CU Financial Markets Trends Questions

1st assignment is :

ANSWER THE FOLLOWING QUESTIONS:

1. Discuss Primary Markets and Secondary Markets. How they are different?  Chapter # 2. MINIMUM ONE PAGE REQUIREMENT.

2. Discuss how recent trends have changed Financial Markets. What part Technological advances and Globalization have played? Chapter # 2. MINIMUM TWO PAGE REQUIREMENT.

3. What is the difference between Commercial Banks and Investment Banks. Discuss the functions of both. Chapter # 2 MINIMUM ONE PAGE REQUIREMENT.

REFERENCES ARE MANDATORY.

Writing Requirement:

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2nd different assignment is:

i need you to write a brief summary of the important concepts learned from the file below.

Chapter 2
Introduction
The Economy Depends on a Strong Financial System
History shows that a strong financial system is a necessary ingredient for a growing and
prosperous economy. Companies raising capital to finance capital expenditures and investors
saving to accumulate funds for future use require well-functioning financial markets and
institutions.
Over the past few decades, changing technology and improving communications have
increased cross-border transactions and expanded the scope and efficiency of the global
financial system. Companies routinely raise funds throughout the world to finance projects
all around the globe. Likewise, with the click of a mouse an individual investor in Pittsburgh
can deposit funds in a European bank or purchase a mutual fund that invests in Chinese
securities.
These innovations helped spur global economic growth by providing capital to an increasing
number of individuals and businesses throughout the world. Along the way, the financial
industry attracted a lot of talented people who created, marketed, and traded a large
number of new financial products. Despite their benefits many of these same factors led to
excesses that culminated in the financial crisis of 2007 and 2008. This crisis also reaffirmed
how changes in the value of financial assets can quickly spill over and affect other parts of
the economy. For example, a 2014 article in The Wall Street Journal described how a
dramatic drop in many of the leading hot tech stocks (Facebook, King Digital Entertainment,
Netflix, Yelp, and Twitter) suddenly made it more difficult for new start-ups to raise money in
the initial public offering (IPO) market.
In the years since, new technologies have spawned many businesses with exciting products
and services, but these same forces have also led to increased volatility and disruption. For
example, in 2019 many high-profile companies such as Uber, Lyft, Slack, and Beyond Meat
went public but struggled to maintain their high-flying valuations following their IPOs. And in
September 2019, we witnessed the dramatic fall of WeWork and the withdrawal of its
planned IPO.
While these recent events have attracted a lot of attention, it is important to understand
that almost all companies have been affected by changing technology and globalization.
More generally, managers and investors don’t operate in a vacuum—they make decisions
within a large and complex financial environment. This environment includes financial
markets and institutions, tax and regulatory policies, and the state of the economy. We also
saw in 2020 how shocks to oil prices and the coronavirus outbreak dramatically transformed
the economy and financial markets. In short, the environment both determines the available
financial alternatives and affects the outcome of various decisions. Thus, it is crucial that
investors and financial managers have a good understanding of the environment in which
they operate.
Sources: Dan Gallagher, “Tech IPOs Will Face a Much Higher Bar,” The Wall Street Journal
(wsj.com), January 6, 2020; Mike Isaac and Michael J. De La Merced, “Uber Closes $1.6
Billion in Financing,” The New York Times (dealbook.nytimes.com), January 21, 2015; Scott
Austin, Chris Canipe, and Sarah Slobin, “The Billion Dollar Startup Club,” The Wall Street
Journal (graphics.wsj.com/billion-dollar-club/), February 18, 2015; and Rolfe Winkler, Matt
Jarzemsky, and Evelyn Rusli, “Drop in Tech Stocks Hits Startup Funding,” The Wall Street
Journal (wsj.com), April 16, 2014.
Putting Things in Perspective
In Chapter 1, we saw that a firm’s primary financial goal is to maximize long-run shareholder
value. Shareholder value is ultimately determined in the financial markets; so if financial
managers are to make good decisions, they must understand how these markets operate. In
addition, individuals make personal investment decisions; so they too need to know
something about financial markets and the institutions that operate in those markets.
Therefore, in this chapter, we describe the markets where capital is raised, securities are
traded, and stock prices are established, as well as the institutions that operate in these
markets. We will also discuss the concept of market efficiency and demonstrate how
efficient markets help promote the effective allocation of capital.
For additional information regarding the financial crisis, students can refer to
stlouisfed.org/Financial-Crisis. Another good source can be found at fcic.law.stanford.edu,
which focuses on the Financial Crisis Inquiry Commission.
In recent years, the dramatic price swings in the financial markets that have become
increasingly common have led many to question whether markets are always efficient. In
response, there has been increased interest in behavioral finance theory. This theory focuses
on how psychological factors influence individual decisions (sometimes in perverse ways),
and the resulting impact these decisions have on financial markets.
When you finish this chapter, you should be able to do the following:
Identify the different types of financial markets and financial institutions, and explain how
these markets and institutions enhance capital allocation.
Explain how the stock market operates, and list the distinctions between the different types
of stock markets.
Explain how the stock market has performed in recent years.
Discuss the importance of market efficiency, and explain why some markets are more
efficient than others.
Develop a simple understanding of behavioral finance.
2-1. The Capital Allocation Process
Businesses, individuals, and governments often need to raise capital. For example, Carolina
Power & Light Energy (CP&L) forecasts an increase in the demand for electricity in North and
South Carolina, so it will build a new power plant to meet those needs. Because CP&L’s bank
account does not contain the $1 billion necessary to pay for the plant, the company must
raise this capital in the financial markets. Similarly, the proprietor of a San Francisco
hardware store wants to expand into appliances. Where will he get the money to buy the
initial inventory of TV sets, washers, and freezers? Or suppose the Johnson family wants to
buy a home that costs $200,000, but they have only $50,000 in savings. Where will they
obtain the additional $150,000? The city of New York needs $200 million to build a new
sewer plant. Where can it obtain this money? Finally, the federal government needs more
money than it receives from taxes. Where will the extra money come from?
On the other hand, some individuals and firms have incomes that exceed their current
expenditures, in which case they have funds available to invest. For example, Carol Hawk has
an income of $36,000, but her expenses are only $30,000. That leaves her with $6,000 to
invest. Similarly, Microsoft has accumulated roughly $134.253 billion of cash and marketable
securities. What can Microsoft do with this money until it is needed in the business?
People and organizations with surplus funds are saving today in order to accumulate funds
for some future use. Members of a household might save to pay for their children’s
education and the parents’ retirement, while a business might save to fund future
investments. Those with surplus funds expect to earn a return on their investments, while
people and organizations that need capital understand that they must pay interest to those
who provide that capital.
In a well-functioning economy, capital flows efficiently from those with surplus capital to
those who need it. This transfer can take place in the three ways described in Figure 2.1.
Direct transfers of money and securities, as shown in the top section, occur when a business
sells its stocks or bonds directly to savers, without going through any type of financial
institution. The business delivers its securities to savers, who, in turn, give the firm the
money it needs. This procedure is used mainly by small firms, and relatively little capital is
raised by direct transfers.
As shown in the middle section, transfers may also go through an investment bank (IB) such
as Morgan Stanley, which underwrites the issue. An underwriter facilitates the issuance of
securities. The company sells its stocks or bonds to the investment bank, which then sells
these same securities to savers. The businesses’ securities and the savers’ money merely
“pass through” the investment bank. However, because the investment bank buys and holds
the securities for a period of time, it is taking a risk—it may not be able to resell the
securities to savers for as much as it paid. Because new securities are involved and the
corporation receives the sale proceeds, this transaction is called a primary market
transaction.
Transfers can also be made through a financial intermediary such as a bank, an insurance
company, or a mutual fund. Here the intermediary obtains funds from savers in exchange for
its securities. The intermediary uses this money to buy and hold businesses’ securities, and
the savers hold the intermediary’s securities. For example, a saver deposits dollars in a bank,
receiving a certificate of deposit; then the bank lends the money to a business in the form of
a mortgage loan. Thus, intermediaries literally create new forms of capital—in this case,
certificates of deposit, which are safer and more liquid than mortgages and thus better for
most savers to hold. The existence of intermediaries greatly increases the efficiency of
money and capital markets.
Figure 2.1 Diagram of the Capital Formation Process for Business
Details
Often the entity needing capital is a business (and specifically a corporation), but it is easy to
visualize the demander of capital being a home purchaser, a small business, or a government
unit. For example, if your uncle lends you money to fund a new business, a direct transfer of
funds will occur. Alternatively, if you borrow money to purchase a home, you will probably
raise the funds through a financial intermediary such as your local commercial bank or
mortgage banker. That banker could sell your mortgage to an investment bank, which then
might use it as collateral for a bond that is purchased by a pension fund.
In a global context, economic development is highly correlated with the level and efficiency
of financial markets and institutions. It is difficult, if not impossible, for an economy to reach
its full potential if it doesn’t have access to a well-functioning financial system. In a welldeveloped economy like that of the United States, an extensive set of markets and
institutions has evolved over time to facilitate the efficient allocation of capital. To raise
capital efficiently, managers must understand how these markets and institutions work, and
individuals need to know how the markets and institutions work to earn high rates of returns
on their savings.
SelfTest
Name three ways capital is transferred between savers and borrowers.
Why are efficient capital markets necessary for economic growth?
2-2. Financial Markets
People and organizations wanting to borrow money are brought together with those who
have surplus funds in the financial markets. Note that markets is plural; there are many
different financial markets in a developed economy such as that of the United States. We
describe some of these markets and some trends in their development.
