Chapter 2
The Financial Market Environment
2.1 Financial Institutions (1 of 2)
• 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.
2.1 Financial Institutions (2 of 2)
• Commercial Banks, Investment Banks, and the Shadow
Banking System
– Commercial Banks
▪ Institutions that provide savers with a secure place to
invest their funds and that offer loans to individual and
business borrowers
– Investment Banks
▪ Assist companies in raising capital, advise firms on major
transactions such as mergers or financial restructurings,
and engage in trading and market-making activities
– Shadow Banking System
▪ A group of institutions that engage in lending activities,
much like traditional banks, but that do not accept
deposits and therefore are not subject to the same
regulations as traditional banks
2.2 Financial Markets (1 of 14)
• The Relationship Between Institutions and 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
2.2 Financial Markets (2 of 14)
• The Relationship Between Institutions and Markets
– 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
2.2 Financial Markets (3 of 14)
• The Money Market
– A market where investors trade highly liquid securities
with maturities of one year or less
– Most money market transactions are made in
marketable securities which are short-term debt
instruments, such as:
▪ Treasury bills issues by the government
▪ Commercial paper issued by businesses
▪ Negotiable certificates of deposit issued by financial
institutions
– Investors generally consider marketable securities to
be among the least risky investments available.
2.2 Financial Markets (5 of 14)
• The Capital Market
– A market that enables suppliers and demanders of
long-term funds to make transactions
– Key Securities Traded: Bonds and Stocks
▪ Securities traded in the capital market fall into two
broad categories: debt and equity
▪ Bonds
– Long-term debt instruments used by business
and government to raise large sums of money,
generally from a diverse group of lenders
2.2 Financial Markets (6 of 14)
• The Capital Market
– Key Securities Traded: Bonds and Stocks
▪ Common Stock
– Units of ownership interest, or equity, in a
corporation
▪ Preferred Stock
– A special form of ownership that has features of
both a bond and common stock
2.2 Financial Markets (7 of 14)
• The Capital Market
– Broker Markets and Dealer Markets
▪ Securities Exchanges
– Organizations that provide the marketplace in which
firms can raise funds through the sale of new
securities and in which purchasers can resell
securities
▪ Broker Markets
– Securities exchanges in which the two sides of a
transaction, the buyer and the seller, are brought
together to trade securities
– Trading takes place on centralized trading floors of
national exchanges, such as DSE, N Y S E Euronext,
as well as regional exchanges
2.2 Financial Markets (8 of 14)
• The Capital Market
– Broker Markets and Dealer Markets
▪ Dealer Markets
– Markets, like the NASDAQ, in which the buyer
and seller are not brought together directly but
instead have their orders executed by securities
dealers who “make markets” in the given
security
– The dealer market has no centralized trading
floors
• It is made up of a large number of market
makers who are linked together via a mass-
telecommunications network
2.2 Financial Markets (9 of 14)
• The Capital Market
– Broker Markets and Dealer Markets
▪ Dealer Markets
– As compensation for executing orders, market
makers make money on the bid/ask spread (ask
price – bid price)
• Ask Price: The lowest price a seller is willing
to accept for a security
• Bid Price: The highest price a buyer is willing
to pay for a security
2.4 The Securities Issuing Process
(1 of 12)
• Issuing Common Stock
– Private Equity
▪ External equity financing that is raised via a private
placement, typically by private early-stage firms with
attractive growth prospects
▪ Angel Investors (or Angels)
– Wealthy individual investors who make their own
investment decisions and are willing to invest in
promising startups in exchange for a portion of
the firm’s equity
2.4 The Securities Issuing Process
(2 of 12)
• Issuing Common Stock
– Private Equity
▪ Venture Capitalists (VCs)
– Formal business entities that take in private
equity capital from many individual investors,
often institutional investors such as endowments
