Ch2 MARA 641

INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STK MKTS &RETURNS STK MKT EFF
Chapter 2
Financial Markets and

Institutions
The Capital Allocation Process

Financial Markets
Financial Institutions
Stock Markets and Fair Value
Stock Market Efficiency
2-1
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
How is capital transferred between savers and

borrowers?
• Direct transfers
• Investment banks
• Financial institutions
2-2
The Capital Allocation Process
• In a well-functioning economy, capital flows

efficiently from those who supply capital to those
who demand it.
• Suppliers of capital: individuals and institutions
with “excess funds.” These groups are saving
money and looking for a rate of return on their
investment.
• Demanders of capital: individuals and
institutions who need to raise funds to finance
their investment opportunities. These groups are
willing to pay a rate of return on the capital they
borrow.
2-3
What is a market?
• A market is a venue where goods and services

are exchanged.
• A financial market is a place where individuals
and organizations wanting to borrow funds are
brought together with those having a surplus of
funds.
2-4
Types of Financial Markets

• Physical assets (e.g., buying goods from suppliers) vs.
Financial assets (e.g., buying stock from NYSE)
• Spot (buying today at today price) vs. Futures (buying
today at future price)
• Money (e.g., direct loan from bank to finance operations)
vs. Capital (e.g., corporate bonds to finance long-term
investment)
• Primary (e.g., Morgan Stanley bought SNAP directly from
the company at its first issue-IPO on Mar 2, 2017) vs.
Secondary market (e.g., buying SNAP today in the stock
market)
• Public (e.g., AMAZON) vs. Private (e.g., Koch Industries)
2-5
The Importance of Financial Markets
• Well-functioning financial markets facilitate the flow

of capital from investors to users.
 Markets provide savers with returns on their money
saved/invested, which provide them money in the
future.
 Markets provide users of capital with the necessary
funds to finance their investment projects.
• Well-functioning markets promote economic
growth.
• Economies with well-developed markets perform
better than economies with poorly-functioning
markets.
2-6
What are derivatives? How can they be used to

reduce or increase risk?
• A derivative security’s value is “derived” from the price of

another security (e.g., options and futures).
• Can be used to “hedge” or reduce risk. For example, an
importer, whose profit falls when the dollar loses value,
could purchase currency futures that do well when the
dollar weakens.
• Also, speculators can use derivatives to bet on the
direction of future stock prices, interest rates, exchange
rates, and commodity prices. In many cases, these
transactions produce high returns if you guess right, but
large losses if you guess wrong. Therefore, derivatives
are risky investments.
2-7
Types of Financial Institutions
• Investment banks
• Commercial banks
• Credit unions
• Pension funds
• Life insurance companies
• Mutual funds
• Exchange traded funds
• Hedge funds
• Private equity companies
2-8
What is an IPO?
• An initial public offering (IPO) occurs when 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.
2-9
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.
2-10
INTRO ORGANIZATION CREATING VALUE STK-MGR CONFLICTS STK-DBT CONFLICTS BAL INTERESTS
Stock Prices and Intrinsic Value
• In equilibrium, a stock’s price or market value

should equal its economic value or intrinsic
value.
• Intrinsic value is the long-run fair value.
• To the extent that investor perceptions are
incorrect, a stock’s price in the short run can
deviate from its intrinsic value.
• Ideally, managers should avoid actions that
reduce intrinsic value, even if those decisions
increase the stock price in the short run.
1-11
INTRO ORGANIZATION CREATING VALUE STK-MGR CONFLICTS STK-DBT CONFLICTS BAL INTERESTS
Determinants of Intrinsic Values and Stock

Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate
“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk
Stock’s Stock’s
Intrinsic Value Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
1-12
What is meant by stock market efficiency?
• Securities are normally in equilibrium and are

“fairly priced.”
• Investors cannot “beat the market” except
through good luck or better information.
• Efficiency
Highly Highly
Inefficient Efficient
Small companies not followed by Large companies followed by

many analysts. Not much contact many analysts. Good
with investors. communications with investors.
2-13
Implications of Market Efficiency
• You hear in the news that a medical research

company received FDA approval for one of its
products. If the market is highly efficient, can
you expect to take advantage of this
information by purchasing the stock?
 No, if the market is efficient, this information
will already have been incorporated into the
company’s stock price. So, it’s probably too late
for her to “capitalize” on the information.
However, in reality such news might drive the
stock up significantly.
2-14
Implications of Market Efficiency
• “Hot” IPO is a firm scheduled to go public with a

strong financial position (e.g., Beyond Meat, Inc.
BYND in May 209). Most likely, large financial
institutions get in on the ground floor and receive
an allocation of shares before the stock begins the
public trading. It is usually hard for small investors
to receive shares of hot IPOs before the stock
begins trading.
2-15
Possible Reasons Markets May Not Be