2-2A. Types of Markets
Different financial markets serve different types of customers or different parts of the
country. Financial markets also vary depending on the maturity of the securities being
traded and the types of assets used to back the securities. For these reasons, it is useful to
classify markets along the following dimensions:
Physical asset markets versus financial asset markets. Physical asset markets (also called
“tangible” or “real” asset markets) are for products such as wheat, autos, real estate,
computers, and machinery. Financial asset markets, on the other hand, deal with stocks,
bonds, notes, and mortgages. Financial markets also deal with derivative securities whose
values are derived from changes in the prices of other assets. A share of Ford stock is a “pure
financial asset,” while an option to buy Ford shares is a derivative security whose value
depends on the price of Ford stock.
Spot markets versus futures markets. Spot markets are markets in which assets are bought
or sold for “on-the-spot” delivery (literally, within a few days). Futures markets are markets
in which participants agree today to buy or sell an asset at some future date. For example, a
farmer may enter into a futures contract in which he agrees today to sell 5,000 bushels of
soybeans 6 months from now at a price of $8.7925 a bushel. To continue that example, a
food processor that needs soybeans in the future may enter into a futures contract in which
it agrees to buy soybeans 6 months from now. Such a transaction can reduce, or hedge, the
risks faced by both the farmer and the food processor.
Money markets versus capital markets. Money markets are the markets for short-term,
highly liquid debt securities. The New York, London, and Tokyo money markets are among
the world’s largest. Capital markets are the markets for intermediate- or long-term debt and
corporate stocks. The New York Stock Exchange, where the stocks of the largest U.S.
corporations are traded, is a prime example of a capital market. There is no hard-and-fast
rule, but in a description of debt markets, short-term generally means less than 1 year,
intermediate-term means 1 to 10 years, and long-term means more than 10 years.
Primary markets versus secondary markets. Primary markets are the markets in which
corporations raise new capital. If GE were to sell a new issue of common stock to raise
capital, a primary market transaction would take place. The corporation selling the newly
created stock, GE, receives the proceeds from the sale in a primary market transaction.
Secondary markets are markets in which existing, already outstanding securities are traded
among investors. Thus, if Jane Doe decided to buy 1,000 shares of GE stock, the purchase
would occur in the secondary market. The New York Stock Exchange (NSYE) is a secondary
market because it deals in outstanding, as opposed to newly issued, stocks and bonds.
Secondary markets also exist for mortgages, other types of loans, and other financial assets.
The corporation whose securities are being traded is not involved in a secondary market
transaction and thus does not receive funds from such a sale.
Private markets versus public markets. Private markets, where transactions are negotiated
directly between two or more parties, are differentiated from public markets, where
standardized contracts are traded on organized exchanges. Bank loans and private debt
placements with insurance companies are examples of private market transactions. Because
these transactions are private, they may be structured in any manner to which the relevant
parties agree. By contrast, securities that are traded in public markets (e.g., common stock
and corporate bonds) are held by a large number of individuals. These securities must have
fairly standardized contractual features because public investors do not generally have the
time and expertise to negotiate unique, nonstandardized contracts. Broad ownership and
standardization result in publicly traded securities being more liquid than tailor-made,
uniquely negotiated securities.
Other classifications could be made, but this breakdown shows that there are many types of
financial markets. Also note that the distinctions among markets are often blurred and
unimportant except as a general point of reference. For example, it makes little difference if
a firm borrows for 11, 12, or 13 months, that is, whether the transaction is a “money” or
“capital” market transaction. You should be aware of the important differences among types
of markets, but don’t be overly concerned about trying to distinguish them at the
boundaries.
A healthy economy is dependent on efficient funds transfers from people who are net savers
to firms and individuals who need capital. Without efficient transfers, the economy could
not function: Carolina Power & Light Energy could not raise capital, so Raleigh’s citizens
would have no electricity; the Johnson family would not have adequate housing; Carol Hawk
would have no place to invest her savings; and so forth. Obviously, the level of employment
and productivity (i.e., the standard of living) would be much lower. Therefore, it is essential
that financial markets function efficiently—not only quickly, but also inexpensively.
Table 2.1 is a listing of the most important instruments traded in the various financial
markets. The instruments are arranged in ascending order of typical length of maturity. As
we go through this book, we will look in more detail at many of the instruments listed in
Table 2.1. For example, we will see that there are many varieties of corporate bonds, ranging
from “plain vanilla” bonds to bonds that can be converted to common stocks to bonds
whose interest payments vary depending on the inflation rate. Still, the table provides an
overview of the characteristics and costs of the instruments traded in the major financial
markets.
Table 2.1 Summary of Major Market Instruments, Market Participants, and Security
Characteristics
Security Characteristics
Instrument
Market
Major Participants
Riskiness
Original Maturity
Interest Rate on 3/24/20
(1)
(2)
(3)
(4)
(5)
(6)
U.S. Treasury bills
Money
Sold by U.S. Treasury to finance federal expenditures
Default-free, close to riskless
91 days to 1 year
0.01%
Commercial paper
Money
Issued by financially secure firms to large investors
Low default risk
Up to 270 days
2.35%
Negotiable certificates of deposit (CDs)
Money
Issued by major money-center commercial banks to large investors
Default risk depends on the strength of the issuing bank
Up to 1 year
0.15%
Money market mutual funds
Money
Invest in Treasury bills, CDs, and commercial paper; held by individuals and businesses
Low degree of risk
No specific maturity (instant liquidity)
0.36%
Consumer credit, including credit card debt
Money
Issued by banks, credit unions, and finance companies to individuals
Risk is variable
Variable
Variable, but average APR is 12.90% to 25.49%
U.S. Treasury notes and bonds
Capital
Issued by the U.S. government
No default risk, but price will decline if interest rates rise; hence, there is some risk
2 to 30 years
0.336% on 2-year to 1.446% on 30-year bonds
Mortgages
Capital
Loans to individuals and businesses secured by real estate; bought by banks and other
institutions
Risk is variable; risk is high in the case of subprime loans
Up to 30 years
3.55% adjustable 5-year rate, 3.89% 30-year fixed rate
State and local government bonds
Capital
Issued by state and local governments; held by individuals and institutional investors
Riskier than U.S. government securities but exempt from most taxes
Up to 30 years
2.977% to 4.431% on 20-year AAA-rated to A-rated bonds
Corporate bonds
Capital
Issued by corporations; held by individuals and institutional investors
Riskier than U.S. government securities but less risky than preferred and common stocks;
varying degree of risk within bonds depends on strength of issuer
Up to 40 years
3.111% on 20-year AAA bonds, 4.937% on 20-year A bonds
Leases
Capital
Similar to debt in that firms can lease assets rather than borrow and then buy the assets
Risk similar to corporate bonds
Generally 3 to 20 years
Similar to bond yields
Preferred stocks
Capital
Issued by corporations to individuals and institutional investors
Generally riskier than corporate bonds but less risky than common stock
Unlimited
5.75% to 9.5%
Common stocks
Capital
Issued by corporations to individuals and institutional investors
Riskier than bonds and preferred stock; risk varies from company to company
Unlimited
NA
2-2B. Recent Trends
Financial markets have experienced many changes in recent years. Technological advances in
computers and telecommunications, along with the globalization of banking and commerce,
have led to deregulation, which has increased competition throughout the world. As a
result, there are more efficient, internationally linked markets, which are far more complex
than what existed a few years ago. While these developments have been largely positive,
they have also created problems for policymakers. With these concerns in mind, Congress
and regulators have moved to reregulate parts of the financial sector. The box “Changing
Technology Has Transformed Financial Markets” illustrates some dramatic examples of how
changing technology has transformed financial markets in recent years.
Globalization has exposed the need for greater cooperation among regulators at the
international level, but the task is not easy. Factors that complicate coordination include
(1)
the different structures in nations’ banking and securities industries,
(2)
the trend toward financial services conglomerates, which obscures developments in various
market segments, and
(3)
the reluctance of individual countries to give up control over their national monetary
policies.
Still, regulators are unanimous about the need to close the gaps in the supervision of
worldwide markets.
Changing Technology has Transformed Financial markets
In recent years, changing technology has created numerous innovations and has dramatically
transformed the operation of financial markets. Here are just a few interesting examples:
Changing technology has created a whole class of firms that use computer algorithms to buy
and sell securities, often at speeds of less than a second. The trades conducted by these
high-frequency trading (HFT) firms now represent a very significant fraction of the total
trading volume in a given day. Proponents argue that these HFT firms generate liquidity,
which helps reduce transactions costs and makes it easier for other investors to get in and
out of the market. Critics argue that these activities can create market instability and that
HFT firms often engage in trades that are self-serving to their own interests, to the
detriment of other investors. A recent best-selling book by Michael Lewis, titled Flash Boys,
attracted a lot of attention for its highly critical depiction of HFT firms.
Changing technology has allowed some individuals and firms to bypass intermediaries and
directly raise money from investors to help fund various projects. This activity is referred to
as crowdfunding. Two leading examples of these platforms include Kickstarter and
Indiegogo.
Many financial firms have created “robo-advisors” that utilize algorithmic technology to
create relatively low-cost optimal investment portfolios for investors based on important
factors such as their investment horizon and their tolerance for risk. These products have
begun to have a disruptive effect on many human advisors, who are often more expensive.
At the same time, astute financial advisors continue to find ways to add value and to
incorporate technology in ways that benefit both them and their clients.
Changing technology has changed the way that many people pay for transactions. Many of
us rarely use cash anymore and instead often rely on debit and credit cards for payment.
Others often use electronic commerce services such as PayPal to make online payments.
Likewise, tech companies such as Facebook and Google have long been thought to have an
interest in becoming more involved in banking and payment-related activities. More
recently, there has been a growing interest in Bitcoin and other cryptocurrencies that involve
no intermediary and have no fees. The following chart from The Wall Street Journal
illustrates the recent dramatic swings in Bitcoin’s value. In March 2017, Bitcoin was trading
at just over $1,000. The price surged to a high of $19,783 by mid-December 2017. In the
subsequent 2 years, the currency has fallen in value and was trading just over $6,500 near
the end of March 2020. Although intriguing, many are concerned that the lack of regulation
makes Bitcoin and other cryptocurrencies an attractive vehicle for illegal transactions.
