“Chapter Two- The Financial Environment: Markets, Institutions and

Investment Banks”
Ref: Introduction ot Mangerial Finance - Chapter 3 by: Scott Besley & Eugene Brigham

Capital Allocation Processes

Capital allocation process

The process of capital flows from those with surplus capital to those who need it

Three types of transfer

(1) Direct transfer: a business sells its security directly to investors
(2) Indirect transfer through an investment banker: a business sells its security to an
investment banker, which in turn sells the same security to individual investors (3) Indirect
transfer through a financial intermediary: a financial intermediary obtains funds from
investors by offering its own securities and uses funds to buy other business securities

1. Capital formation process

Most three important source of Financing

Most successful firms have ongoing needs for funds. They can obtain funds from external sources in three
ways. The first source is through a financial institution that accepts savings and transfers them to those that
need funds. A second source is through financial markets, organized forums in which the suppliers and
demanders of various types of funds can make transactions. A third source is through private placement.
Because of the unstructured nature of private placements, here we focus primarily on the role of financial
institutions and financial markets in facilitating business financing.
Financial institutions
Financial institutions serve as intermediaries by channeling the savings of individuals,
businesses, and governments into loans or investments. Many financial institutions directly or
indirectly pay savers interest on deposited funds; others provide services for a fee

Key Customers of Financial Institutions

The key suppliers of funds and the key demanders of funds are individuals, businesses, and governments.
The savings that individual consumers place in financial institutions provide these institutions with a large
portion of their funds. Individuals not only supply funds to financial institutions but also demand funds
from them in the form of loans. However, individuals as a group are the net suppliers for financial
institutions: They save more money than they borrow.

Business firms also deposit some of their funds in financial institutions, primarily in checking accounts
with various commercial banks. Like individuals, firms borrow funds from these institutions, but firms are
net demanders of funds: They borrow more money than they save.

Governments maintain deposits of temporarily idle funds, certain tax payments, and Social Security
payments in commercial banks. They do not borrow funds directly from financial institutions, although by
selling their debt securities to various institutions, governments indirectly borrow from them. The
government, like business firms, is typically a net demander of funds: It typically borrows more than it
saves. We’ve all heard about the federal budget deficit.

Major Financial Institutions

Commercial banks
Institutions that provide savers with a secure place to invest funds and they offer both
individuals and companies loans to finance investments, such as the purchase of a new home
or the expansion of a business.
Investment banks
Institutions that (1) assist companies in raising capital, (2) advise firms on major transactions
such as mergers or financial restructurings, and (3) engage in trading and market making
activities.
Glass-Steagall Act
An act of Congress in 1933 that created the federal deposit insurance program and separated
the activities of commercial and investment banks.
Shadow banking system
A group of institutions that engage in lending activities, much like traditional banks, but these
institutions do not accept deposits and are therefore not subject to the same regulations as
traditional banks
The Financial Markets
Financial markets are a system that includes individuals and institutions, instruments, and procedures that
bring together borrowers and savers no matter the location. The primary role of financial markets is to
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

Types of Markets
Financial markets also vary depending on the maturity of the securities being traded and the types of assets used
to back the securities. For these reasons, it is useful to classify markets along the following dimensions:

1. Physical asset markets versus financial asset markets. Physical asset markets (also called “tangible” or “real”
asset markets) are for products such as wheat, autos, real estate, computers, and machinery. Financial asset
markets, on the other hand, deal with stocks, bonds, notes, and mortgages. Financial markets also deal with
derivative securities whose values are derived from changes in the prices of other assets.

2. Spot markets versus futures markets. Spot markets are markets in which assets are bought or sold for “on-the-
spot” delivery (literally, within a few days). Futures markets are markets in which participants agree today to
buy or sell an asset at some future date. For example, a farmer may enter into a futures contract in which he
agrees today to sell 5,000 bushels of soybeans 6 months from now at a price of $5 a bushel. To continue that
example, a food processor that needs soybeans in the future may enter into a futures contract in which it agrees
to buy soybeans 6 months from now. Such a transaction can reduce, or hedge, the risks faced by both the farmer
and the food processor
3. Money markets versus capital markets. Money markets are the markets for short- term, highly liquid debt
securities. The New York, London, and Tokyo money markets are among the world’s largest. Capital markets
are the markets for intermediate- or long-term debt and corporate stocks. The New York Stock Exchange, where
the stocks of the largest U.S. corporations are traded, is a prime example of a capital market. There is no hard-
and-fast rule, but in a description of debt markets, short-term generally means less than 1 year, intermediate-
term means 1 to 10 years, and long-term means more than 10 years.

