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households makes direct investment difficult. A small investor seeking to lend money to busi-
nesses that need to finance investments doesn™t advertise in the local newspaper to find a will-
ing and desirable borrower. Moreover, an individual lender would not be able to diversify
across borrowers to reduce risk. Finally, an individual lender is not equipped to assess and
monitor the credit risk of borrowers.
financial
For these reasons, financial intermediaries have evolved to bring lenders and borrowers
intermediaries
together. These financial intermediaries include banks, investment companies, insurance com-
panies, and credit unions. Financial intermediaries issue their own securities to raise funds to Institutions that
purchase the securities of other corporations. “connect” borrowers
For example, a bank raises funds by borrowing (taking deposits) and lending that money to and lenders by
accepting funds from
other borrowers. The spread between the interest rates paid to depositors and the rates charged
lenders and loaning
to borrowers is the source of the bank™s profit. In this way, lenders and borrowers do not need
funds to borrowers.
to contact each other directly. Instead, each goes to the bank, which acts as an intermediary be-
tween the two. The problem of matching lenders with borrowers is solved when each comes
independently to the common intermediary.
Financial intermediaries are distinguished from other businesses in that both their assets
and their liabilities are overwhelmingly financial. Table 1.3 shows that the balance sheets of
financial institutions include very small amounts of tangible assets. Compare Table 1.3 to the
aggregated balance sheet of the nonfinancial corporate sector in Table 1.4. The contrast arises
because intermediaries simply move funds from one sector to another. In fact, the primary so-
cial function of such intermediaries is to channel household savings to the business sector.
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12 Part ONE Elements of Investments



TA B L E 1.3
Balance sheet of financial institutions

Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total

Tangible assets Liabilities
Equipment and structures $ 528 3.1% Deposits $ 3,462 20.1%
Land 99 0.6 Mutual fund shares 1,564 9.1
Life insurance reserves 478 2.8
Total tangibles $ 628 3.6%
Pension reserves 4,651 27.0
Money market securities 1,150 6.7
Bonds and mortgages 1,589 9.2
Other 3,078 17.8
Financial assets
Total liabilities
Deposits and cash $ 364 2.1% $15,971 92.6%
Government securities 3,548 20.6
Corporate bonds 1,924 11.2
Mortgages 2,311 13.4
Consumer credit 894 5.2
Other loans 1,803 10.4
Corporate equity 3,310 19.2
Other 2,471 14.3
Total financial assets Net worth
16,625 96.4 1,281 7.4
Total $17,252 100.0% Total $17,252 100.0%

Note: Column sums subject to rounding error.
Source: Balance Sheets for the U.S. Economy, 1945“94, Board of Governors of the Federal Reserve System, June 1995.




TA B L E 1.4
Balance sheet of nonfinancial U.S. business

Liabilities and
Assets $ Billion % Total Net Worth $ Billion % Total

Real assets Liabilities
Equipment and software $ 3,346 18.9% Bonds & mortgages $ 2,754 15.6%
Real estate 4,872 27.6 Bank loans 929 5.3
Inventories 1,350 7.6 Other loans 934 5.3
Trade debt 1,266 7.2
Total real assets $ 9,568 54.2%
Other 2,804 15.9
Total liabilities
Financial assets $ 8,687 49.2%
Deposits and cash $ 532 3.0%
Marketable securities 509 2.9
Consumer credit 72 0.4
Trade credit 1,705 9.7
Other 5,275 29.9
Total financial assets Net worth
8,093 45.8 8,974 50.8
Total $17,661 100.0% $17,661 100.0%

Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2001.
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Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition




13
1 Investments: Background and Issues


Other examples of financial intermediaries are investment companies, insurance compa-
nies, and credit unions. All these firms offer similar advantages in their intermediary role.
First, by pooling the resources of many small investors, they are able to lend considerable
sums to large borrowers. Second, by lending to many borrowers, intermediaries achieve sig-
nificant diversification, so they can accept loans that individually might be too risky. Third, in-
termediaries build expertise through the volume of business they do and can use economies of
scale and scope to assess and monitor risk.
Investment companies, which pool and manage the money of many investors, also arise investment
out of economies of scale. Here, the problem is that most household portfolios are not large companies
enough to be spread among a wide variety of securities. It is very expensive in terms of bro- Firms managing funds
kerage fees and research costs to purchase one or two shares of many different firms. Mutual for investors. An
funds have the advantage of large-scale trading and portfolio management, while participat- investment company
may manage several
ing investors are assigned a prorated share of the total funds according to the size of their
mutual funds.
investment. This system gives small investors advantages they are willing to pay for via a
management fee to the mutual fund operator.
Investment companies also can design portfolios specifically for large investors with partic-
ular goals. In contrast, mutual funds are sold in the retail market, and their investment philoso-
phies are differentiated mainly by strategies that are likely to attract a large number of clients.
Economies of scale also explain the proliferation of analytic services available to investors.
Newsletters, databases, and brokerage house research services all engage in research to be sold
to a large client base. This setup arises naturally. Investors clearly want information, but with
small portfolios to manage, they do not find it economical to personally gather all of it. Hence,
a profit opportunity emerges: A firm can perform this service for many clients and charge for it.


<
2. Computer networks have made it much cheaper and easier for small investors to Concept
trade for their own accounts and perform their own security analysis. What will be
CHECK
the likely effect on financial intermediation?