While many debate the true value of Bitcoin, even many of its skeptics believe that its
underlying blockchain technology has the potential to be transformative. A 2015 article in
The Economist provides an excellent early summary of the promise of this technology. Here’s
a relevant quote from that article:
But most unfair of all is that bitcoin’s shady image causes people to overlook the
extraordinary potential of the “blockchain”, the technology that underpins it. This innovation
carries a significance stretching far beyond cryptocurrency. The blockchain lets people who
have no particular confidence in each other collaborate without having to go through a
neutral central authority. Simply put, it is a machine for creating trust.
Details
Professor David Yermack of NYU, a leading academic expert on blockchain, believes that this
technology will have profound effects for the accounting and financial system in the years
ahead. His website (stern.nyu.edu/faculty/bio/david-yermack) is an excellent resource if you
are looking for more details.
Sources: “The Trust Machine: The Technology Behind Bitcoin Could Transform How the
Economy Works,” The Economist (economist.com), October 31, 2015; and Steven Johnson,
“Beyond the Bitcoin Bubble,” The New York Times (nytimes.com), January 16, 2018.
Another important trend in recent years has been the increased use of derivatives. A
derivative is any security whose value is derived from the price of some other “underlying”
asset. An option to buy IBM stock is a derivative, as is a contract to buy Japanese yen 6
months from now. The value of the IBM option depends on the price of IBM’s stock and the
value of the Japanese yen “future” depends on the exchange rate between yen and dollars.
The market for derivatives has grown faster than any other market in recent years, providing
investors with new opportunities but also exposing them to new risks.
To illustrate the growing importance of derivatives, consider the case of credit default swaps
(CDS). Credit default swaps are contracts that offer protection against the default of a
particular security. Suppose a bank wants to protect itself against the default of one of its
borrowers. The bank could enter into a credit default swap where it agrees to make regular
payments to another financial institution. In return, that financial institution agrees to insure
the bank against losses that would occur if the borrower defaulted. The CDS market grew
from less than $1 trillion at the beginning of 2001 to over $60 trillion by the end of 2007 (the
beginning of the financial crisis). Over 10 years later, the market is only at $3.5 trillion due to
the impact of the financial crisis and tougher regulations on banks. However, the CDS market
is currently experiencing renewed growth due to recent market volatility.
Derivatives can be used to reduce risks or to speculate. Suppose a wheat processor’s costs
rise and its net income falls when the price of wheat rises. The processor could reduce its
risk by purchasing derivatives—wheat futures—whose value increases when the price of
wheat rises. This is a hedging operation, and its purpose is to reduce risk exposure.
Speculation, on the other hand, is done in the hope of high returns; but it raises risk
exposure. For example, several years ago Procter & Gamble disclosed that it lost $150
million on derivative investments. More recently, losses on mortgage-related derivatives
helped contribute to the credit collapse in 2008.
If a bank or any other company reports that it invests in derivatives, how can one tell if the
derivatives are held as a hedge against something like an increase in the price of wheat or as
a speculative bet that wheat prices will rise? The answer is that it is very difficult to tell how
derivatives are affecting the firm’s risk profile. In the case of financial institutions, things are
even more complicated—the derivatives are generally based on changes in interest rates,
foreign exchange rates, or stock prices, and a large international bank might have tens of
thousands of separate derivative contracts. The size and complexity of these transactions
concern regulators, academics, and members of Congress. Former Fed Chairperson Alan
Greenspan noted that in theory, derivatives should allow companies to better manage risk,
but that it is not clear whether recent innovations have increased or decreased the inherent
stability of the financial system.
SelfTest
Distinguish between physical asset markets and financial asset markets.
What’s the difference between spot markets and futures markets?
Distinguish between money markets and capital markets.
What’s the difference between primary markets and secondary markets?
Differentiate between private and public markets.
Why are financial markets essential for a healthy economy and economic growth?
2-3. Financial Institutions
Direct funds transfers are common among individuals and small businesses and in
economies where financial markets and institutions are less developed. But large businesses
in developed economies generally find it more efficient to enlist the services of a financial
institution when it comes time to raise capital.
In the United States and other developed nations, a set of highly efficient financial
intermediaries has evolved. Their original roles were generally quite specific, and regulation
prevented them from diversifying. However, in recent years regulations against
diversification have been largely removed; today, the differences between institutions have
become blurred. Still, there remains a degree of institutional identity. Therefore, it is useful
to understand the major categories of financial institutions. Keep in mind, though, that one
company can own a number of subsidiaries that engage in the different functions described
next.
1.
Investment banks traditionally help companies raise capital. They
(1)
help corporations design securities with features that are currently attractive to investors,
(2)
buy these securities from the corporation, and
(3)
resell them to savers. Because the investment bank generally guarantees that the firm will
raise the needed capital, the investment bankers are also called underwriters.
The credit crisis has had a dramatic effect on the investment banking industry. Bear Stearns
collapsed and was later acquired by JP Morgan, Lehman Brothers went bankrupt, and Merrill
Lynch was forced to sell out to Bank of America. The two “surviving” major investment banks
(Morgan Stanley and Goldman Sachs) received Federal Reserve approval to become
commercial bank holding companies.
2.
Commercial banks, such as Bank of America, Citibank, Wells Fargo, and JP Morgan Chase, are
the traditional “department stores of finance” because they serve a variety of savers and
borrowers. Historically, commercial banks were the major institutions that handled checking
accounts and through which the Federal Reserve System expanded or contracted the money
supply. Today, however, several other institutions also provide checking services and
significantly influence the money supply. Also note that the larger banks are generally part of
financial services corporations as described next.
3.
Financial services corporations are large conglomerates that combine many different
financial institutions within a single corporation. Most financial services corporations started
in one area but have now diversified to cover most of the financial spectrum. For example,
Citigroup owns Citibank (a commercial bank), an investment bank, a securities brokerage
organization, insurance companies, and leasing companies.
4.
Credit unions are cooperative associations whose members are supposed to have a common
bond, such as being employees of the same firm. Members’ savings are loaned only to other
members, generally for auto purchases, home improvement loans, and home mortgages.
Credit unions are often the cheapest source of funds available to individual borrowers.
5.
Pension funds are retirement plans funded by corporations or government agencies for their
workers and administered primarily by the trust departments of commercial banks or by life
insurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and real
estate.
6.
Life insurance companies take savings in the form of annual premiums; invest these funds in
stocks, bonds, real estate, and mortgages; and make payments to the beneficiaries of the
insured parties. In recent years, life insurance companies have also offered a variety of taxdeferred savings plans designed to provide benefits to participants when they retire.
7.
Mutual funds are corporations that accept money from savers and then use these funds to
buy stocks, long-term bonds, or short-term debt instruments issued by businesses or
government units. These organizations pool funds and thus reduce risks by diversification.
They also achieve economies of scale in analyzing securities, managing portfolios, and
buying and selling securities. Different funds are designed to meet the objectives of different
types of savers. Hence, there are bond funds for those who prefer safety, stock funds for
savers who are willing to accept significant risks in the hope of higher returns, and money
market funds that are used as interest-bearing checking accounts.
Another important distinction exists between actively managed funds and indexed funds.
Actively managed funds try to outperform the overall markets, whereas indexed funds are
designed to simply replicate the performance of a specific market index. For example, the
portfolio manager of an actively managed stock fund uses his or her expertise to select what
he or she thinks will be the best-performing stocks over a given time period. By contrast, an
index fund that tracks the S&P 500 index will simply hold the basket of stocks that comprise
the S&P 500. Both types of funds provide investors with valuable diversification, but actively
managed funds typically have much higher fees—in large part, because of the extra costs
involved in trying to select stocks that will (hopefully) outperform the market. In any given
year, the very best actively managed funds will outperform the market index, but many will
do worse than the overall market—even before taking into account their higher fees.
Furthermore, it is extremely difficult to predict which actively managed funds will beat the
market in a particular year. For this reason, many academics and practitioners have
encouraged investors to rely more heavily on indexed funds.
There are literally thousands of different mutual funds with dozens of different goals and
purposes. Excellent information on the objectives and past performances of the various
funds are provided in publications such as Value Line Investment Survey and Morningstar
Mutual Funds, which are available in most libraries and on the Internet.
8.
Exchange-Traded Funds (ETFs) are similar to regular mutual funds and are often operated by
mutual fund companies. ETFs buy a portfolio of stocks of a certain type—for example, the
S&P 500 or media companies or Chinese companies—and then sell their own shares to the
public. ETF shares are generally traded in the public markets, so an investor who wants to
invest in the Chinese market, for example, can buy shares in an ETF that holds stocks in that
particular market. Table 2.2 provides a list of the top ETFs in early March 2020 ranked
according to the ETFs’ assets under management (AUM).
9.
Hedge funds are also similar to mutual funds because they accept money from savers and
use the funds to buy various securities, but there are some important differences. While
mutual funds (and ETFs) are registered and regulated by the Securities and Exchange
Commission (SEC), hedge funds are largely unregulated. This difference in regulation stems
from the fact that mutual funds typically target small investors, whereas hedge funds
typically have large minimum investments (often exceeding $1 million) and are marketed
primarily to institutions and individuals with high net worths. Hedge funds received their
name because they traditionally were used when an individual was trying to hedge risks. For
example, a hedge fund manager who believes that interest rate differentials between
corporate and Treasury bonds are too large might simultaneously buy a portfolio of
corporate bonds and sell a portfolio of Treasury bonds. In this case, the portfolio would be
“hedged” against overall movements in interest rates, but it would perform especially well if
the spread between these securities became smaller.
