chapter 2 - key concepts (financial markets and institutions)

Question 1

What are the three ways that capital is transferred between savers and borrowers?

Answer 1

How is capital transferred between savers and borrowers?

• Direct transfers
• Investment banks
• Financial intermediaries

Question 2

What are examples of each?

• Direct transfers
• Investment banks
• Financial intermediaries

Answer 2

direct transfers: Private company sells shares

investment banks: Transfers that go through an investment bank such as Goldman Sachs or Morgan Stanley

financial intermediaries: Bank loans are the most common
You deposit money in a bank, bank then lends money out

Question 3

direct transfers

Answer 3

• Business sells its stocks or bonds directly to savers without going through any financial institutions
• Both sides know each other
• Typically used by small firms and little capital is raised

Examples: PRIVATE COMAPNY sells shares

Pro: easy
Con: you must have trust. No verification

Question 4

investment banks

Answer 4

IPO (initial public offering): when companies go public and when they do they almost go public with an investment BANKS

• Transfers that go through an investment bank such as Goldman Sachs or Morgan Stanley
• Goldman Sachs or Morgan Stanly are underwriters
• Investment banks (middle man) makes money by selling the stock to savers
• Companies sells stock or bonds to the underwriter, which is then sold by the investment bank to savers
• Underwriters are taking on risk

Question 5

investment banks/underwriting (IPOs) are also called

Answer 5

Also called primary market transactions
(when the money actually goes to the company)

Question 6

financial intermediaries

Answer 6

Loans made through a financial intermediary such as a bank, insurance company, or a mutual fund

• The intermediary obtains funds from savers in exchange for securities
• Creates new forms of capital, such as CDs, which are safer and more liquid than other securities, such as mortgages
• Bank loans are the most common
• You deposit money in a bank, bank then lends money out

Question 7

Why do most companies use underwriters to raise capital instead of using direct transfers?
What purpose do investment banks serve in the underwriting process?

Answer 7

Companies sells stock or bonds to the underwriter (the banks), which is then sold by the investment bank to savers. direct transfers do not have verification.

LOT EASIER TO VET COMPANIES GOING PUBLIC BY USING PUBLIC BANKS

Underwriters/investment banks are taking on risk

Question 8

Describe the capital allocation process and what role the suppliers of capital plays and the
role that the users of capital play.

Answer 8

Economic growth requires capital flows from those who can supply capital to those who need additional capital –> We have supplier and demanders of capital

Suppliers of capital:
- Individuals, institution, governments with funds that aren’t needed
- Suppliers of capital are willing to provide funds in exchange for rate of return

Demanders of capital
individuals:
- institutions and governments that need to raise funds to finance investment opportunities
- Demanders of capital are willing to pay a rate of return in exchange for receiving access to funds

Question 9

Why is the financial system often described as the circulatory system of the economy?

Answer 9

Individuals, institution, governments with funds that aren’t needed supply to individuals , institutions and governments that need to raise funds to finance investment opportunities

Question 10

What is a market?

Answer 10

A market is a venue where goods and services are exchanged

Question 11

What is the main difference between private and public markets?

Answer 11

Private markets: transactions are negotiated directly between two or more parties
- Bank loans, private debt placements
- Unique negotiations, not traded

Public markets: standardized contracts traded on organized exchanges
- Multiple instances of the same contract
- EX: shares of a stock

Question 12

The derivative market exceeds 700 trillion. What type of derivative is most common?

Answer 12

what is a derivate?
A derivative security’s value is derived from the price of another security (options and futures)
- Good or bad depending on how they’re used
- Can be used to increase or decrease risk

Most COMMON:
interest rate derivatives are the biggest derivatives (car loans, mortgage loans, corporate bonds, credit card debt)

Question 13

primary versus secondary markets

Answer 13

Primary markets: markets in which corporations raise new capital, typically newly issued stock or bonds. Corps get money from issuing stocks or bonds.
- EX: GE sells new stocks
- IPOs, SEOs (seasoned so it is already existing), Bond Issuance (corp sells bonds to public with interest rate through the investment bank)

Secondary markets: an already existing security is traded among investors
- Company already issued something, now it is being traded by members of the public.
- Buy 10 shares of Amazon from a broker

Question 14

Know the difference between primary and secondary market transactions and be
able to identify one from the other.

Answer 14

Primary market transaction means you are purchasing new shares. The company receives additional capital during the process.
- EX: Netflix uses an investment banker to complete a SEC (seasoned equity offering). You purchase some of the newly issued shares.

