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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and investment banking and repealed in 1999— is offered to illustrate the evolution of financial markets and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.
Suggested Answer to Opener-in-Review Question
In the chapter opener, students learned about Airbnb’s spectacular rise. In 2009, Sequoia Capital invested
$600,000 in this “unicorn” in return for a 10% ownership stake. These figures imply Airbnb was worth $6
billion at the time. If the company was worth $31 billion in 2017, students were then asked, how much did the
value of Airbnb grow in that eight-year period? The answer is 516,566.7% [($31 billion/$6 million – 1) x
100]
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
2-3 Commercial banks, investment banks, and the shadow-banking system are all financial institutions.
Broadly speaking, commercial banks transform the deposits of net savers into loans to net borrowers.
Investment banks, in contrast, do not “transform” the liquidity and riskiness of financial assets. Instead,
2-4. Financial markets facilitate direct interaction of suppliers and demanders of funds. In primary
markets, debt and equity instruments are sold the first time—a direct exchange between the firm or
government issuing securities and the purchasers. An example is Microsoft Corporation selling new
market. Similarly, financial institutions and financial markets are far from independent. Commercial
banks, for example, hold large inventories of U.S. Treasury securities to improve the liquidity and
2-5 A private placement is the sale of a new security directly to an investor or a small group of
sophisticated investors (such as insurance companies and pension funds). A public offering, in
2-6. The money market features trading in short-term, highly marketable debt instruments; “short term”
here means an original maturity of one year or less. Money-market instruments typically carry low
risk of capital losses. Examples of money-market instruments include U.S. Treasury bills,
2-7. The capital market features trading in instruments with original maturities exceeding one year such as
bonds and stock (common and preferred). Capital-market instruments are exchanged in broker and
Microsoft stock from the dealer at the ask price. “Ask” exceeds “bid,” so the dealer’s reward for
maintaining an inventory of Microsoft stock is the opportunity to “buy low, sell high.” The
2-8 Firms see the capital market as a source of external finance for long-term projects. Put another way,
they sell new bonds and stock to raise funds to build factories, launch marketing campaigns, and
expand into new markets. Accordingly, they want a liquid market—one “deep” enough to accept
react swiftly to new information. Capital-market efficiency means investors need not waste time
trying to identify over or undervalued securities or exploitable patterns in securities prices. Instead,
2-9 The first years of Great Depression featured the worst contraction in American history. Between
August 1929 and March 1933, industrial production fell 52%, the Dow Jones Industrial Average
tumbled 89%, unemployment soared to nearly 25%, and roughly 9,000 banks failed (37% of those
factors thought to have caused the slump. To protect depositors from losses in bank failures, the
Banking Act of 1933 created federal deposit insurance. To prevent failures in the first place, the Act
2-10 Both Acts required companies wishing to participate in securities markets to disclose significant
information to the public. The Securities Act of 1933 focused on the primary market, compelling
sellers of new securities provide reasonably accurate portrayals of their firms to prospective
2-11 Angel investors and venture capitalists are both sources of private equity. “Angels” are usually
wealthy individuals who fund promising start-ups in return for a slice of firm equity. Venture
2-12 Venture capitalists (VCs) are organized as (i) limited partnerships (most common), (ii) small business
investment companies (SBICs), (iii) financial funds, and (iv) corporate funds. The principal
difference is how the VC was created. The federal government charters SBICs. Financial institutions
pricing. Deal structure allocates responsibilities between the start-up and VC and may include
2-13 Firms wishing to go public must (i) secure approval from current shareholders, (ii) obtain
certification of the accuracy of their financial documents from company auditors and lawyers, (iii)
after the investment bank has finalized issue terms and offer price, and (vii) sell the issue to the
2-14 Broadly speaking, an investment bank facilitates a firm’s issuance of new securities. In a common-
stock issue, the bank helps the issuer file a registration statement with the SEC and market the
2-15 Securitization is the process of creating highly liquid marketable securities out of illiquid assets. The
first assets securitized on a large scale were residential mortgages—securitizers “pooled” the
mortgages and then issued debt claims backed by cash flows from those pools. In other words, the
interest and principal on “mortgage-backed” securities (MBSs) paid to investors came from mortgage
2-16 A mortgage-backed security (MBS) is a debt instrument backed by residential mortgages. “Backed”
means principal and interest paid to MBS investors come from payments by residential homeowners
2-17 When a home buyer takes out a mortgage, initial equity—the difference between purchase price and
mortgage-loan balance—is simply the down payment. Over time, equity will rise as the borrower
reduces the mortgage balance with monthly principal and interest payments. Should housing prices
2-18. A large decline in housing prices could push the value of a borrower’s home below the mortgage
balance. With negative equity, the borrower could hold the loss at the original down payment by
future lenders will understand the circumstances.
