LODescribe the role of the financial system in the economy and the two basic ways in which money fl ows through the system.
Discuss direct financing and the important role that investment banks play in this process.
Describe the primary, secondary, and money markets, explaining the special importance of secondary and money markets to business organizations.
Explain what an efficient market is and why market effi ciency is important to financial managers.
Explain how financial institutions serve the needs of consumers, small businesses, and corporations.
Compute the nominal and the real rates of interest, differentiating between them.


2.1 THE FINANCIAL SYSTEM

financial assets
assets that are claims on the cash flows from other assets; business loans, stocks, and bonds are financial assets
real assets
nonfinancial assets such as plant and equipment; productive assets are real assets; many financial assets are claims on cash flows from real assets



The Financial System at Work

How Funds Flow through the Financial System
DIRECT- FINANCIAL MARKETS    INDIRECT - FINANCIAL INSTITUTIONS

2.2 DIRECT FINANCING

A Direct Market Transaction

Investment Banks and Direct Financing
investment banks
firms that underwrite new security issues
money center banks
large commercial banks that provide both traditional and investment banking services throughout the world


Origination
Underwriting
Distribution

2.3 TYPES OF FINANCIAL MARKETS

Primary and Secondary Markets
primary market
a financial market in which new security issues are sold by companies directly to investors

secondary market
a financial market in which the owners of outstanding securities can sell them to other investors


Marketability versus Liquidity
marketability
the ease with which a security can be sold and converted into cash


liquidity
the ability to convert an asset into cash quickly without loss of value


Brokers versus Dealers
brokers
market specialists who bring buyers and sellers together, usually for a commission


dealers
market specialists who “make markets” for securities by buying and selling from their own inventories


Exchanges and Over-the-Counter Markets

Money and Capital Markets
money markets
markets where short-term financial instruments are traded


Public and Private Markets
public markets
financial markets where securities registered with the SEC are sold


private placement
the sale of an unregistered security directly to an investor, such as an insurance company or a wealthy individual


Futures and Options Markets - derivative securities
Futures markets- two famous- the New York Board of Trade and the Chicago Board of Trade
options- The Chicago Board Options

2.4 MARKET EFFICIENCY
true (intrinsic) value
for a security, the value of the cash flows an investor who owns that security can expect to receive in the future


efficient market
market where prices reflect the knowledge and expectations of all investors


market operational efficiency
the degree to which the transaction costs of bringing buyers and sellers together are minimized


market informational efficiency
the degree to which current market prices reflect relevant information and, therefore, the true value of the security


Efficient Market Hypotheses
efficient market hypothesis
a theory concerning the extent to which information is refl ected in security prices and how information is incorporated into
security prices
strong-form of theefficient market hypothesis
the theory that security prices reflect all information

private information
information that is not available to all investors


semistrong-form of the efficient market hypothesis
the theory that security prices reflect all public information but not all private information
public information
information that is available to all investors


weak-form of the efficient market hypothesis
the theory that security prices reflect all information in past prices but do not reflect all private or all public information


2.5 FINANCIAL INSTITUTIONS AND INDIRECT FINANCING
financial intermediation
conversion of securities with one set of characteristics into securities with another set of characteristics


Indirect Market Transactions

Financial Institutions and Their Services
Commercial Banks
Life and Casualty Insurance Companies
Pension Funds
Investment Funds
Business Finance Companies

Corporations and the Financial System
initial public offering (IPO) the first offering of a corporation’s stock to the public
2.6 THE DETERMINANTS OF INTEREST RATE LEVELS
The Real Rate of Interest
real rate of interest
the interest rate that would exist in the absence of inflation
nominal rate of interest
the rate of interest that is unadjusted for inflation

Determinants of the Real Rate of Interest
Returns on Investments
Time Preference for Consumption
Equilibrium Condition

Fluctuations in the Real Rate

Loan Contracts and Inflation

The Fisher Equation and Inflation

Cyclical and Long-Term Trends in Interest Rates