STUDY GUIDE: CHAPTER 2

FINANCIAL MARKETS AND INSTITUTIONS

Overview
It is critical that financial managers understand the environment and markets within which they operate. In this
chapter, we examine the markets in which capital is raised, securities are traded, and stock prices are established.
We examine the institutions that operate in these markets and through which securities transactions are conducted.
Finally, we discuss market efficiency, what that means, why some people believe markets are efficient and others
do not, and the conclusions reached about market efficiency.

Outline
I.

In a well-functioning economy, capital will flow efficiently from those who supply capital to those
who demand it. Transfers of capital between savers and borrowers take place in three different ways.
A. Direct transfers of money and securities occur when a business sells its stocks or bonds directly to
savers, without going through any type of financial institution.
B. Transfers through an investment bank occur when it underwrites the issue serving as a middleman and
facilitating the issuance of securities.
C. Transfers through a financial intermediary occur when a bank, insurance company, or mutual fund
obtains funds from savers in exchange for its own securities, and then uses these funds to purchase
other businesses securities.
1. Intermediaries literally create new forms of capital.
2. The existence of intermediaries greatly increases the efficiency of money and capital markets.
D. In a global context, economic development is highly correlated with the level and efficiency of
financial markets and institutions.
1. It is difficult for an economy to reach its full potential if it doesnt have access to a wellfunctioning financial system.
2. In a well-developed economy, an extensive set of markets and institutions have evolved over time
to facilitate the efficient allocation of capital.
3. To raise capital efficiently, managers must understand how these markets and institutions work;
and individuals need to know how the markets and institutions work to earn high rates of return on
their savings.

II.

Financial markets bring together people and organizations wanting to borrow money with those
having surplus funds.
A. There are many different financial markets in a developed economy. Each deals with a different type
of instrument, serves a different set of customers, or operates in a different part of the country.
B. The major types of financial markets include:
1. Physical asset markets (also called tangible or real asset markets) are the markets for products
such as wheat, autos, real estate, computers, and machinery.
2. Financial asset markets deal with stocks, bonds, notes, mortgages, and derivative securities.
3. Spot markets are markets in which assets are bought or sold for on-the-spot delivery.

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4. Futures markets are markets in which participants agree today to buy or sell an asset at some future
date.
5. Money markets are the markets for short-term, highly liquid debt securities, those securities that
mature in less than one year.
6. Capital markets are the markets for intermediate- or long-term debt and corporate stocks.
7. Primary markets are the markets in which corporations raise new capital.
8. Secondary markets are the markets in which existing, already outstanding securities are traded
among investors.
9. Private markets are the markets where transactions are negotiated directly between two parties.
10. Public markets are the markets where standardized contracts are traded on organized exchanges.
C. A healthy economy is dependent on efficient funds transfers from people who are net savers to firms
and individuals who need capital.
1. Without efficient transfers, the economy could not function.
D. Financial markets have experienced many changes in recent years.
1. Technological advances in computers and telecommunications, along with the globalization of
banking and commerce, have led to deregulation, which has increased competition throughout the
world.
2. As a result, there are much more efficient, internationally linked markets, which are far more
complex than what existed a few years ago.
a. With globalization has come the need for greater cooperation among regulators at the
international level.
b. Complicating coordination are: (1) the different structures in nations banking and securities
industries, (2) the trend toward financial services conglomerates, and (3) the reluctance of
individual countries to give up control over their national monetary policies.
E. Another important trend in recent years has been the increased use of derivatives.
1. A derivative is any security whose value is derived from the price of some other underlying
asset.
2. 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.
3. Derivatives can be used either to manage risks or to speculate.
a. Credit default swaps are examples of derivatives.
(1.)

They are contracts that offer protection against the default of a particular security.

(2.)

A bank agrees to make regular payments to another financial institution. In return, the
financial institution agrees to insure the bank against losses that would occur if the
borrower defaulted.

b. Purchasing derivatives to reduce a companys risk of a decline in an assets value is a hedging

operation.
c. Speculation is done in the hope of high returns, but it raises risk exposure.
4. According to former Fed Chairperson Greenspan, in theory derivatives should allow companies to
manage risk better, but it is not clear whether recent innovations have increased or decreased the
inherent stability of the financial system.

