THE FINANCIAL ENVIRONMENT:
MARKETS, INSTITUTIONS, AND
INVESTMENT BANKING
BY
FLORENCE C. OKENWA
The Financial Markets
Financial markets
a system of individuals and institutions, instruments, and
procedures that unite borrowers and savers, regardless
of their location.
Primary role
facilitate the flow of funds from individuals and
businesses that have surplus funds to individuals,
businesses, and governments that need funds in excess
of their incomes.
Flow of Funds
Three financial phases
Young adults borrow
Older working adults save (invest)
Retired adults spend savings
How funds transfer from savers (investors) to
borrowers
Direct transfer
Indirect transfers
o Investment banks
o Financial intermediaries
Diagram of the Capital Formation Process
1. Direct Transfers
Business’s Securities (Stocks or Bonds)
Business
Business Savers
Savers
(Borrower)
(Borrower) Funds (Investors)
(Investors)
2. Indirect Transfers through an Investment Banker
Securities Investment Banker Firm’s Stocks
Business
Business (Stocks/Bonds) Helps corporations issue or Bonds Savers
Savers
(Borrower) securities (stocks or bonds) (Investors)
(Borrower) Funds less (Investors)
issuing costs Receives fees from the issue
Funds
3. Indirect Transfers through a Financial Intermediary
(Debt owed to Intermediary’s
intermediary) Financial Intermediary Liability
Business
Business Borrower’s Uses funds to buy/create loans (Account at Savers
Savers
Liability intermediary)
(Borrower)
(Borrower) and other financial instruments (Investors)
(Investors)
Funds Pays a return/interest to attract Funds
funds from savers
Market Efficiency
Economic Efficiency
Funds are allocated to their optimal use (highest return)
at the lowest costs (interest rate).
Informational Efficiency
security prices are adjusted quickly to reflect all current
information.
Market Efficiency (Informational)
Return
Abnormal
Returns
Return*
Normal Risk Adjusted Return
Risk
Risk*
Efficiency Markets Hypothesis
(EMH)
EMH: Prices fully, accurately, and instantaneously
reflect all relevant information.
Implication It is impossible to earn an abnormal
return
o Weak-form—current prices reflect all information contained in
past prices.
o Semistrong-form—current prices reflect all publicly available
information.
o Strong-form—current prices reflect all pertinent information,
both public and private.
Types of Financial Markets
Money markets versus capital markets
Debt markets versus equity markets
Primary markets versus secondary markets
Derivatives markets
General Stock Market Activities
Secondary market—trading in the outstanding,
previously issued shares of investment instruments.
Primary market—additional shares sold by
established, publicly owned companies.
Seasoned Offerings
IPO market—new offerings by privately held firms that
are “going public” with their shares.
Stock Markets
Physical stock exchanges
NYSE and regional exchanges
Exchange members
Floor brokers
Designated market makers (specialists)
Supplemental liquidity providers (SLPs)
Stock Markets
Listed requirements on an exchange
Apply to the exchange
Pay a relatively small fee
Meet the exchange’s minimum requirements
Listing Requirements:
Stock Exchanges and the NASDAQ
NYSE Regional NASDAQ
Exchanges
Round-lot shareholders 400 800 300
# public shares (millions) 1.1 0.5 1.1
Assets ($ millions) $75 $4 $50
Pre-tax income ($ millions) $2.00 $0.75 $1.00
Stock Markets
Over-the-Counter Markets
Network of brokers and dealers (NASD members)
Dealer market vs an auction type of market
Organized Investment Networks
NASDAQ – Distinct OTC Market
Electronic Communications Networks (ECNs) aka:
Alternative Trading Systems
automated system that matches buy and sell orders for
securities.
Registered with SEC
Regulation of Securities Markets
Securities and Exchange Commission (SEC)
Has jurisdiction over most interstate offerings of new
securities to the general public.
Regulates national securities exchanges.
Has power to prohibit manipulation of securities’ prices.
Has control over stock trades by corporate insiders.
FINRA – Financial Industry Regulatory Authority
Self-regulatory organization (SRO)
Regulates securities brokers and the firms they work for
Overseen by SEC
The Investment Banking Process
Investment Banks
Help companies design securities with features that are
attractive to investors.
Buy the securities from the issuing firm
Sell the securities to investors
Raising Capital: Stage I Decisions (firm level)
Determine dollars to be raised
Select the type of securities to be used
Decide between competitive bid versus negotiated deal
Select an investment banker
The Investment Banking Process
Raising Capital: Stage II Decisions
Reevaluate the initial decisions
Best efforts or underwritten issues
o Underwritten Arrangement—investment bank guarantees the sale
by purchasing the securities from the issuer.
o Best Effort Arrangement—investment bank gives no guarantee
that the securities will be sold.
Issuance (flotation) Costs
Setting the offering price
The Investment Banking Process
Net proceeds = Amount of issue - Flotation costs
= Amount of issue (1 - F) - OC
NP + OC
Amount of issue =
(1 F)
Where:
NP = Net proceeds
F = flotation costs as a decimal (%)
OC = other costs ($)
The Investment Banking Process
Example: A firm needs $440,000; flotation costs are 6%
percent of total issue amount and other flotation costs are
$30,000.
NP + OC
Amount of issue =
(1 F)
$440,000 30,000
$500,000
(1 0.06)
Total flotation costs = $60,000 = $500,000(0.06) + $30,000,
which leaves $440,000 for the firm to use.
The Investment Banking Process
Selling Procedures
Underwriting Syndicate—a group of investment firms
join to spread the risk associated with the distribution of
a new security issue.
Lead or Managing Underwriter—the member of an
underwriting syndicate who manages the distribution
and sale of a new security offering.
Selling Group—a network of brokerage firms formed for
the purpose of distributing a new security issue.
The Investment Banking Process
Shelf Registrations
Securities registered with the SEC for sale at a later date
(SEC Rule 415)
Held “on the shelf” until the sale when market
conditions are favorable.
Maintenance of a Secondary Market
For IPOs, the investment banker is obligated to maintain
a market for the shares after the issue has been
completed.
o The lead underwriter agrees to “make a market” in the stock and
keep it reasonably liquid.
The Role of Financial
Intermediaries
Facilitate the transfer of funds from those who have
excess funds (savers) to those who need funds
(borrowers).
Create a variety of financial products that take the
form of either loans or saving/investment
instruments.
Benefits of Financial Intermediaries
Reduced costs for borrowers and increased returns
for savers (investors).
Diversification (risk reduction)
Funds divisibility/pooling
Financial flexibility
Related services
Types of Financial Intermediaries
Commercial banks
Credit unions
Thrifts (aka savings and loan associations)
Mutual funds
Whole life insurance companies
Pension funds
International Financial Markets
U.S. stock markets represent 40-45% of the total
value worldwide
was 70% in 1970.
U.S. markets dominates any individual stock
markets in other countries.
50% of worldwide trading activity
Financial Organizations in Other Parts
of the World
Historically, U.S. financial institutions are more
heavily regulated than most non-U.S. firms.
limitations on branching (expansion)
limitations on services offered, and
limitations on relationships with non-financial
businesses.
In the past, regulatory restrictions have impaired
the growth of U.S. financial intermediaries
compared to foreign intermediaries.
Legislation of Financial Markets
Typically, when financial markets perform poorly,
Congress tends to increase regulation on financial
activities.
When financial markets are performing efficiently
and producing above-normal returns, Congress
tends to deregulate financial activities.
