Lecture 4 - Financial Markets & Institutions Flashcards
Financial markets & intermediaries
Financial markets are one of the key factors to modern economies because they facilitate the financing of corporations growth
A modern financing system offers financing in many different forms depending on the company’s age, growth rate and nature of business
The flow of saving to corporations
The funds that corporations invest in real assets comes ultimately from savings by investors
The channeling of funds from the savers (lenders) to corporations (borrowers) is made through financial markets, financial intermediaries or both
Financing of private corporations
Corporation - investment in real assets
Investors - shareholders of closely-held corporations
- cash raised from share issues
- cash reinvested
Investors:
- use their savings to buy additional shares
- ‘save’ when the corporation invest on their behalf
Financing of public corporations
Financial markets
Investors - shareholders worldwide
Financial intermediaries & institutions
Corporation - investment in real assets
Financial markets
A market where funds are traded for securities issues by corporations
- primary market: initial sale of securities is made (a.k.a. Initial public offering or IPO)
- secondary market: previously issued securities are traded among investors
- over the counter (OTC) market: a network of banks and security dealers
Stock markets
A financial market in which stocks of publicly listed corporations are traded
The trading takes place either in physical exchanges (NYSE,LSE) or OTC (NASDAQ)
The stock of major corporations trade in many markets throughout the world on a continuous basis
Other financial markets
Fixed income (or bond) markets are the markets for the trading of long-term debt securities
Capital markets are markets for long term financing (debt & equity). Examples are the stock and bond markets
Money markets are the markets for the trading of short term debt (less than 1 year) such as treasury bills (aka T-bills)
More financial markets
Foreign exchange markets are OTC markets for the trading of foreign exchange
Commodity markets are markets for the trading of commodities such as corn, wheat, oil, gas etc.
Derivatives markets are markets for the trading of derivative products such as forwards, futures, options and swaps
Financial Intermediaries
Organisations that raise funds from investors and provide financing for individuals and corporations
Three main types:
- mutual funds
- hedge funds
- pension funds
Mutual funds
An investment company that pools the savings of many investors (through the selling of shares) and invests in a portfolio of securities
The advantage for investors is that mutual funds offer lower cost diversification and professional management ( in exchange for a set fee)
Hedge funds
A private investment pool, open to wealthy institutional investors, that is lightly regulated and pursued more speculative policies than mutual funds
The manager of a hedge fund is compensated with performance related fees and not by a fixed percentage of the assets under management as in mutual funds
Pension funds
An investment plan set up by an employer to provide for employees retirement
Pension funds are designed for long run investment, provide professional management, diversification and important tax advantages
Financial institutions
An intermediary that provides a variety of services further than just pool and invest savings
Three main types:
- commercial banks
- investment banks
- insurance companies
Commercial banks
- Attract deposits by providing interest rates r1
- The funds raised are used for providing loans at an interest rate r2
- Receives interest from loans
- Pays interest to depositors
Banks profit since r1
Investment banks
Do not take deposits or produce (usually) loans to corporations. Their job is to advice and assist companies in raising financing
- underwrite stock offerings
- provide advice on takeovers and M&As
- manage investment portfolios
- fun trading desk for F/X, commodities etc
- invest in start-ups and other ventures
Insurance companies
- Sells policies that provide compensation in case any pre-agree damages/losses occur
- The funds raised are used for providing long-term loans at an interest rate r
- Receives interest from loans
- Pays compensation to policyholders
Functions of financial markets
Financial markets and interned provide financing for businesses. In addition they provide a variety of other economic functions to the corporation:
- transporting cash across time
- risk transfer & diversification
- liquidity
- payment mechanism
- information
Transporting cash across time
Savers have the opportunity to enter into contracts that will allow them to transport purchasing power to future periods
Borrowers have the opportunity to enter into contracts that will allow them to use now funds that will be earned in future periods
Risk transfer and diversification
Financial markets and intermediaries allow investors and businesses to reduce and reallocate risk. Consider for example:
- insurances policies
- mutual funds
- derivatives
Liquidity
The ability to turn an investment back into cash quickly and without significant losses
Are deposits liquid ?
Are shares of large public companies liquid?
Is the real estate market liquid ?
Payment mechanism
Payment services provided by banks and other financial institutions allow firms and individuals to send/receive payments quickly and safely over long distance. Consider, for example:
- checking accounts
- credit cards
- electronic transfers
Information
Well functioning financial markets provide information that aid the financial manager to make decisions that will best maximise the long-run value of the corporation. Consider, for example :
- commodity prices
- company values
- cost of debt
Cost of capital
Financial managers looks to financial markets to estimate the cost of capital
The cost of capital is the minimum acceptable rate of return for capital investment
Investment projects offering rates of return higher (lower) than the cost of capital add (subtract) value to the firm
Opportunity cost of capital
Cash
Firm
Option a - investment opportunity
Option b - pay out cash to shareholders