Investment Bankers
Just as economies of scale and specialization create profit opportunities for financial interme-
diaries, so too do these economies create niches for firms that perform specialized services for
businesses. Firms raise much of their capital by selling securities such as stocks and bonds to
the public. Because these firms do not do so frequently, however, investment banking firms
that specialize in such activities can offer their services at a cost below that of maintaining an
in-house security issuance division.
Investment bankers such as Goldman, Sachs, or Merrill Lynch, or Salomon Smith Barney investment
advise the issuing corporation on the prices it can charge for the securities issued, appropriate bankers
interest rates, and so forth. Ultimately, the investment banking firm handles the marketing of Firms specializing in
the security issue to the public. the sale of new
Investment bankers can provide more than just expertise to security issuers. Because in- securities to the
public, typically by
vestment bankers are constantly in the market, assisting one firm or another in issuing securi-
underwriting the
ties, the public knows that it is in the banker™s own interest to protect and maintain its reputation
issue.
for honesty. The investment banker will suffer along with investors if the securities it under-
writes are marketed to the public with overly optimistic or exaggerated claims; the public will
not be so trusting the next time that investment banker participates in a security sale. The in-
vestment banker™s effectiveness and ability to command future business thus depend on the
reputation it has established over time. Obviously, the economic incentives to maintain a trust-
worthy reputation are not nearly as strong for firms that plan to go to the securities markets only
once or very infrequently. Therefore, investment bankers can provide a certification role”a
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
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14 Part ONE Elements of Investments


“seal of approval””to security issuers. Their investment in reputation is another type of scale
economy that arises from frequent participation in the capital markets.

1.7 MARKETS AND MARKET STRUCTURE
Just as securities and financial institutions are born and evolve in response to investor de-
mands, financial markets also develop to meet the needs of particular traders. Consider what
would happen if organized markets did not exist. Any household wishing to invest in some
type of financial asset would have to find others wishing to sell.
This is how financial markets evolved. Meeting places established for buyers and sellers of
financial assets became a financial market. A pub in old London called Lloyd™s launched the
maritime insurance industry. A Manhattan curb on Wall Street became synonymous with the
financial world.
We can differentiate four types of markets: direct search markets, brokered markets, dealer
markets, and auction markets.

Direct Search Markets
A direct search market is the least organized market. Buyers and sellers must seek each other
out directly. An example of a transaction in such a market is the sale of a used refrigerator
where the seller advertises for buyers in a local newspaper. Such markets are characterized by
sporadic participation and low-priced and nonstandard goods. It does not pay most people or
firms to seek profits by specializing in such an environment.

Brokered Markets
The next level of organization is a brokered market. In markets where trading in a good is active,
brokers find it profitable to offer search services to buyers and sellers. A good example is the real
estate market, where economies of scale in searches for available homes and for prospective
buyers make it worthwhile for participants to pay brokers to conduct the searches. Brokers in
particular markets develop specialized knowledge on valuing assets traded in that market.
An important brokered investment market is the so-called primary market, where new is-
primary market
sues of securities are offered to the public. In the primary market, investment bankers who
A market in which
market a firm™s securities to the public act as brokers; they seek investors to purchase securi-
new issues of
ties directly from the issuing corporation.
securities are offered
to the public. Another brokered market is that for large block transactions, in which very large blocks of
stock are bought or sold. These blocks are so large (technically more than 10,000 shares but
usually much larger) that brokers or “block houses” often are engaged to search directly for
other large traders, rather than bring the trade directly to the stock exchange where relatively
smaller investors trade.

Dealer Markets
When trading activity in a particular type of asset increases, dealer markets arise. Dealers
dealer markets
specialize in various assets, purchase these assets for their own accounts, and later sell them
Markets in which
for a profit from their inventory. The spreads between dealers™ buy (or “bid”) prices and sell
traders specializing in
(or “ask”) prices are a source of profit. Dealer markets save traders on search costs because
particular assets buy
and sell for their own market participants can easily look up the prices at which they can buy from or sell to dealers.
accounts. A fair amount of market activity is required before dealing in a market is an attractive source
of income. The over-the-counter (OTC) market is one example of a dealer market.
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition




15
1 Investments: Background and Issues


Trading among investors of already-issued securities is said to take place in secondary secondary
markets. Therefore, the over-the-counter market is also an example of a secondary market. markets
Trading in secondary markets does not affect the outstanding amount of securities; ownership Already existing
is simply transferred from one investor to another. securities are bought
and sold on the
exchanges or in the
Auction Markets OTC market.
The most integrated market is an auction market, in which all traders converge at one place
to buy or sell an asset. The New York Stock Exchange (NYSE) is an example of an auction auction market
market. An advantage of auction markets over dealer markets is that one need not search A market where all
across dealers to find the best price for a good. If all participants converge, they can arrive at traders meet at one
mutually agreeable prices and save the bid-ask spread. place to buy or sell an
asset.
Continuous auction markets (as opposed to periodic auctions, such as in the art world) re-
quire very heavy and frequent trading to cover the expense of maintaining the market. For this
reason, the NYSE and other exchanges set up listing requirements, which limit the stocks
traded on the exchange to those of firms in which sufficient trading interest is likely to exist.
The organized stock exchanges are also secondary markets. They are organized for in-
vestors to trade existing securities among themselves.


<
3. Many assets trade in more than one type of market. What types of markets do the Concept
following trade in?
CHECK
a. Used cars
b. Paintings
c. Rare coins

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