Fundamentals of Corporate Finance 2: Financial Markets and Institutions
Based on chapter 2 of Fundamentals of Corporate Finance International Edition (11th edition) by Brealey, Myers, Marcus.
Financial markets and financial intermediaries channel savings to real investment. They also channel money from individuals who want to save for the future to those who need cash to spend today. A third function of financial markets is to allow individuals and businesses to adjust their risk. For example, mutual funds, such as the Vanguard Index fund, and ETFs, such as SPDRs or “spiders,” allow individuals to spread their risk across a large number of stocks. Financial markets provide other mechanisms for sharing risks. For example, a wheat farmer and a baker may use the commodity markets to reduce their exposure to wheat prices. Financial markets and intermediaries allow investors to turn an investment into cash when needed. For example, the shares of public companies are liquid because they are traded in huge volumes on the stock market. Banks are the main providers of payment services by offering checking accounts and electronic transfers. Finally, financial markets provide information. For example, the CFO of a company that is contemplating an issue of debt can look at the yields on existing bonds to gauge how much interest the company will need to pay.
Financial markets include stock markets, fixed-income markets (aka bond markets), capital markets (long term debt and equity), money markets (short term (<1 year), e.g. T-bills, CDs, commercial paper), foreign exchange markets, commodities market, derivative markets, and futures markets. Financial markets allow securities to be traded, enabling the flow of funds from savers to borrowers, encouraging investment. Financial markets provide useful information: stock prices can give hints to investor sentiment, market expectations, company performance and value, and cost of capital; bond markets provide guidance as to the interest rate a corporation could issue their own bonds at; and FOREX and commodity price trends can be used to predict the impacts on corporations reliant on foreign currencies or commodities. Derivative markets are a major source of finance for many corporations, which they use for risk management.
Securities traded in active financial markets are liquid assets. Liquidity enables investors to sell securities quickly if they need cash. Banks provide liquidity by maintaining a fractional reserve, so unless there is a bank run, an individual should be able to withdraw their funds without issue. Central banks and deposit insurance schemes also provide backups in a low-liquidity event.
Financial intermediaries make it easier for investors to lend to corporations. Investors can invest in corporations directly, through the purchase of securities, or indirectly, through a financial intermediary. Financial intermediaries include mutual funds, hedge funds, commercial banks, pension plans, and insurance companies. Commercial banks raise money from depositors and make loans to individuals and businesses. Mutual funds enable diversification and professional management at relatively low costs, so are good for individual investors with low capital amounts. Mutual funds don’t directly own or provide assets. They are not corporations but investment companies; they pay no tax, providing that all income from dividends and price appreciation is passed on to the funds’ shareholders. Pension funds are major investors in corporate equities. Insurance companies take savings (in the form of sold premiums) and invest them, such as in corporations. The purchaser of the premium may indirectly benefit if they also have shares in the corporations the insurance company invested their premium in.
Financing for public corporations do not need to flow through financial markets, and financing for private corporations do not need to flow through financial intermediaries. A small, private firm finance its capital investments through personal savings, friends and family loans, and bank loans. Cash retained and reinvested in the firm’s operations is cash saved and invested on behalf of the firm’s shareholders. A new issue of shares (a primary issue) increases both the amount of cash held by the company and the number of shares held by the public. This can lead to dilution, which can cause the share price to drop, which can upset existing shareholders. Investment (aka merchant) banks support corporate finance activities such as IPOs, M&As, etc. Trading existing shares happens on the secondary market.