CHAPTER 2

FINANCIAL MARKETS AND

INSTITUTIONS

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 Capital Allocation Process
▣ Businesses, individuals, and governments often need
to raise capital.
▣ Some individuals and firms have incomes that exceed
their current expenditure.
▣ The surplus fund they have are accumulated as
savings for some future use.

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 Financial Institutions & Markets

Firms that require funds from external

sources can obtain them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements

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 Financial Institutions
● Financial institutions are intermediaries that
channel the savings of individuals, businesses,
and governments into loans or investments.
● The key suppliers and demanders of funds are
individuals, businesses, and governments.
● In general, individuals are net suppliers of
funds, while businesses and governments are
net demanders of funds.

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Commercial Banks

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 Commercial Banks
▣ Commercial banks are the traditional “departmental
store” of finance serving a variety of savers (deposits)
and borrowers (loans).
▣ In every country there is a central bank who monitors
and guides all the other commercial banks. Example:
Bangladesh Bank, Federal Reserve of USA.
▣ They earn through interest rate differentials.

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Investment Banks

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 Investment Banks
▣ Investment banks are organizations that underwrite
and distribute new investment securities and help
businesses obtain funds. Sometimes they also
participate in investment with their own share of
funds along with their client investors.
e.g. JP Morgan Chase, Goldman Sachs, Citigroup

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Mutual Funds

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 Mutual Funds
▣ Mutual Funds are organizations that pool investor
funds to purchase financial securities and thus divides
the risk and achieve economies of scale in security
analysis and trading costs.

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FINANCIAL MARKETS

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 Money Markets
▣ Money Markets are the markets for short-term, highly liquid debt
securities like US Treasury bills, commercial papers, negotiable
certificates of deposits etc. (also known as marketable securities).

▣ Some individuals, businesses, governments, and financial

institutions have temporarily idle funds that they wish to invest in
a relatively safe, interest-bearing asset. The money market brings
together these suppliers and demanders of short-term funds.

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 Capital Markets
▣ Capital Markets are the markets for intermediate or
long-term debt and equity securities like bonds,
common stocks, preferred stocks.
▣ Bonds are long-term debt instruments used by
business and government to raise large sums of
money.
▣ Common Stocks and Preferred Stocks are equity
instruments.

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What are Stocks?

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 Primary Markets VS Secondary
Markets
▣ Primary Markets are the markets in which corporations
raise new capital. When securities are sold for the first time
directly from the issuer it is a transaction in the primary
market.

▣ Secondary Markets are markets in which existing, already

outstanding, securities are traded among investors. It is the
place where securities are sold “second-hand”

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 Stock Market
▣ The most active secondary market and most
important to financial managers is the stock
market.
▣ There are two basic types of Stock Markets:
◼ Physical Location Stock Exchange/Broker Markets
◼ Over-the-counter (OTC) Market/Dealer Market

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 Physical Location Exchange
▣ Physical Location Exchange: Formal Organizations having
tangible physical locations that conduct trades of designated
(listed) securities. Example: New York Stock Exchange
(NYSE), Dhaka Stock Exchange (DSE).
▣ Sells trading license or “seats” to brokers which gives them the right
to trade for the investors.

▣ Trading takes place on centralized trading floors.

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 Over-the-Counter Markets
▣ Over-the-counter (OTC) markets are a large collection of
brokers and dealers, connected electronically by telephones
and computers, that provides for trading in unlisted
securities. Example: National Association of Securities
Dealers Automated Quotations (NASDAQ),

▣ Dealers state the bid price (buying price) of the stocks and
the ask price (selling price). The difference between the two
is the dealer’s profit, known as bid-ask spread.

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 Stock Market Transactions
▣ Apple Computer decides to issue additional stock
with the assistance of its investment banker. An
investor purchases some of the newly issued shares.
Is this a primary market transaction or a secondary
market transaction?
◼ Since new shares of stock are being issued, this is a
primary market transaction.
▣ What if instead an investor buys existing shares of
Apple stock in the open market – is this a primary or
secondary market transaction?
◼ Since no new shares are created, this is a secondary
market transaction.
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 What is an IPO?

▣ An initial public offering (IPO) is where a company

issues stock in the public market for the first time.
▣ “Going public” enables a company’s owners to raise
capital from a wide variety of outside investors.
Once issued, the stock trades in the secondary
market.
▣ Public companies are subject to additional regulations
and reporting requirements.

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