Fin 303 Ch 2: Financial Markets and Institiutions

We can classify stock market transactions into three distinct categories:

1) Outstanding shares of established publicly owned companies that are traded: the secondary market. 2)Additional shares sold by established publicly owned companies 3)Initial public offerings made by privately held firms: the IPO market

when the demand for an initial public offering of securities exceeds the number of securities issued, the offering is deemed

oversubscribed

Hedging

protecting against cost increases with contracts that allow a company to buy supplies in the future at designated prices

According to the efficient markets hypothesis, 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

pensions funds

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 invest primarily in bonds, stocks, mortgages, and real estate.

Indirect Transfers 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.

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.

capital markets

The financial markets for stocks and for intermediate (1-10 years)- or long-term debt (longer than ten years ). The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a prime example of a capital market

Public Markets

markets in which standardized contracts are traded on organized exchanges securities that are traded in public markets (for example, common stock and corporate bonds) are held by a large number of individuals. 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 being more liquid than private securities

they collect a pool of funds from investors for the purpose of diversifying risk, earning interest or dividends, and/or generating profits from the investments' increased value.

mutual funds mutual funds company is a corporation that manages a portfolio of mutual funds. A mutual fund is a type of collective investment system in which funds are collected from investors and invested in securities that comply with the mutual fund's objective.

Exchange Traded Funds

offshoots of mutual funds that allow investors to trade index portfolios 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

private equity companies

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.

According to the efficient markets hypothesis, if a stock's price is "too high,"

rational traders will sell the stock, pushing the price down to its equilibrium level

money market

market in which money is lent for periods of less than a year markets for short-term, highly liquid debt securities. The New York, London, and Tokyo money markets are among the world's largest.

P/E Ratio (Price Earnings Ratio)

market price per share/earnings per share

Physical Asset Markets

(also called "tangible" or "real" asset markets) for products such as wheat, autos, real estate, computers, and machinery

dutch auction

A method of issuing securities (common stock) by which investors place bids indicating how many shares they are willing to buy and at what price. The price the stock is then sold for becomes the lowest price at which the issuing company can sell all the available shares. the actual transaction price is set at the highest price (the clearing price) that causes all of the offered shares to be sold

closely held corporation

A corporation that is owned by a few individuals who are typically associated with the firm's management. privately owned closely held stock

publicly owned corporation

A corporation that is owned by a relatively large number of individuals who are not actively involved in the firm's management. publicly held stock

over the counter market

A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities. When a stock is traded infrequently, perhaps because the firm is new or small, few buy and sell orders come in, and matching them within a reasonable amount of time is difficult. To avoid this problem, some brokerage firms maintain an inventory of such stocks and stand prepared to make a market for them. These "dealers" buy when individual investors want to sell, and they sell part of their inventory when investors want to buy. At one time, the inventory of securities was kept in a safe; and the stocks, when bought and sold, were literally passed over the counter.

mutual funds

A pool of money used by a company to purchase a variety of stocks, bonds or money market instruments. Provides diversification and professional management for investors. 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.

derivatives

Any financial asset whose value is derived from the value of some other "underlying" asset. 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.

A small startup firm has each of the partners contribute $50,000 in capital to help the company make payroll for the next three months.

Direct transfer of funds

Steve's grandfather loans him $30,000 to start a small coffee shop in the East Village in Manhattan.

Direct transfer of funds

investment banks

Financial institutions that assist firms in the process of issuing securities to investors. also advise firms engaged in mergers and acquisitions, and they are active in the business of selling and trading securities in secondary markets. 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.

Indicate the markets in which each of the following transactions will be traded in: The state of california issues new bonds to the public with an investment bank serving as the underwriter to raise capital. Public or Private Market?

