Section II Investment analysis
Part One Investment decision rules
Chapter 15 The ﬁnancial markets
A ship in a harbour is safe but is not what ships are built for
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 to a listed company’s capital increase or when a bank places a corporate bond issue with individual investors. In the second case, or indirect ﬁnance, ﬁnancial intermediaries, such as banks, buy ‘‘securities’’ – i.e., loans – issued by companies. The banks in turn collect funds, in the form of demand or savings deposits, or issue their own securities that they