FINANCIAL MARKET q The mechanism by which borrowers
FINANCIAL MARKET q The mechanism by which borrowers (those who need funds) and lenders (those with excess funds) are brought together. q The primary role of a financial market is to facilitate the flow of funds from those who have surplus funds to those who have needs for funds in excess of their current income. FINANCE 1
FLOW OF FUNDS q Three financial phases § Young adults borrow § Older working adults save § Retired adults use savings q Funds transferred from savers to borrowers § Direct transfer § Investment banking house § Financial intermediary FINANCE 2
TRANSFER OF FUNDS Direct Transfers Borrower (Business) Securities (stocks or bonds) Saver (Investor) Dollars Indirect Transfers through an Investment Banker Borrower Securities (Business) Dollars Securities Investment Banker Dollars Saver (Investor) Indirect Transfers through a Financial Intermediary Borrower (Business) Business Securities Dollars (Loans) Financial Intermediary FINANCE Intermediary Securities Dollars (Deposits) Saver (Investor) 3
EFFICIENCY OF FINANCIAL MARKETS q If we can borrow at the lowest cost and invest at the highest returns, the use of money is efficient and the standard of living is higher than it otherwise would be. FINANCE 4
EFFICIENCY OF FINANCIAL MARKETS q Economic Efficiency—funds are allocated to their optimal use at the lowest costs q Informational Efficiency—investment prices are adjusted quickly to reflect current information o Weak-form—all information contained in past price movements is reflected in current market prices o Semistrong-form—current prices reflect all publicly available information o Strong-form—current prices reflect all pertinent information, both public and private FINANCE 5
TYPES OF FINANCIAL MARKETS q Different financial markets exist because savers and borrowers have different needs. q Types of financial markets o Money versus capital markets o Debt versus equity markets o Primary versus secondary markets o Derivatives markets FINANCE 6
INVESTMENT BANKING q Investment banking house—an organization that acts as a middleman to help firms and governments raise funds by issuing financial instruments. q Helps corporations design securities attractive to investors. q Generally buys the securities from the corporation and then resells them to investors. FINANCE 7
INVESTMENT BANKING q Flotation costs—issuing costs q Setting the offering price (rate) q Shelf registration q IPO—initial public offering § Maintaining a market FINANCE 8
EFFECTS OF FLOTATION COSTS Peach Software must raise $575 million to fund its growth. Peach plans to issue new common stock to raise the needed funds. Peach’s investment banker will charge the firm 8 percent of the total amount issued to help raise the funds. How much stock must Peach issue to net $575 million after flotation costs. FINANCE 9
EFFECTS OF FLOTATION COSTS Needed funds = $575 million Flotation costs = 8 percent of the amount issued If Peach issues 8 percent more stock than the amount of “needed funds” (i. e. , $575 million), will it have enough to support its growth? NO! If it issues 8 percent more stock: Issue amount = $575(1. 08) = $621 ≠ If $621 million is issued, flotation costs will be: Flotation costs = $621(0. 08) = $49. 68 Net proceeds = $621 – $49. 68 = $571. 32 = $621(1 – 0. 08) FINANCE 10
EFFECTS OF FLOTATION COSTS To determine the amount that must be issued to “net” a specific amount after flotation costs, use the following equation: NP = net proceeds, which is the amount the firm wants/needs after paying flotation costs OC = other issuing costs, such as legal fees, printing, etc. F = investment banking flotation costs stated in decimal form FINANCE 11
EFFECTS OF FLOTATION COSTS Needed funds = $575 million Flotation costs = 8 percent of the amount issued If the firm issues $625 million, the net proceeds will be: Flotation costs = $625(0. 08) = $50 Net proceeds = $625 – $50 = $575 = $625(1 – 0. 08) FINANCE 12
FINANCIAL INTERMEDIARIES q Organizations that take “deposits” and use the money to generate returns by creating loans or other investments. q Manufacture a variety of financial products. q Facilitate the transfer of funds from those who have funds (savers) to those who need funds (borrowers). FINANCE 13
TYPES OF FINANCIAL INTERMEDIARIES • Commercial bank • Credit union • Savings and loan association (thrift) • Mutual funds • Whole life insurance • Pension fund FINANCE 14
FINANCIAL INTERMEDIARIES q Improved standard of living q Reduced costs q Risk/diversification q Funds divisibility/pooling q Financial flexibility q Related services FINANCE 15
FOREIGN VERSUS U. S. FINANCIAL MARKETS q U. S. financial markets/intermediaries face greater restrictions. o Branching o Services, especially non-financial q More participants in U. S. markets. q U. S. financial markets are more efficient. q More independent financial intermediaries in the United States than in other countries. FINANCE 16
CHAPTER 3 QUESTIONS 1. What is a financial market? What is the role of a financial market? 2. Why is it important for financial markets to be somewhat efficient? 3. Why are there so many different types of financial markets? 4. What is an investment banking house? What role do investment bankers play in the financial markets? 5. What is a financial intermediary? In what ways do financial intermediaries improve the standard of living in an economy? 6. How do financial markets and financial intermediaries in the United States differ from financial markets in other parts of the world? FINANCE 17
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