2-19 The Great Recession of 2007–09 illustrates how a financial-sector crisis can metastasize. In the years
running up to the recession, securitizers increasingly pooled mortgage loans to borrowers with less-
than-stellar credit. At the time, “subprime” loans seemed relatively low risk because of rapidly rising
produced an economy-wide decline in consumer and investment spending. Investment banks,
meanwhile, were large players in the money market—Lehmann, for example, routinely sold a large
Suggested Answer to Focus on Practice Box: Berkshire Hathaway: Can
Buffet Be Replaced?
Thinking about the principal-agent problem from Chapter 1, why might Buffett use different incentive
schemes in firms with different growth prospects?
In this Focus on Practice box, the principal is the funding provider—Warren Buffett and Berkshire
Hathaway— while the agent is the firm owner/manager receiving the funds. Buffett wants the highest
return on his investment over a specific time horizon; the owner/manager may wish to pursue other short-
Suggested Answer to Focus on Ethics Box: Should Insider Trading Be
Legal?
Suppose insider trading were legal. Would it still present an ethical issue for insiders wishing to trade on non-
public information?
Yes, even if legal, insider trading could still raise ethical concerns because of potential conflict between an
executive’s duty to shareholders and her concern for personal wealth. Suppose, for example, a senior
Answers to Warm-Up Exercises
E2-1 Suppliers and demanders of funds (LG 1)
Answer: Individuals as a whole (i.e., the household sector) spend less than they earn and invest the
surplus in firms directly (by purchasing their stocks and bonds) or indirectly (through financial
institutions —as in making deposits a commercial bank who then lends the funds to firms). If
E2-2 Raising funds (LG 2)
Answer: Gaga can raise the needed $10 million by borrowing from a commercial bank or issuing stocks
or bonds in the primary market. To obtain $10 million from a commercial bank, Gaga will likely
need an ongoing deposit relationship with that bank. Such a relationship gives the bank low-cost
information about Gaga’s cash flows that reduce the cost of lending to the firm. Over time, as
E2-3 Money market vs. capital market (LG 3)
Answer: Short-term, highly liquid, low-risk debt trades in the money market. Reputable firms needing
cash for one year or less to fund ongoing operations have traditionally tapped the money market.
Suppose a well-known, financially sound firm specializing in recreational-vehicle (RV) sales
E2-4 Biggest benefit of government regulation (LG 4)
Answer: The scale and scope of government involvement in the economy will always be subject to
debate, but most economists agree on the need for some financial-sector regulation. Well-
E2-5 Determining net proceeds from stock sale (LG 5)
Answer: Net proceeds = (1,000,000 $20 x 0.95) + (250,000 $20 0.90)
E2-6. Mortgage-backed securities (MBSs) (LG 6)
Answer: Students should start by asking about the following:
a. The location of houses securing the underlying mortgages (As the old saying goes, the three
most important determinants of real-estate prices are “location, location, location.”)
b. The percentage of underlying mortgages in foreclosure or “under water” (i.e., with market
f. The condition of homes securing the underlying mortgages (e.g., would repairs be needed to
payments)
Solutions to Problems
P2-1. Transactions costs (LG3)
a. Bid/Ask Spread = Ask Price – Bid Price = $263,770 – $262,850 = $920
b. If Scottrade routes the buy order to the NYSE (a broker market), a market maker will execute
the trade at the midpoint of the bid/ask spread. In this transaction, the market maker serves as
c. If Scottrade routes the buy order to the NASDAQ (a dealer market), the market maker will
d. The midpoint of the bid/ask spread is the implied market value of the stock, and the market
value of the trade equals the product of the market value of the stock and the number of shares
traded.
