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Chapter 2
The Financial-Market Environment
Instructor’s Resources
Chapter Overview
This chapter provides an overview of the institutional framework for channeling funds from net savers to net
borrowers. The discussion begins with three basic types of financial institutions—commercial banks,
investment banks, and the shadow-banking system. Financial markets more broadly are then introduced along
with the distinction between (i) money and capital markets and (ii) primary and secondary markets.
Considerable attention is also focused on the oft-misunderstood topic of “efficient markets.” In the capital-
markets discussion, the step-by-step process for Initial Public Offerings of common stock is described to
provide a real-world example of funds travelling from net savers to net borrowers and illustrate the role
investment bankers play in that journey. Next, key features of U.S. financial regulation—deposit insurance,
the Securities Act of 1933, and the Securities Exchange Act of 1934, and Dodd Frank are—are laid out. The
history of Glass-Steagall—enacted in the 1930s to prevent future banking crises by separating commercial
and investment banking and repealed in 1999— is offered to illustrate the evolution of financial markets and
regulatory responses to those changes. The chapter concludes with an exploration of the role of housing
finance in the Financial Crisis and the Great Recession of 2007–09.
Answers to Review Questions
2-1. Financial institutions are intermediaries that facilitate the flow of individual, business, and government
savings into loans and investments. Broadly speaking, net savers (primarily individuals) prefer low risk
and easy access to their money while net borrowers (businesses and government) would like to take
2-2 Overall, the same entities that supply funds—individuals, businesses, and governments—also demand
them, so these three groups are all financial-institution customers. That said, the key demanders of
© 2015 Pearson Education, Inc.
E2-1 Suppliers and demanders of funds (LG 1)
E2-2 Raising funds (LG 2)
E2-3 Money market vs. capital market (LG 3)
E2-4 Biggest benefit of government regulation (LG 4)
E2-5 Determining net proceeds from stock sale (LG 5)
© 2015 Pearson Education, Inc.
P2-3. Initial public offerings (LG 5)
a. Total proceeds = (IPO offer price) × (IPO shares issued) = $11 × 10.5 million = $115,500,000
b. Percentage underwriting discount = (Underwriting discount) / Offer price = $0.77/$11 = 7%
P2-4. Initial public offerings (LG5)
a. Total proceeds = (IPO offer price) × (Number of IPO shares issued) = ($18) × (8.25 million)
–10.56%
f. Negative underpricing indicates secondary-market investors are not willing to pay as much for
© 2015 Pearson Education, Inc.
Group Exercise
