368 Part Four Financing Decisions and Market Efficiency
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the New York, London, or Hong Kong stock exchanges. In other cases there is no organized
exchange, and the assets are traded by a network of dealers. Such markets are known as over-
the-counter (OTC) markets. For example, in the United States most government and corporate
bonds are traded OTC.
Some financial markets are not used to raise cash but instead help firms to manage their
risks. In these markets firms can buy or sell derivatives, whose payoffs depend on the prices
of other securities or commodities. For example, if a chocolate producer is worried about ris-
ing cocoa prices, it can use the derivatives markets to fix the price at which it buys its future
cocoa requirements.Financial Intermediaries
A financial intermediary is an organization that raises money from investors and provides
financing for individuals, companies, and other organizations. Banks, insurance companies,
and investment funds are all intermediaries. These intermediaries are important sources of
financing for corporations. They are a stop on the road between savings and real investment.
Why is a financial intermediary different from a manufacturing corporation? First, it may
raise money in different ways, for example, by taking deposits or selling insurance policies.
Second, it invests that money in financial assets, for example, in stocks, bonds, or loans to
businesses or individuals. In contrast, a manufacturing company’s main investments are in
plant, equipment, or other real assets.
Look at Table 14.2, which shows the financial assets of the different types of intermediar-
ies in the United States. It gives you an idea of the relative importance of different interme-
diaries. Of course, these assets are not all invested in nonfinancial businesses. For example,
banks make loans to individuals as well as to businesses.^19Investment Funds
We look first at investment funds, such as mutual funds, hedge funds, and pension funds.
Mutual funds raise money by selling shares to investors. This money is then pooled and
invested in a portfolio of securities.^20 Investors in a mutual fund can increase their stake in
the fund’s portfolio by buying additional shares, or they can sell their shares back to the fund
if they wish to cash out. The purchase and sale prices depend on the fund’s net asset value
(NAV) on the day of purchase or redemption. If there is a net flow of cash into the fund, the(^19) Intermediaries often invest in each other also. For instance, an investor might buy shares in a mutual fund that then invests in Bank
of America’s new share issue. If the money then finds its way from Bank of America to Exxon, it would show up as a financial asset
of both Bank of America (its loan to Exxon) and the mutual fund (its shareholding in Bank of America).
(^20) Mutual funds are not corporations but investment companies. They pay no tax, providing that all income from dividends and price
appreciation is passed on to the funds’ shareholders. The shareholders pay personal tax on this income.
$ Billions
Mutual funds $12,314
Money market funds 2,522
Closed-end funds 296
ETFs 1,822
Hedge fundsa 1,840
Pension funds 17,333
Banks and savings institutions 16,433
Insurance companies 7,707
❱ TABLE 14.2 Financial assets of
intermediaries in the United States, second
quarter, 2014.
a Total assets of 305 largest U.S. hedge funds, 2014.
Sources: Board of Governors of the Federal Reserve System,
Division of Research and Statistics, Flow of Funds Accounts
(www.federalreserve.gov); and L. Delevingne, “Billion Dollar
Club,” Absolute Return Magazine, September 28, 2014, http://
http://www.cnbc.com/id/102030681#.