FIN3244 EXAM 41. Securities market institutions: contribute to the efficiency of financial markets through investment banks, brokers and dealers, and organized exchangesThese institutions reduce costs of matching savers and borrowers and provide risk-sharing, liquidity, and information services.Securities market institutions are NOT financial intermediaries because they do not acquire funds from savers to invest in borrowers; they only make it easier for investors to locate suitable borrowers and to reduce borrowers’ costs in raising fundsA) Investment Banks—informationAssist businesses in raising new capital in primary markets, and advise them on the best way to do so1st way: Investment bankers earn income through underwriting a firm’s new stock or bond issueUnderwriters guarantee a price to the issuing firm, sell the issue at a higher price, and keep the profit (aka spread)In exchange for spread, underwriting investment bank assumes risk of not being able to resell securities2nd way: Investment bank can also sell the issue on an all-or-none basisIn this case, the company issuing the securities receives nothing unless the investment bank sells the complete issue at the offering price3rd way: best efforts: Allows the investment bank to make no guarantee, requiring it to sell to investors only as much of the issue as it canSmall issues may be underwritten by a single investment bankerLarge issues are sold by groups of underwriting investment banks called syndicatesSyndicated sale: lead investment bank acts as manager and keeps part of the spreadRemainder of spread is split among the syndicate members buying issue and to brokerage firms selling issue to publicUnderwriting lowers information costs between lenders and borrowers because investment banks put their reputations behind the firms they underwriteIn the 1980s, investment banks engaged in merchant banking—they placed their own funds at risk by investing in firms that were undergoing restructuringB) Secondary Markets—liquidity and risk sharingi.) Brokers and dealersfacilitate the exchange of securities in financial markets by locating buyers when sellers want cashdecrease in time and cost required in secondary markets improves liquidity in those marketsBrokers: earn commissions by matching ultimate buyers and sellers in a particular marketDealers: trade between ultimate buyers and sellers; they hold inventories of securities and sell them for a higher price than they paid for them, earning the spread between the bid and asked priceSEC regulates brokers and dealers to ensure disclosure of info, prevent fraud, and restrict trading based on insider informationii.) ExchangesSecurities may be traded in one of two ways: through exchanges or in over-the-counter marketsExchanges: physical location at which securities are tradedDon’t set prices but provide way for buyers and sellers to trade anonymously, lowering info costs for saversBest known are NYSE and AMEX in New YorkAround the world there are 142 exchangesSize of the issuing firms determines the exchange on which a stock is listedSecurities of oldest/largest on AMEXThose of smaller/younger business firms are generally traded in over-the-counter marketsIn NYSE, buyers and sellers are matched on floor by a broker-dealer known as specialist who represents one or more stocksiii.) Over-the-counter tradingOTC markets: trading takes place over the telephone/by computerTraders keep track of market by examining individual issues on their computersMember broker-dealers regulate themselves through the NASDiv.) Trading bondsMarket for US Treasury bonds and US government agency securities is most liquid market in the worldBonds usually traded on organized exchanges such as NYSEVast majority of secondary market trading of corporate bonds is done in over-the-counter marketsFor corporate bonds, the more highly rated bonds typically have the lower bid-asked spreads then lower-rated bonds doe-trading: latest source of competition for exchanges around the world—provide efficient service, low costs, and comfort from homeECNs (electronic communications networks): innovative stock-trading systems that rely on computer software to match buy and sell orders2. Financial Intermediary Asset SizeFinance companies: intermediaries that raise large amounts of money through the sale of commercial paper and securitiesThey use these funds to make small loans to households and businesses3 main types of finance companiesA) Consumer financemake loans to enable consumers:To buy cars, furniture, and appliancesto finance home improvementsto refinance household debtsconsumer finance customers have higher default risk than good-quality bank customers do so they are charged higher interest ratesB) Business financeEngage in factoring—the purchase of accounts receivable of small firms at a discountPurchase expensive equipment (airplanes) and lease it to businesses over a fixed length of timeDoing this, they specialize in gathering info about the value of collateralFactoring loans generally short term but leasing contracts can be 5+ yearsC) Sales financeAffiliated with companies that manufacture or sell big ticket goodsPurpose is to promote the business of the underlying manufacturer or retailerFor example: General Motors Acceptance Corporation offers financing to customers when they buy new GM carsFor example: Department stores issue credit cards with which customers finance purchases at those stores (Sears, Macy’s)Contractual saving institutions: allow individuals topay money to transfer the risk of financial hardship to someone elseTo save in a disciplined manner for retirement2 different types:A) Life Insurance Companies (not taxed on net income): two typesi) Mutual companies: owned by policy holdersThe largest US life insurance firms are generally mutual companies, which account for over half the industry’s assetsOnly account for 10% of all life insurance companiesii) Stock companies: owned by shareholdersMore than 90% of insurance companies are organized as stock companiesB) Property and Casualty Insurance Companies (taxed on net income)Because events such as natural disasters are harder to predict statistically than death rates, the portfolio of these insurers largely contain liquid assets, such as short-term and long-term credit market instrumentsControl assets of $2 trillion in 2006, insure policyholders against events other than deathOrganized as both stock and mutual companies3. Investment
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