Table 2.2 The 10 Largest Exchange-Traded Funds (March 2020)
Symbol
Fund Name
Assets Under Management (Billions of Dollars)
Underlying Index
SPY
SPDR S&P 500 ETF
$226.14
S&P 500
IVV
iShares Core S&P 500 ETF
153.54
S&P 500
VOO
Vanguard S&P 500 ETF
110.73
S&P 500
VTI
Vanguard Total Stock Market ETF
109.98
CRSP U.S. Total Market
QQQ
Invesco QQQ
82.93
NASDAQ 100
AGG
ishares Core U.S. Aggregate Bond ETF
66.61
Barclays Capital U.S. Aggregate Bond
VEA
Vanguard FTSE Developed Markets ETF
57.66
MSCI EAFE
IEFA
iShares Core MSCI EAFE ETF
55.21
MSCI EAFE Investable Market Index
BND
Vanguard Total Bond Market ETF
49.51
Barclays Capital U.S. Aggregate Bond
GLD
SPDR Gold Trust
48.31
Gold Bullion
Source: etfdb.com/compare/market-cap/
Lower Fees Motivate Investors to Move Toward Index Funds
In the text, we point out that actively managed funds and hedge funds often have
considerably higher fees than passive investment products that include index funds and
ETFs. A passive fund generally costs less because you don’t have to pay a group of often
expensive fund managers to try to beat the market—instead, the fund is just simply
replicating the given market using technology. If anything, increased competition and
improving technology have further accelerated the drop in passive investment fees. For
example, a 2017 Wall Street Journal article utilizing Morningstar data reports that the
average annual cost per $10,000 invested in an actively managed U.S. stock fund is $81—
which is more than five times higher than the $14 average cost for passively managed U.S.
stock funds. Moreover, more than 100 passive mutual funds and exchange-traded funds
charge less than $10 for every $10,000 invested.
As you might expect, this gap in fees has led many investors to shift their money toward
passive products. Morningstar’s Annual Funds Flow report illustrates (see below) active
versus passive U.S. equity flows from 2007 through 2018.
Details
Further strengthening the case for passive investments is the historical evidence, which has
convincingly shown that the average actively managed fund typically fails to produce higher
returns than the corresponding index funds. So investors in actively managed products are
often paying more for poorer relative performance. Keep in mind, however, that in any given
year, the best-performing actively managed funds will outperform the corresponding index.
The challenge, however, is to find funds that consistently beat the overall market.
Relatedly, Warren Buffet attracted a lot of attention in 2007 when he made a “million-dollar
bet” with Ted Seides, co-manager of the asset-management firm Protégé Partners. Each
party put $500,000 toward charity and the bet concerned which of two hypothetical
investments would generate the higher performance over the following 10 years. Buffet’s
investment was in a low-cost S&P 500 index fund managed by Vanguard. Seides chose
instead to invest in five hedge funds. In February 2018, Buffett reported the final results in
his 2017 letter to shareholders: the index fund rose 125.8%, which translates into an average
annual compounded return of 8.5%. By contrast, the five hedge funds’ returns during the
10-year period ranged from 2.8% to 87.7%, with annual returns ranging between 0.3% to
6.5%.
Sources: Tom Lauricella and Gabrielle DiBenedetto, “A Look at the Road to Asset Parity
Between Passive and Active U.S. Funds,” Morningstar (morningstar.com), June 12, 2019;
Bernice Napach, “Passive Investments Drive Record Fund Flows in 2017: Morningstar,”
ThinkAdvisor (thinkadvisor.com), January 29, 2018; Carol J. Loomis, “Warren Buffett Scorches
the Hedge Funds,” Fortune (fortune.com), February 25, 2017; Jason Zweig and Sarah Krouse,
“Fees on Mutual Funds and ETFs Tumble Toward Zero,” The Wall Street Journal (wsj.com),
January 26, 2016; and Warren Buffett’s Annual Letter to Berkshire Hathaway Shareholders
(berkshirehathaway.com/letters/2017ltr.pdf), February 24, 2018.
However, some hedge funds take on risks that are considerably higher than that of an
average individual stock or mutual fund. The 10 biggest hedge fund failures to date are
Bernard L. Madoff Investment Securities, SAC Capital, The Galleon Group, Long-Term Capital
Management, Pequot Capital, Amaranth Capital, Tiger Funds, Aman Capital, Marin Capital,
and Bailey Coates Cromwell Fund. While the Madoff hedge fund was a ponzi scheme and the
SAC, Galleon, and Pequot hedge funds failed due to insider trading, the remaining funds
failed for other reasons. Long-Term Capital Management implemented arbitrage strategies
that were intended to take advantage of temporary changes in market behavior; however, its
highly leveraged trading strategies didn’t pan out, and this fund nearly collapsed the global
financial system in 1998. The Federal Reserve bailed it out, and its creditors took over.
Amaranth Capital used convertible bond arbitrage strategies; however, the fund folded in
2006 when some of its derivative bets failed to pay off, losing more than $6.5 billion. Tiger
Funds failed in 2000 when it shorted overpriced tech stocks (sold borrowed shares in the
hope of purchasing them later at a lower price, returning them to the lender, and profiting
from the difference) and tech stocks continued to soar during the bull market in technology.
The fund suffered massive losses as a result. Aman Capital failed in 2005 when its leveraged
trades in credit derivatives resulted in an estimated loss of hundreds of millions of dollars.
Marin Capital failed in 2005, when it used credit arbitrage and convertible arbitrage to make
a large bet on GM. The fund was crushed when GM’s stock price declined, and GM’s bonds
were downgraded to junk bonds. Finally, Bailey Coates Cromwell failed in 2005 when it
made bad bets on the movements of U.S. stocks and poor decisions involving leveraged
trades.
Table 2.3 lists the 10 largest hedge funds for the second quarter of 2019. While hedge funds
have grown tremendously over the past two decades, the road has been a bit bumpy in
recent years. Hedge fund assets under management fell sharply after the financial crisis, and
it wasn’t until 2013 that they once again reached their pre-crisis levels. At the same time,
many hedge funds have come under fire for their high fees and sub-optimal performance.
They have also faced increased competition from other products and investment advisors. In
the midst of this challenging environment, some funds have reduced their minimum
investment requirements and fees.
Table 2.3 The 10 Largest Hedge Funds (Second Quarter, 2019)
Fund
Assets under Management (Billions of Dollars)
Bridgewater Associates, LP
$132.05
Renaissance Technologies
110.00
Man Group
62.00
AQR Capital Management
60.84
Two Sigma Investments
42.90
Millennium Management LLC
38.78
Elliott Management
37.77
BlackRock
32.91
Citadel Advisors LLC
32.24
Davidson Kempner Capital Management
30.88
Source: “Largest Hedge Fund Firms,” Wikipedia
(en.wikipedia.org/wiki/List_of_hedge_funds), Second Quarter 2019.
10.
Private equity companies are organizations that operate much like hedge funds, but rather
than purchasing some of the stock of a firm, private equity players buy and then manage
entire firms. Most of the money used to buy the target companies is borrowed. While
private equity activity slowed around the financial crisis, over the past decade a number of
high-profile companies (including H.J. Heinz, Dell Computer, Harrah’s Entertainment,
Albertson’s, Neiman Marcus, Clear Channel, and Keurig Green Mountain) have been
acquired by private equity firms. In September 2017, BDT Capital Partners and JAB Holding
acquired Panera Bread for $7.16 billion. Also, in September 2017, Sycamore Partners
purchased Staples for $6.9 billion. In May 2018, Bain Capital completed its deal to buy the
memory chip unit of Toshiba for about $18 billion. Bain teamed up with Apple, Dell, Sk Hynix
and others, while Toshiba kept a 40% stake in the business. In July 2018, Keurig Green
Mountain, backed by JAB Holding, purchased Dr. Pepper Snapple for $18.7 billion. Other
leading private equity firms include The Carlyle Group, Kohlberg Kravis Roberts, The
Blackstone Group, Apollo Global Management, and TGP.
With the exception of hedge funds and private equity companies, financial institutions are
regulated to ensure the safety of these institutions and to protect investors. Historically,
many of these regulations—which have included a prohibition on nationwide branch
banking, restrictions on the types of assets the institutions could purchase, ceilings on the
interest rates they could pay, and limitations on the types of services they could provide—
tended to impede the free flow of capital and thus hurt the efficiency of the capital markets.
Recognizing this fact, policymakers took several steps during the 1980s and 1990s to
deregulate financial services companies. For example, the restriction barring nationwide
branching by banks was eliminated in 1999.
Many believed that excessive deregulation and insufficient supervision of the financial sector
were partially responsible for the 2007–2008 financial crisis. With these concerns in mind,
Congress passed the Dodd-Frank Act. The legislation’s main goals were to create a new
agency for consumer protection, work to increase the transparency of derivative
transactions, and force financial institutions to take steps to limit excessive risk taking and to
hold more capital. Since its enactment, the effectiveness of Dodd-Frank has been vigorously
debated. Some have argued that it has effectively accomplished its main goals—while others
(including President Trump) contend that it has imposed significant compliance costs on the
financial services industry and have called for its repeal. In fact, President Donald Trump
signed legislation on May 24, 2018, that rewrites parts of the Dodd-Frank Act. This
legislation will lessen regulatory scrutiny on smaller banks, including regional banks like
BB&T, Sun Trust Banks, Key Bank, and American Express, as well as community banks and
credit unions.