Public

Physical Location Exchanges

Formal organizations having tangible physical locations that conduct auction markets in designated ("listed") securities. Each of the larger exchanges occupies its own building, allows a limited number of people to trade on its floor, and has an elected governing body—its board of governors. Members of the NYSE formerly had "seats" on the exchange The exchange members with sell orders offer the shares for sale, and they are bid for by the members with buy orders. Thus, the exchanges operate as auction markets

dealer markets

Includes all facilities that are needed to conduct security transactions not conducted on the physical location exchanges. 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.

California Public Employees Retirement System (CalPERS) manages pension and health benefits of public employees and retirees. CalPers collects money from its participants and creates a pool of assets. It manages these assets by making investments across domestic and international markets.

Indirect Transfers through a Financial Intermediary

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 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 _______ greatly increases the efficiency of money and capital markets.

Indirect Transfers through a Financial Intermediary

xEdu.com is an early-stage start-up company that plans to issue its first public common stock - called an initial public offering- in six months. It hires an investment back to underwrite the issue.

Indirect transfers through investment bankers

these financial intermediaries that share the financial risk of the ultimately demise of their policyholders, who make regular payments to financial intermediairies for taking the risk.

Life insurance companies policies are contracts in which the insurer agrees to pay a certain amount of money to the insured individual's beneficiary in case of the policyholder's death or other event. In return, the insured individual agrees to pay a certain amount of money at the regular annual intervals (policy premium)/ Life insurance companies collect premiums and invest these funds, bonds, real estate, and other securities

strong form efficiency

Market prices reflect all information, both public and private investors (even corporate insiders) will not be able to earn above-average returns, because any information that they may trade on has already been incorporated in the current stock price

Indicate the markets in which each of the following transactions will be traded in: Sheila saves $10,000 and buys a CD that will mature in six months. Money market or Capital market?

Money market bc the financial transaction is highly liquid and has a short term maturity maturities with more than one year are capital market transactions (bonds, stocks, insurance, leases, and mortgages)

actively managed funds

Mutual funds that have portfolio managers who constantly buy and sell assets in an attempt to generate high returns. portfolio manager uses his or her expertise to select what he or she thinks will be the best-performing stocks over a given time period. 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

money market funds

Mutual funds that invest in short-term, low-risk securities and allow investors to write checks against their accounts

Indicate the markets in which each of the following transactions will be traded in: Mr. and Mrs. Smith buy a new house in Walnut Creek, California. They paid the entire amount, $800,000, in cash. Physical asset markets or Financial asset markets?

Physical asset markets bc it involves an exchange for a house and a house is a tangible asset

How to read a stock quote

Prev Close: Price of share when stock market closed Open: Price of share when stock market open Bid: buy price Ask: sell price a buyer had offered to purchase 200 shares at a bid price of $47.83, and a seller was offering to sell 900 shares at an ask price of $47.84. Volume: daily trading units P/E (ttm): Price per sharee by the most recent 12 months P/E ratio => Share price/Earning Per Share EPS => earnings per share EPS=> Net income - Preferred Div/weighted avg shares outstanding

Private Markets

markets in which transactions are worked out directly between two parties Bank loans and private debt placements with insurance companies they may be structured in any manner to which the two parties agree

Indirect transfers through investment bankers

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 transfers may also go through an investment bank (iBank) such as Morgan Stanley, which underwrites the issue. An underwriter facilitates the issuance of securities. 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.

When markets are inefficient, investors may be

afraid to invest and may put their money "under the pillow," which will lead to a poor allocation of capital and economic stagnation

When markets are efficient, investors can

buy and sell stocks and be confident that they are getting good prices

bid-ask spread

difference between bid and ask prices, represents the dealer's markup, or profit.

identify the financial institiution: these financial conglomerates provide a range of services, such as investment banking, commercial banking, and financial advising.

financial services corporation Ex: Citigroup owns Citibank (a commercial bank), Smith Barney (brokerage, investment banking, and asset management services) and other divisions providing financial services

