that do not accept deposits and therefore are not subject to

the same regulations as traditional banks.

Chapter 2: THE → Investment banks can act as an intermediary between

these two parties and help facilitate a loan and thereby
become part of the shadow banking system.

financial market
environment 2.2 Financial Markets
Financial markets are forums in which suppliers and
demanders of funds can transact business directly.
2.1 Financial Institutions
Two key financial markets:
Financial institutions serve as intermediaries by (1) money market – Short-term debt instruments,
channeling the savings of individuals, businesses, and or marketable securities
governments into loans or investments. (2) capital market – Long-term securities—bonds
and stocks
→ examples are: commercial banks, investment banks, investment
funds, insurance companies, and pension funds. To raise money,
(1) private placement – involves the sale of a new
→ the key suppliers of funds and the key demanders of funds are security directly to an investor or group of investors, such as
individuals, businesses, and governments (large portion of the an insurance company or a pension fund
funds come from individual consumers) (2) public offering – the sale of either bonds or
(1) individuals as a group are net suppliers for financial stocks to the general public.
institutions: They save more money than they borrow.

(2) firms are net demanders of funds: They borrow more Markets based on issuance:
money than they save. (1) primary market – Financial market in which
(3) government, like business firms, is typically a net securities are initially issued; the only market in which the
demander of funds: It typically borrows more than it saves issuer is directly involved in the transaction.
(2) secondary market – Financial market in which
preowned securities (those that are not new issues) are
traded.
Commercial Banks, Investment Banks, and the
Shadow Banking System
The Relationship Between Institutions and Markets
Commercial banks
Commercial banks – Institutions that provide savers with a
secure place to invest their funds and that offer loans to
individual and business borrowers.

→ traditional business model of a commercial bank—taking

in and paying interest on savings deposits and investing or
lending those funds back out at higher interest rates

→ Glass-Steagall Act – An act of Congress in 1933 that

created the Federal Deposit Insurance Corporation (FDIC)
and separated the activities of commercial and investment
banks. (an institution engaged in taking in deposits could not
also engage in the somewhat riskier activities of securities
The Money Market
underwriting and trading)
money market – a market where investors trade highly
Investment banks liquid securities with maturities of 1 year or less
Investment banks are financial institutions that
(1) assist companies in raising capital, marketable securities – short-term debt instruments, such
(2) advise firms on major transactions such as as U.S. Treasury bills, commercial paper, and negotiable
mergers or financial restructurings, and certificates of deposit issued by government, business, and
(3) engage in trading and market-making activities financial institutions, respectively. Least risky investments
available.
• Commercial and investment banks remained essentially
separate for more than 50 years, but Congress, with the Eurocurrency market – international equivalent of the
approval of President Clinton, repealed Glass-Steagall in domestic money market.
1999. → arise when a corporation or individual makes a bank
deposit in a currency other than the local currency of the country
Shadow Banking System where the bank is located
shadow banking system – A group of institutions that → nearly all Eurodollar deposits are time deposits, which
engage in lending activities, much like traditional banks, but means the bank would promise to repay the deposit, with interest,
at a fixed date in the future

FIN 12 Notes from book│ 1

 The Capital Market (2) dealer market, the market in which the buyer and seller
are not brought together directly but instead have their
capital market – enables suppliers and demanders of long-
orders executed by securities dealers who “make markets” in
term funds to make transactions
the given security.
• Key Securities Traded: Bonds and Stocks • → will have good liquidity if dealers are willing to buy and sell
quickly in response to the orders they receive.
• The term debt refers to a loan that a borrower must repay. → market maker acts as a dealer and by doing so collects
Equity, in contrast, refers to a security issued by a business one-half of the bid/ask spread for each side of the trade
that provides the security holder with an ownership stake in → total transaction cost for each of the traders is one-half the
the firm. bid/ask spread plus the brokerage commission
→ routes your order
Bonds are long-term debt instruments used by business and
government to raise large sums of money, generally from a Note: In broker markets the orders from investors provide
diverse group of lenders liquidity, and in dealer markets the dealers provide liquidity

Common stock are shares that are units of ownership, or

equity, in a corporation
Broker Markets
Preferred stock – a hybrid or special form of ownership securities exchanges – Organizations that provide the
having a fixed periodic dividend that must be paid prior to marketplace in which firms can raise funds through the sale
payment of any dividends to common stockholders. (if a firm of new securities and purchasers can resell securities.
cannot pay dividends, preferred stockholders cannot force it
into bankruptcy as bondholders can) → broker/dealer as it must act as a broker first, when public
orders are available to provide the necessary liquidity, and as a
dealer second, when there are no public orders to provide the
requisite liquidity.
• Broker Markets and Dealer Markets •