Panel A of Table 2.4 lists the 10 largest U.S. bank holding companies, and Panel B shows the
leading world banking companies. Among the world’s 10 largest, only one is based in the
United States. While U.S. banks have grown dramatically as a result of recent mergers, they
are still small by global standards. Panel C of the table lists the 10 leading global IPO
underwriters in terms of dollar volume of new equity issues. Five of the top underwriters are
also listed as major commercial banks or are part of bank holding companies shown in
Panels A and B, which confirms the continued blurring of distinctions between different
types of financial institutions.
Table 2.4 Largest Banks and Underwriters
Panel A: U.S. Bank Holding Companies
Panel B: World Banking Companies
Panel C: Leading Global IPO Underwriters
JPMorgan Chase & Co.
Industrial & Commercial
Bank of China Ltd. (China)
Morgan Stanley
Bank of America Corp.
China Construction Bank
Corporation (China)
Goldman Sachs & Co.
Citigroup Inc.
Agricultural Bank of China Ltd (China)
BofA Merrill Lynch
Wells Fargo & Co.
Bank of China Ltd. (China)
JPMorgan
Goldman Sachs Group, Inc.
China Development Bank (China)
Citi
Morgan Stanley
BNP Paribas SA (France)
Credit Suisse
U.S. Bancorp
JPMorgan Chase Bank National Association (USA)
Deutsche Bank
PNC Financial Services Group, Inc.
MUFG Bank Ltd. (Japan)
China International Capital Co.
TD Group US Holdings LLC
Japan Post Bank Co. Ltd. (Japan)
UBS
Capital One Financial Corp.
Credit Agricole SA (France)
Nomura
Source: Thomson Reuters, “Global Equity Capital Markets Review: Managing Underwriters,
Full Year 2018,” February 20, 2019, p. 3.
Securitization has Dramatically Transformed the Banking Industry
At one time, commercial banking was a simpler business than it is today. A typical bank
received money from its depositors and used it to make loans. In the vast majority of cases,
the banker held the loan on its books until it matured. Because they originated the loan and
continued to hold it on their books, the banks generally knew the risks involved. However,
because banks often had limited funding, there was a cap on the number of loans they could
hold on their books. And because most of the loans were made to individuals and
businesses in their local market, banks were less able to spread their risk.
To address these concerns, financial engineers came up with the idea of securitizing loans.
This is a process whereby an agent (such as an investment bank) creates an entity that buys
a large number of loans from a wide range of banks and then issues securities that are
backed by the loan payments. Securitization began in the 1970s when government-backed
entities purchased pools of home mortgages and then issued securities backed by the cash
flows from the diversified portfolio of mortgages. In many respects, securitization was a
tremendous innovation. Banks no longer had to hold their mortgages, so they could quickly
convert the originated loan to cash, enabling them to redeploy their capital to make other
loans. At the same time, the newly created securities gave investors an opportunity to invest
in a diversified portfolio of home mortgages. In addition, these securities traded on the open
market so that investors were able to easily buy and sell them as their circumstances and
views of the mortgage markets changed over time.
Over the last few decades, this process has accelerated. Bankers have securitized different
types of loans into all types of different securities. One notable example is collateralized debt
obligations (CDOs), where an entity issues several classes of securities backed by a portfolio
of loans. For example, an investment bank purchases $100 million of mortgage loans from
banks and mortgage brokers throughout the country. The investment bank uses the
collateral to create $100 million in new securities, which are divided into three classes (often
referred to as tranches). The Class A bonds have the first claim on the cash flows from the
mortgages. Because they have the first claim, they are the least risky and are rated AAA by
the rating agencies. The Class B bonds get paid after the Class A bonds are paid, but they too
will generally have a high rating. Finally, the Class C bonds get paid. Because they are last in
line, they will have the highest risk, but they will also sell for the lowest price. If the
underlying mortgages perform well, the C bonds will realize the highest returns, but they will
suffer the most if the underlying mortgages don’t perform well.
CDOs backed by pools of higher risk (subprime) mortgages played a major role in the 2007–
2008 financial crisis. During the housing boom, financial institutions and mortgage brokers
originated a large number of new mortgages, and investment bankers hungry for fees were
more than happy to create new CDOs backed by these subprime mortgages. The securities
created through these CDOs were sold primarily to other commercial and investment banks
and to other financial institutions, such as hedge funds, mutual funds, and pension funds.
Buoyed by the mistaken belief that housing prices would never fall, many viewed these
securities as solid investments, and they received additional comfort from the fact that they
were highly rated.
When the housing market collapsed, the value of these securities plummeted, destroying
the balance sheets of many financial institutions. Making matters worse, it became very hard
to value these securities because they were backed by such a large, diverse pool of
mortgages. Not sure what they had on their books, many institutions tried to sell these
securities at the same time, and the “rush to the exit” further depressed prices, causing the
cycle to deepen.
Following the crisis, many have looked to reform the securitization business, and others have
criticized the rating agencies for routinely assigning high credit ratings to what in hindsight
were extremely risky securities. At the same time, an article in Barron’s highlights the
important role that securitization plays in the capital markets and raises concerns that the
economy won’t thrive again until the securitization business recovers.
Source: David Adler, “A Flat Dow for 10 Years? Why It Could Happen,” Barron’s
(barrons.com), December 28, 2009.
SelfTest
What’s the difference between a commercial bank and an investment bank?
List the major types of financial institutions, and briefly describe the primary function of
each.
What are some important differences between mutual funds, exchange-traded funds, and
hedge funds? How are they similar?
2-4. The Stock Market
As noted earlier, outstanding, previously issued securities are traded in the secondary
markets. Approximately 75% of U.S. stocks are owned by long-term investors, while only
25% are held by short-term investors. By far, the most active secondary market—and the
most important one to financial managers—is the stock market, where the prices of firms’
stocks are established. Because the primary goal of financial managers is to maximize
shareholder wealth, knowledge of the stock market is important to anyone involved in
managing a business.
There are a number of different stock markets. The two leaders are the New York Stock
Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations
(NASDAQ). Stocks are traded using a variety of market procedures, but there are two basic
types:
(1)
physical location exchanges, which include the NYSE and several regional stock exchanges,
and
(2)
electronic dealer-based markets, which include the NASDAQ, the less formal over-thecounter market, and the electronic communications networks (ECNs).
(See the box “The NYSE and NASDAQ Go Global.”) Because the physical location exchanges
are easier to describe and understand, we discuss them first.
2-4A. Physical Location Stock Exchanges
Physical location exchanges are tangible entities. Each of the larger exchanges occupies its
own building, allows a limited number of people to trade on its floor, and has an elected
governing body—its board of governors. Members of the NYSE formerly had “seats” on the
exchange, although everybody stood. Today the seats have been exchanged for trading
licenses, which are auctioned to member organizations and cost about $50,000 per year.
Most of the larger investment banks operate brokerage departments. They purchase seats
on the exchanges and designate one or more of their officers as members. The exchanges
are open on all normal working days, with the members meeting in a large room equipped
with telephones and other electronic equipment that enable each member to communicate
with his or her firm’s offices throughout the country.
Like other markets, security exchanges facilitate communication between buyers and sellers.
For example, Goldman Sachs (the second-largest brokerage firm) might receive an order
from a customer who wants to buy shares of GE stock. Simultaneously, Morgan Stanley (the
largest brokerage firm) might receive an order from a customer wanting to sell shares of GE.
Each broker communicates electronically with the firm’s representative on the NYSE. Other
brokers throughout the country are also communicating with their own exchange members.
The exchange members with sell orders offer the shares for sale, and they are bid for by the
members with buy orders. Thus, the exchanges operate as auction markets.
Global Perspectives The NYSE and NASDAQ Go Global
Advances in computers and telecommunications that spurred consolidation in the financial
services industry have also promoted online trading systems that bypass the traditional
exchanges. These systems, which are known as electronic communications networks (ECNs),
use electronic technology to bring buyers and sellers together. The rise of ECNs accelerated
the move toward 24-hour trading. U.S. investors who wanted to trade after the U.S. markets
closed could utilize an ECN, thus bypassing the NYSE and NASDAQ.
Recognizing the new threat, the NYSE and NASDAQ took action. First, both exchanges went
public, which enabled them to use their stock as “currency” that could be used to buy ECNs
and other exchanges across the globe. For example, NASDAQ acquired the Philadelphia
Stock Exchange, several ECNs, and 15% of the London Stock Exchange. In addition, NASDAQ
acquired Marketwired to strengthen its global corporate services and acquired International
Securities Exchange (ISE) to strengthen its equities options business. The NYSE also looked
for acquisition targets, including a merger with the largest European exchange, Euronext, to
form NYSE Euronext and then acquiring the American Stock Exchange (AMEX).
However, NYSE Euronext itself became a takeover target, when it was acquired by the
Intercontinental Exchange (ICE) on November 3, 2013. The deal combined ICE’s futures,
over-the-counter, and derivatives trading with the NYSE’s stock trading. On June 24, 2014,
ICE spun off Euronext. On January 31, 2017, the NYSE acquired the National Stock Exchange,
giving the NYSE Group an additional U.S. exchange license. On April 9, 2018, the NYSE
allowed trading of all U.S. stocks and exchange-traded funds on its trading floor, ending a
decades-old restriction that kept stocks listed on rival exchanges from being bought and sold
on its trading floor. Most of the U.S. stock exchanges already allow trading of any security, no
matter where it is listed. NYSE’s restriction made less sense as the markets went electronic
and many rival trading platforms emerged, aided by regulations that encouraged greater
competition among the exchanges. The NYSE had been the only exchange that limited
trading to its own listed securities.
These actions illustrate the growing importance of global trading, especially electronic
trading. Indeed, many pundits have concluded that the floor traders who buy and sell stocks
on the NYSE and other physical exchanges will soon become a thing of the past. That may or
may not be true, but it is clear that stock trading will continue to undergo dramatic changes
in the upcoming years. To find a wealth of up-to-date information on the NYSE and NASDAQ,
go to Google (or another search engine) and do NYSE history and NASDAQ history searches.
