IBM option depends on the price of IBM's stock and the value of the Japanese yen "future" depends on the exchange rate between yen and dollars. The market for derivatives has grown faster than any other market in recent years, providing investors with new opportunities but also exposing them to new risks. If a bank or any other company reports that it invests in derivatives, how can one tell if the derivatives are held as a hedge against something like an increase in the price of wheat or as a speculative bet that wheat prices will rise? The answer is that it is very difficult to tell how derivatives are affecting the firm's risk profile. In the case of financial institutions, things are even more complicated—the derivatives are generally based on changes in interest rates, foreign exchange rates, or stock prices; and a large international bank might have tens of thousands of separate derivative contracts
Efficient market
A market in which prices are close to intrinsic values and stocks seem to be in equilibrium
Actively managed funds vs index funds
Actively managed funds try to outperform the overall markets, whereas indexed funds are designed to simply replicate the performance of a specific market index. For example, the portfolio manager of an actively managed stock fund uses his or her expertise to select what he or she thinks will be the best-performing stocks over a given time period. By contrast, an index fund that tracks the S&P 500 index will simply hold the basket of stocks that comprise the S&P 500. Both types of funds provide investors with valuable diversification, but actively managed funds typically have much higher fees—in large part, because of the extra costs involved in trying to select stocks that will (hopefully) outperform the market. In any given year, the very best actively managed funds will outperform the market index, but many will do worse than the overall market—even before taking into account their higher fees. Furthermore, it is extremely difficult to predict which actively managed funds will beat the market in a particular year. For this reason, many academics and practitioners have encouraged investors to rely more heavily on indexed funds
Outstanding shares of established publicly owned companies that are traded: the secondary market.
Allied Food Products, the company we study in Chapters 3 and 4, has 50 million shares of stock outstanding. If the owner of 100 shares sells his or her stock, the trade is said to have occurred in the secondary market. Thus, the market for outstanding shares, or used shares, is the secondary market. The company receives no new money when sales occur in this market
Primary market transaction
As shown in the middle section, transfers may also go through an investment bank (iBank) such as Morgan Stanley, which underwrites the issue. An underwriter facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which then sells these same securities to savers. The businesses' securities and the savers' money merely "pass through" the investment bank. However, because the investment bank buys and holds the securities for a period of time, it is taking a risk—it may not be able to resell the securities to savers for as much as it paid. Because new securities are involved and the corporation receives the sale proceeds, this transaction is called a primary market transaction
Credit Default Swaps
Credit default swaps are contracts that offer protection against the default of a particular security. Suppose a bank wants to protect itself against the default of one of its borrowers. The bank could enter into a credit default swap where it agrees to make regular payments to another financial institution. In return, that financial institution agrees to insure the bank against losses that would occur if the borrower defaulted
Hedging Operation
Derivatives can be used to reduce risks or to speculate. Suppose a wheat processor's costs rise and its net income falls when the price of wheat rises. The processor could reduce its risk by purchasing derivatives—wheat futures—whose value increases when the price of wheat rises. This is a hedging operation, and its purpose is to reduce risk exposure
Additional shares sold by established publicly owned companies: the primary marke
If Allied Food decides to sell (or issue) an additional 1 million shares to raise new equity capital, this transaction is said to occur in the primary market
Money markets vs Capital Markets
Money markets are the markets for short-term, highly liquid debt securities. The New York, London, and Tokyo money markets are among the world's largest. Capital markets are the markets for intermediate- or long-term debt and corporate stocks. The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a prime example of a capital market. There is no hard-and-fast rule, but in a description of debt markets, short-term generally means less than 1 year, intermediate-term means 1 to 10 years, and long-term means more than 10 years
Physical Asset Markets vs Financial asset markets
Physical asset markets (also called "tangible" or "real" asset markets) are for products such as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, and mortgages. Financial markets also deal with derivative securities whose values are derived from changes in the prices of other assets. A share of Ford stock is a "pure financial asset," while an option to buy Ford shares is a derivative security whose value depends on the price of Ford stock
Primary markets vs Secondary markets
Primary markets are the markets in which corporations raise new capital. If GE were to sell a new issue of common stock to raise capital, a primary market transaction would take place. The corporation selling the newly created stock, GE, receives the proceeds from the sale in a primary market transaction. Secondary markets are markets in which existing, already outstanding securities are traded among investors. Thus, if Jane Doe decided to buy 1,000 shares of GE stock, the purchase would occur in the secondary market. The New York Stock Exchange is a secondary market because it deals in outstanding, as opposed to newly issued, stocks and bonds. Secondary markets also exist for mortgages, other types of loans, and other financial assets. The corporation whose securities are being traded is not involved in a secondary market transaction and thus does not receive funds from such a sale.