Liquidity – The ability to quickly buy or sell a security without

having an impact on the security’s price. If a security trades Dealer Markets
in an illiquid market, selling or buying that security quickly → dealer/broker because it can act as dealer first, whenever it
may prove difficult and may require a price concession by suits her to provide liquidity, and as broker second, whenever it
the investor to facilitate the trade. doesn’t suit her to provide liquidity

• … brokerage service, for which the brokerage charges the → A key feature of the dealer market is that it has no centralized
investor a fee called a commission trading floors. Instead, it is composed of a large number of
market makers linked together via a mass-
market order – An order to either buy or sell a security at telecommunications network.
the prevailing market prices.
→ bid price – The highest price a buyer in the market is Nasdaq market – An all-electronic trading platform used to
willing to pay for a security. execute securities trades.
→ ask price – The lowest price a seller in the market is
over-the-counter (OTC) market – A market where
willing to accept for a security. smaller, unlisted securities are traded
The difference between the bid and ask prices is the bid/ask
• Founded in 1971, the National Association of Securities
spread. Dealers Automated Quotation System, or simply Nasdaq,
had its origins in the OTC market but today is a totally
separate entity that’s no longer part of the OTC market.
Formally recognized as a listed exchange in 2006.
market maker – a securities dealer who makes a market in
one or more securities by offering to buy or sell them at • An increasing amount of trading takes place today “off
stated bid/ask prices. exchange,” often in private trading venues known as “dark
pools.”
The essential difference between broker and dealer markets
is a technical point that deals with the way trades are
executed
• International Capital Markets •
(1) broker market, the market maker brings the buyer’s
order and the seller’s order together to execute the trade at Eurobond market – The market in which corporations and
the midpoint of the bid/ask spread. governments typically issue bonds denominated in dollars
→ will have a high degree of liquidity if many investors want to and sell them to investors located outside the United States.
buy and many want to sell
→ market maker acts as a broker and by doing so forgoes foreign bond market – an international market for long-
collecting the bid/ask spread term debt securities.
→ the only transaction cost for each trader is their brokerage
foreign bond – a bond issued by a foreign corporation or
commission
government that is denominated in the investor’s home
→ matches your order
currency and sold in the investor’s home market. Smaller
than Eurobond market

FIN 12 Notes from book│ 2

international equity market – market that allows corporations Securities and Exchange Commission (SEC) – The
to sell blocks of shares to investors in a number of different primary government agency responsible for enforcing federal
countries simultaneously securities laws.
→ created by the Securities Exchange Act of 1934

The Role of Capital Markets

• firm’s perspective, a capital market should be a liquid 2.4 The Securities Issuing Process
market where firms can interact with investors to obtain
valuable external financing resources Issuing Common Stock
• investors’ perspectives, a capital market should be an
• Private Equity •
efficient market – establishes correct prices for the
securities that firms sell and allocates funds to their most private equity – External equity financing that is raised via a
productive uses private placement, typically by private early-stage firms with
attractive growth prospects.

• The Efficient Market Hypothesis •

angel financing – Private equity financing provided to a
young firm by a wealthy individual investing his or her own
efficient market hypothesis (EMH) money.
→ basic theory describing the behavior of such a market,
venture capital – Equity financing provided by a firm that
specifically states the following:
specializes in financing young, rapidly growing firms. Venture
1. Securities are typically in equilibrium, which
capital firms raise pools of money from outside investors
means they are fairly priced and their expected returns equal
which they then use to purchase equity stakes in small
their required returns.
private companies.
2. At any point in time, security prices fully reflect all
information available about the firm and its securities, and angel investors (angels) – Wealthy individual investors
these prices react swiftly to new information. who make their own investment decisions and are willing to
3. Because stocks are fully and fairly priced, invest in promising startups in exchange for a portion of the
investors need not waste their time trying to find mispriced firm’s equity.
(undervalued or overvalued) securities.
venture capitalists (VCs) – Formal business entities that
take in private equity capital from many individual investors,
• unbiased means that stock prices are neither often institutional investors such as endowments and
systematically overpriced nor underpriced pension funds or individuals of high net worth, and make
private equity investment decisions on their behalf.
• Advocates of behavioral finance, an emerging field that
blends ideas from finance and psychology, argue that stock
prices and prices of other securities can deviate from their Organization and Investment Stages
true values for extended periods and that these deviations
may lead to predictable patterns in stock prices

2.3 Regulation of Financial Markets and Institutions

Regulations Governing Financial Institutions

Federal Deposit Insurance Corporation (FDIC) – An agency
created by the Glass-Steagall Act that provides insurance for
deposits at banks and monitors banks to ensure their safety
and soundness.

