Financial Markets and

the Investment Banking Process

Chapter 3
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Financial Markets
A system comprised of individuals and
institutions, instruments, and procedures that
bring together borrowers and savers.

Flow of Funds
Provides the ability to transfer income
through time
o Borrowing sacrifices
future income to increase
current income.
o Saving, or investing, sacrifices
current income in exchange
for greater expected income
in the future.

Flow of Funds
1. Direct Transfer
o business sells its stock directly to investors

Flow of Funds
2. Indirect Transfer through Investment Bankers
o investment banker acts as middleman and facilitates issuance of
securities by reselling the securities to savers

Flow of Funds
3. Indirect Transfer through financial intermediary
o bank or mutual fund obtains funds
from savers and uses
the money to lend
or purchase securities

Market Efficiency
Economic Efficiency
o Funds are allocated to their optimal use at the lowest cost
o Transactions costs associated with buying and selling

Market Efficiency
Information Efficiency
oPrices of investments reflect
existing information and adjust
quickly when new information
enters the market
oThree categories

Informational Efficiency
1.

Weak-form efficiency
o
o

all information contained in past price movements is fully reflected

in current market prices
information about recent or past price trends is of no use when
searching for abnormal returns

Informational Efficiency
2.

Semistrong-form efficiency
o
o
o

current market prices reflect all publicly available information

financial analysis is of no use for finding mispriced securities
insiders can profit on their own companys stock

Informational Efficiency
3.

Strong-form efficiency
o
o

current market prices reflect all pertinent information, whether

publicly available or privately held
even insiders cannot earn abnormal returns

Types of Financial
Markets
Money Markets
o instruments traded mature in one year or less

Capital Markets
o includes instruments with maturities greater than one year

Types of Financial
Markets
Debt Markets
o treasury, corporate, mortgage-backed, money market, municipal, etc...

Equity Markets
o stock markets

Equity Markets
Primary
o corporations raise funds by issuing new securities

Secondary
o securities are traded among investors after they have been issued

Derivatives Markets
Options, futures and swaps are securities whose
value is determined, or derived directly from
other assets
These can be used to manage risk or to speculate

Types of Stock Market

Transactions
1.

Secondary market
o

2.

trading existing stocks

Primary market
o

3.

existing firm issues additional shares

Initial Public Offering (IPO)

o
o

privately held company offers stock to the public for the first
time
called going public

The Physical Stock

Exchanges
Physical exchanges
o
o
o
o

New York Stock Exchange (NYSE)

American Stock Exchange (AMEX)
Chicago Stock Exchange (CHX)
Philadelphia Stock Exchange (PHLX)

NYSE Members
1.
2.
3.
4.

Commission brokers
Independent brokers
Competitive traders
Specialists

Listing Requirements
Quantitative and qualitative characteristics a firm
must possess to be listed on an exchange
Vary by exchange
Number of shareholders, number of public shares,
market value of public shares, pre-tax income,
etc...

NetworksThe Over-theCounter Market (OTC)

Collection of brokers and dealers connected
electronically
Provides for trading in securities not listed on the
organized exchanges

Over-the-Counter Market
(OTC)
1.
2.
3.

Dealers hold inventory and make a market

Brokers act as agents in bringing together
dealers with investors
Electronic network provides communications
link

NASD
Many of the dealers and brokers of the OTC are
members of the National Association of Securities
Dealers (NASD), which licenses and oversees
trading practices.

NASDAQ
The computerized trading network used by NASD
is the NASD Automated Quotation System
(NASDAQ) and is a sophisticated market of its
own, separate from the OTC.

Communications
Networks (ECN)
Electronic systems that transfer information
about securities transactions to facilitate the
execution of orders
Automatically matches buy and sell orders for a
large number of transactions

Investment Banker
Organization that underwrites and distributes new
issues of securities
Helps businesses and other entities obtain
needed financing

Investment Banking
Process
1.

2.
3.

Help corporations design securities with the

features that are most attractive to investors
given existing market conditions.
Buy these securities from the corporations.
Then resell the securities to investors
(savers).

Raising Capital: Stage I

Decisions
1.
2.
3.
4.

Dollars to be raised
Type of securities used
Competitive bid or negotiated deal
Selection of an investment banker

Raising Capital: Stage II

Decisions
1.
2.
3.
4.

Reevaluating the initial decisions

Best efforts or underwritten issues
Issuance (flotation) costs
Setting the offering price

Selling Procedures
Registration statement
o filed with the SEC

Prospectus
o summarizes a new security issue and the issuing company

Underwriting syndicate
o group of investment banking firms to distribute the new issue

Shelf Registration
Securities registered with the SEC for sale at a
later date

Maintenance of the
Secondary Market
To facilitate orderly market for the new security,
the investment banker maintains a market for the
security following its issue.

Regulation of Securities
Markets
Securities and Exchange Commission (SEC)
o U.S. government agency regulates the issuance and trading of stocks
and bonds
o to ensure investors receive fair financial disclosures
o to discourage fraud and misleading stock manipulation

SEC Regulation
1.

2.

Jurisdiction over interstate offerings of new

securities to the general public in amounts of
$1.5 million or more
Regulates national securities exchanges, and
listed companies must file annual reports

SEC Regulation
3.
4.

Control stock trades by corporate insiders

Prohibit manipulation of securities prices by
pools or wash sales

International Financial
Markets
Increasingly global markets
Greatest growth in emerging markets of the
Pacific Rim
U. S. exchanges still dominate worldwide trading
activity

End of Chapter 3

Financial Markets
and the
Investment
Banking Process