Ch 12 What Financial Institutions Do Securities Market Institutions Securities Market Institutions Contribute to the efficiency of financial markets o Investment banks brokers and dealers organized exchanges o Reduce the costs of matching savers and borrowers and proved risk sharing liquidity and information services that enable financial markets to function smoothly Information Investment Banking Investment Banks Assist businesses in raising new capital in primary markets and advise them on the best way to do so o Recommend a stock issue or structuring debt contracts to attract investors Underwriting The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities o Underwriters guarantee a price to the issuing firm sell the issue at a higher price and keep the profit spread o Underwriters assume the risk of not being able to resell the securities to investors o Lowers information costs between lenders and borrowers because investment banks put their reputations behind the firms they underwrite Conditions the investment bank might sell the issue under o All or None Basis The company issuing the securities receives nothing unless the investment bank sells the complete issue at the offering price o Best Efforts Allows the investment bank to make no guarantee requiring it to sell to investors only as much of the issue as it can Syndicates A professional financial services group formed temporarily for the purpose of handling a large transaction that would be hard or impossible for the entities involved to handle individually o Lead investment bank acts as manager and keeps part of the spread o Rest of the spread is split among the syndicate Shelf Registration SEC Rule 415 Allows a firm to register a new issue with the SEC and then wait as long as 2 years before selling it Merchant Banking Bank puts its own funds at risk by investing in firms that are undergoing restructuring Liquidity and Risk Sharing Secondary Markets Brokers Earn commissions by matching ultimate buyers and sellers in a particular market Dealers Trade between ultimate buyers and sellers they hold inventories of securities and sell them for a price higher than they paid for them earning the spread between the bid and asked price Insider Information Available to individuals within an organization or to parties in a transaction but unavailable to the general public Exchange A physical location at which securities are traded Specialist A member of an exchange who acts as the market maker to facilitate the trading of a given stock The specialist holds an inventory of the stock posts the bid and ask prices manages limit orders and executes trades Over the Counter Trading Trading takes place over the phone or by computer Trading Bonds o The market for US Treasury Bonds and US government agency securities is the most liquid market in the world o The market for most individual bonds is illiquid o Junk Bonds These are the bonds that pay high yields to bondholders because the borrowers don t have any other option Their credit ratings are less than pristine making it difficult for them to acquire capital at an inexpensive cost Junk bonds are typically rated at BB Ba or less o Think of a bond rating as the report card for a company s credit rating Blue chip firms that provide a safer investment have a high rating while risky companies have a low rating Although junk bonds pay high yields they also carry higher than average risk that the company will default on the bonds The chart below illustrates the different bond rating scales from the two major rating agencies Moody s and Standard and Poor s Bond Rating Moody s Aaa Aa A Baa Ba B Caa Ca C C Standard Poor s AAA AA A BBB BB B CCC CC C D Grade Risk Investment Investment Investment Investment Medium Risk Lowest Risk Low Risk Low Risk Junk Junk Junk High Risk Highest Risk In Default Investment Institutions Investment Institutions Raise funds to invest in loans and securities o Mutual funds and finance companies Mutual Funds Mutual Funds Financial intermediaries that convert small individual claims into diversified portfolios of stocks bonds mortgages and money market instruments by pooling the resources of many small savers o Obtain money by selling shares in portfolios of financial assets and then using the funds of many savers to maintain and expand those portfolios Types of Funds o Closed End Mutual Funds Mutual fund company issues a fixed number of nonredeemable shares which investors may then trade in the OTC markets like common stock o Open End Mutual Funds Issue redeemable shares at a price tied to the underlying o No Load Funds Earn income only from management fees not from sales value of the assets commissions o Load Funds Charge commissions for purchases and sales o Money Market Mutual Funds Hold high quality short term assets such as treasury bills negotiable certificates of deposit and commercial paper Finance Companies Finance Companies Intermediaries that raise large amounts of money through the sale of commercial paper and securities o 3 types of finance companies consumer finance business finance sales finance o Consumer Finance Make loans to enable consumers to buy cars furniture and appliances to finance home improvements and to refinance household debts o Business Finance Engage in factoring Factoring The purchase of accounts receivable of small firms at a discount Another activity is to purchase expensive equipment and then lease it to businesses over a fixed length of time o Sales Finance Affiliated with companies that manufacture or sell big ticket goods Purpose is to promote the business of the underlying manufacturer Contractual Saving Insurance Companies Contractual Saving Institutions Allow individuals to pay to transfer the risk of financial hardship to someone else or to save in a disciplines manner for retirement Insurance Companies Insurance Companies Financial intermediaries that specialize in writing contracts to protect their policyholders from the risk of financial loss associated with particular events o Obtain funds by issuing promises to pay under certain conditions and then lending the money to borrowers o Premium The specified amount of payment required periodically by an insurer to provide coverage under a given insurance plan for a defined period of time The premium is paid by the insured party to the insurer and primarily compensates the insurer for
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