Finance (Chapter 2)

Created @September 10, 2022 4:53 PM

Class Finance 01

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FINANCIAL MARKETS AND INSTITUTIONS

📌 financial institutions act as middlemen or intermediaries between two persons in order to facilitate
the transaction

Overview:

The Capital Allocation Process

Financial Markets

Financial Institutions

Stock Markets and Returns

Stock Market Efficiency

How is capital transferred between Savers and Borrowers

Direct Transfers

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 — direct transfers of money and securities occur when a company sells its stocks or bonds directly to
savers rather than through a financial institution.

Investment Banks

— Transfers may also go through an indirect transfer through investment bankers. An investment
bank is a financial institution that assists individuals and corporations in raising capital through
underwriting. An underwriter facilitates the issuance of securities. The company sells its stocks or bonds
to an investment bank, which subsequently sells them to savers.

Financial Intermediaries

— In this case, the intermediary receives funds from savers in exchange for securities. The intermediary
utilizes this money to acquire and hold securities issued by businesses, while savers hold securities
issued by the middleman.

The Capital Allocation Process

In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand
it.

Suppliers of capital: individuals and institutions with “excess funds.” These groups are saving money
and looking for a rate of return on their investment.

Demanders or users of capital: individuals and institutions who need to raise funds to finance their
investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

A saver refers to the one who deposit their money in bank, invest in company share
and pays premium to an insurance company with objective to earn interest, dividend
and profit.

However, a borrower just the reverse to saver. A borrower borrowed the money from
saver by financial market to fulfill their need and need to effort the interest charge or
give the dividend to saver.

The capital allocation process can either be direct or indirect:

Direct:

these are transaction in which the business organization directly deals with the savers (ex. ABC
Corporation sells its stocks directly to DEF Corporation and in turn receives cash) So this is a direct
transaction because it is mainly done by the business organization.

These are usually done by small firms that need to raise only little capital

Indirect:

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 these are transactions in which the business and the Savers do not meet but the securities and
funds are exchanged, and reaches the other through a link; middleman, an intermediary which we
call financial institutions. So these institutions could either be an investment bank or financial
intermediary.

Underwriters:
are those who help when a company is still having their initial public offering or their IPO.

📌 When a private company first sells shares of stock to the public, this process is known as an initial
public offering (IPO). In essence, an IPO means that a company's ownership is transitioning
from private ownership to public ownership

1. A market is a venue where goods and services are exchanged.

2. A financial market is a place where individuals and organizations wanting to borrow funds are brought
together with those having a surplus of funds.

In financial market, buying and selling transactions occur and the type of transaction involved determines
what kind of Market it is. It is also determined by the nature of Securities involved and the circumstances
of the transaction.

Securities - refers to stocks and bonds or sources of capital

THE TYPES OF FINANCIAL MARKETS

Physical assets vs. Financial assets

— Physical asset markets, often known as "tangible" or "real" asset markets, are for commodities such as
wheat, automobiles, real estate, computers, and machinery. In contrast, financial asset markets deal with
stocks, bonds, notes, mortgages, and financial securities.

— Physical assets: tangible, this means something that you can touch or something that has a physical
form.

— Financial assets: intangible, this means something that you cannot touch or does not have a physical
form.
take note: with regards to financial transactions, you usually receive a document that symbolizes or is
proof of your stock bonds or notes (they prove the existence of your stocks, bonds, and notes). Even
though you receive something physical or tangible, it is only a mere representation of your actual asset
and your actual financial assets are intangible

Spot vs. Futures

— the main difference of the two is time, when the asset is delivered

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 — Spot market refers to when assets are delivered on the spot or within a few days, whereas futures
markets are markets in which participants agree today to buy or sell an item at some future date.

— Spot: is when the asset is delivered either on the spot or within a few days
— Futures: or futures transactions mean that the asset will be delivered at some future time but the price
is already agreed upon today.

— In the futures transaction — Although you have not yet received the asset, the price is already decided
beforehand and this is so, that you are not affected by the risk in changing prices and this is called a
hedging transaction.

Money vs. Capital

— the main difference or distinction is the length of the Securities involved; or whether or not it is short-
term or long term

— Money market refers to where instruments with high liquidity are traded and the length of the securities
involves short-term, while a capital market is where assets are bought and sold for long-term.

— take note: although there is no strict definition or no strict rule in determining what is short-term and
long-term because some authors or it is a general definition that short-term usually pertains to less than a
year to a year and long term refers to more than a year.

— In short term or long term: risk is affected by the time period, so the longer the period, the higher the
chance of not being paid.

Primary vs. Secondary

— Primary market are the markets in which corporations raise new capital and are when securities are
still initially issued, while secondary markets are when securities are no longer freshly issued by the
corporation but have already been issued but resold by the owner of the securities and traded among
investors.