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III.

In the U.S. and other developed nations, a set of highly efficient financial intermediaries has evolved.
Their original roles were quite specific, and regulation prevented them from diversifying. In recent
years regulations against diversification have been largely removed; and today the differences
between institutions have become blurred. Still, there remains a degree of institutional identity, so a
description of the major categories follows.
A. Investment banks underwrite and distribute new investment securities and help businesses obtain
financing.
1. They help corporations design securities with features that are attractive to investors.
2. They then buy these securities from the corporation.
3. They then resell them to savers.
B. Commercial banks are the traditional department stores of finance serving a variety of savers and
borrowers.
1. Historically, they were the major institutions that handled checking accounts and through which the
Federal Reserve System expanded or contracted the money supply.
2. Several other institutions also provide checking services and significantly influence the money
supply.
C. Financial services corporations are large conglomerates that combine many different financial
institutions within a single corporation.
1. They offer a wide range of financial services, including investment banking, brokerage operations,
insurance, and commercial banking.
D. Credit unions are cooperative associations whose members are supposed to have a common bond.
1. They are often the cheapest source of funds available to individual borrowers.
E. 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.
F. 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.
G. Mutual funds are corporations that accept money from savers and use these funds to buy stocks, longterm bonds, or short-term debt instruments issued by business or government units.
1. These organizations pool funds and thus reduce risks by diversification.
2. They also achieve economies of scale in analyzing securities, managing portfolios, and buying and
selling securities.
3. They have grown more rapidly than most other institutions in recent years, in large part because of
a change in the way corporations provide for employees retirement. Most workers turn their
retirement funds over to a mutual fund.
H. Exchange Traded Funds (ETFs) are similar to regular mutual funds and are often operated by mutual
fund companies.
1. These funds buy a portfolio of stocks of a certain type and then sell their own shares to the public.
2. ETF shares are generally traded in the public markets.

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I.

Hedge funds are similar to mutual funds because they accept money from savers and use the funds to
buy various securities, but there are some important differences.
1. Hedge funds are largely unregulated.
2. Hedge funds typically have large minimum investments (often exceeding $1 million) that are
marketed primarily to institutions and individuals with high net worths.
3. Hedge funds received their name because they were traditionally used when an individual was
trying to hedge risks.
4. Some hedge funds take on risks that are considerably higher than that of an average individual
stock or mutual fund.
5. As hedge funds have become more popular, many of them have begun to lower their minimum
investment requirements. Their rapid growth and shift toward smaller investors have also led to a
call for more regulations.

J. Private equity companies are organizations that operate much like hedge funds; but rather than buying
some of the stock of a firm, private equity players buy and then manage entire firms.
1. Most of the money used to buy the target company is borrowed.
IV.

The most active secondary market, and the most important one to financial managers, is the stock
market because it is here where prices of firms stocks are established. Because the primary goal of
financial managers is to maximize their firms stock prices, knowledge of the stock market is
important to anyone involved in managing a business. There are two basic types of stock markets.
A. The physical location exchanges, typified by the New York Stock Exchange (NYSE) and the American
Stock Exchange (AMEX), are tangible, physical entities.
1. They are formal organizations that have tangible physical locations and conduct auction markets in
designated listed securities.
2. Each of these larger exchanges occupies its own building, has a limited number of members, and
has an elected governing body, its board of governors.
3. Like other markets, security exchanges facilitate communication between buyers and sellers.
4. 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.
B. The electronic dealer-based markets include the Nasdaq stock market, the less formal over-the-counter
market, and the recently developed electronic communications networks (ECNs).
1. The dealer market includes all facilities that are needed to conduct security transactions not
conducted on the physical location exchanges.
2. Traditionally referred to as the over-the-counter (OTC) market, which is a large collection of
brokers and dealers, connected electronically by telephones and computers, it provides for trading
in unlisted securities.
3. Brokers and dealers who participate in the over-the-counter market are members of a selfregulatory body known as the National Association of Securities Dealers (NASD), which licenses
brokers and oversees trading practices.
4. Since most of the largest companies trade on the NYSE, the market capitalization of NYSE-traded
stocks is much higher than for stocks traded on Nasdaq. However, reported volume (number of
shares traded) is often larger on Nasdaq, and more companies are listed on Nasdaq.
a. One transaction on Nasdaq generally shows up as two separate trades (the buy and the sell).
This double counting makes it difficult to compare the volume between stock markets.

