The FinanciaI Environment

Financial Brokers

Certain financial institutions perform a necessary brokerage function. When brokers bring together parties who need funds with those who have savings, they are not performing a  direct lending function but rather are acting as matchmakers, or middlemen.

Investment bankers are middlemen involved in the sale of corporate stocks and bonds. When a company decides to raise funds, an investment banker will often buy the issue (at wholesale) and then turn around and sell it to investors (at retail). Because investment bankers are continually in the business of matching users of funds with suppliers, they can sell issues more efficiently than can the issuing companies. For this service investment bankers receive fees in the form of the difference between the amounts received from the sale of the securities to the public and the amounts paid to the companies. Much more will be said about the role of investment bankers in Part 7, when we consider long-term financing.

Mortgage bankers are involved in acquiring and placing mortgages. These mortgages come either directly from individuals and businesses or, more tJpicaily, through builders and real estate agents. In turn, the mortgage banker locates institutional and other investors for the mortgages. Although mortgage bankers do not tlpically hold mortgages in their own portfolios for very long, they usually service mortgages for the ultimate investors. This involves receiving payments and following through on delinquencies. For this service they receive fees.

The Secondary Market

Various security exchanges and markets facilitate the smooth functioning of the financial system. Purchases and sales of existing hnancial assets occur in the secondary market. Transactions in this market do not increase the total amount of financial assets ouistanding, but the presence of a viable secondary market increases the liquidity of {inancial assets and therefore enhances the primary or direct market for securities. In this regard, organized exchanges, such as the New York Stock Exchange, the American Stock Exchange, Jnd the New York Bond Exchange, provide a means by which buy and sell orders can be efficiently matched. In this matching, the forces of supply and demand determine price.

In addition, rhe over-the-counter (OTC) market serves as part of the secondarymarket for stocks and bonds not listed on an exchange as well as for certain listed securities. It is composed of brokers and dealers who stand ready to buy and sell securities at quoted prices. Most corporate bonds, and a growing number of stocks, are traded OTC as oppoied to being traded on an organized exchange. The OTC market has become highly mechanized, with market participants linked together by a telecommunications network. They do not come together in a single place as they would on an organized exchange. The National Association of Securities Dealers Automated Quotation Service (NASDAQ, pronounced "nas-dac") maintains this network, and price quotations are instantaneous. Whereas once it was considered a matter of prestige, as well as a necessity in many cases, for a company to list its shares on a major exchange, the electronic age has changed that. Many companies now prefer to have their shares traded OTC, despite the fact that they qualify for listing, because they feel that they get as good or sometimes better execution of buy and sell orders.

Although there are a number of other financial institutions, we have looked only at those interacting with business lirms. As the book continues, we will become better acquainted with many of those discussed. Our purpose here was only to introduce you briefly to them; further explanation will come later.

Altocation of Funds and lntenest Rates

The allocation of funds in an economy occurs primarily on the basis of price, expressed in terms of expected return. Economic units in need of funds must outbid others for their use. Although the allocation process is affected by capital rationing, government restrictions, and institutional constraints, expected return constitutes the primary mechanism by which supply and demand are brought into balance for a particular financial instrument across financial markets. If risk is held constant, economic units willing to pay the highest expected return are the ones entitled to the use of funds. If people are rational, the economic units bidding the highest prices will have the most promising investment opportunities. As a result, savings will tend to be allocated to the most efflcient uses.

It is important to recognize that the process by which savings are allocated in an economy occurs not only on the basis of expected return but on the basis of risk as wel1. Different financial instruments have different degrees of risk. In order for them to compete for funds, these instruments must provide different expected returns, or yields. Figure 2.2 illustrates the idea of the market-imposed "trade-off " between risk and return for securities - that is, the higher the risk of a security, the higher the expected return that must be offered to the investor. If all securities had exactly the same risk characteristics, they would provide the same expected returns if markets were in balance. Because of differences in default risk, marketability, maturity, ta-xability, and embedded options, however, different instruments pose different degrees of risk and provide different expected returns to the investor.