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- Posted one message on the class bulletin board introducing yourself
- Read the first chapter.
- Investigated various Finance jobs.
- Learned about internships in Finance.
- Decided that this is the most fun class you have EVER had.--It is Right???
- Called home to tell your parents what a great class you have and to tell them you miss them!
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Possibly the most important thing of all in finance is to understand why we are doing it. So let's begin off with a very broad view (which we will continually go back to).The Financial system (or the economy if you prefer) is composed of consumers, manufacturers, distributors. For simplicity many economists assume that households have excess money (surplus spending units) and corporations that need money (deficit spending units). (This is obviously a gross simplification. At any given point some individuals have excess money to invest where others need to borrow. The same is true for corporations and other organizations, but the simplified model makes things easier for the moment.)
The purpose of the Financial System is to make sure that the money flows to those who value it the highest (that is those who can put it to the "best" use).
Now
Households >>>>> Money >>>> Corporations
(Have money to invest) (need money to build etc.)Now, these households are not going to just give corporations money. They will demand their money back at some time in the future and a bit more for the use of their money and risks incurred etc.
In the Future
Households <<<< Money <<<< Corporations
Everything else we study in finance is just looking at this model in more detail. (Seriously, EVERYTHING!)
An interesting aside is in order here, two of my former students recently took jobs on Wall Street as Investment Bankers at two different firms. The first thing in each of their trainings was this model of the financial system, so it is relevant--a fact that is always reassuring.
Financial intermediaries exist to help make the money flow easier from one side to the other. For example a bank will take many the money from many deposits and then lend it out all at once to a firm. Or a mutual fund will take the money from many investors and invest in assets such as stocks and bonds.
Firms can raise the money they need in various ways. As mentioned above they can borrow from banks, ot they can borrow from public investors (they do this by selling an IOU called a bond), or they can sell a part of the firm (that is equity in the firm or a share of the firm called stock.)
Any understanding of finance begins off needing to know what a share of stock is so we will begin with a simple question: What is a stock?
A stock is a certificate of ownership of a corporation.
Stock is not a new idea. Hundreds of years ago as companies grew, it became more and more costly to buy everything that was needed. Fairly quickly it became too expensive (and too risky) for a single person to provide all of the cash that a firm needed. Someone got the idea to sell shares in the firm. These shares were a percentage ownership. Those that bought the shares were called investors. Investors did not like to put money into a firm without being able to get it back out if they need it. Thus, the shares were made transferable. That means the shares can be sold to other investors. Those who wanted to buy or sell shares obviously needed a place to meet, and so were born the first stock markets.
The sale of the shares from the firm to the initial investor is takes place in the primary market. This is not an actual location but more of a virtual market. The shares may take place in person, or over the phone, or over a computer network. The sale in the primary generates cash for the firm.
Shares can be sold and resold. After the primary market transaction, all subsequent sales take place in the secondary market. Sales that take place in the secondary market are almost always between investors. These sales do not generate any cash for the firm.
Types of markets
There are many ways to classify markets in finance. For example you have already seen primary and secondary. But there are also stock and bond markets, Dealer vs Auction markets, Exchange vs. OTC. and many others. For now we must concern ourselves with a Dealer vs. Auction market.
In the US, stocks traditionally have sold on the both exchanges and Over the Counter. An Exchange is a central location where buyers and sellers come together to trade. Many cities used to have their own exchanges the largest of these was and still is the NYSE. Many of the other exchanges have fallen by the wayside but there are still several “regional” exchanges including the Philadelphia Stock Exchange, the Chicago Stock Exchange, the Boston Stock Exchange, and the Pacific Stock Exchange.
The words Exchange and Auction Market are often used synonymously. They refer to a market that has a physical location (usually although that too is changing with ECNs). The main purpose of an auction market is to bring together buyers and sellers. Most of the participants in an auction market do not buy and sell for themselves but rather as representatives for others. Thus they are agents (or brokers) and do not need to actually own the shars they are trading. (An exception to this is the NYSE specialist.)
In Over-The-Counter (OTC) markets (such as the Nasdaq) most traders do trade form themselves and are called dealers. The distinctions between a dealer and a broker is pretty important. (think drug dealer vs real estate broker). A dealer market is a market where the participants take possession of the shares that they trade. Thus Nasdaq dealers who "make markets" in the shares are buying and selling out of their own account.
In the US there are two main markets. The NYSE (which is an exchange or Auction market) and the Nasdaq (which is a dealer market.) The NYSE has stricter listing requirements and is therefore made up mostly of larger firms whereas the Nasdaq has more firms but they tend to be much smaller. (with some notable exceptions)
The NYSE is the best known of all stock markets. It is located on Wall Street in New York City and can trace its roots back to the 1790s when trading was done under a buttonwood tree.
While we classify the NYSE as an auction market, each stock that trades on the NYSE also has one important dealer who is called a specialist. The specialist is a dealer who can trade on his/her own account. The specialist maintains a special limit order book which lists all orders that are coming up. A specialist makes his money by trading and not by investing. The specialist must occasionally take the opposite side of a trade to offset market imbalances. The vast majority of trades (upwards of 90%) take place without the specialists help.
Regulation
Most countries have a regulatory agency that is responsible for overseeing and regulating the financial markets in that country. In the US it is the Securities and Exchange Commission or simply the SEC.
Super Short Summary:
The financial system brings those with money together with those that do not have money.
Quick Quiz:
1. What are deficit spending units?2. What is the role of the financial System?
3. What is the role of financial intermediaries?
4. Give some examples of financial intermediaries.
5. What is the difference between the primary market and the secondary market?
6. What is the SEC and what is its role?
WARNING: You will see much of this again when we talk about capital structure and long term financing later in the year. Also in Financial Institutions and Money and Banking.
Assignment: go to Yahoo's Finance Page and look up 3 stocks that trade on the NYSE and three that trade on the Nasdaq. What do you see different? Hint: how many letters are in the stocks ticker symbol?
You have now completed the first chapter. You are expected to go to the Text's web page and take the end of chapter quiz. You can take it as many times as you want. When you get a satisfactory score, copy the page and email it to FinanceProfessor@yahoo.com
Answers to Quick Quiz #1.
1. Deficit Spending Units are those participants that need money to sustain their spending needs.
2. The financial system brings DSUs and SSUs together and assures that the money goes to where it is most useful.
3. Financial intermediaries help lower the transactions costs of both buyers and sellers.
4. Mutual Funds, Stock Markets, Banks, Brokers, etc.
5. In the primary market the issuing organization get the proceeds of the sale. In the secondary market trades are between investors and the firm (generally) has no role.
6. The SEC is the regulatory agency that oversees US financial markets.
Any questions? Email me: JimMahar@FinanceProfessor.com