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Chapter 2- Financial Markets and Institutions.docx

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York University
FINE 2000
Mehdi Beyaghi

Chapter 2: Financial Markets and Institutions FINE 2000 The Importance of Financial Markets and Institutions  A modern financial system offers financing in many different forms, depending on the company’s age, its growth rate and the nature of its business The Flow of Savings to Corporations  Money that corporations invest in real assets comes ultimately from savings by investors  But there can be stops in between the paths through financial markets, financial intermediaries or both  Small corporation: o Investors purchase shares with personal savings (1) o Savings are invested in firm’s operations (2) o Business generates cash (3) o Cash is either reinvested (4a) o Or Cash represents additional savings on behalf of shareholders (4b)  The flow of savings to large corporations: o Savings, which can come from investors worldwide, might flow through financial markets or financial intermediaries. o Savings might also flow into financial intermediaries through financial markets through financial intermediaries The Stock Market  Financial market: market in which securities are issued and traded  Securities: a traded financial asset such as a share of stock  Corporations grow, requirements for outside capital can expand dramatically o Some point the company will go public by issuing shares to the public o The first issue if called initial public offering  An IPO is not the only occasion on which newly issued stock is sold to the public. Such offers are known as seasoned equity offers or follow-on offers  A new issue of shares increases both the amount of cash held by company and the number of shares held by the public. Such an issue is known as a primary issue and it is sold in the primary market: market for the sale of new securities by corporations  Secondary market: market in which already issued securities are traded among investors  Stock markets are also called equity markets since shareholders are said to own the common equity of the firm  Toronto Stock Exchange is the main stock exchange for trading shares of large Canadian corporations  Trading in the shares of smaller and emerging Canadian companies is done through the TSX Venture Exchange  NYSE lists the largest companies in the United States and is one of the few stock markets in which stocks are physically bought and sold by traders on the trading floor o Also in the states: Nasdaq  Financial manager plays on a global stage Agency Problems and Corporate Governance  The flow of savings to public corporations requires separation of ownership and control: the ultimate owners of a corporation are not its managers o That creates the agency problems Chapter 2: Financial Markets and Institutions FINE 2000  Agency problems exist because managers will consider their own interests as well as shareholders’  Corporations try to align managers’ and shareholders’ interests (by granting stock or options to top management i.e.) but the alignment can never be perfect  Separation of ownership and control is necessary because outside investors cannot know enough about the firm’s problems and prospects to make good financial decisions  Financing moves from investors to firms only if investors are protected, this creates the need for a system of corporate governance Other Financial Markets  Debt securities are also traded in financial markets (i.e. lending bond term bonds to investors)  Few corporate debt securities are traded on a stock exchange, many debt securities are traded over the counter  Bond vs. stock: o Share is just a proportional ownership claim on a firm o Bonds and other debt securities can vary in maturity, the degree of protection or collateral offered by the issuer, and the level and timing of interest payments o Some bonds make “floating” interest payments tied to the future level of interest rates o Some can be “called” (repurchased and retired) by the issuing company o Some bond can be converted into other securities  Fixed income market: market for debt securities  Capital market: market for long term securities  Money market: market for short term securities  Financial manager also encounters: o Foreign exchange markets – for companies operating in international trade –need the market for currencies o Commodities markets- buying or selling commodities through NYME for instance o Markets for Options and other derivatives- securities whose payoffs depend on the prices of other securities or commodities Financial Intermediaries  Financial intermediary: an organization that raises money from investors and provides financing individuals, corporations or other organizations  Five classes of intermediaries: o Mutual Funds: managed investment fund, pooling the savings of many investors and investing in a portfolio of securities o Exchange-Traded Fund (ETF): an investment fund, traded on a stock exchange, that pools the savings of many investors and invests in a portfolio of securities, selected to replicate an established securities index  Advantages of MF/ETFs: you cannot manage/buy 83-stock/ 326-bond portfolio, not efficiently o Hedge Fund: private investment pool, open to wealthy or institutional investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds  Differ from mutual funds in two ways:  Usually follow complex high-risk investment strategies  Try to attract the most talented managers by compensating them with high performance related fees Chapter 2: Financial Markets and Institutions FINE 2000 o Private Equity Fund: investment fund focused on investing in equity of privately owned businesses. Some important categories: venture capital, angel investing, leveraged buyouts o Pension Funds: investment plan set up by an employer to provide for employees’ retirement. Several types (i.e. defined contribution plan). Designed for long-term investment Financial Institutions  Financial Institution: A bank, insurance
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