4. Primary markets versus secondary markets. Primary markets are the markets in which corporations raise new
capital. If GE were to sell a new issue of com- mon stock to raise capital, a primary market transaction would
take place. The corporation selling the newly created stock, GE, receives the proceeds from the sale in a primary
market transaction. Secondary markets are markets in which existing, already outstanding securities are traded
among investors.

5. Private markets versus public markets. Private markets, where transactions are negotiated directly between
two parties, are differentiated from public markets, where standardized contracts are traded on organized
exchanges. Bank loans and private debt placements with insurance companies are examples of private market
transactions. Because these transactions are pri- vate, they may be structured in any manner to which the two
parties agree. By contrast, securities that are traded in public markets (for example, common stock and corporate
bonds) are held by a large number of individuals. These securities must have fairly standardized contractual
features because public investors do not generally have the time and expertise to negotiate unique,
nonstandardized contracts. Broad ownership and standardization result in publicly traded securities being more
liquid than tailor-made, uniquely negotiated securities.

Assignment:

Why are financial markets essential for a healthy economy and economic growth?

Financial Institutions

1. Investment banks traditionally help companies raise capital. They (a) help corporations design
securities with features that are currently attractive to investors, (b) buy these securities from the
corporation, and (c) resell them to savers. Since the investment bank generally guarantees that the firm
will raise the needed capital, the investment bankers are also called underwriters.
2. Commercial banks were the major institutions that handled checking accounts and through which the
Federal Reserve System expanded or contracted the money supply. Today, however, several other
institutions also provide checking services and sig- nificantly influence the money supply.
3. Financial services corporations are large conglomerates that combine many different financial
institutions within a single corporation. Most financial serv- ices corporations started in one area but
have now diversified to cover most of the financial spectrum. For example, Citigroup owns Citibank (a
commercial bank), Smith Barney (an investment bank and securities brokerage organization), insurance
companies, and leasing companies. Simply A firm that offers a wide range of financial services, including
investment banking, brokerage oper- ations, insurance, and commercial banking.

4. Credit unions are cooperative associations whose members are supposed to have a common bond, such
as being employees of the same firm. Members’ savings are loaned only to other members, generally
for auto purchases, home improvement loans, and home mortgages. Credit unions are often the
cheapest source of funds available to individual borrowers.

5. Pension funds are retirement plans funded by corporations or government agencies for their workers
and administered primarily by the trust depart- ments of commercial banks or by life insurance
companies. Pension funds invest primarily in bonds, stocks, mortgages, and real estate.
6.

7. Life insurance companies take savings in the form of annual premiums; invest these funds in stocks,
bonds, real estate, and mortgages; and make payments to the beneficiaries of the insured parties.
 8. Mutual funds are corporations that accept money from savers and then use these funds to buy stocks,
long-term bonds, or short-term debt instruments issued by businesses or government units. These
organizations pool funds and thus reduce risks by diversification. They also achieve economies of scale
in analyzing securities, managing portfolios, and buying and selling securities. Different funds are
designed to meet the objectives of different types of savers.

9. Exchange Traded Funds (ETFs) are similar to regular mutual funds and are often operated by mutual
fund companies. ETFs buy a portfolio of stocks of a certain type—for example, the S&P 500 or media
companies or Chinese companies—and then sell their own shares to the public. ETF shares are
generally traded in the public markets, so an investor who wants to invest in the Chinese market, for
example, can buy shares in an ETF that holds stocks in that particular market.

Hedge funds are also similar to mutual funds because they accept money from savers and use the funds to buy
various securities, but there are some important differences. While mutual funds (and ETFs) are registered and
regulated by the Securities and Exchange Commission (SEC), hedge funds are largely unregulated. This
difference in regulation stems from the fact that mutual funds typically target small investors, whereas hedge
funds typically have large minimum investments

10.