Sources: Alexander Osipovich, “NYSE Opens Doors to Stocks from Rival Exchanges, Ending
Decades-Old Policy,” The Wall Street Journal (wsj.com), April 9, 2018; John McCrank and
Luke Jeffs, “ICE to Buy NYSE Euronext for $8.2 Billion,” reuters.com, December 20, 2012; Inti
Landauro, “ICE Plans Euronext IPO,” The Wall Street Journal (wsj.com), May 27, 2014; Alex
Gavrish, “Euronext NV: Recent Spin-Off Warrants Further Monitoring,” ValueWalk
(valuewalk.com), August 25, 2014; “Nasdaq Reaches 52-Week High on Compelling
Acquisitions,” nasdaq.com, March 14, 2016; “NYSE Agrees to Acquire National Stock
Exchange,” Business Wire (businesswire.com), December 14, 2016; and Alexander Osipovich,
“NYSE to Open Floor Trading to Stocks Listed at Rival Exchanges,” The Wall Street Journal
(wsj.com), January 11, 2017.
2-4B. Over-the-Counter (OTC) and The NASDAQ Stock Markets
Although the stocks of most large companies trade on the NYSE, a larger number of stocks
trade off the exchange in what was traditionally referred to as the over-the-counter (OTC)
market. An explanation of the term over-the-counter will help clarify how this term arose. As
noted earlier, the exchanges operate as auction markets—buy and sell orders come in more
or less simultaneously, and exchange members match these orders. When a stock is traded
infrequently, perhaps because the firm is new or small, few buy and sell orders come in, and
matching them within a reasonable amount of time is difficult. To avoid this problem, some
brokerage firms maintain an inventory of such stocks and stand prepared to make a market
for them. These “dealers” buy when individual investors want to sell, and they sell part of
their inventory when investors want to buy. At one time, the inventory of securities was kept
in a safe, and the stocks, when bought and sold, were literally passed over the counter.
Today these markets are often referred to as dealer markets. A dealer market includes all
facilities that are needed to conduct security transactions, but the transactions are not made
on the physical location exchanges. The dealer market system consists of
(1)
the relatively few dealers who hold inventories of these securities and who are said to
“make a market” in these securities,
(2)
the thousands of brokers who act as agents in bringing the dealers together with investors,
and
(3)
the computers, terminals, and electronic networks that provide a communication link
between dealers and brokers.
The dealers who make a market in a particular stock quote the price at which they will pay
for the stock (the bid price) and the price at which they will sell shares (the ask price). Each
dealer’s prices, which are adjusted as supply and demand conditions change, can be seen on
computer screens across the world. The bid-ask spread, which is the difference between bid
and ask prices, represents the dealer’s markup, or profit. The dealer’s risk increases when
the stock is more volatile or when the stock trades infrequently. Generally, we would expect
volatile, infrequently traded stocks to have wider spreads in order to compensate the
dealers for assuming the risk of holding them in inventory.
Brokers and dealers who participate in the OTC market are members of a self-regulatory
body known as the Financial Industry Regulatory Authority (FINRA), which licenses brokers
and oversees trading practices. The computerized network used by FINRA is known as
NASDAQ, which originally stood for “National Association of Securities Dealers Automated
Quotations.”
NASDAQ started as a quotation system, but it has grown to become an organized securities
market with its own listing requirements. Over the past decade, the competition between
the NYSE and NASDAQ has become increasingly fierce. As noted earlier, the NASDAQ has
invested in the London Stock Exchange and other market makers, while the NYSE merged
with Euronext (which was later spun off) and was purchased by Intercontinental Exchange—
further adding to the competition. Because most of the larger companies trade on the NYSE,
the market capitalization of NYSE-traded stocks is much higher than for stocks traded on
NASDAQ. As of May 2019, the market cap of listed companies on the NYSE was $23.21
trillion, and the NASDAQ’s market cap was $11.22 trillion.
Interestingly, many high-tech companies such as Microsoft, Google (now Alphabet Inc.), and
Intel have remained on NASDAQ even though they meet the listing requirements of the
NYSE. At the same time, however, other high-tech companies have left NASDAQ for the
NYSE. Despite these defections, NASDAQ’s growth over the past decade has been
impressive. In the years ahead, competition between NASDAQ and NYSE will no doubt
remain fierce.
SelfTest
What are the differences between the physical location exchanges and the NASDAQ stock
market?
What is the bid-ask spread?
2-5. The Market for Common Stock
Some companies are so small that their common stocks are not actively traded; they are
owned by relatively few people, usually the companies’ managers. These firms are said to be
privately owned, or closely held, corporations; their stock is called closely held stock. In
contrast, the stocks of most large companies are owned by thousands of investors, most of
whom are not active in management. These companies are called publicly owned
corporations, and their stock is called publicly held stock.
2-5A. Types of Stock Market Transactions
We can classify stock market transactions into three distinct categories:
Outstanding shares of established publicly owned companies that are traded: the secondary
market. Allied Food Products, the company we study in Chapters 3 and 4, has 75 million
shares of stock outstanding. If the owner of 100 shares sells his or her stock, the trade is said
to have occurred in the secondary market. Thus, the market for outstanding shares, or used
shares, is the secondary market. The company receives no new money when sales occur in
this market.
Additional shares sold by established publicly owned companies: the primary market. If
Allied Food decides to sell (or issue) an additional 1 million shares to raise new equity
capital, this transaction is said to occur in the primary market.
Initial public offerings made by privately held firms: the IPO market. Whenever stock in a
closely held corporation is offered to the public for the first time, the company is said to be
going public. The market for stock that is just being offered to the public is called the initial
public offering (IPO) market. In the summer of 2004, Google sold shares to the public for the
first time at $85 per share. By March 2020, its parent company’s stock (Alphabet Inc.) was
selling for more than $1,160. Another noteworthy deal was when General Motors (GM)
went public as part of its reorganization following its government bailout. Other high-profile
recent IPOs include Lyft, Uber, Peloton, Beyond Meat, Slack, LinkedIn Corp, Alibaba,
Facebook, Twitter, Snap (the parent company of Snapchat), and Dropbox.
The number of new IPOs rises and falls with the stock market. When the market is strong,
many companies go public to bring in new capital and to give their founders an opportunity
to cash out some of their shares. As you might expect, not all IPOs are well received. The
most striking example is Facebook, which had the largest and highest-profile IPO of 2012.
Amid much fanfare, the company went public on May 18, 2012, at a price of $38 per share.
In the 2 weeks after the IPO, the stock had fallen to below $28, and just a few months later
in September, the price reached a low of $17.55. By year-end 2012, the stock rebounded to
$26.62, which was still 30% below the initial offering price. So, although Facebook raised a
lot of money through its IPO, its initial investors did not quickly realize the big return that
many were looking to capture. However, it is important to note that despite its rocky start,
investors who continued to hold Facebook stock did quite well. In contrast, the box titled
“Initial Buzz Surrounding IPOs Doesn’t Always Translate into Long-Lasting Success”
demonstrates Twitter’s disappointing post-IPO performance, despite a much higher first-day
return. These experiences led many analysts to ask the following question in early 2017
following Snap’s IPO: “Is Snap the next Facebook or the next Twitter”? A chart of Snap’s
stock price performance since its IPO indicates that, for now, Snap’s experience has been
more like Twitter’s than Facebook’s.
Initial Buzz Surrounding IPOs Doesn’t always Translate into Long-Lasting Success
A recent article in Fortune cautions IPO investors: “Don’t be fooled by the drama of first-day
performance.” The article suggests that there is not always a strong correlation between the
market’s initial reaction to an IPO and the stock’s longerrun performance. As a case in point,
Fortune compares the post-IPO performance of Facebook and Twitter. As we mention in the
text, Facebook’s stock slid sharply in the aftermath of its IPO. However, since then
Facebook’s stock has impressively rebounded. By contrast, Twitter’s IPO generated a lot of
initial buzz, but since then the stock has languished. In late March 2020, its share price
hovered around $25.00. The following chart illustrates Twitter’s post-IPO struggles and
highlights the major events the company faced after going public.
Details
Source: Erin Griffith, “The Tale of Two IPOs: Facebook and Twitter,” Fortune (fortune.com),
February 19, 2015; and finance.yahoo.com for daily historical prices.
For information on IPOs, refer to Professor Jay Ritter’s (University of Florida) web page
site.warrington.ufl.edu/ritter/ipo-data/.
Even if you are able to identify a “hot” issue, it is often difficult to purchase shares in the
initial offering. These deals are often oversubscribed, which means that the demand for
shares at the offering price exceeds the number of shares issued. In such instances,
investment bankers favor large institutional investors (who are their best customers), and
small investors find it hard, if not impossible, to get in on the ground floor. They can buy the
stock in the aftermarket, but evidence suggests that when an investor does not get in on the
ground floor, over the long run IPOs often underperform the overall market.
Other critics point out that when an IPO’s price dramatically jumps the first day of trading,
this implies that the underwriter set the price too low and failed to maximize the issuer’s
potential proceeds by “leaving money on the table.”
Google’s highly publicized IPO attracted attention both because of its size (Google raised
$1.67 billion in stock) and because of the way the sale was conducted. Rather than having
the offer price set by its investment bankers, Google conducted a Dutch auction, where
individual investors placed bids for shares directly. In a Dutch auction, the actual transaction
price is set at the highest price (the clearing price) that causes all of the offered shares to be
sold. Investors who set their bids at or above the clearing price received all of the shares
they subscribed to at the offer price, which turned out to be $85. While Google’s IPO was in
many ways precedent setting, few companies going public since then have been willing or
able to use the Dutch auction method to allocate their IPO shares.
