Lecture 4 - Financial Markets & Institutions Flashcards Preview

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Flashcards in Lecture 4 - Financial Markets & Institutions Deck (24):

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

- 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

1. Attract deposits by providing interest rates r1
2. The funds raised are used for providing loans at an interest rate r2
3. Receives interest from loans
4. 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

1. Sells policies that provide compensation in case any pre-agree damages/losses occur
2. The funds raised are used for providing long-term loans at an interest rate r
3. Receives interest from loans
4. 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



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



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



Option a - investment opportunity

Option b - pay out cash to shareholders