FIN 305 Fall 2024 FTU 12/11/2024

Learning Objectives

Financial Markets and

Institutions
The Capital Allocation Process
Chapter 2
Financial Markets
Financial Institutions
Stock Markets and Returns
Stock Market Efficiency

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How is Capital Transferred Between Savers and

The Capital Allocation Process Borrowers?

 In a well-functioning economy, capital flows

efficiently from those who supply capital to
those who demand it. Direct transfers

 Suppliers of capital: individuals and institutions

with “excess funds.” These groups are saving Indirect transfers
money and looking for a rate of return on their through investment banks
investment.
 Demanders or users of capital: individuals and
institutions who need to raise funds to finance Financial intermediaries
their investment opportunities. These groups
are willing to pay a rate of return on the capital
they borrow.

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Figure 2.1 from eText What is a market?

 A market is a venue where goods and services

are exchanged.
 A financial market is a place where individuals
and organizations wanting to borrow funds are
brought together with those having a surplus of
funds.

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FIN 305 Fall 2024 FTU 12/11/2024

Types of Financial Markets In the Text, see Table 2.1 on pages 35-36

Physical assets
Spot vs. Money vs.
vs. Financial
Futures Capital
assets

Primary vs. Public vs.

Secondary Private

Note: Table 2.1 in the text provides a summary of

major market instruments, market participants, and
security characteristics.
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The Importance of Financial Markets Derivatives

 Well-functioning financial markets facilitate the  What are derivatives? How can they be used to
flow of capital from investors to the users of reduce or increase risk?
capital. • A derivative security’s value is “derived” from the price
• Markets provide savers with returns on their money of another security (e.g., options and futures).
saved/invested, which provide them money in the
future. • Can be used to “hedge” or reduce risk. For example,
• Markets provide users of capital with the necessary an importer, whose profit falls when the dollar loses
funds to finance their investment projects. value, could purchase currency futures that do well
when the dollar weakens.
 Well-functioning markets promote economic
growth. • Also, speculators can use derivatives to bet on the
direction of future stock prices, interest rates,
 Economies with well-developed markets exchange rates, and commodity prices. In many
perform better than economies with poorly- cases, these transactions produce high returns if you
functioning markets. guess right, but large losses if you guess wrong.
Here, derivatives can increase risk.
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Types of Financial Institutions Types of Financial Institutions (cont.)

 1. Investment banks  6. Life insurance companies

 2. Commercial banks  7. Mutual funds

 3. Financial services corporations  8. Exchange traded funds (ETFs)

 4. Credit unions  9. Hedge funds

 5. Pension funds  10. Private equity companies

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FIN 305 Fall 2024 FTU 12/11/2024

Stock Market Transactions What is an IPO?

 Apple decides to issue additional stock with the  An initial public offering (IPO) occurs when a
assistance of its investment banker. An investor company issues stock in the public market for
purchases some of the newly issued shares. Is the first time.
this a primary market transaction or a
secondary market transaction?
 “Going public” enables a company’s owners to
raise capital from a wide variety of outside
• Since new shares of stock are being issued, this investors. Once issued, the stock trades in the
is a primary market transaction. secondary market.
 What if instead an investor buys existing  Public companies are subject to additional
shares of Apple stock in the open market. Is regulations and reporting requirements.
this a primary or secondary market transaction?
• Since no new shares are created, this is a
secondary market transaction.

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S&P 500 Index, Total Returns: Dividend Yield +

Capital Gain or Loss, 1968-2019
What is meant by stock market efficiency?

 Securities are normally in equilibrium and are

“fairly priced.”
 Investors cannot “beat the market” except
through good luck or better information.
 Efficiency continuum
Highly Highly
Inefficient Efficient

Small companies not followed Large companies followed by

by many analysts. Not much many analysts. Good
Sources: Data taken from various issues of The Wall Street Journal “Investment contact with investors. communications with
investors.
Scoreboard” section and “S&P 500 Annual Total Return Historical Data”
(ycharts.com/indicators/sandp_500_total_return_annual), March 27, 2020.
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Forms of market efficiency Forms of EMH described in footnote on p.56

footnote 21
 Weak form
• pertains to past stock price trends

 Semi-strong form
• pertains to all publicly available information such
as financial statements and news reports

 Strong form
• pertains to inside information

(note these terms are defined in the text in a footnote)

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FIN 305 Fall 2024 FTU 12/11/2024

Implications of Market Efficiency Implications of Market Efficiency

You hear in the news that a medical research company A small investor has
Probably not. The long-
received FDA approval for one of its products. If the been reading about a
run track record of hot
market is highly efficient, can you expect to take “hot” IPO that is
IPOs is not that great,
advantage of this information by purchasing the stock? scheduled to go public
unless you are able to
later this week. She
get in on the ground
wants to buy as many
floor and receive an
shares as she can get
No. If the market is efficient, this information will allocation of shares
her hands on, and is
already have been incorporated into the company’s before the stock begins
planning on buying a
trading. It is usually
stock price. So, it’s probably too late for you to lot of shares the first
hard for small investors
“capitalize” on the information. day once the stock
to receive shares of hot
begins trading. Would
IPOs before the stock
you advise her to do
begins trading.
this?

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Behavioral Finance:
Possible Implications for Market Efficiency
End of Chapter 2
 It is costly and/or risky for traders to take
advantage of mispriced assets.
 Cognitive biases cause investors to make systematic
mistakes that lead to inefficiencies. This is an area
of research know as “behavioral finance.”
Behavioral finance borrows insights from
psychology to better understand how irrational
behavior can be sustained over time. Some
examples include:
• Evaluating risks differently in up and down markets.
• Investors become "anchored" to certain viewpoints,
and fail to optimally respond to new information that
conflicts with their existing views.

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21 in whole or in part, except for use as permitted in a license distributed with a certain product or service or
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© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5

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