Indicate the markets in which each of the following transactions will be traded in: An oil trader contracts at the New York Mercantile Exchange, and he locks in the current future price of heating oil for delivery in the winter season. Future or Spot markets?

future

financial service corporation

large conglomerates that combine many different financial institutions within a single corporation

Efficient Market Hypothesis

the hypothesis that prices of securities fully reflect available information about securities

bid price

the price a dealer is willing to pay for a security

spot market

market in which a transaction is made immediately at the prevailing price

semistrong form efficiency

Current market prices reflect all relevant publicly available information including trading information, annual reports, press releases, etc. If the market is semistrong form efficient, then investors cannot earn abnormal returns by trading on public information Implies that fundamental analysis will not lead to abnormal returns

Direct transfer of funds

The firm seeking cash sells its securities directly to savers (investors) who are willing to purchase them in hopes of earning a large return. without going through any type of financial institution used mainly by small firms, and relatively little capital is raised by direct transfers.

Fernando, a trader, wants to buy 1,000 shares of XYZ stock, while a second trader, Ally, is willing to sell 1,500 chares of the same stock. Unfortunately, Fernando and Ally don't know one another, and must complete their transactions using the stock exchnage's market-making dealer. XYZ's market-maker is willing to sell her shares for $29.05 per share and purchase additional shares for $28.50 per share. what is the bid price, ask price, and bid-ask spread? If the market-maker is willing to purchase the entire block of 1,500 chares from Ally and, from that block, resell 1,000 shares to Fernando, then the market-maker's net profit from Fernando's transaction - excluding any inventory effects - will be

bid price = buy price = $28.50 ask price = selling price = $29.05 bid-ask spread = 28.50-29.05 = $0.55 she will purchase 1, 500 share resell 1000 of those shares to fernando 1000 shares at bid price - 1000 shares at ask price = 29050-28500 = $550

credit unions

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. are often the cheapest source of funds available to individual borrowers.

weak form efficiency

current prices reflect all relevant historical and current information, such as past and current price movements Investors will be unable to earn above-average returns simply by examining the company's past and current stock price trends

Financial Asset Markets

deal with stocks, bonds, notes, and mortgages 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.

indexed funds

designed to simply replicate the performance of a specific market index tracks the S&P 500 index will simply hold the basket of stocks that comprise the S&P 500.

A corn processor in nebraska has decided to purchase a futures contract for corn. The contract will increase in value if the pricde of corn rises, thereby offsetting the processors' increased costs.decreased net income. In this example, the corn processor is ____.

hedging the purpose of purchasing future is to reduce the risk or corn processors. allows them to lock in the price it will be paying for the corn at future dates removes the uncertainty related to the price it will have to pay for the corn

primary market

market for selling financial assets that can only be redeemed by the original holder 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.

hedge funds

similar to mutual funds because they accept money from savers and use the funds to buy various securities, but are largely unregulated typically have large minimum investments (often exceeding $1 million) and are marketed primarily to institutions and individuals with high net worths

Initial Public Offering (IPO) Market

the market for stocks of companies that are in the process of going public When the market is strong, many companies go public to bring in new capital and to give their founders an opportunity to cash out some of their shares

secondary market

the market in which previously issued securities are traded among investors if Jane Doe decided to buy 1,000 shares of GE stock, the purchase would occur in the secondary market. 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.

Future Markets

the markets in which participants agree today to buy or sell an asset at some future date 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.

ask price

the price at which a dealer or other trader will sell a security

commercial banks

traditional "department stores of finance" because they serve a variety of savers and borrowers

Financial intermediaries such as banks and mutual funds help transfer capital from those with a surplus of funds to those who need capital. True or false?

true

When looking at a stock market quote online you will sometimes see the letters 'ttm' following the company's price/earnings ratio and earnings per share. In this case, ttm stands for "trailing twelve months," and it contrasts with data based on analysts' forecasts. True or false?

true

when the stock price trades at a value equal to the intrinsic value

true value of a stock