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CHAPTER 5

Financial Markets andInstitutions

The Capital Allocation Process

Financial markets Financial institutions Stock Markets and Returns Stock Market Efciency

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The Capital Allocation

Process In a well-unctionin! economy" capital #ows

efciently rom those who supply capital to thosewho demand it$

Suppliers o capital % indi&iduals and institutionswith 'e(cess unds)$ These !roups are sa&in!money and lookin! or a rate o return on theirin&estment$

*emanders or users o capital % indi&iduals andinstitutions who need to raise unds to +nance theirin&estment opportunities$ These !roups are willin!to pay a rate o return on the capital they ,orrow$

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ow is capital transerred

,etween sa&ers and ,orrowers. *irect transers

In&estment

,ankin! house Financial

intermediaries

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/hat is a market. A market is a &enue where !oods

and ser&ices are e(chan!ed$

A +nancial market is a place where

indi&iduals and or!ani0ationswantin! to ,orrow unds are

,rou!ht to!ether with those ha&in!a surplus o unds$

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Types o +nancial markets Physical assets &s$ Financial assets

Money &s$ Capital

Primary &s$ Secondary

Spot &s$ Futures

Pu,lic &s$ Pri&ate

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The importance o +nancial

markets /ell-unctionin! +nancial markets acilitate the #ow

o capital rom in&estors to the users o capital$ Markets pro&ide sa&ers with returns on their money

sa&ed1in&ested" which pro&ides them money in the uture$ Markets pro&ide users o capital with the necessary unds

to +nance their in&estment pro2ects$

/ell-unctionin! markets promote economic !rowth$

Economies with well-de&eloped markets perorm

,etter than economies with poorly-unctionin!markets$

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/hat are deri&ati&es. ow can they

,e used to reduce or increase risk. A deri&ati&e security3s &alue is 'deri&ed) rom

the price o another security 4e$!$" optionsand utures5$

Can ,e used to 'hed!e) or reduce risk$ Fore(ample" an importer" whose pro+t alls whenthe dollar loses &alue" could purchasecurrency utures that do well when the dollarweakens$

Also" speculators can use deri&ati&es to ,eton the direction o uture stock prices" interestrates" e(chan!e rates" and commodity prices$In many cases" these transactions produce

hi!h returns i you !uess ri!ht" ,ut lar!elosses i you !uess wron!$ ere" deri&ati&es

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Types o +nancial

institutions Commercial ,anks

In&estment ,anks

Mutual sa&in!s ,anks Credit unions

Pension unds

6ie insurance companies Mutual unds

ed!e unds

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Physical location stock

e(chan!es &s$ Electronic dealer-,ased markets Auction market

&s$ *ealer market

4E(chan!es &s$7TC5

89SE &s$ 8asda:

*i;erences arenarrowin!

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Stock Market Transactions Apple Computer decides to issue additional

stock with the assistance o its in&estment,anker$ An in&estor purchases some o the

newly issued shares$ Is this a primary markettransaction or a secondary market transaction. Since new shares o stock are ,ein! issued" this is a

primary market transaction$

/hat i instead an in&estor ,uys e(istin! shares

o Apple stock in the open market % is this aprimary or secondary market transaction. Since no new shares are created" this is a secondary

market transaction$

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/hat is an IP7. An initial pu,lic o;erin! 4IP75 is where a

company issues stock in the pu,lic

market or the +rst time$ '

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istorical stock market

perormance" S=P >?? 4@B-D??5

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/here can you +nd a stock

:uote" and what does one looklike. Stock :uotes can ,e ound in a &ariety o print sources

4Wall Street Journalor the local newspaper5 and onlinesources 49ahooFinance" C88Money" or MS8

MoneyCentral5$

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/hat is the Efcient Market

ypothesis 4EM5. Securities are normally in

e:uili,rium and are 'airly priced$)

In&estors cannot ',eat the market)e(cept throu!h !ood luck or ,etterinormation$

6e&els o market efciency /eak-orm efciency Semistron!-orm efciency Stron!-orm efciency

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/eak-orm efciency Can3t pro+t ,y lookin! at past

trends$ A recent decline is no

reason to think stocks will !o up4or down5 in the uture$

E&idence supports weak-orm

EM" ,ut 'technical analysis) isstill used$

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Semistron!-orm efciency All pu,licly a&aila,le inormation

is re#ected in stock prices" so it

doesn3t pay to o&er analy0eannual reports lookin! orunder&alued stocks$

6ar!ely true" ,ut superioranalysts can still pro+t ,y +ndin!and usin! new inormation$

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Stron!-orm efciency All inormation" e&en inside

inormation" is em,edded in

stock prices$ 8ot true--insiders can !ain ,y

tradin! on the ,asis o insider

inormation" ,ut that3s ille!al$

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Conclusions a,out market

efciency Empirical studies su!!est the stock

market isG i!hly efcient in the weak orm$ Reasona,ly efcient in the semistron! orm$ 8ot efcient in the stron! orm$ Insiders ha&e

made a,normal 4and sometimes ille!al5pro+ts$

Heha&ioral +nance Incorporates elements o co!niti&e psycholo!y

to ,etter understand how indi&iduals andmarkets respond to di;erent situations$

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Implications o market

efciency 9ou hear in the news that a medical

research company recei&ed F*A appro&al

or one o its products$ I the market issemi-stron! efcient" can you e(pect totake ad&anta!e o this inormation ,ypurchasin! the stock.

8o % i the market is semi-stron! efcient"this inormation will already ha&e ,eenincorporated into the company3s stock price$So" it3s pro,a,ly too late

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Implications o market

efciency A small in&estor has ,een readin! a,out a 'hot)

IP7 that is scheduled to !o pu,lic later thisweek$ She wants to ,uy as many shares as she

can !et her hands on" and is plannin! on ,uyin!a lot o shares the +rst day once the stock,e!ins tradin!$ /ould you ad&ise her to do this. Pro,a,ly not$ The lon!-run track record o hot IP7s is

not that !reat" unless you are a,le to !et in on the!round #oor and recei&e an allocation o shares ,eorethe stock ,e!ins tradin!$ It is usually hard or smallin&estors to recei&e shares o hot IP7s ,eore the stock,e!ins tradin!$