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Principles of Finance

1.5 Markets and Participants

Principles of Finance1.5 Markets and Participants

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Identify primary and secondary markets.
  • Identify key market players.

Primary and Secondary Markets

Simply put, the primary market is the market for “new” securities, and the secondary market is the market for “used” securities. Think of the primary market as equivalent to the sale of new cars and the secondary market as equivalent to the sale of used cars. In practice, many market locales trade both new and used securities. For example, the stock markets trade equity securities daily, and most of the trading takes place among individual and institutional investors who own shares in publicly traded companies. Trading a share of Amazon, Facebook, or Nike stock has little impact and no direct cash flow to the underlying firm. However, the information provided by such transactions is valuable, as it is a costly and public real-time statement by investors of their perceptions of firm’s value and a reflection of satisfaction and expectations.

Some, though many fewer, transactions in the equity market are for the purchase and sale of new securities. Firms issue new shares of stock called seasoned equity offerings (SEOs) or initial public offerings (IPOs) into the market. These are issues of new shares of stock, previously untraded, and their issuance sends cash flows directly to the underlying firms. SEOs are new shares issued by established firms, and IPOs are new shares issued by firms going public for the very first time. Once the initial transaction takes place, purchasers of these new securities may trade them. However, the second and subsequent trades are secondary, not primary, market transactions.

Extensive primary market transactions take place weekly, when the Treasury Department auctions billions of dollars of new Treasury securities. These new securities repay maturing Treasury securities and provide for the ongoing liquidity and long-term borrowing needs of the federal government. Again, subsequent trading of this government debt occurs as secondary market transactions.

Key Market Players

Key market players in finance include dealers, brokers, financial intermediaries, and you and me. Each of these players facilitates the exchange of products, information, and capital in different ways. The presence of these players makes financial transactions, easier, faster, and safer—essentially more efficient. You and your friends might engage in direct financial transactions, such as buying a coffee or borrowing money for a movie. These are typically small transactions. However, for transactions that are larger or more complicated, you need advanced financial entities with capital, expertise, and networks. The two segments of the secondary markets are broker markets and dealer markets, as Figure 1.7 shows. The primary difference between broker and dealer markets is the way each executes securities trades.

Flowchart of a secondary market, which is classified into broker markets and dealer markets. The broker markets are further classified into national and regional exchanges. Examples of the national exchanges are the New York Stock Exchange and the American Stock Exchange. Examples of the regional exchanges are Boston, Chicago, National, and Philadelphia. The Dealer markets are classified into NASDAQ and OTC. Examples of the NASDAQ are the NASDAQ Global Selec Market, NADAQ National Market, and the NASDAQ Capital Market. Examples of the dealer markets are the OTC Bulletin Board or the O T C B B and the Pink Sheets.
Figure 1.7 Broker and Dealer Markets

Dealers

Financial dealers own the securities that they buy or sell. When a dealer engages in a financial transaction, they are trading from their own portfolio. Dealers do not participate in the market in the same manner as an individual or institutional investor, who is simply trying to make their investments worth as much as possible. Instead, dealers attempt to “make markets,” meaning they are willing and able to buy and sell at the current bid and ask prices for a security. Rather than relying on the performance of the underlying securities to generate wealth, dealers make money from the volume of trading and the spread between their bid price (what they are willing to pay for a security) and their ask price (the price at which they are willing to sell a security). By standing ready to always buy or sell, dealers increase the liquidity and efficiency of the market. Dealers in the United States fall under the regulatory jurisdiction of the Securities and Exchange Commission (SEC). Such regulatory oversight ensures that dealers execute orders promptly, charge reasonable prices, and disclose any potential conflicts of interest with investors.

Brokers

Brokers act as facilitators in a market, and they bring together buyers and sellers for a transaction. Brokers differ from dealers who buy and sell from their own portfolio of holdings. These firms and individuals traditionally receive a commission on sales.

In the world of stockbrokers, you may work with a discount broker or a full-service broker, and the fees and expenses are significantly different. A discount broker executes trades for clients. Brokers are required for clients because security exchanges require membership in the exchange to accept orders. Discount brokers or platforms such as Robinhood or E-Trade charge no or very low commissions on many of their trade executions, but they may receive fees from the exchanges. They also do not offer investment advice.

Full-service brokers offer more services and charge higher fees and commissions than discount brokers. Full-service brokers may offer investment advice, retirement planning, and portfolio management, as well as execute transactions. Morgan Stanley and Bank of America Merrill Lynch are examples of full-service brokers that serve both institutional and individual investors.

Financial Intermediaries

A financial intermediary, such as a commercial bank or a mutual fund investment company, serves as an intermediary to enable easier and more efficient exchanges among transacting parties. For instance, a commercial bank accepts deposits from savers and investors and creates loans for borrowers. An investment company pools funds from investors to inexpensively purchase and manage portfolios of stocks and bonds. These transactions differ from those of a dealer or broker. Brokers facilitate trades, and dealers stand ready to buy or sell from their own portfolios. Financial intermediaries, however, accept money from investors and may create a completely different security all together. For example, if the borrower defaults on a mortgage loan created by the commercial bank where you have your certificate of deposit, your investment is still safely earning interest, and you are not directly affected.

Financial institutions usually facilitate financial intermediation. However, occasionally lenders and borrowers are able to initiate transactions without the help of a financial intermediary. When this occurs on a large scale, the process, known as disintermediation, can cause much turmoil in the financial markets. In the 1970s, inflation rose above 10% on an annual basis, and yet commercial banks were limited to offering maximum rates of 5% on their savings deposits.7 Savers bypassed banks and savings and loan associations to invest directly into Treasury securities and other short-term marketable securities. This lack of deposit funds and the subsequent behavior of the industry essentially eliminated the savings and loan industry and led to significant deregulation of commercial and investment banking in the United States.

The advantages of a robust network of financial intermediaries are many. They add efficiency to the financial system through lower transaction costs. They gather and disperse information to minimize financial abuse and fraud. They provide economies of scale and specialized knowledge. Finally, financial intermediaries are critical for the functioning of a capitalist economy.

Footnotes

  • 7United States President and Council of Economic Advisers. “The 1970s: Inflation, High Interest Rates, and New Competition.” Economic Report of the President. 1991. https://fraser.stlouisfed.org/files/docs/publications/ERP/pages/6688_1990-1994.pdf
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