It is important to recognize that firms can go public without raising any additional capital.
For example, the Ford Motor Company was once owned exclusively by the Ford family.
When Henry Ford died, he left a substantial part of his stock to the Ford Foundation. When
the Foundation later sold some of the stock to the general public, the Ford Motor Company
went public, even though the company itself raised no capital in the transaction. Most
recently, Spotify went public on April 3, 2018—through the first direct listing of an NYSE
company. Direct listings differ from traditional IPOs in that no new shares are issued, so all
shares sold come from existing shareholders. In this regard, Spotify did not raise any capital
in the transaction, but it did provide a useful vehicle for some of its shareholders to “cash in”
and make shares available to a wider range of investors.
SelfTest
Differentiate between closely held and publicly owned corporations.
Differentiate between primary and secondary markets.
What is an IPO?
What is a Dutch auction, and what company used this procedure for its IPO?
2-6. Stock Markets and Returns
Anyone who has invested in the stock market knows that there can be (and generally are)
large differences between expected and realized prices and returns. Figure 2.2 shows how
total realized portfolio returns have varied from year to year. As logic would suggest (and as
is demonstrated in Chapter 9), a stock’s expected return as estimated by investors at the
margin is always positive; otherwise, investors would not buy the stock. However, as Figure
2.2 shows, in some years, actual returns are negative.
Figure 2.2 S&P 500 Index, Total Returns: Dividend Yield + Capital Gain or Loss, 1968–2019
Details
Source: Data taken from various issues of The Wall Street Journal “Investment Scoreboard”
section and “S&P 500 Annual Total Return Historical Data”
(ycharts.com/indicators/sandp_500_total_return_annual), March 27, 2020.
2-6A. Stock Market Reporting
Up until a few years ago, the best source of stock quotations was the business section of
daily newspapers such as The Wall Street Journal. One problem with newspapers, however,
is that they report yesterday’s prices. Now it is possible to obtain quotes throughout the day
from a wide variety of Internet sources. One of the best is Yahoo!’s finance.yahoo.com;
Figure 2.3 shows a detailed quote for Twitter, Inc. (TWTR) for March 27, 2020. As the
heading shows, Twitter is traded on the NYSE under the symbol TWTR. The information right
below the company name and ticker symbol shows the real-time quote at 11:57 a.m. EDT of
$24.98, which is down $1.43 (or −5.43%) from the previous day’s close. Twitter stock closed
on Thursday, March 26, 2020, at $26.41 per share, and it opened for trading on Friday,
March 27, 2020, at $25.56 per share. As of noon March 27, 2020, Twitter’s stock had traded
from a low of $24.76 to a high of $25.82, and the price range during the past 52 weeks was
between $20.00 and $45.86.
Figure 2.3 Stock Quote for Twitter, Inc., March 27, 2020
Details
Source: Twitter, Inc. (TWTR), finance.yahoo.com, March 27, 2020.
The two lines above the daily and yearly price range give the bid (buy) and ask (sell) price
range for the stock—the difference between the two represents the dealer’s spread or
profit. (In this example, the bid price is $24.78. and the ask price is $24.84.) As of noon on
March 27, 2020, 8,790,844 shares of stock had traded hands. Twitter’s average daily trading
volume (based on the past 3 months) was 20,662,029 shares, so trading on this day looks to
be below the average daily trading volume.
The total value of all of Twitter’s stock, called its “market cap,” was $19.644 billion. Its beta
(a measure of the stock’s volatility relative to the market) is 0.37. So Twitter’s stock price is
roughly 40% as volatile as the market. Twitter’s P/E ratio (price per share divided by the most
recent 12 months’ earnings) is 13.41, and its earnings per share for the most recent 12
months was $1.87. The firm’s next earnings announcement is April 30, 2020. The 1-year
target estimate represents the median 1-year target price as forecasted by analysts covering
the stock. It is estimated at $33.05. Twitter doesn’t pay a dividend, so the dividend and yield
information is shown as N/A.
In Figure 2.3, the chart to the right plots the stock price during the day; however, the links
above the chart allow you to pick different time intervals for plotting data. As you can see,
Yahoo! provides a great deal of information in its detailed quote, and even more detail is
available on the screen page below the basic quote information.
2-6B. Stock Market Returns
In Chapters 8 and 9, we discuss in detail how a stock’s rate of return is calculated, what the
connection is between risk and returns, and what techniques analysts use to value stocks.
However, it is useful at this point to give you an idea of how stocks have performed in recent
years. Figure 2.2 shows how the returns on large U.S. stocks have varied over the past years,
and the box titled “Measuring the Market” provides information on the major U.S. stock
market indices and their performances since the mid-1990s.
The market trend has been strongly up since 1968, but by no means does it go up every year.
Indeed, as we can see from Figure 2.2, the overall market was down in 11 of the last 52
years, including the three consecutive years of 2000–2002. The stock prices of individual
companies have likewise gone up and down. Of course, even in bad years, some individual
companies do well; so “the name of the game” in security analysis is to pick the winners.
Financial managers attempt to do this, but they don’t always succeed. In subsequent
chapters, we will examine the decisions managers make to increase the odds that their firms
will perform well in the marketplace.
Measuring the Market
Stock market indexes are designed to show the performance of the stock market. However,
there are many stock indexes, and it is difficult to determine which index best reflects
market actions. Some are designed to represent the entire stock market, some track the
returns of certain industry sectors, and others track the returns of small-cap, mid-cap, or
large-cap stocks. In addition, there are indexes for different countries. We discuss here the
three leading U.S. indexes. These indexes are used as a benchmark for comparing individual
stocks with the overall market, for measuring the trend in stock prices over time, and for
determining how various economic factors affect the market.
Dow Jones Industrial Average
Unveiled in 1896 by Charles H. Dow, the Dow Jones Industrial Average (DJIA) began with just
12 stocks, was expanded in 1916 to 20 stocks, and then was increased to 30 stocks in 1928,
when the editors of The Wall Street Journal began adjusting the index for stock splits and
making periodic substitutions. In 2015, Apple replaced AT&T on the DJIA, recognizing the
importance of computer technology and social media companies. In 2018, Walgreens Boots
Alliance Inc. replaced GE on the DJIA, recognizing the importance of the consumer and
health care sectors in the economy. Today the DJIA still includes 30 companies. They
represent about a fifth of the market value of all U.S. stocks, and all are leading companies in
their industries and widely held by individual and institutional investors.
S&P 500 Index
Created in 1926, the S&P 500 Index is widely regarded as the standard for measuring largecap U.S. stock market performance. The stocks in the S&P 500 are selected by the Standard
& Poor’s Index Committee, and they are the leading companies in the leading industries. It is
weighted by each stock’s market value, so the largest companies have the greatest influence.
The S&P 500 is one of the most commonly used benchmarks for the U.S. stock market. Index
funds designed to mirror the same performance of the index have grown in number and size
over the last decade. The number of index funds has more than quadrupled in the last
decade, and U.S.-focused index equity funds make up nearly 14% of the American stock
market, up from roughly 7% in 2010.
NASDAQ Composite Index
The NASDAQ Composite Index measures the performance of all stocks listed on the
NASDAQ. Currently, it includes approximately 3,300 companies, and because many
companies in the technology sector are traded on the computer-based NASDAQ exchange,
this index is generally regarded as an economic indicator of the high-tech industry. Apple,
Microsoft, Amazon, Facebook, and Google (now known as Alphabet Inc.) make up almost
40% of the index’s market value. For this reason, substantial movements in the same
direction by these five companies can move the entire index.
Recent Performance
The accompanying figure plots the value that an investor would now have if he or she had
invested $1 in each of the three indexes on January 1, 1995, through January 1, 2020. The
returns on the three indexes are compared with an investment strategy that invests only in
1-year Treasury bills (T-bills). During the last 25 years, the average annualized returns of
these indexes ranged from 8.11% for the S&P 500 to 10.51% for the NASDAQ. (The Dow’s
annualized return during this same period was 8.32%).
Growth of a $1 Investment Made on January 1, 1995 through January 1, 2020
Details
SelfTest
Would you expect a portfolio that consisted of the NYSE stocks to be more or less risky than
a portfolio of NASDAQ stocks?
If we constructed a chart like Figure 2.2 for a typical S&P 500 stock, do you think it would
show more or less volatility? Explain.
2-7. Stock Market Efficiency
To begin this section, consider the following definitions:
Market price: The current price of a stock. For example, the Internet showed that on one
day, Twitter’s stock traded at $24.98. The market price had varied from $24.76 to $25.82
during that same day as buy and sell orders came in.
Intrinsic value: The price at which the stock would sell if all investors had all knowable
information about a stock. This concept was discussed in Chapter 1, where we saw that a
stock’s intrinsic value is based on its expected future cash flows and its risk. Moreover, the
market price tends to fluctuate around the intrinsic value, and the intrinsic value changes
over time as the company succeeds or fails with new projects, competitors enter or exit the
market, and so forth. We can guess (or estimate) Twitter’s intrinsic value, but different
analysts will reach somewhat different conclusions.
Equilibrium price: The price that balances buy and sell orders at any given time. When a
stock is in equilibrium, the price remains relatively stable until new information becomes
available and causes the price to change.
Efficient market: A market in which prices are close to intrinsic values and stocks seem to be
in equilibrium.
When markets are efficient, investors can buy and sell stocks and be confident that they are
getting good prices. When markets are inefficient, investors may be afraid to invest and may
put their money “under the pillow,” which will lead to a poor allocation of capital and
economic stagnation. From an economic standpoint, market efficiency is good.
