Financial Market Environment PDF

# The Financial Market Environment ## Financial Institutions & Markets - Firms that require funds from external sources can obtain them in three ways: - through a financial institution - through financial markets - through private placements ## Financial Institutions & Markets: Financ...

# The Financial Market Environment ## Financial Institutions & Markets - Firms that require funds from external sources can obtain them in three ways: - through a financial institution - through financial markets - through private placements ## Financial Institutions & Markets: Financial Institutions - Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. - The key suppliers and demanders of funds are individuals, businesses, and governments. - In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds. ## Commercial Banks, Investment Banks, and the Shadow Banking System - Commercial banks are institutions that provide savers with a secure place to invest their funds and that offer loans to individual and business borrowers. - Investment banks are institutions that assist companies in raising capital, advise firms on major transactions such as mergers or financial restructurings, and engage in trading and market making activities. ## Financial Institutions & Markets: Financial Markets - Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. - Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market. - A private placement involves the sale of a new security directly to an investor or group of investors. - Most firms, however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public. ## Financial Institutions & Markets: Financial Markets (cont.) - The primary market is the financial market in which securities are initially issued; the only market in which the issuer is directly involved in the transaction. - Secondary markets are financial markets in which preowned securities (those that are not new issues) are traded. ## Figure 2.1 Flow of Funds A diagram shows the flow of funds between suppliers of funds, demanders of funds, financial institutions, financial markets and private placements. - **Suppliers of Funds:** Supply funds to financial institutions and markets through deposits/shares and securities. - **Financial Institutions:** Receive funds from suppliers of funds, and loan them to demanders of funds. - **Private Placement:** Receive funds from suppliers of funds and sell securities to demanders of funds. - **Financial Markets:** Receive funds from suppliers of funds through securities and sell securities to demanders of funds. - **Demanders of Funds:** Receive funds from financial institutions, private placement and financial markets. ## The Money Market - The money market is created by a financial relationship between suppliers and demanders of short-term funds. - Most money market transactions are made in marketable securities which are short-term debt instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions, respectively. - Investors generally consider marketable securities to be among the least risky investments available. ## The Capital Market - The capital market is a market that enables suppliers and demanders of long-term funds to make transactions. - The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity, or ownership). - **Bonds:** are long-term debt instruments used by businesses and government to raise large sums of money, generally from a diverse group of lenders. - **Common Stock:** are units of ownership interest or equity in a corporation. - **Preferred Stock:** is a special form of ownership that has features of both a bond and common stock. ## Broker Markets and Dealer Markets - **Broker markets:** are securities exchanges on which the two sides of a transaction, the buyer and seller, are brought together to trade securities. - Trading takes place on centralized trading floors. - Examples include: NYSE Euronext, American Stock Exchange ## Broker Markets and Dealer Markets (cont.) - **Dealer markets:** are markets in which the buyer and seller are not brought together directly but instead have their orders executed by securities dealers that "make markets" in the given security. - The dealer market has no centralized trading floors. Instead, it is made up of a large number of market makers who are linked together via a mass-telecommunications network. - The Nasdaq market is one example. - As compensation for executing orders, market makers make money on the spread (bid price - ask price). ## International Capital Markets - In the **Eurobond market**, corporations and governments typically issue bonds denominated in dollars and sell them to investors located outside the United States. - The **foreign bond market:** is a market for bonds issued by a foreign corporation or government that is denominated in the investor's home currency and sold in the investor's home market. - The **international equity market:** allows corporations to sell blocks of shares to investors in a number of different countries simultaneously. ## The Role of Capital Markets - From a firm's perspective, the role of capital markets is to be a liquid market where firms can interact with investors in order to obtain valuable external financing resources. - From investors' perspectives, the role of capital markets is to be an efficient market that allocates funds to their most productive uses. - An efficient market allocates funds to their most productive uses as a result of competition among wealth-maximizing investors and determines and publicizes prices that are believed to be close to their true value. ## The Role of Capital Markets (cont.) - Advocates of behavioral finance, an emerging field that blends ideas from finance and psychology, argue that stock prices and prices of other securities can deviate from their true values for extended periods. - These people point to episodes such as the huge run up and subsequent collapse of the prices of Internet stocks in the late 1990s, or the failure of markets to accurately assess the risk of mortgage-backed securities in the more recent financial crisis, as examples of the principle that stock prices sometimes can be wildly inaccurate measures of value. ## Business Taxes - Both individuals and businesses must pay taxes on income. - The income of sole proprietorships and partnerships is taxed as the income of the individual owners, whereas corporate income is subject to corporate taxes. - Both individuals and businesses can earn two types of income - ordinary income and capital gains income. - Under current law, tax treatment of ordinary income and capital gains income change frequently due frequently changing tax laws.