Chapter 2: Financial Markets and Institutions
Learning Objectives
7
Chapter 2
Financial Markets and Institutions
Learning Objectives
After reading this chapter, students should be able to:
◆ Identify the different types of financial markets and financial institutions, and explain how these
markets and institutions enhance capital allocation.
◆ Explain how the stock market operates, and list the distinctions between the different types of stock
markets.
◆ Explain how the stock market has performed in recent years.
◆ Discuss the importance of market efficiency, and explain why some markets are more efficient than
others.
◆ Develop a simple understanding of behavioral finance.
Lecture Suggestions
Chapter 2 presents an overview of financial markets and institutions. Students definitely have an interest in
financial markets and institutions. We base our lecture on the integrated case. The case goes
systematically through the key points in the chapter, and within a context that helps students see the real
world relevance of the material in the chapter. We ask the students to read the chapter, and also to “look
over” the case before class. However, our class consists of about 1,000 students, many of whom view the
lecture on TV, so we cannot count on them to prepare for class. For this reason, we designed our lectures
to be useful to both prepared and unprepared students.
Since we have easy access to computer projection equipment, we generally use the electronic slide
show as the core of our lectures. We make the electronic slides available to our students, and we strongly
suggest to our students that they print a copy of the
PowerPoint
slides for the chapter and bring it to class.
This will provide them with a hard copy of our lecture, and they can take notes in the space provided.
DAYS ON CHAPTER: 2 OF 56 DAYS (50-minute periods)
Chapter 2: Financial Markets and Institutions
Answers and Solutions
9
Answers to End-of-Chapter Questions
2-1 The prices of goods and services must cover their costs. Costs include labor, materials, and capital.
Capital costs to a borrower include a return to the saver who supplied the capital, plus a mark-up
2-2 In a well-functioning economy, capital will flow efficiently from those who supply capital to those
who demand it. This transfer of capital can take place in three different ways:
1. Direct transfers of money and securities occur when a business sells its stocks or bonds directly
2. Transfers may also go through an investment bank that underwrites the issue. An underwriter
3. Transfers can also be made through a financial intermediary. Here the intermediary obtains
funds from savers in exchange for its own securities. The intermediary uses this money to buy
2-3 A primary market is the market in which corporations raise capital by issuing new securities. An
2-4 A money market transaction occurs in the financial market in which funds are borrowed or loaned
for short periods (less than one year). A capital market transaction occurs in the financial market in
which stocks and intermediate—or long-term debt (one year or longer)—are issued.
2-5 If people lost faith in the safety of financial institutions, it would be difficult for firms to raise capital.
10
Answers and Solutions
Chapter 2: Financial Markets and Institutions
2-6 Financial markets have experienced many changes during the last two decades. Technological
advances in computers and telecommunications, along with the globalization of banking and
2-7 The physical location exchanges are tangible entities. Each of the larger ones occupies its own
building, allows a limited number of people to trade on its floor, and has an elected governing
2-8 The two leading stock markets today are the New York Stock Exchange (NYSE) and the Nasdaq
2-9 There is an “efficiency continuum,” with the market for some companies’ stocks being highly
Chapter 2: Financial Markets and Institutions
Answers and Solutions
11
12
Integrated Case
Chapter 2: Financial Markets and Institutions
Integrated Case
2-1
Smyth Barry & Company
Financial Markets and Institutions
Assume that you recently graduated with a degree in finance and have just
reported to work as an investment adviser at the brokerage firm of Smyth Barry
& Co. Your first assignment is to explain the nature of the U.S. financial markets
to Michelle Varga, a professional tennis player who recently came to the United
States from Mexico. Varga is a highly ranked tennis player who expects to invest
substantial amounts of money through Smyth Barry. She is very bright;
therefore, she would like to understand in general terms what will happen to her
money. Your boss has developed the following questions that you must use to
explain the U.S. financial system to Varga.