Academics and financial professionals have studied the issue of market efficiency
extensively. As generally happens, some people think that markets are highly efficient, some
think that markets are highly inefficient, and others think that the issue is too complex for a
simple answer. With this point in mind, it is interesting to note that the 2013 Nobel Prize in
Economics was awarded to three distinguished scholars (Eugene Fama, Lars Hansen, and
Robert Shiller) for their “empirical analysis of asset prices.” Professor Hansen was cited for
his work in developing statistical models for testing the rationality of markets. Also,
acknowledging the validity of different views in this area, the Nobel Committee saw fit to
simultaneously recognize Professor Fama (a pioneer in developing efficient market theory)
and Professor Shiller (a noted skeptic of market efficiency).
Those who believe that markets are efficient note that there are 100,000 or so fulltime,
highly trained professional analysts and traders operating in the market. Many have PhDs in
physics, chemistry, and other technical fields in addition to advanced degrees in finance.
Moreover, there are fewer than 3,000 major stocks; so if each analyst followed 30 stocks
(which is about right, as analysts tend to focus on a specific industry), on average, 1,000
analysts would be following each stock. Further, these analysts work for organizations such
as Goldman Sachs, JPMorgan Chase, and Deutsche Bank or for Warren Buffett and other
billionaire investors who have billions of dollars available to take advantage of bargains. Also,
the SEC has disclosure rules that, combined with electronic information networks, means
that new information about a stock is received by all analysts at about the same time,
causing almost instantaneous revaluations. All of these factors help markets to be efficient
and cause stock prices to move toward their intrinsic values.
However, other people point to data suggesting that markets are not very efficient. For
example, on May 6, 2010, the Dow Jones Index fell nearly 1,000 points only to rebound
rapidly by the end of the day. In 2000, Internet stocks rose to phenomenally high prices, and
then fell to zero or close to it the following year. No truly important news was announced
that could have caused either of these changes; if the market was efficient, it’s hard to see
how such drastic changes could have occurred. Another situation that causes people to
question market efficiency is the apparent ability of some analysts to consistently
outperform the market over long periods. Warren Buffett comes to mind, but there are
others. If markets are truly efficient, then each stock’s price should be close to its intrinsic
value. That would make it hard for any analyst to consistently pick stocks that outperform
the market.
The following diagram sums up where most observers seem to be today. There is an
“efficiency continuum,” with the market for some companies’ stocks being highly efficient
and the market for other stocks being highly inefficient. The key factor is the size of the
company—the larger the firm, the more analysts tend to follow it and thus the faster new
information is likely to be reflected in the stock’s price. Also, different companies
communicate better with analysts and investors, and the better the communications, the
more efficient the market for the stock. In an inefficient market, it might be possible to
purchase the company’s stock at a low price and then be able to turn around and sell it at a
higher price making a profit. This is called arbitrage.
Details
As an investor, would you prefer to purchase a stock whose price was determined in an
efficient or an inefficient market? If you thought you knew something that others didn’t
know, you might prefer inefficient markets. But if you thought that those physics PhDs with
unlimited buying power and access to company CEOs might know more than you, you would
probably prefer efficient markets, where the price you paid was likely to be the “right” price.
From an economic standpoint, it is good to have efficient markets in which everyone is
willing to participate. So the SEC and other regulatory agencies should do everything they
can to encourage market efficiency.
Thus far we have been discussing the market for individual stocks. But the notion of
efficiency applies to the pricing of all assets. For example, the dramatic rise and subsequent
collapse of housing prices in many U.S. markets suggests that there was a lot of inefficiency
in these markets. It is also important to realize that the level of market efficiency also varies
over time. In one respect, we might expect that lower transactions costs and the increasing
number of analysts would cause markets to become increasingly efficient over time.
However, the recent housing bubble and the previous bubble for Internet stocks provides
some contrary evidence. Indeed, these recent events have caused many experts to look for
alternative reasons for this apparent irrational behavior. A lot of their research looks for
psychologically based explanations, which we discuss in the next section.
2-7A. Behavioral Finance Theory
The efficient markets hypothesis (EMH) remains one of the cornerstones of modern finance
theory. It implies that, on average, asset prices are about equal to their intrinsic values. The
logic behind the EMH is straightforward. If a stock’s price is “too low,” rational traders will
quickly take advantage of this opportunity and buy the stock, pushing prices up to the
proper level. Likewise, if prices are “too high,” rational traders will sell the stock, pushing the
price down to its equilibrium level. Proponents of the EMH argue that these forces keep
prices from being systematically wrong.
Although the logic behind the EMH is compelling, many events in the real world seem
inconsistent with the hypothesis, which has spurred a growing field called behavioral
finance. Rather than assuming that investors are rational, behavioral finance theorists
borrow insights from psychology to better understand how irrational behavior can be
sustained over time. Pioneers in this field include psychologists Daniel Kahneman, Amos
Tversky, and Richard Thaler. Their work has encouraged a growing number of scholars to
work in this promising area of research.
Professor Thaler and his colleague Nicholas Barberis argue that behavioral finance’s criticism
of the EMH rests on two key points. First, it is often difficult or risky for traders to take
advantage of mispriced assets. For example, even if you know that a stock’s price is too low
because investors have overreacted to recent bad news, a trader with limited capital may be
reluctant to purchase the stock for fear that the same forces that pushed the price down
may work to keep it artificially low for a long time. Similarly, during the recent stock market
bubble, many traders who believed (correctly) that stock prices were too high lost a great
deal of money selling stocks short in the early stages of the bubble because prices went even
higher before they eventually collapsed. Thus, mispricings may persist.
The second point deals with why mispricings can occur in the first place. Here insights from
psychology come into play. For example, Kahneman and Tversky suggested that individuals
view potential losses and gains differently. If you ask average individuals whether they would
rather have $500 with certainty or flip a fair coin and receive $1,000 if a head comes up and
nothing if a tail comes up, most would prefer the certain $500, which suggests an aversion to
risk. However, if you ask people whether they would rather pay $500 with certainty or flip a
coin and pay $1,000 if it’s a head and nothing if it’s a tail, most would indicate that they
prefer to flip the coin. Other studies suggest that people’s willingness to take a gamble
depends on recent performance. Gamblers who are ahead tend to take on more risk,
whereas those who are behind tend to become more conservative.
These experiments suggest that investors and managers behave differently in down markets
than they do in up markets, which might explain why those who made money early in the
stock market bubble continued to invest their money in the market even as prices went ever
higher. Other evidence suggests that individuals tend to overestimate their true abilities. For
example, a large majority of people (upward of 90% in some studies) believe that they have
above-average driving ability and above-average ability to get along with others. Barberis
and Thaler point out:
Overconfidence may in part stem from two other biases, self-attribution bias and hindsight
bias. Self-attribution bias refers to people’s tendency to ascribe any success they have in
some activity to their own talents, while blaming failure on bad luck rather than on their
ineptitude. Doing this repeatedly will lead people to the pleasing, but erroneous, conclusion
that they are very talented. For example, investors might become overconfident after several
quarters of investing success [Gervais and Odean (2001)]. Hindsight bias is the tendency of
people to believe, after an event has occurred, that they predicted it before it happened. If
people think they predicted the past better than they actually did, they may also believe that
they can predict the future better than they actually can.
Behavioral finance has been studied in both the corporate finance and investments areas.
For example, Mark Grinblatt and Matti Keloharju conducted a recent study demonstrating
that investors who are characterized as being overconfident and prone to “seeking
sensations” trade more frequently. Likewise, a study by Ulrike Malmendier of Stanford and
Geoffrey Tate of Wharton found that overconfidence leads managers to overestimate their
abilities and thus the profitability of their projects. This may explain why so many corporate
projects fail to live up to their stated expectations.
2-7B. Conclusions about Market Efficiency
As noted previously, if the stock market is efficient, it is a waste of time for most people to
seek bargains by analyzing published data on stocks. That follows because if stock prices
already reflect all publicly available information, they will be fairly priced, and a person can
beat the market only with luck or inside information. So rather than spending time and
money trying to find undervalued stocks, it would be better to buy an index fund designed
to match the overall market as reflected in an index such as the S&P 500. However, if we
worked for an institution with billions of dollars, we would try to find undervalued stocks or
companies because even a small undervaluation would amount to a great deal of money
when investing millions rather than thousands. Also, markets are more efficient for
individual stocks than for entire companies; so for investors with enough capital, it does
make sense to seek out badly managed companies that can be acquired and improved.
Note, though, that a number of private equity players are doing exactly that; so the market
for entire companies may soon be as efficient as that for individual stocks.
However, even if markets are efficient and all stocks and companies are fairly priced, an
investor should still be careful when selecting stocks for his or her portfolio. Most
importantly, the portfolio should be diversified, with a mix of stocks from various industries
along with some bonds and other fixed-income securities. We will discuss diversification in
greater detail in Chapter 8, but it is an important consideration for most individual investors.
SelfTest
What does it mean for a market to be “efficient”?
Is the market for all stocks equally efficient? Explain.
Why is it good for the economy that markets be efficient?
Is it possible that the market for individual stocks could be highly efficient, but the market
for whole companies could be less efficient? Explain.
What is arbitrage?
What is behavioral finance? What are the implications of behavioral finance for market
efficiency?
Tying It All Together
In this chapter, we provided a brief overview of how capital is allocated and discussed the
financial markets, instruments, and institutions used in the allocation process. We discussed
physical location exchanges and electronic markets for common stocks, stock market
reporting, and stock indexes. We demonstrated that security prices are volatile—investors
expect to make money, which they generally do over time—but losses can be large in any
given year. Finally, we discussed the efficiency of the stock market and developments in
behavioral finance. After reading this chapter, you should have a general understanding of
the financial environment in which businesses and individuals operate, realize that actual
returns are often different from expected returns, and be able to read stock market
quotations from business newspapers or various Internet sites. You should also recognize
that the theory of financial markets is a “work in progress,” and much work remains to be
done.