CH 2

Chapter 2
The Financial
Market
Environment
Copyright © 2012 Pearson Education

Learning Goals
LG1 Understand the role that financial institutions

play in managerial finance.
LG2 Contrast the functions of financial institutions

and financial markets.
LG3 Describe the differences between the capital

markets and the money markets.
© 2012 Pearson Education 2-2

Financial Institutions & Markets
Firms that require funds from external sources can obtain

them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements

Financial Institutions &
Markets: Financial Institutions
• Financial institutions are intermediaries that channel the
savings of individuals, businesses, and governments into
loans or investments.
• The key suppliers and demanders of funds are individuals,
businesses, and governments.
• In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.

Commercial Banks, Investment Banks,
and the Shadow Banking System
• Commercial banks are institutions that provide savers

with a secure place to invest their funds and that offer
loans to individual and business borrowers.
• Investment banks are institutions that assist companies
in raising capital, advise firms on major transactions such
as mergers or financial restructurings, and engage in
trading and market making activities.

Commercial Banks, Investment Banks,
and the Shadow Banking System (cont.)
• The shadow banking system describes a group of

institutions that engage in lending activities, much like
traditional banks, but these institutions do not accept
deposits and are therefore not subject to the same
regulations as traditional banks.

Financial Institutions &
Markets: Financial Markets
• Financial markets are forums in which suppliers of
funds and demanders of funds can transact business
directly.
• Transactions in short term marketable securities take
place in the money market while transactions in long-term
securities take place in the capital market.
• A private placement involves the sale of a new security
directly to an investor or group of investors.
• Most firms, however, raise money through a public
offering of securities, which is the sale of either bonds or
stocks to the general public.
Financial Institutions & Markets:
Financial Markets (cont.)
• The primary market is the financial market in which
securities are initially issued; the only market in which the
issuer is directly involved in the transaction.
• Secondary markets are financial markets in which
preowned securities (those that are not new issues) are
traded.

Figure 2.1
Flow of Funds

The Money Market
• The money market is created by a financial relationship

between suppliers and demanders of short-term funds.
• Most money market transactions are made in marketable
securities which are short-term debt instruments, such as
U.S. Treasury bills, commercial paper, and negotiable
certificates of deposit issued by government, business,
and financial institutions, respectively.
• Investors generally consider marketable securities to be
among the least risky investments available.

The Money Market (cont.)
• The international equivalent of the domestic (U.S.) money

market is the Eurocurrency market.
• The Eurocurrency market is a market for short-term bank
deposits denominated in U.S. dollars or other marketable
currencies.
• The Eurocurrency market has grown rapidly mainly
because it is unregulated and because it meets the needs
of international borrowers and lenders.

The Capital Market
• The capital market is a market that enables suppliers and

demanders of long-term funds to make transactions.
• The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity, or
ownership).
– Bonds are long-term debt instruments used by businesses and
government to raise large sums of money, generally from a
diverse group of lenders.
– Common stock are units of ownership interest or equity in a
corporation.
– Preferred stock is a special form of ownership that has features
of both a bond and common stock.
Broker Markets and
Dealer Markets
Broker markets are securities exchanges on which the two
sides of a transaction, the buyer and seller, are brought
together to trade securities.
– Trading takes place on centralized trading floors.
– Examples include: NYSE Euronext, American Stock Exchange

Broker Markets and
Dealer Markets (cont.)
Dealer markets are markets in which the buyer and seller
are not brought together directly but instead have their
orders executed by securities dealers that “make markets” in
the given security.
– The dealer market has no centralized trading floors. Instead, it is
made up of a large number of market makers who are linked
together via a mass-telecommunications network.
– The Nasdaq market is one example
As compensation for executing orders, market makers make
money on the spread (bid price – ask price).

International Capital Markets
• In the Eurobond market, corporations and governments

typically issue bonds denominated in dollars and sell
them to investors located outside the United States.
• The foreign bond market is a market for bonds issued by
a foreign corporation or government that is denominated
in the investor’s home currency and sold in the investor’s
home market.
• The international equity market allows corporations to
sell blocks of shares to investors in a number of different
countries simultaneously.

The Role of Capital Markets
• From a firm’s perspective, the role of capital markets is to be a

liquid market where firms can interact with investors in order to
obtain valuable external financing resources.
• From investors’ perspectives, the role of capital markets is to be an
efficient market that allocates funds to their most productive uses.
• An efficient market allocates funds to their most productive uses
as a result of competition among wealth-maximizing investors and
determines and publicizes prices that are believed to be close to
their true value.

The Role of Capital Markets
(cont.)
• 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 true values for extended periods.
• These people point to episodes such as the huge run up
and subsequent collapse of the prices of Internet stocks in
the late 1990s, or the failure of markets to accurately
assess the risk of mortgage-backed securities in the more
recent financial crisis, as examples of the principle that
stock prices sometimes can be wildly inaccurate measures
of value.

Review of Learning Goals
LG1 Understand the role that financial institutions play in

managerial finance.
– Financial institutions bring net suppliers of funds and net demanders
together to help translate the savings of individuals, businesses, and
governments into loans and other types of investments.
LG2 Contrast the functions of financial institutions and financial
markets.
– Financial institutions collect the savings of individuals and channel
those funds to borrowers such as businesses and governments.
Financial markets provide a forum in which savers and borrowers can
transact business directly.

Review of Learning Goals
(cont.)
LG3 Describe the differences between the capital markets and the
money markets.
– In the money market, savers who want a temporary place to deposit
funds where they can earn interest interact with borrowers who have a
short-term need for funds. In contrast, the capital market is the forum
in which savers and borrowers interact on a long-term basis.

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Chapter 2

Copyright © 2012 Pearson Education

LG1 Understand the role that financial institutions

LG2 Contrast the functions of financial institutions

LG3 Describe the differences between the capital

© 2012 Pearson Education 2-2

Firms that require funds from external sources can obtain

© 2012 Pearson Education 2-3

© 2012 Pearson Education 2-4

• Commercial banks are institutions that provide savers

© 2012 Pearson Education 2-5

• The shadow banking system describes a group of

© 2012 Pearson Education 2-6

© 2012 Pearson Education 2-8

© 2012 Pearson Education 2-9

• The money market is created by a financial relationship

© 2012 Pearson Education 2-10

• The international equivalent of the domestic (U.S.) money

© 2012 Pearson Education 2-11

• The capital market is a market that enables suppliers and

© 2012 Pearson Education 2-13

© 2012 Pearson Education 2-14

• In the Eurobond market, corporations and governments

© 2012 Pearson Education 2-15

• From a firm’s perspective, the role of capital markets is to be a

© 2012 Pearson Education 2-16

© 2012 Pearson Education 2-17

LG1 Understand the role that financial institutions play in

© 2012 Pearson Education 2-18

© 2012 Pearson Education 2-19

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