The Financial Environment

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 A market is a venue where goods and
What is a services are exchanged.
Financial
market?

A financial market is a place where

individuals and organizations wanting to
borrow funds are brought together with
2 those having a surplus of funds.
Flow of Funds:

• Funds flow indirectly from ultimate

lenders [households] through
financial intermediaries [banks or
insurance companies] or directly
through financial markets [stock
exchange/bond markets] to ultimate
borrowers [business firms,
government, or other households].
• In order for financial system to
function smoothly, must be adequate
information about the markets and
their operation.

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Flow of Funds:

• Financial system provides a

transmission mechanism between
saver-lenders and borrower-spenders.
• Savers benefit—earn interest
• Investors benefit—access to
money otherwise not available
• Economy benefits—efficient
means of bringing savers and
borrowers together
Flow of funds from lenders to
borrowers:

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The Financial Markets:

• Physical VS. Financial asset markets

• Spot VS. future markets
• Money VS. capital markets
• Primary VS. secondary markets
• Public VS. private markets

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 • Physical Asset Markets:
It is a market for such products as wheat, autos, real estate, and
machinery.
• Financial Asset Markets:
It deals with stocks, bonds, notes, mortgages, and derivatives.
The
Financial
Markets:

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The Financial Markets:
• Spot Markets:
It is a market in which assets are bought and
sold for on the spot delivery.
• Futures Markets:
It is a market in which participants agree
today to buy or sell an asset at some future
date.

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The Financial Markets:

• The Money Market:

• Exchange of short-term
instruments—less than one year
• Highly liquid, minimal risk
• Commercial paper—short-term
liabilities of prime business
firms and finance companies
• Bank Certificates of
Deposits—liabilities of issuing
bank, interest bearing to
corporations that hold them

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The Financial
Markets:
• The Capital Market:
• Exchange of long-term securities—in excess of
one year
• Generally used to secure long-term financing for
capital investment.
• Stock market—Largest part of capital market
and held by private and institutional investors
• Residential and commercial mortgages—
Held by commercial banks and life insurance
companies
• Corporate bond market—Held by insurance
companies, pension and retirement funds

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Types of
Capital Market
• EQUITY CAPITAL
• DEBT CAPITAL
The Financial
Markets:
• Primary Markets:
• Market for issuing a new security and
distributing to saver-lenders.
• Initial Public Offering Market
(IPO).
• Investment Banks—Information and
marketing specialists for newly issued
securities.
• Secondary Markets:
• Market where existing securities can be exchanged

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Financial Institutions:

Funds are transferred between those who

have funds and those who need funds by
three processes:

• Direct transfers,
• Investment banking houses, or
• Financial intermediaries.

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Types of
Financial
Intermediaries
 Act as agents in transferring funds from savers-
Act lenders to borrowers-spenders.

Role of
Financial
Intermediaries:
Acquire funds by issuing their liabilities to public
and use money to purchase financial assets
Acquire • Earn profits on difference between interest paid and earned
• Diversify portfolios and minimize risk
• Lower transaction costs

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 Most prominent

Range in size from huge to small

Commercial
Banks: Major source of funds used to be demand
deposits of public, but now rely more on “other
liabilities”

Also accept savings and time deposits—interest

earning

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 • Traditionally acquired funds through savings
Savings and deposits
Loan • Used funds to make home mortgage loans
• Now perform same functions as
Associations commercial banks
• issue checking accounts
[S&L’s]: • make consumer and business loans

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 Organized as cooperatives for people
with common interest
Members buy shares [deposits] and
Credit can borrow
Unions: Changes in the law in early 1980’s
broadened their powers
checking [share] accounts
make long-term mortgage loans

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Pension and
Retirement Funds:

• Concerned with long run

• Receive funds from
working individuals
building “nest-egg”
• Accurate prediction of
future use of funds
• Invest mainly in long-
term corporate bonds
and high-grade stock
• Invest in wide variety of
securities—minimize
risk

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 Life Insurance Companies:

01 02 03 04
Insure against death Receive funds in form Use of funds is based Invest in long-term
of premiums on mortality securities—high yield
statistics—predict • Long-term corporate
when funds will be bonds
needed • Long-term commercial
mortgages

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 Mutual Funds:

1 2 3
Stock or bond market Pool funds from Invest in wide variety
related institutions many people of securities—
minimize risk

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The Stock Market:
 Organized Security
Exchanges:
 PSE
 Actual physical locations
Over-the-Counter Markets:
 Network of brokers and dealers
 Auction market
Organized Investment Network
Electronic Communications
Networks
 The Cost of Money:
Four factors that affect the cost of money:

• Production opportunities
• Time preferences for
consumption
• Risk
• Expected inflation

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 The Cost of Money:

• What do we call the price, or cost, of debt capital?

The Interest Rate

• What do we call the price, or cost, of equity capital?

Return on Equity =Dividends +Capital Gains

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Interest Rate Levels
and Stock Prices:
• The higher the rate of interest, the lower
a firm’s profits

• Interest rates affect the level of economic

activity, and economic activity affects
corporate profits

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 Risks associated with investing overseas:
• Exchange rate risk – If an investment is denominated in
a currency other than U.S. dollars, the investment’s
value will depend on what happens to exchange rates.
• Country risk – Arises from investing or doing business
in a particular country and depends on the country’s
economic, political, and social environment.

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