Secondary market transaction means you’re buying existing shares. The company receives no additional capital.
- EX: You purchase shares of Netflix using an online broker such as Fidelity

Question 15

What are the five (ten total) different types of financial markets?

Answer 15

• Physical assets vs. Financial assets
• Spot vs. Futures
• Money vs. Capital
• Primary vs. Secondary
• Public vs. Private

Question 16

Physical vs Financial asset markets

Answer 16

Physical asset markets: markets for physical products such as wheat, autos, machinery, etc. (this is actually sent/shipped)
- Tangible or real asset markets

Financial asset markets: markets for assets such as stocks, bonds and mortgages, also derivatives (don’t receive anything directly. There is a piece of paper that give you the right of cash flows - stocks, mortgage payments,)

Question 17

Spot vs futures markets

Answer 17

Spot markets: assets are bought or sold for on-the-spot delivery, typically within few days (you will receive and pay for something that day)

Future markets: assets are bought or sold at a future date at a price agreed on today (you receive later for paying today)
- Commodities, currencies, etc.
- Farmer may enter into a futures contract to sell 5,000 bushels of soybeans 6 months from now at $6.60 a bushel
- Lots of risk here…

Question 18

Money markets vs capital markets

Answer 18

Money markets: short-term, highly liquid securities that have a duration of less than year (these are safe)
- US treasury bills (30, 60, 90 days) (bill is less than a year)
- Commercial paper and money market funds or prime paper (corporate short term debt - pretty safe)

Capital market: intermediate or long-term debt and corporate stock (greater than a year) (tons of risk, investment)
- Corporate bonds (bond is greater than a year, 10, 30, 2 years)
- Bonds can mature because the world changes over the years

Question 19

Primary vs. secondary markets
(repeat)

Answer 19

Primary markets: markets in which corporations raise new capital, typically newly issued stock or bonds. Corps get money from issuing stocks or bonds.
- EX: GE sells new stocks
- IPOs, SEOs (seasoned so it is already existing), Bond Issuance (corp sells bonds to public with interest rate through the investment bank)

Secondary markets: an already existing security is traded among investors
- Company already issued something, now it is being traded by members of the public.
- 10 shares of amazon

Question 20

Private vs public markets

Answer 20

Private markets: transactions are negotiated directly between two or more parties
- Bank loans, private debt placements
- Unique negotiations, not traded

Public markets: standardized contracts traded on organized exchanges
- Multiple instances of the same contract
- EX: shares of a stock

Question 21

What are derivatives?
* Which type of derivative is most frequently used? Which?
* Hedgers versus speculators (important)

Answer 21

A derivative security’s value is derived from the price of another security (options and futures)

• most common: Interest rate derivatives are the biggest derivatives (car loans, mortgage loans, corporate bonds, credit card debt)
• hedgers: the SELLERS! individuals who use a derivative security’s value to “hedge” or reduce risk.
  EX: Farmer can LOCK IN a certain PRICE for crops
• speculators: the BUYERS! use derivatives to bet on the direction of future stock prices, interest rates, exchange rates and commodity prices

Question 22

What is an IPO? Why do companies go public?

Answer 22

An initial public offering (IPO) occurs when a company issues publicly traded stock for the first time. Shares are listed on the stock exchange and available for trading via a broker.

• “Going public” enables the company’s owners to raise capital for future investment projects
• This allows the firm to grow more quickly

Question 23

On average, do IPOs make or lose money over time? Why is it so important for
private equity funds to invest in a large number of IPOs?

Answer 23

IPOs usually lose money over five years

its important to invest in many IPOs to diversify what you have. some markets are more likely to outperform others.

Question 24

What are the implications of market efficiency?

Answer 24

Investors cannot “beat the market” except through random chance – so you can’t pick stocks that will outperform
Some assets are more likely to be efficient than others:

Highly inefficient: small companies not followed by many analysts. Not much contact with investors. Bias causes prices to deviate from the correct amount. Sometimes you can find something that has been overlooked with these small companies that can become large.

Highly efficient: large companies followed by many analysts. Good communications with investors. Price reflects all available information. Usually LARGE companies because there is a lot of information and so many investors and analysts focusing on these companies.

Question 25

What is behavioral finance? Know the four behavioral biases discussed in class.

Answer 25

An alternative to the efficient market theory is behavioral finance:

Cognitive biases cause investors to make systematic mistakes that lead to errors in asset valuations

errors include..
- Over-optimism/overconfidence
- Prospect theory: care more about losses than gains.
- Anchoring: care about the first piece of information that you see too much.
- Herding: investors have a tendency to revise their initial forecasts to be closer to the average forecast.