A. What are the three primary ways in which capital is transferred
between savers and borrowers? Describe each one.
Answer: [Show S2-1 through S2-3 here.] Transfers of capital can be made (1)
by direct transfer of money and securities, (2) through an investment
Chapter 2: Financial Markets and Institutions
Integrated Case
13
B. What is a market? Differentiate between the following types of
markets: physical asset markets versus financial asset markets, spot
markets versus futures markets, money markets versus capital
markets, primary markets versus secondary markets, and public
markets versus private markets.
Answer: [Show S2-4 and S2-5 here.] A market is a venue where assets are
bought and sold. There are many different types of financial markets,
each one dealing with a different type of financial asset, serving a
14
Integrated Case
Chapter 2: Financial Markets and Institutions
C. Why are financial markets essential for a healthy economy and
economic growth?
Answer: [Show S2-6 here.] In a global context, economic development is
highly correlated with the level and efficiency of financial markets and
D. What are derivatives? How can derivatives be used to reduce risk?
Can derivatives be used to increase risk? Explain.
Chapter 2: Financial Markets and Institutions
Integrated Case
15
Answer: [Show S2-7 here.] Derivatives are any financial asset whose value is
E. Briefly describe each of the following financial institutions:
investment banks, commercial banks, financial services corporations,
pension funds, mutual funds, exchange traded funds, hedge funds,
and private equity companies.
Answer: [Show S2-8 here.] Investment banks are organizations that
underwrite and distribute new investment securities and help
16
Integrated Case
Chapter 2: Financial Markets and Institutions
Chapter 2: Financial Markets and Institutions
Integrated Case
17
F. What are the two leading stock markets? Describe the two basic
types of stock markets.
Answer: [Show S2-9 here.] The two leading stock markets today are the New
York Stock Exchange and the Nasdaq stock market. There are just
two basic types of stock markets: (1) physical location exchanges,
make a market in these securities; (2) the thousands of brokers who
18
Integrated Case
Chapter 2: Financial Markets and Institutions
G. If Apple Computer decided to issue additional common stock and
Varga purchased 100 shares of this stock from Smyth Barry, the
underwriter, would this transaction be a primary or a secondary
market transaction? Would it make a difference if Varga purchased
previously outstanding Apple stock in the dealer market? Explain.
Answer: [Show S2-10 here.] If Varga purchased newly issued Apple stock, this
H. What is an initial public offering (IPO)?
Answer: [Show S2-11 here.] An initial public offering (IPO) occurs when a
Chapter 2: Financial Markets and Institutions
Integrated Case
19
I. What does it mean for a market to be efficient? Explain why some
stock prices may be more efficient than others.
Answer: [Show S2-14 here.] If markets are efficient, investors can buy and
sell stocks and be confident that they are getting good prices. If
J. After your consultation with Michelle, she wants to discuss these two
possible stock purchases:
(1) While in the waiting room of your office, she overheard an analyst on
a financial TV network say that a particular medical research company
just received FDA approval for one of its products. On the basis of this
“hot” information, Michelle wants to buy many shares of that
company’s stock. Assuming the stock market is highly efficient, what
advice would you give her?
Answer: [Show S2-15 here.] If the market is highly efficient, this stock’s
20
Integrated Case
Chapter 2: Financial Markets and Institutions
J. (2) She has read a number of newspaper articles about a huge IPO being
carried out by a leading technology company. She wants to purchase
as many shares in the IPO as possible and would even be willing to
buy the shares in the open market immediately after the issue. What
advice do you have for her?
Answer: [Show S2-16 here.] Not all IPOs are well received. And, even if you
are able to identify a “hot” issue, it is often difficult to purchase shares
K. How does behavioral finance explain the real world inconsistencies of
the efficient markets hypothesis (EMH)?
Answer: [Show S2-17 here.] Behavioral finance borrows insights from
psychology to better understand how irrational behavior can be
Chapter 2: Financial Markets and Institutions
Integrated Case
21