Gramm-Leach-Bliley Act – An act that allows business

combinations (i.e., mergers) between commercial banks,
investment banks, and insurance companies and thus Deal Structure and Pricing
permits these institutions to compete in markets that prior
→ deal structure allocates responsibilities and ownership
regulations prohibited them from entering.
interests between the existing owners (typically the founders)
and the venture capitalist, and its terms depend on
numerous factors related to the founders; the business
structure, stage of development, and outlook; and other
Regulations Governing Financial Markets
market and timing issues
Securities Act of 1933 – An act that regulates the sale of
securities to the public via the primary market. → deal pricing is a function of the value of the business, the
amount of funding provided, and the perceived risk of
Securities Exchange Act of 1934 – An act that regulates business operations
the trading of securities such as stocks and bonds in the
secondary market; also imposes limits on the extent to which
corporate “insiders,” such as senior managers, can trade in
their firm’s securities

FIN 12 Notes from book│ 3

 • Going Public • market price –The price of the firm’s shares as determined
by the interaction of buyers and sellers in the secondary
(1) a private placement, in which the firm sells new market.
securities directly to an investor or group of investors;
market capitalization – The total market value of a publicly
(2) a rights offering, in which the firm sells new
traded firm’s outstanding stock. Calculated as the market
shares to existing stockholders; or
price times the number of shares of stock outstanding
(3) a public offering, in which it offers its shares for
sale to the general public

initial public offering (IPO) – The first public sale of a firm’s

stock. IPO market price –The final trading price on the first day in
the secondary market.
Prospectus – A portion of a security registration statement
that describes the key aspects of the issue, the issuer, and IPO underpricing –The percentage change from the final IPO
its management and financial position offer price to the IPO market price, which is the final trading
price on the first day in the secondary market; this is also
red herring – A preliminary prospectus made available to
called the IPO initial return.
prospective investors during the waiting period between the
registration statement’s filing with the SEC and its approval.

quiet period – to make sure that all potential investors have

access to the same information about the company— the
information presented in the preliminary prospectus—and
that no one is privy to any unpublished data that might confer 2.5 Financial Markets in Crisis
an unfair advantage
Financial Institutions and Real Estate Finance
roadshow – a series of presentations to potential investors Securitization – The process of pooling mortgages or other
around the country and sometimes overseas types of loans and then selling claims or securities against
that pool in the secondary market.

mortgage-backed securities – Securities that represent

• The Investment Bank’s Role •
claims on the cash flows generated by a pool of mortgages.
investment bank – Financial intermediary that specializes
in selling new security issues and advising firms with regard
to major financial transactions. • Falling Home Prices and Delinquent Mortgages •

Underwriting – The role of the investment bank in bearing subprime mortgages – Mortgage loans made to borrowers
the risk of reselling, at a profit, the securities purchased from with lower incomes and poorer credit histories as compared
an issuing corporation at an agreed-on price. to “prime” borrowers. Loans granted often have adjustable,
rather than fixed, interest rates, which makes subprime
IPO offer price – The price at which the issuing firm sells its borrowers particularly vulnerable if interest rates rise
securities.

originating investment bank – The investment bank

initially hired by the issuing firm, it brings other investment
banks in as partners to form an underwriting syndicate.

underwriting syndicate – A group of other banks formed by

the originating investment bank to share the financial risk
associated with underwriting new securities.

Tombstone – The list of underwriting syndicate banks,

presented in such a way to indicate a syndicate member’s
level of involvement, located at the bottom of the IPO
prospectus cover page.

selling group – A large number of brokerage firms that join

the originating investment bank(s); each accepts
responsibility for selling a certain portion of a new security
issue on a commission basis. Members of the selling group
earn a fee known as the selling concession

total proceeds – The total amount of proceeds for all

shares sold in the IPO. Calculated as the IPO offer price
times the number of IPO shares issued.

FIN 12 Notes from book│ 4