Market
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2.1 The Basic Structure of the
U.S. Financial Markets (pg. 20)
2.2 The Financial Marketplace:
Financial Institutions (pgs. 2025)
2.3 The Financial Marketplace:
Securities Markets (pgs. 2630)
Objective 1. Describe the structure and functions of
financial markets.
Objective 3. Describe the different securities markets
for bonds and stock.
Objective 2. Distinguish between commercial banks
and other financial institutions in the financial
marketplace.
Part 1 Introduction to Financial Management
(Chapters 1, 2, 3, 4)
Part 2 Valuation of Financial Assets
(Chapters 5, 6, 7, 8, 9, 10)
Part 3 Capital Budgeting (Chapters 11, 12, 13, 14)
Part 4 Capital Structure and Dividend Policy
(Chapters 15, 16)
Part 5 Liquidity Management and Special Topics in Finance
(Chapters 17, 18, 19, 20)
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Chapter Outline
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If you have a student loan or a car loan, you have already been introduced to financial markets. You are
spending more than you currently earn and have borrowed money through the financial markets to
make ends meet. But once you graduate and enter the workforce, you may earn more than you spend
and therefore be able to save. Once again, you will become involved in the financial markets, but this
time as a saver rather than a borrower. This pattern of borrowing and saving also holds true for busi-
nesses, as they borrow money to finance their investments and as they invest their savings in the hopes
of generating even more money in the future.
In this chapter we provide a preliminary overview of the U.S. financial markets. We first review some
of the primary institutions that facilitate the transfer of money from investors to companies and indi-
viduals. Next, we discuss the securities markets in which different securities issued by businesses are
bought and sold. The primary objective of this chapter is to provide a sense of the richness of the fi-
nancial marketplace, the critical role that it plays in each of our lives, and how corporations use the fi-
nancial markets to raise capital.
19
When reading this chapter, you should keep in mind two of the
basic principles of finance introduced in Chapter 1: Principle 2:
There Is a Risk-Return Tradeoff and Principle 4: Market
Prices Reflect Information. Financial markets are organized to
offer investors a wide range of investment opportunities that
have different risks and different expected rates of return that re-
flect those risks. The goal of these markets is to provide investors
with opportunities that best fit their risk and return objectives,
while at the same time to provide businesses with opportunities
to raise fundsto train employees, do research, and build new
plantsat prices that appropriately reflect the prospects of the
business.
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P
Principles 2 and 4 Applied
P P
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20 PART 1 | Introduction to Financial Management
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2.1
The Basic Structure of the U.S.
Financial Markets
In Chapter 1, we showed that businesses typically opt to take on the form of a corporation when
they need to raise large amounts of capital. In this chapter, we will demonstrate how a corpo-
ration raises capital using the U.S. financial markets.
As discussed in Chapter 1, a financial market is any place where money and credit are ex-
changed. When you take out a car loan from your bank, you participate in the financial mar-
kets. Within the financial markets there are three principal sets of players that interact:
1. BorrowersThose who need money to finance their purchases. This includes businesses
that need money to finance their investments or to expand their inventories as well as in-
dividuals who borrow money to purchase a new automobile or a new home.
2. Savers (Investors)Those who have money to invest. These are principally individuals
who save money for a variety of reasons, such as accumulating a down payment for a home
or saving for a return to graduate school. Firms also save when they have excess cash.
3. Financial Institutions (Intermediaries)The financial institutions and markets that
help bring borrowers and savers together. The financial institution you are probably most
familiar with is the commercial bank, a financial institution that accepts deposits and
makes loans, such as Bank of America or Citibank, where you might have a checking ac-
count. However, as we discuss in the next section, there are many other types of financial
institutions that bring together borrowers and savers.
2.2
The Financial Marketplace: Financial
Institutions
The financial markets facilitate the movement of money from savers, who tend to be individ-
uals, to borrowers, who tend to be businesses. In return for the use of the savers money, bor-
rowers provide the savers with a return on their investment.
As shown in Figure 2.1, the institutions that make up the financial marketplace consist of
commercial banks, finance companies, insurance companies, investment banks, and invest-
ment companies. We call these institutions that help bring together individuals and businesses
financial intermediaries, because these institutions stand between those who have money to
invest and those who need money. Financial markets are often described by the maturities of
When you start your first job after graduat-
ing, your employer will probably give you the
option of automatically investing part of your
paycheck each pay period for your retire-
ment. Learning about the financial markets
will help you analyze your options and make
good selections. Twenty years ago, retirement plans were typically defined benefit plans. You
would work for only one company, and the company would reward your loyalty and hard work by
paying you a pension during your retirement based on your years of employment and the level of
pay that you earned. In other words, the company set aside money to pay your pension ben-
efit and invested it for you. Today, people change jobs often, and pension plans like the one
just described are very rare. Instead, most employers now offer their employees defined con-
tribution plans, such as a 401(k) savings plan. With a defined contribution pension plan, you, the
employee, and your employer make periodic cash contributions to your retirement fund that you
must take responsibility for investing. So, it doesnt matter whether youre a doctor, lawyer, truck
driver, or salesperson, you are going to be a pension fund manager.
Your Turn: See Study Question 21.