P2-2. Transactions costs (LG 3)
a. Transactions costs = (Number of shares) [(0.50) x (Bid/ask spread)]
+ Brokerage commission
b. Twitter is listed on the NYSE, a broker market. So, had Charles Schwab routed the order to the
NYSE, it could have been executed against a buy order, and total transaction costs would have
been only the $29.95 brokerage commission. But transaction costs included half the bid/ask
c. Transactions costs = (Number of shares) [(0.50) (Bid/ask spread)]
+ Brokerage commission
d. Total transactions costs = Transactions costs from sale + Transactions costs from purchase
Total transactions costs = $59.95 + $47.95 = $107. 90
Costs could have been reduced costs by placing both trades online with a request for routing to
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/$11 = 7%
c. Underwriting fee ($) = ($0.77) (10.5 million shares) = $8,085,000.
d. Net proceeds = Total proceeds – Underwriting fee = $115,500,000 – $8,085,000 =
P2-4. Initial public offerings (LG5)
a. Total proceeds = (IPO offer price) (Number of IPO shares issued) = ($18) (8.25 million)
= $148,500,000
b. Underwriting fee ($) = (6.5%) ($148,500,000) = $9,652,500
e. IPO underpricing = [(Market price) – (Offer price)] / Offer price = [$16.10 – $18] / $18 =
–10.56%
f. Negative underpricing indicates secondary-market investors are not willing to pay as much for
P2-5. Ethics problem (LG 4)
An ethical issue arises because of access to material nonpublic information and the potential
conflict between an insider’s duty to shareholders and concern for personal wealth. For example,
suppose an insider knows about a planned acquisition and quietly buys shares of the target firm— a
Case
Case studies are available on www.pearson.com/mylab/finance.
Pros and Cons of Being Publicly Listed
a.Going public will enable Robo-Tech to raise more external capital without additional bankruptcy
risk. [Unlike creditors, shareholders cannot take the firm to bankruptcy court if expected dividends are
not paid.] Going public will also allow the company to continue operating after Mr. Bradley (the
b.The disadvantages of going public include (i) more burdensome SEC reporting requirements, (ii)
potential dilution of Mr. Bradley’s managerial control (e.g., if the IPO left him with fewer than 50% of
c.Robo-Tech is probably too small to meet NYSE and NASDAQ listing requirements. The firm will
probably trade over-the-counter or on regional exchanges.
d.If the capital market is efficient, the price of Robo-Tech stock will provide an unbiased estimate of firm
value. Efficiency also implies movements in stock price following news about the company will also be
Spreadsheet Exercise
Answers to Chapter 2’s MuleSoft spreadsheet problem are available on www.pearson.com/mylab/finance.
Group Exercise
There is no group exercise for Chapter 2.
Integrative Case 1: Merit Enterprise Corp.
a. Option 1 is borrowing $4 billion from JPMorgan Chase (or a syndicate of banks). The pros are the
benefits of not going public. Going public means costly SEC disclosure requirements and potentially
less scope for current owners to run the company over the long run. [Indeed, if current owners found
insist on restrictive covenants to limit Merit’s discretion in using the funds. And, if a loan payment were
missed, bank lenders (unlike shareholders) could take the firm to bankruptcy court.
b. Option 2 is going public to raise the needed $4 billion. The pros are the benefits of going public:
(i) access to more external capital over time, (ii) insulation of Merit owners from personal liability for
firm debts, (iii) opportunities for Merit owners to sell some of their ownership stake to increase
c. Ms. Lehn’s should choose the option that maximizes the wealth of the current owners. The information
Ms. Lehn should recommend an IPO to the board.