— Primary market is when your security is still initially issued and the Issuer is the seller of the Securities

— Secondary markets: the Securities are no longer freshly issued by the corporation but have already
been issued but resold by the owner of the securities

— Key takeaway: in a primary transaction, the corporation is directly involved (it is considered a direction
section)

Private vs. Public

— Public market involves the exchange of securities over the counter with any investor and traded in
standard exchanges. On the other hand, in a private market, refers to those transaction that are not done
in public setting where there is no need to use facilities or the services of a financial institution or
intermediary, and this is usually done for simple loans.

— Private: refers to those transaction that are done in private markets where there is no need to use
facilities or the services of a financial institution or intermediary, and this is usually done for simple loans.

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 — Public: is usually done for stocks and bonds which are traded in standard exchanges such as the
Philippine Stock Exchange. So, the transactions in public are regularly recurring and they occur almost
every day.

DISTINCTIONS BETWEEN PRIMARY AND SECONDARY

MARKET
Primary Market Secondary Market

Seller Issuing Corporation Existing Investor

Parties Involved Issuer and Investor Two Investors - one existing, one potential

Proceeds To the issuing corporation To the selling investor

Securities New Preowned

IMPORTANCE OF FINANCIAL MARKETS

Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.

Markets provide savers with returns on their money saved/invested, which provide them money in the
future.

Markets provide users of capital with the necessary funds to finance their investment projects.

— the better the market, the faster these transactions are. the better the market, the higher the
returns of savings

Well- functioning markets promote economic growth

Economies with well-developed markets perform better than economies with poorly-functioning markets

Why are financial markets essential for a healthy economy and economic
growth?

— A well-developed and smoothly operating financial sector plays an important role in increasing a country's
economic growth efficiency. A healthy economy is based on efficient funds transfers from net savers to
enterprises and individuals in need of capital. Basically, the economy could not function without efficient
transfers. Additionally, well-functioning financial markets help in the efficient direct flow of savings and
investments in the economy which promotes the accumulation of capital and contribute in the production of
goods and services. Therefore, it is crucial that financial markets run efficiently—not only promptly, but
also inexpensively.

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 What are derivatives? How can they be used to reduce or increase
risk?
A derivative security’s value is “derived” from the price of another security (e.g., options and futures)

Can be used to “hedge” or reduce risk. For example, an importer, whose profit falls when the dollar loses
value, could purchase currency futures that do well when the dollar weakens.

— Basically, in derivatives, this is where you are betting your money on the direction of future stock prices,
interest rates, exchange rates, and commodity prices. Since you are betting, if you guess right, you can
produce high returns, if you guess wrong, then you can also incur large losses. This is why derivatives can
increase risk

Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates,
exchange rates, and commodity prices. In many cases, these transactions produce high returns if you
guess right, but large losses if you guess wrong. Here, derivatives can increase risk.

— Derivatives are financial instruments whose values are generated from other assets such as stocks, bonds,
or foreign exchange. The value of a derivative security is "derived" from the price of another security, such as
options and futures. Derivatives can be used to "hedge," or minimize risk, and to protect against the risk of an
asset's adverse move, or to speculate on future movements in the underlying instrument. In essence,
derivatives are bets on the direction of future stock prices, interest rates, currency rates, and commodity
prices. Because one is betting, they can earn significant returns if they estimate correctly, but they can also
incur large loses if they guess incorrectly. Derivatives can increase risk in this way.

FINANCIAL INSTITUTIONS
Functions:

1. provision of financial services

2. performance as an intermediary

— when there is a financial institutions, there is an indirect transaction hence when that organization acts as a
middleman where money is transferred from one person to another, that is a financial institution because it
facilitates the transfer of funds

THE TYPES OF FINANCIAL INSTITUTIONS

Investment Banks

Commercial Banks

Financial Services Corporations

Pension Funds

Mutual Funds

Exchange Traded Funds

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 Hedge Funds

Private Equity Funds

etc.

1) Traditionally, investment banks assist companies in raising capital and specialize in providing services
designed to facilitate corporate operations, such as capital expenditure financing and equity offerings,
including initial public offerings (IPO).

2) Commercial banks are the traditional “department stores of finance” because they serve a wide range
of savers and borrowers.
3) Financial services corporations are large conglomerates that combine a variety of financial
institutions into a single corporation. Most financial services companies began in one area and have since
expanded to encompass the majority of the financial spectrum.
4) Pension funds are retirement plans funded by corporations or government agencies for their
employees and primarily handled by trust departments of commercial banks or life insurance companies.

5) Mutual funds are corporations that accept money from depositors savers and invest it in these funds
stocks, long-term bonds, or short-term debt instruments issued by businesses or governments.

6) Exchange-Traded Funds (ETFs) are investment funds that hold assets such as stocks, commodities,
bonds, or foreign currency. An exchange-traded fund, like a mutual fund, is a pooled investment fund that
provides an investor with an interest in a professionally managed, diverse portfolio of investments.

7) A hedge fund is a limited partnership of private investors whose money is managed by professional
fund managers that use a variety of strategies to produce above-average investment returns, such as
leveraging or trading non-traditional assets.