FINANCIAL MARKETS AND INSTITUTIONS

V.

Closely held corporations are those owned by a few individuals who are typically associated with the
firms management. Publicly owned corporations are those owned by a relatively large number of
individuals who are not actively involved in its management. Institutional investors have a
significant influence on the prices of individual stocks.
A. Stock market transactions can be classified into three distinct categories.
1. Trading in the outstanding shares of established, publicly owned companies occurs in the
secondary market.
a. Companies receive no new money when sales occur in this market.
2. Additional new shares are sold by established, publicly owned companies in the primary market.
3. Initial public offerings (IPOs) by privately held firms in the process of going public comprise the
IPO market.
a. Going public is the act of selling stock to the public at large by a closely held corporation or its
principal stockholders.
b. It is often difficult to purchase shares in the initial offering because they are generally
oversubscribed, which means the demand for shares at the offering price exceeds the number
of shares issued.
c. IPOs often underperform the overall market over the long run.
d. In a Dutch auction, individual investors place bids for shares directly. The actual transaction
price is set at the highest price (the clearing price) that causes all of the offered shares to be
sold.
e. Firms can go public without raising any additional capital. For example, the Ford Foundation
sold Ford stock to the public, but Ford itself raised no capital in the transaction.

VI.

There generally are large differences between expected and realized prices and returns. A stocks
expected return as estimated by investors at the margin is always positive, for otherwise investors
would not purchase the stock. However, in some years actual returns turn out to be negative.
A. Besides newspapers, it is now possible to obtain quotes from a wide variety of internet sources.
However, unlike newspapers, its possible to obtain quotes all during the day from these internet
sources.
1. A great deal of information is often contained in these quotes.
B. Since 1968 the market trend has been strongly up, but by no means does it go up every year.
1. Even in bad years some individual companies do well, so the name of the game in security
analysis is to pick the winners.

VII.

When markets are efficient, investors can buy and sell stocks and be confident that they are getting
good prices. When markets are inefficient, investors may be afraid to invest which will lead to a poor
allocation of capital and economic stagnation. From an economic standpoint, market efficiency is
good.
A. There is an efficiency continuum with the market for some companies stocks being highly efficient
and the market for other stocks being highly inefficient.
1. The key factor is the size of the company. The larger the firm, the more analysts tend to follow it
and thus the faster new information is likely to be reflected in the stocks price.
2. Different companies communicate better with analysts and investors; and the better the
communications, the more efficient the market for the stock.

