5. 2-
5
The Flow of Capital:
Public Corporations
Financial Market:
Market where securities are issued and traded.
Primary Market:
Market for the sale of new securities by corporations.
Secondary Market:
Market in which previously issued securities are traded among investors.
6. 2-
6
Financial Markets
Initial Public Offering (IPO):
First offering of stock to the general public.
Fixed-Income Market:
Market for debt securities
7. 2-
7
Financial Markets:
Markets for Debt
Capital Markets are used for long-term financing
Example of long-term debt: Bonds
Money Markets are used for short-term financing.
Example of short-term debt: Commercial Paper
8. 2-
8
Information Provided by
Financial Markets:
• Commodity Prices
• Interest Rates
• Company Value
• Cost of Capital
9. 2-
9
Financial Intermediaries
• Mutual Fund
•An investment company that pools the savings of many
investors and invests in a portfolio of securities
• Hedge Fund
•A private investment pool, open to wealthy or institutional
investors, that is only lightly regulated and therefore can pursue
more speculative policies than mutual funds
• Pension Fund
•Fund set up by an employer to provide for employees’
retirement
10. 2-
10
Flow of Cash Example:
Mutual Fund
$ $
Bank of
America Explorer Investors
Fund
Sells
shares
Issues
shares
11. 2-
11
A Closer Look:
Financial Institutions
Commercial Bank
Investment Bank
Insurance Company
12. 2-
12
Companies and Intermediaries
Company
Obligations Funds
Intermediaries
Banks
Insurance Companies
Brokerage Firms
14. 2-
14
Cash Flow Example:
Banks
Banks
Depositors
$2.5 mil
Cash
Loan
Deposits
Company
Intermediary
Investor
15. 2-
15
Cash Flow Example:
Insurance Company
Insurance
Company
Policyholders
$2.5 mil
Intermediary
Cash
Issue Debt
Company
Sell Policies
Investor
16. 2-
16
Function of Financial Markets
and Intermediaries
Transport cash across time
Risk transfer and diversification
Liquidity
17. 2-
17
Function of Financial Markets
and Intermediaries
Payment mechanism
Provide information
18. 2-
18
Financial Crisis 2007-2009:
Homebuyers
overextended
Causes
Federal Reserve
Easy-Money
Policy
The U.S.
Government
encouraged
expansion of credit
to low-income
housing
Bankers
aggressively
promoted
subprime
Credit Rating mortgages
Agencies gave many
AAA ratings to MBS
that shortly went into
default
A Perfect Storm:
•Falling Housing Prices
•Bankruptcy
•Credit Freeze
•International Effect
19. 2-
19
Financial Crisis 2007-2009:
The Response
Government Bailouts
Government Bailout
(or arranged acquisition)
No Government Bailout
Bear Stearns (JP Morgan Chase) Lehman Brothers
Fannie Mae
Freddie Mac
Merrill Lynch (Bank of America)
AIG
Did this response effectively decrease the uncertainty in the
market?
Government Response: TARP
What was the rationale behind TARP?
20. 2-
20
Appendix A:
Total U.S. Equity Financing
Holdings of Corporate Equities, 3rd Quarter 2010
21. 2-
21
Appendix B:
Total U.S. Debt Financing
Holdings of Corporate & Foreign Bonds, 3rd Quarter 2010
Editor's Notes
Chapter 2 Learning Objectives
Understand how financial markets and institutions channel savings to corporate investment.
Understand the basic structure of mutual funds, pension funds, banks, and insurance companies.
Explain the functions of financial markets and institutions.
Understand the main events behind the financial crisis of 2007–2009.
Chapter 2 Outline
The Financing Decision
The Flow of Savings to Corporations
Closely Held Corporations vs. Public Corporations
Financial Markets
Types
Information Provided by Financial Markets
Financial Intermediaries
Financial Institutions
Function of Financial Markets and Intermediaries
The Financial Crisis of 2007-2009
Note: Contrast the Financing Decision with the Investment Decision presented in Chapter 1.
Definitions
Financing Decision – The form and amount of financing of a firm’s investments.
Capital Structure – The mix of long-term debt and equity financing.
Financial Market – Market where securities are issued and traded.
Primary Market – Market for the sale of new securities by corporations.
Secondary Market – Markets in which previously issued securities are traded among investors.
Initial Public Offering – First offering of stock to the general public.
Fixed-Income Market – Market for debt securities.
Capital Market– Market for long-term financing
Money Market – Market for short-term financing (less than one year).
Note: What is meant by over the counter?
Cost of Capital – Minimum acceptable rate of return on capital investment
Note: How is the value of a company measured by the market?
Financial Intermediary – An organization that raises money from investors and provides financing for individuals, corporations, or other organizations
Mutual Fund – An investment company that pools the savings of many investors and invests in a portfolio of securities
Hedge Fund – A private investment pool, open to wealthy or institutional investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds
Pension Fund – Fund set up by an employer to provide for employees’ retirement
Mutual Fund – An investment company that pools the savings of many investors and invests in a portfolio of securities.
Financial Institution – A bank, insurance company or similar financial intermediary
Liquidity – The ability to sell an asset on short notice at close to the market price.
Note: What does the Federal Reserve’s Easy-Money Policy imply out interest rates and the time value of money?
Note: Bankers aggressively promoted subprime mortgages as well as bundled and resold these riskier securitized mortgages with others mortgages. The so-called mortgage backed securities were promoted as virtually risk-free.
Note: Is the securitization of mortgages necessarily a bad thing? Why? Why not?
TARP – Troubled Asset Relief Program, the Treasury’s program which spent $700 billion to purchase “toxic” mortgage-backed securities.