8) Lastly, private equity companies are organizations that function similarly to hedge funds, except instead
of purchasing a portion of a company's shares, private equity players buy and then manage entire firms.

STOCK MARKET TRANSACTIONS

What are the two leading stock markets? Describe the two basic types of stock markets

There are a number of different stock markets. The New York Stock Exchange (NYSE) and the National
Association of Securities Dealers Automatic Quotation System (NASDAQ) are the two leading stock
markets.

Stocks are traded using a variety of market procedures, but there are two basic types: (1) physical location
exchanges, which include the NYSE and several regional stock exchanges and this exchanges are tangible
entities. The second basic type is (2) electronic dealer-based markets, which include the NASDAQ, the less
formal over-the-counter market, and newly established electronic communications networks. Although most
large firms' equities trade on the NYSE, a higher number of stocks trade off the exchange in what is known as
the over-the-counter (OTC) market.

Apple decides to issue additional stock with the assistance of its investment banker. An investor
purchases some of the newly issued shares. Is this a primary market transaction or a secondary market

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 transaction.

— Since new shares of stock are being issued, this is a primary market transaction

What if instead an investor buys existing shares of Apple stock in the open market. Is this a primary or
secondary market transaction?

— Since no new shares are created, this is a secondary market transaction

An initial public offering (IPO) occurs when a company issues stock in the public market for the first time.
(this usually happens in two situations, (a) when the corporation is newly created, and (b) when the
corporations cease to be a closely held corporation and becomes a public corporation). “Going public”
enables a company’s owners to raise capital from a wide variety of outside investors. Once issued, the
stock trades in the secondary market.

Public companies are subject to additional regulations and reporting requirements.

When a corporation issues stock in the public market for the first time, the company is said to be going public.
The market for newly issued or offered stock is known as the initial public offering (IPO) market. This
usually happens in two situations, (a) when the corporation is newly created, and (b) when the corporations
ceases to be a closely held corporation and becomes a public corporation.

— Since initial public offering (IPO) occurs when a company issues stock in the public market for the first time,
we can say it is a primary market transaction, because primary transactions refers to one that is between the
issuing corporator and the investor or public in general.

STOCK MARKET EFFICIENCY

Market price: is the price derived by investors when they are basing it off on perceived information.

Intrinsic price: is the price derived by investors when they have true information or when they have all
information available about a certain stock or company.

Equilibrium: is the phenomenon or the point at which market price equals intrinsic price and this remains
stable until new information comes in.

Securities are normally in equilibrium and are fairly priced

Investors cannot “beat the market” except through good luck or better information

Efficiency continuum - which tells us small companies are highly inefficient while large companies are
highly efficient

What does it mean for a market to be efficient? Explain why some stock prices may be more efficient
than others.

Answer:

Market efficiency is the ability of markets to contain information that offers the maximum number of
opportunities for traders to buy and sell assets without incurring additional transaction costs. When markets
are efficient, investors can purchase and sell equities with confidence that they are getting fair value. When
markets are inefficient, investors may be scared to invest and may place their money "under the pillow,"
resulting in poor capital allocation and economic stagnation. Thus, market efficiency is beneficial from an

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 economic aspect. Furthermore, the stock market for some firms' stocks is highly efficient, whereas the market
for other companies' stocks is highly inefficient. The size of the company is the most important factor—the
larger the company, the more analysts tend to watch it, and thus the faster new information is likely to be
reflected in the stock price.

IMPLICATIONS OF MARKET EFFICIENCY

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 BEHAVIORAL FINANCE: POSSIBLE IMPLICATIONS FOR MARKET
EFFICIENCY
It is costly and/or risky for traders to take advantage of mispriced assets

Cognitive biases cause investors to make systematic mistakes that lead to inefficiencies. This is an area
of research know as “behavioral finance.”

Behavioral finance borrows insights from psychology to better understand how irrational behavior can be
sustained over time. Some examples include:

— Evaluating risks differently in up and down markets.

— Investors become “anchored” to certain viewpoints, and fail to optimally respond to new information that
conflicts with their existing views.
How does behavioral finance explain the real-world inconsistencies of the efficient markets
hypothesis (EMH)?

Answer:

One of the pillars of modern finance theory is the efficient markets hypothesis (EMH). It implies that asset
prices are roughly equal to their intrinsic values on average. The reasoning behind the EMH is simple. If a
stock's price is "too low," rational traders will seize the opportunity and buy the stock, pushing prices up to the
appropriate level. Similarly, if prices are "too high," rational traders will sell the stock, bringing it back down to
its equilibrium level. Proponents of the EMH argue that these forces prevent prices from being systematically
incorrect. Although the logic behind the EMH is compelling, many events in the real world appear to contradict
the hypothesis, spawning a growing field known as behavioral finance. Instead of assuming that investors are

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 rational, behavioral finance theorists use psychological insights to better understand how irrational behavior
can be sustained over time.

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