Gamble lost $150 million on derivative investments, and Orange County (California)
went bankrupt as a result of its treasurer’s speculation in derivatives.
Thesizeandcomplexityofderivativestransactionsconcernregulators,academics,
and members of Congress. Fed Chairman Greenspan noted that, in theory, deriva-
tivesshouldallowcompaniestomanageriskbetter,butthatitisnotclearwhetherre-
cent innovations have “increased or decreased the inherent stability of the financial
system.”
Anothermajortrendinvolvesstockownershippatterns.Thenumberofindividu-
als who have a stake in the stock market is increasing, but the percentage of corpo-
ratesharesownedbyindividualsisdecreasing.Howcanbothofthesetwostatements
be true? The answer has to do with institutional versus individual ownership of
shares. Although more than 48 percent of all U.S. households now have investments
in the stock market, more than 57 percent of all stock is now owned by pension
funds, mutual funds, and life insurance companies. Thus, more and more individuals
are investing in the market, but they are doing so indirectly, through retirement
plansandmutualfunds.Inanyevent,theperformanceofthestockmarketnowhasa
greater effect on the U.S. population than ever before. Also, the direct ownership of
stocks is being concentrated in institutions, with professional portfolio managers
making the investment decisions and controlling the votes. Note too that if a fund
holds a high percentage of a given corporation’s shares, it would probably depress
thestock’spriceifittriedtosellout.Thus,tosomeextent,thelargerinstitutionsare
“locked into” many of the shares they own. This has led to a phenomenon called
relationship investing,where portfolio managers think of themselves as having an
active, long-term relationship with their portfolio companies. Rather than being
passive investors who “vote with their feet,” they are taking a much more active role
in trying to force managers to behave in a manner that is in the best interests of
shareholders.
Distinguish between: (1) physical asset markets and financial asset markets; (2)
spot and futures markets; (3) money and capital markets; (4) primary and sec-
ondary markets; and (5) private and public markets.
What are derivatives, and how is their value related to that of an “underlying
asset”?
What is relationship investing?
Financial Institutions
Transfers of capital between savers and those who need capital take place in the three
different ways diagrammed in Figure 1-2:
1.Direct transfersof money and securities, as shown in the top section, occur when a
business sells its stocks or bonds directly to savers, without going through any type
of financial institution. The business delivers its securities to savers, who in turn
give the firm the money it needs.
- As shown in the middle section, transfers may also go through an investment bank-
ing housesuch as Merrill Lynch, which underwritesthe issue. An underwriter serves
as a middleman and facilitates the issuance of securities. The company sells its
stocks or bonds to the investment bank, which in turn sells these same securities to
savers. The businesses’ securities and the savers’ money merely “pass through” the
investment banking house. However, the investment bank does buy and hold the
16 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
14 An Overview of Corporate Finance and the Financial Environment