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Self-Test
Definitional Questions
1. Markets for short-term debt securities are called _______ markets, while markets for intermediate- or long-term
debt and corporate stocks are called _________ markets.
2. Firms raise capital by selling newly issued securities in the _________ markets, while existing, already
outstanding securities are traded in the ___________ markets.
3. An institution that issues its own securities in exchange for funds and then uses these funds to purchase other
businesses securities is called a financial ______________.
4. A(n) ____________ bank facilitates the transfer of capital between savers and borrowers by acting as a
middleman.
5. The two basic types of stock markets are the __________ location exchanges, such as the NYSE, and the
electronic ________-_______ or ______-_____-_________ market.
6. ___________ markets bring together people and organizations wanting to borrow money with those having
surplus funds.
7. ________ transfers of money and securities occur when a business sells its stock or bonds to savers, without
going through any type of financial institution.
8. A(n) ____________ is any security whose value is derived from the price of some other underlying asset.
9. The result of ongoing regulatory changes has been a blurring of the distinctions between the different types of
financial institutions. As a result, in the U.S. the trend has been toward huge ___________ services
corporations, large conglomerates that combine many different financial institutions within a single
corporation.
10. The _______ market is one of the most important markets to financial managers because it is here where the
prices of firms stocks are established.
11. The initial ________ offering market is the market in which firms go public by offering shares to the public
for the first time.
12. _________ markets are markets in which transactions are negotiated directly between two parties.
13. ________ markets are markets in which standardized contracts are traded on organized exchanges.
14. ______ markets are the markets in which assets are bought or sold for on-the-spot delivery.
15. _________ markets are the markets in which participants agree today to buy or sell an asset at some future date.
16. __________ asset markets are the markets for products such as wheat, autos, real estate, computers, and
machinery.
17. ___________ asset markets deal with stocks, bonds, notes, mortgages, and derivative securities.
18. In a global context, __________ development is highly correlated with the level and efficiency of financial
markets and institutions.
19. ____________ banks are the traditional department stores of finance serving a variety of savers and borrowers.
20. ________ unions are cooperative associations whose members are supposed to have a common bond.
21. _________ 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.

FINANCIAL MARKETS AND INSTITUTIONS

22. Life ___________ companies take savings in the form of annual premiums; invest these funds in stocks, bonds,
real estate, and mortgages; and make payments to beneficiaries.
23. ________ funds are regulated corporations that accept money from savers, pool these funds to reduce risks by
diversification, and use the funds to buy stocks, long-term bonds, or short-term debt instruments issued by
businesses or government units.
24. _______ funds are similar to mutual funds except that they are largely unregulated; typically have large
minimum investments that are marketed primarily to institutions and individuals with high net worths.
25. _________ held corporations are those owned by a few individuals who are typically associated with the firms
management.
26. __________ owned corporations are those owned by a relatively large number of individuals who are not
actively involved in its management.
27. Going ________ is the act of selling stock to the public at large by a closely held corporation or its principal
stockholders.
28. Initial offerings are often ________________, which means that the demand for shares at the offering price
exceeds the number of shares issued.
29. If the stock market is ___________, it is a waste of time for most people to seek bargains by analyzing
published data on stocks.
30. In a(n) _______ _________, individual investors place bids for shares directly. The actual transaction price is
set at the highest price (the clearing price) that causes all of the offered shares to be sold.

Conceptual Questions
1. Which of the following statements is not correct?
a. One of the major benefits of well-developed stock markets is that they increase liquidity, which makes it
easier for firms to raise capital.
b. In the United States, we have a number of specialized financial institutions, but, according to the text, the
trend is toward larger, more diversified institutions that offer broad arrays of financial services.
c. The dealer market is a formal organization that has a tangible physical location and conducts auction
markets in designated listed securities.
d. A healthy economy is dependent on efficient transfers of funds from people who are net savers to firms and
individuals who need capital.
e. Technological advances in computers and telecommunications, along with the globalization of banking and
commerce, have led to deregulation, and this has increased competition throughout the world.
2. Which of the following statements is not correct?
a. Firms can go public without raising any additional capital.
b. Additional new shares are sold by established, publicly owned companies in the secondary market.
c. Going public is the act of selling stock to the public at large by a closely held corporation or its principal
stockholders.
d. A stocks expected return as estimated by investors at the margin is always positive, for otherwise investors
would not purchase the stock.
e. Besides newspapers, it is now possible to obtain quotes from a wide variety of internet sources.

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Answers
Definitional Questions
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.

money; capital
primary; secondary
intermediary
investment
physical; dealer-based; over-the-counter
(OTC)
Financial
Direct
derivative
financial
stock
public
Private
Public
Spot
Futures

16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.

Physical
Financial
economic
Commercial
Credit
Pension
insurance
Mutual
Hedge
Closely
Publicly
public
oversubscribed
efficient
Dutch auction

Conceptual Questions
1. c. This statement is false. This is the definition for a physical location exchange.
2. b. This statement is false. Trading in the outstanding shares of established, publicly owned
companies occurs in the secondary market.