Efficient
• Mispricing stocks
• Uncertainty
• Behavioral finance (systematic) borrows insights
from psychology to better understand how
irrational behavior can be sustained over time.
Some examples include:
 Evaluating risks differently.
 Stress.
 Overconfidence.
2-16
Question 1
Which of the following statements is CORRECT?
a. The most important difference between spot markets versus futures markets is that
the maturity of the instruments that are traded on spot market is less than one year
whereas futures markets is greater than one year.
b. Capital market transactions involve only stocks.
c. If General Electric (GE) issues additional stocks and sells them directly to
Goldman Sachs Bank, this would be considered a primary market transaction.
d. Money market transactions do not involve securities denominated in currencies
other than the U.S. dollar.
e. None of the above.
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
17
Question 2
You recently sold 100 shares of Microsoft stock to your
brother at a family reunion. At the reunion your brother gave
you a check for the stock and you gave your brother the
stock certificates. Which of the following best describes this
transaction?
a. This is an example of a direct transfer of capital.
b. This is an example of a primary market transaction.
c. This is an example of an exchange of physical assets.
d. This is an example of a money market transaction.
e. This is an example of a derivative market transaction.
18
Question 3
Which of the following is a primary market transaction?
a. You sell 200 shares of IBM stock on the NYSE through your broker.
b. You buy 200 shares of IBM stock from your brother. The trade is not made through
a broker; you just give him cash and he gives you the stock.
c. IBM issues 80,000 shares of new stock and sells them to an investment bank.
d. One financial institution buys 200,000 shares of IBM stock from another institution.
An investment banker arranges the transaction.
e. IBM sells 2,000,000 shares of treasury stock to its employees when they exercise
options that were granted in prior years.
19
Question 4
Money markets are mainly to finance
a. Foreign currencies.
b. Physical assets.
c. Common stocks.
d. Long-term bonds.
e. Short-term operations.
20
Question 5
Which of the following statements is CORRECT?
a. The NYSE does not exist as a physical location. Rather it represents a loose
collection of dealers who trade stock electronically.
b. An example of a primary market transaction would be your uncle transferring 100
shares of Walmart stock to you as a birthday gift.
c. Capital market instruments include long-term bonds and common stocks.
d. If your uncle in New York sold 100 shares of Microsoft through his broker to an
investor in Los Angeles, this would be a primary market transaction.
e. While the two frequently perform similar functions, investment banks generally
specialize in lending money, whereas commercial banks generally help companies
raise large blocks of capital from investors.
21
Question 6
Which of the following statements is NOT CORRECT?
a. When a corporation's shares are owned by a few individuals, we say that the firm is
"closely, or privately, held."
b. "Going public" establishes a firm's true intrinsic value and ensures that a
liquid market will always exist for the firm's shares.
c. The stock of publicly owned companies must generally be registered with and
reported to a regulatory agency such as the SEC.
d. When stock in a closely held corporation is offered to the public for the first time, the
transaction is called "going public, or an IPO," and the market for such stock is called
the new issue or IPO market.
e. It is possible for a firm to go public and yet not raise any additional new capital for
owners (board of directors).
22
Question 7
Which of the following can be considered a financial
derivative
a. TWTR (Twitter) stock.
b. USD (U.S. dollar).
c. E-mini S&P500 (future contract).
d. WMT (Wal-Mart) 10years bonds.
e. Corporate Tax.
23
Question 8
Stock intrinsic value is:
a. Stock market value.
b. Stock economic value.
c. Stock fair value.
d. “a” and “b”.
e. “b” and “c”.
24
Question 9
On Dec.21, 2017, LJPC (La Jolla Pharmaceutical Co.)
received FDA approval for one of its products. Would you be
expecting its stock price to go up?
a. Yes, if the market is efficient.
b. Yes, if the market is inefficient.
c. Yes, if the LJPC has less than 40% of its capital financed by long-term debt.
d. It depends on the last year sales of different products .
e. None of the above.
25
Question 10
Possible Reasons for inefficient market is (are):
a. Investors behavior and differences in risk assessment.

b. Overconfidence and uncertainty.
c. corporate income and cash flow.
d. “a” and “b”.
e. “b” and “c”.
26

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INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STK MKTS &RETURNS STK MKT EFF

Financial Markets and

The Capital Allocation Process

How is capital transferred between savers and

The Capital Allocation Process

• In a well-functioning economy, capital flows

• A market is a venue where goods and services

Types of Financial Markets

The Importance of Financial Markets

• Well-functioning financial markets facilitate the flow

What are derivatives? How can they be used to

• A derivative security’s value is “derived” from the price of

Types of Financial Institutions

• An initial public offering (IPO) occurs when a

Stock Market Transactions

• Apple Computer decides to issue additional stock

Stock Prices and Intrinsic Value

• In equilibrium, a stock’s price or market value

Determinants of Intrinsic Values and Stock

“True” Investor “True” “Perceived” Investor “Perceived”

What is meant by stock market efficiency?

• Securities are normally in equilibrium and are

Small companies not followed by Large companies followed by

Implications of Market Efficiency

• You hear in the news that a medical research

Implications of Market Efficiency

• “Hot” IPO is a firm scheduled to go public with a

Possible Reasons Markets May Not Be

a. Investors behavior and differences in risk assessment.

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