Chapter 2

Financial Markets & InstitutionsTopics Covered

• The Importance of Financial Markets & Institutions

• The Flow of Savings to Corporations

• Functions of Financial Markets & of Financial Intermediaries

• Value Maximization and the Cost of Capital

2.1 The Importance of Financial Markets

Financial market is a market where securities are issued and traded.

• Financial markets provide financing to the corporation’s growth

• A modern financial system offers financing in many different forms, depending on the company’s age, growth rate and nature of its business.

Financial Markets

Primary

Markets

Secondary

Markets

OTC

Markets

Money

2.2 Flow of Savings to Corporations

Company

Issue Securities

Cash

InvestorsCash Reinvested

Investment in real assets

Flow of savings in a closely held corporation

Corporation

Investment in real assets

Investorsworldwide

Financial markets

Stock marketsFixed-income marketsMoney marketsMarkets for Commodities Foreign exchange Derivatives

Financial Intermediaries

Mutual Funds Pension funds

Financial Institutions

Banks Insurance companies

Reinvestment

Flow of savings for large, public corporation

The Stock Market

Financial market is a market where securities are issued and traded.• Common stocks of publicly traded companies are traded in

stock or equity markets. (Newyork Stock Exchange, İMKB)

• The initial sale of securities or initial public offering (IPO), and receipt of cash to the corporation, is in the primary market.

• Subsequent sale of securities in financial markets, between investors, are in secondary markets. Secondary market provides liquidity to investors.

Agency Problems & Corporate Governance

An agency problem arises when a manager owns less than the total common stock of the firm. This fractional ownership can lead the managers to shirk and to consume more perquisites because other owners bear part of the costs.

An important theme of corporate governance is to ensure the accountability of the managers in a company through mechanisms that try to reduce or eliminate the principal-agent problem.

Other Financial Markets

• Debt securities (contractual obligations to pay) are traded in the fixed-income market or bond markets.

• The market for long-term debt and equity securities is called the capital market, whereas the market for short-term, high quality, liquid debt securities is called the money market.

• Other financial asset (security) markets for immediate or spot or future delivery (foreign exchange, futures, options) and real assets (commodities) exist throughout the world.

Financial Intermediary

• A financial intermediary is an organization that raises money from investors and provides financing for individuals, companies and other organizations.

• Savings may flow to real investment directly through financial markets or indirectly through financial intermediaries.

• Financial intermediaries, such as commercial banks, finance companies, life and casualty insurance companies, credit unions, and savings and loan associations raise funds by issuing contracts (stock, corporate bonds, loans, mortgages) to savers.

Financial Intermediary

Mutual funds issue shares to savers and invest in a variety of portfolios of financial assets, providing professional management and diversification.

• A financial investor (saver) may own corporate stock or securities directly (hold the shares) or indirectly through financial intermediaries, such as mutual funds.

Bank of America

Windsor Fund

Investors

$ $

Sells shares

Issues shares

Financial Intermediary

Hedge funds a private investment pool, open to wealthy or institutional investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds.

Pension funds, funds contributed by employers and/or employees for future retirement, are a significant financial intermediary today and a very large common stock investor.

Financial InstitutionsFinancial intermediaries, that also provide payment, investing, lending, and risk management services, are called financial institutions.

Commercial banks and insurance companies intermediate funds from savings to investment (two contracts), but also provide contracts for financial services (checking services and insurance).

Investment banks help companies raise money by issuing and selling securities in the financial markets (stocks and bonds), as well as providing advice on transactions such as mergers and acquisitions.

The primary function of insurance companies is to protect individuals and corporations. At the same time, insurance companies invest heavily in corporate stocks and bonds. They are more important than banks for the long-term financing of corporations.

Functions of Financial Markets

Transporting cash across time Risk transfer and diversification Liquidity Payment mechanism Provide information

Functions of Financial Markets

Transporting cash across time

transport purchasing power to future periods (retirement funds).

transporting future income to present consumption.

Functions of Financial Markets

Risk transfer and diversification

Insurance contracts, futures, options

Portfolio diversification

Functions of Financial Markets

Liquidity Secondary markets

Payment Mechanism send and receive payments quickly and safely over long distance.

Information Provided by Financial Markets A continuous flow of information about economic levels,

commodity prices, interest rates and company stock prices aids the financial manager to make decisions that will best maximize the long-run value of the corporation.

Value Maximization & Cost of Capital

The cost of capital is the minimum acceptable of return needed on capital investments to maintain the current value of their securities. It is the minimum return demanded by investors for investments of a certain risk level available in the market

The rates of return on investments outside the corporation set the minimum return for investment projects inside the corporation, i.e., the cost of capital for corporate investments is set by the rates of return on investment opportunities in financial markets – the opportunity cost of capital.

Investment projects offering rates of return higher than the cost of capital add value to the firm. Projects offering rates of return less than the cost of capital subtract value and should not be undertaken.

Value Maximization