Module 1.1 Flashcards
Financial Market
A market in which financial assets (securities)
such as stocks and bonds can be purchased or
sold. Funds are transferred in financial markets
when one party purchases financial assets
previously held by another party.
Role of Financial Markets (1 of 3)
Financial markets transfer funds from those who have
excess funds to those who need funds.
▪ Surplus units: participants who receive more money
than they spend, such as investors.
▪ Deficit units: participants who spend more money
than they receive, such as borrowers.
▪ Securities: represent a claim on the issuers
▪ Debt securities - debt (also called credit, or borrowed funds)
incurred by the issuer.
▪ Equity securities - (also called stocks) represent equity or
ownership in the firm.
Role of Financial Markets (2 of 3)
Accommodating Corporate Finance Needs: The
financial markets serves as the mechanism whereby
corporations (acting as deficit units) can obtain funds from
investors (acting as surplus units).
Accommodating Investment Needs: Financial
institutions serve as intermediaries to connect the
investment management activity with the corporate
finance activity.
Role of Financial Markets (3 of 3)
Primary versus Secondary Markets
▪ Primary markets - facilitate the issuance of new
securities
▪ Secondary markets - facilitate the trading of existing
securities, which allows for a change in the ownership
of the securities
▪ Liquidity is the degree to which securities can easily be
liquidated (sold) without a loss of value.
▪ If a security is illiquid, investors may not be able to find a
willing buyer for it in the secondary market and may have to
sell the security at a large discount just to attract a buyer.
Securities Traded in Financial Markets (1 of 8)
Securities can be classified as money market securities,
capital market securities, or derivative securities.
Money Market Securities
▪ Money markets facilitate the sale of short-term debt
securities by deficit units to surplus units.
▪ Debt securities that have a maturity of one year or less.
Securities Traded in Financial Markets (2 of 8)
Capital Market Securities - facilitate the sale of long-term
securities by deficit units to surplus units.
▪ Bonds - long-term debt securities issued by the Treasury,
government agencies, and corporations to finance their
operations.
▪ Mortgages - long-term debt obligations created to finance the
purchase of real estate.
▪ Mortgage-backed securities - debt obligations representing
claims on a package of mortgages.
▪ Stocks - represent partial ownership in the corporations that
issued them.
Securities Traded in Financial Markets (3 of 8)
Derivative Securities - financial contracts whose values
are derived from the values of underlying assets
▪ Speculation - allow an investor to speculate on movements in
the value of the underlying assets without having to purchase
those assets.
▪ Risk management - financial institutions and other firms can
use derivative securities to adjust the risk of their existing
investments in securities.
Securities Traded in Financial Markets (4 of 8)
Valuation of Securities
▪ Impact of information on valuation
▪ Estimate future cash flows by obtaining information that may
influence a stock’s future cash flows. (Exhibit 1.2)
▪ Use economic or industry information to value a security.
▪ Use published opinions about the firm’s management to value a
security.
▪ Impact of the internet on valuation
▪ More timely pricing
▪ More accurate pricing
▪ More informative pricing
Securities Traded in Financial Markets (5 of 8)
Valuation of Securities (cont.)
▪ Impact of Behavioral Finance on Valuation
▪ Various conditions can affect investor psychology. Behavioral
finance can sometimes explain the movements of a security’s
price.
▪ Behavioral Finance - the application of psychology to make
financial decisions.
▪ Uncertainty Surrounding Valuation of Securities
▪ Limited information leads to uncertainty in the valuation of
securities.
Securities Traded in Financial Markets (6 of 8)
Securities Regulations
▪ Required Disclosure
▪ The Securities Act of 1933 was intended to ensure complete
disclosure of relevant financial information on publicly offered
securities and to prevent fraudulent practices in selling these
securities.
▪ The Securities Exchange Act of 1934 extended the disclosure
requirements to secondary market issues.
▪ Regulatory Response to Financial Reporting Scandals
▪ The Sarbanes-Oxley Act required that firms provide more
complete and accurate financial information.
Securities Traded in Financial Markets (7 of 8)
International Securities Transactions
▪ Financial markets vary across the world in terms of:
▪ Degree of financial market development
▪ Volume of funds transferred from surplus to deficit units
▪ Foreign Exchange Market - International financial
transactions normally require the exchange of
currencies. The foreign exchange market facilitates this
exchange.
Securities Traded in Financial Markets (8 of 8)
Government Intervention in Financial Markets
In recent years, government has increased its role in
financial markets.
▪ During credit crisis
▪ Federal Reserve purchased various debt securities
▪ Intent – ensure more liquidity in the debt securities and
therefore encourage investors to purchase
▪ Government regulations changed the manner by
which the credit risks of bonds were assessed.
▪ Increased monitoring of stock trading
▪ Prosecuted insider information trading cases
▪ Ensure no investor had an unfair advantage
Role of Financial Institutions (1 of 7)
Financial institutions are needed to resolve the limitations
caused by market imperfections such as limited
information regarding the creditworthiness of borrowers.
Role of depository institutions - Depository institutions
accept deposits from surplus units and provide credit to
deficit units through loans and purchases of securities.
▪ Offer liquid deposit accounts to surplus units
▪ Provide loans of the size and maturity desired by deficit units
▪ Accept the risk on loans provided
▪ Have more expertise in evaluating creditworthiness
▪ Diversify their loans among numerous deficit units
`
Role of Financial Institutions (2 of 7)
Role of Depository Institutions (cont.)
▪ Commercial Banks
▪ The most dominant type of depository institution
▪ Transfer deposit funds to deficit units through loans or
purchase of debt securities
▪ Federal Funds Market - facilitates the flow of funds between
depository institutions
▪ Savings Institutions
▪ Also called thrift institutions and include Savings and Loans
(S&Ls) and Savings Banks
▪ Concentrate on residential mortgage loans
▪ Credit Unions
▪ Nonprofit organizations
▪ Restrict business to CU members with a common bond
Role of Financial Institutions (3 of 7)
Role of Non-depository Institutions
▪ Finance companies - obtain funds by issuing securities and
lend the funds to individuals and small businesses.
▪ Mutual funds - sell shares to surplus units and use the funds
received to purchase a portfolio of securities.
▪ Securities firms - provide a wide variety of functions in
financial markets. (Broker, Underwriter, Dealer, Advisory)
▪ Insurance companies - provide insurance policies that reduce
the financial burden associated with death, illness, and damage
to property. Charge premiums and invest in financial markets.
▪ Pension funds – manage funds until they are withdrawn for
retirement