Chapter 1 - Introduction and Overview of Financial Markets
Why study Financial Markets and Institutions?
1. Dynamic and evolving markets. DJIA rose from 2800 in 1990 to more than 11,000 by 2000 (25%
annual returns in the 90s), then the stock market declined for three consecutive years (2000, 2001 and
2002), the first time since 1930s. Now how is the market doing?
2. Financial institutions (FI) have made a full historical circle. Banking industry operated as a full
service industry ("universal banking") until the 1930s, when commercial and investment banking were
separated by regulation. In 1970s and 1980s, lots of innovation took place in the unregulated financial
services industry (investment banking side) like mutual funds, money market accounts, commercial
paper, junk bonds, mortgage securitization resulting in financial disintermediation. We are now
moving again towards full service (universal) banking due to deregulation, technology and financial
innovation, e.g. Citigroup. Also, global competition is increasing in the banking industry.
Risk becomes increasing important in this evolving, dynamic, competitive global market for financial
markets. The more frequent and the more unpredictable the changes, the greater the risk. This course
provides an overview and analysis of the global financial system in which financial managers and
investors operate, with special attention to the risks faced by FIs and investors the strategies used to
OVERVIEW OF FINANCIAL MARKETS
1. Primary vs. Secondary Markets
are markets where firms raise funds by issuing new securities, e.g. stocks,
bonds, commercial paper, to finance new projects, expansion, construction of new buildings, R&D,
etc., for which the firms do not have sufficient internal funds. Process: Firm hires an investment bank
(Merrill-Lynch or Morgan Stanley) as the underwriter of the security issue, to get initial advice on the
price per share, number of shares, and then to sell the securities to investors, sometimes at a guaranteed
price, in a
(see page 5, Figure 1-1).
Alternatively, a primary market sale can be through a
, where the entire issue is sold
to a private investment group, usually an institutional investor such as a pension fund, or a group of
institutional buyers. Disadvantage? Illiquid. Advantage? Potential high return.
Two general types of primary market issues: a) IPO (initial public offering), a first-time issue of stock,
e.g. Ebay had an IPO in 1998, selling 3.5m shares at $18, raising $63m for Ebay. Price went to $54 in
a few days, the founder kept 14.7m shares, and was worth $700m on paper!
b) Subsequent to an IPO, a firm could issue additional shares of stock at a later date, to raise additional