and pension funds or individuals of high net
worth, and make private equity investment
decisions on their behalf
– Organization and Investment Stages
▪ VC Limited Partnership is the most common
structure
2.4 The Securities Issuing Process
(4 of 12)
• Issuing Common Stock
– Going Public
▪ Private Placement
– The firm sells new securities directly to an
investor or group of investors
▪ Rights Offering
– The firm sells new shares to existing
stockholders
▪ Public Offering
– The firm sells new shares to the general public
2.4 The Securities Issuing Process
(5 of 12)
• Issuing Common Stock
– Going Public
▪ Initial Public Offering (IPO)
– The first public sale of a firm’s stock, typically made
by small, rapidly growing companies that either
require additional capital to continue growing or have
met a milestone for going public that was established
in an earlier agreement to obtain VC funding
▪ Prospectus
– A portion of a security registration statement that
describes the key aspects of the issue, the issuer,
and its management and financial position
2.5 Financial Markets in Crisis (1 of 6)
• Financial Institutions and Real Estate Finance
– Securitization
▪ The process of pooling mortgages or other types of
loans and then selling claims or securities against
that pool in the secondary market
– Mortgage-Backed Securities
▪ Securities that represent claims on the cash flows
generated by a pool of mortgages
▪ A primary risk associated with mortgage-backed
securities is that homeowners may not be able to, or
may choose not to, repay their loans
2.5 Financial Markets in Crisis (2 of 6)
• Financial Institutions and Real Estate Finance
– Falling Home Prices and Delinquent Mortgages
▪ Rising home prices between 1987 and 2006 kept
mortgage default rates low
▪ Lenders relaxed standards for borrowers and created
subprime mortgages
▪ As housing prices fell from 2006 to 2009, many
borrowers had trouble making payments, but were
unable to refinance
▪ As a result, there was a sharp increase in the number of
delinquencies and foreclosures
▪ Subprime Mortgages
– Mortgage loans made to borrowers with lower
incomes and poorer credit histories as compared with
“prime” borrowers
2.5 Financial Markets in Crisis (3 of 6)
• Financial Institutions and Real Estate Finance
– Crisis of Confidence in Banks
▪ With delinquency rates rising, the value of
mortgage-backed securities began to fall and so did
the fortunes of financial institutions that had invested
heavily in real estate assets
▪ Only 3 banks failed in 2007, but 25 failed in 2008,
140 failed in 2009, peaking at 157 bank failures in
2010
▪ It was not until 2015 that bank failures fell back into
the single digits
2.5 Financial Markets in Crisis (4 of 6)
• Spillover Effects and Recovery from the Great Recession
– As banks came under intense financial pressure in
2008, they began to tighten their lending standards,
dramatically reduce the quantity of loans they made,
and increase the rates that they charged borrowers.
– Corporations found that they could no longer raise
money in the money market, or could only do so at
extraordinarily high rates
– As a consequence, businesses began to hoard cash
and cut back on expenditures, and economic activity
contracted
2.5 Financial Markets in Crisis (5 of 6)
• Pandemic Effects on Financial Markets
– On January 11, 2020, Chinese state media reported
the death of a 61-year-old man who had died from an
unknown virus that had infected many others in
Wuhan.
– Just 10 days later, came the first confirmed case in the
United States and soon dozens of countries reported
outbreaks.
– By March 13, President Trump declared a national
emergency, and within days many states issued
“shelter-in-place” orders to residents and shuttered
nonessential businesses.
2.5 Financial Markets in Crisis (6 of 6)
• Pandemic Effects on Financial Markets
– The effects on financial markets were immediate and
dramatic.
▪ S&P 500 Stock Index, which had peaked in
February, fell in 17 out of the next 23 trading
sessions, dropping by more than 30%, perhaps the
most rapid decline in stocks in U.S. history.
▪ Yields on investment-grade corporate bonds, a
measure of what it costs financially sound
companies to borrow money, rose from 2.36% to
4.12% in two weeks
▪ For companies with less than stellar finances,
borrowing costs soared from 6% to more than 11%.