Corporate Finance Theory and Practice, Third Edition

Chapter 15

THE FINANCIAL MARKETS

Now let's step into the realm of finance

The introduction to this book discussed the role of financial securities in a market economy. This section will analyse the behaviour of the investor who buys those instruments that the financial manager is trying to sell. An investor is free to buy a security or not and, if he decides to buy it, he is then free to hold it or resell it in the secondary market.

The financial investor seeks two types of returns: the risk-free interest rate (which we call the time value of money) and a reward for risk-taking. This section looks at these two types of returns in detail but, first, here are some general observations about capital markets.

Section 15.1

THE RISE OF CAPITAL MARKETS

The primary role of a financial system is to bring together economic agents with surplus financial resources, such as households, and those with net financial needs, such as companies and governments. This relationship is illustrated below:

To use the terminology of John Gurley and Edward Shaw (1960), the parties can be brought together directly or indirectly.

In the first case, known as direct finance, the parties with excess financial resources directly finance those with financial needs. The financial system serves as a broker, matching the supply of funds with the corresponding demand. This is what happens when a small shareholder subscribes ...