Private markets vs Public markets
Private markets, where transactions are negotiated directly between two parties, are differentiated from public markets, where standardized contracts are traded on organized exchanges. Bank loans and private debt placements with insurance companies are examples of private market transactions. Because these transactions are private, they may be structured in any manner to which the two parties agree. By contrast, securities that are traded in public markets (for example, common stock and corporate bonds) are held by a large number of individuals. These securities must have fairly standardized contractual features because public investors do not generally have the time and expertise to negotiate unique, nonstandardized contracts. Broad ownership and standardization result in publicly traded securities being more liquid than tailor-made, uniquely negotiated securities
Behavioral Finance
Rather than assuming that investors are rational, behavioral finance theorists borrow insights from psychology to better understand how irrational behavior can be sustained over time. Pioneers in this field include psychologists Daniel Kahneman, Amos Tversky, and Richard Thaler. Their work has encouraged a growing number of scholars to work in this promising area of research
Speculation
Speculation, on the other hand, is done in the hope of high returns; but it raises risk exposure. For example, several years ago Procter & Gamble disclosed that it lost $150 million on derivative investments. More recently, losses on mortgage-related derivatives helped contribute to the credit collapse in 2008
Spot markets vs futures market
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. For example, a farmer may enter into a futures contract in which he agrees today to sell 5,000 bushels of soybeans 6 months from now at a price of $9.75 a bushel. To continue that example, a food processor that needs soybeans in the future may enter into a futures contract in which it agrees to buy soybeans 6 months from now. Such a transaction can reduce, or hedge, the risks faced by both the farmer and the food processor
Market Price
The current price of a stock. For example, the Internet showed that on one day, Twitter's stock traded at $47.62. The market price had varied from $47.13 to $48.08 during that same day as buy and sell orders came in
Intrinsic Value
The price at which the stock would sell if all investors had all knowable information about a stock. This concept was discussed in Chapter 1, where we saw that a stock's intrinsic value is based on its expected future cash flows and its risk. Moreover, the market price tends to fluctuate around the intrinsic value; and the intrinsic value changes over time as the company succeeds or fails with new projects, competitors enter or exit the market, and so forth
Equilibrium Price
The price that balances buy and sell orders at any given time. When a stock is in equilibrium, the price remains relatively stable until new information becomes available and causes the price to change
Financial Intermediary/ Secondary market transactio
Transfers can also be made through a financial intermediary such as a bank, an insurance company, or a mutual fund. Here the intermediary obtains funds from savers in exchange for its securities. The intermediary uses this money to buy and hold businesses' securities, and the savers hold the intermediary's securities. For example, a saver deposits dollars in a bank, receiving a certificate of deposit; then the bank lends the money to a business in the form of a mortgage loan. Thus, intermediaries literally create new forms of capital—in this case, certificates of deposit, which are safer and more liquid than mortgages and thus better for most savers to hold. The existence of intermediaries greatly increases the efficiency of money and capital markets
Initial public offerings made by privately held firms: the IPO market
Whenever stock in a closely held corporation is offered to the public for the first time, the company is said to be going public. The market for stock that is just being offered to the public is called the initial public offering (IPO) market
Credit Unions
are cooperative associations whose members are supposed to have a common bond, such as being employees of the same firm. Members' savings are loaned only to other members, generally for auto purchases, home improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to individual borrowers.
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. These organizations pool funds and thus reduce risks by diversification. They also achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities. Different funds are designed to meet the objectives of different types of savers. Hence, there are bond funds for those who prefer safety, stock funds for savers who are willing to accept significant risks in the hope of higher returns, and money market funds that are used as interest-bearing checking accounts
Financial Service Corporations
are large conglomerates that combine many different financial institutions within a single corporation. Most financial services corporations started in one area but have now diversified to cover most of the financial spectrum. For example, Citigroup owns Citibank (a commercial bank), an investment bank, a securities brokerage organization, insurance companies, and leasing companies
Private equity companies
are organizations that operate much like hedge funds; but rather than purchasing some of the stock of a firm, private equity players buy and then manage entire firms. Most of the money used to buy the target companies is borrowed
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. Pension funds invest primarily in bonds, stocks, mortgages, and real estate.
Exchange Traded Funds
are similar to regular mutual funds and are often operated by mutual fund companies. ETFs buy a portfolio of stocks of a certain type—for example, the S&P 500 or media companies or Chinese companies—and then sell their own shares to the public. ETF shares are generally traded in the public markets, so an investor who wants to invest in the Chinese market, for example, can buy shares in an ETF that holds stocks in that particular market
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. The business delivers its securities to savers, who, in turn, give the firm the money it needs. This procedure is used mainly by small firms, and relatively little capital is raised by direct transfers
Efficient markets hypothesis
remains one of the cornerstones of modern finance theory. It implies that, on average, asset prices are about equal to their intrinsic values. The logic behind the EMH is straightforward. If a stock's price is "too low," rational traders will quickly take advantage of this opportunity and buy the stock, pushing prices up to the proper level. Likewise, if prices are "too high," rational traders will sell the stock, pushing the price down to its equilibrium level. Proponents of the EMH argue that these forces keep prices from being systematically wrong
Commercial Banks
such as Bank of America, Citibank, Wells Fargo, and JP Morgan Chase, are the traditional "department stores of finance" because they serve a variety of savers and borrowers. Historically, commercial banks were the major institutions that handled checking accounts and through which the Federal Reserve System expanded or contracted the money supply. Today, however, several other institutions also provide checking services and significantly influence the money supply. Note too that the larger banks are generally part of financial services corporations as described next
Life Insurance Companies
take savings in the form of annual premiums; invest these funds in stocks, bonds, real estate, and mortgages; and make payments to the beneficiaries of the insured parties. In recent years, life insurance companies have also offered a variety of tax-deferred savings plans designed to provide benefits to participants when they retire
Investment Banks
traditionally help companies raise capital. They (1) help corporations design securities with features that are currently attractive to investors, (2) buy these securities from the corporation, and (3) resell them to savers. Because the investment bank generally guarantees that the firm will raise the needed capital, the investment bankers are also called underwriters
