Let's now talk about Public Capital Markets.

Well, what does that mean?

Imagine the following situation.

We will put a standard charts so this is the,

these are the investors and these are businesses that produce

demand for this money and imagine the following setup that these businesses say,

"We would like to take the money from you on the following terms.

You can engage either in the fixed income investment

or lending or you can participate in equity financing,

namely you can become our partners."

But, in this case,

if there is lending,

this is a special lending.

So here, we can see no collateral and I with have no insurance,

deposit insurance or you can

engage in equity financing and say,

Wait a minute, wait a minute."

In the second week of this course,

we analyzed the situation of equity financing and said that this is not realistic because

the project owner has always an incentive to

lie to the investor that the low state of the world occurred.

So how come? Now we observe in the reality,

huge stock markets will the volumes of dozens of trillions of US dollars.

So clearly something must be wrong here,

because stock markets are in essence equity markets.

Well, there is no contradiction as always because we said

that equity investing is unrealistic without monitoring,

with the presence of unobserved ability and if there

is any monitoring or if there is any observable to them they're quite realistic.

So, we can see that somehow we see that there is a new big skyscraper here that

probably will try to facilitate this process

and we so far do not know exactly how this works.

But what we do know is that,

there must be something that replaces these problems in

lending and sort of ensures at least sue the monitoring.

Now, so basically these people are said "Look,

you give us your money,

you have little protection,

if at all and you decide whether you participate or you don't."

Well there is a problem that investors,

these are the people who oftentimes have specific risk profile you can say well clearly

there are speculators or aggressive investors or

risk takers entrepreneurs all these kinds of people they do exist.

However, most of the people who have saved some money after having purchased a house,

after having sent their kids to college,

you know these people may be older,

these people may be more conservative and

these people are not satisfied with this tough terms.

Moreover, among these people there maybe not these small banks but

large banks and these are institutional investors.

So, these people have got these institutions they have guidelines.

So, they should invest in certain securities with some specific risk profile.

So, they may sometimes be openly prohibited from investing in very high risk instruments.

So, we see that here comes a problem of risk again and then,

these people and those people they should somehow

get something in exchange and they should feel

protected about some of the really poor outcomes in

the future and this something is insured by the fact that there is a market for them.

Put it like this. So see what happens,

let's say I would like to lend to these people without collateral,

without monitoring, without insurance.

I may not give a private loan,

but I might buy a bond because what is a bond?

The bond is a fixed income security that is issued

by the borrower and that does not carry any collateral,

but there is a market for those.

So let's say, I bought a bond a bond.

So I lent some money effectively to that and then I sit with his bond

and I do not control what happens with this company, the market does.

So, if everything is great then the bond price

behaves properly and there are other contributors to

this bond price that are independent of

the actual behavior and the actual financial situation of this borrow.

Let's say, if the interest rates go up,

then all bond prices go down and they

go down different rates depending upon the maturity,

from the duration and some other features that we'll talk about

in much greater detail in the final weeks of the next course,

then we study valuation.

But this story is, that I as an investor have the right to sell this bond

because there is active market in which these bonds are

bought and sold and if for any reason,

I would like to get out of this investing scheme,

I just sell this bond in the market to someone else

and this someone else now becomes the lender to the business.

So this ability is hugely important for investors,

because the market with higher liquidity and

liquidity here is somewhat different from liquidity to study of red triangles,

like with here means the ability to sell

the investment to someone else at a limited loss,

well maybe at the profit but this is a great case.

So, if and when I would like to get out of the first contract,

I don't have to negotiate with the borrower.

I just sell my bond and I'm out of this,

I get and get my cash.

So see what happens,

the existence of this market it serves as if you will sue

the insurance and that provides a way for me to get out,

if for any reason I would like to do so.

I saw a nightmare,

I need my cash earlier,

I just stopped believing in these businesses,

whatever and then I sell my bonds and then I'm out,

by the same token when it comes to the stock.

Indeed, I do not observe what's going on here,

but the market sort of watches there and again if for any reason,

I would like to stop being the equity investor in

this company I would like to stop being a shareholder and I like to get out,

if there exists a liquid market for

the stock I just sell it to someone else and then I'm out, that's it.

So you can see that the whole idea of public markets is very important here.

Now, the question only is.

I will reproduce that once again,

if here are the investors and here are

these businesses and all

this is the market.

The question is who makes this market?

Who fills this pool with existing securities?

Who supports the idea that stocks and bonds are bought and sold?

Who does that?

Well clearly, this is again the case that produces

huge demand for a special institution that let's say,

fills the pool with

securities and then

supports the market.

All that is done by investment bank, I'll put up.

I B, Let's put it.

Well I dropped the red marker,

so I'll put it like this.

Now and when we say, who fills?

Well clearly you say wait a minute the investment bank does not issue securities,

well unless this is the use of it's own.

Yes indeed, but it helps these people to issue securities and to fill this pool.

You know, the normal story of any security goes that the company started somewhere and

finally I guess the point of

issuing its securities in the way of the IPO we talk about that in greater,

in the episodes to follow.

But for now, we have to realize that

the fundamental demand for the existence of an investment bank is provided

by the need to ensure efficient movement of

money between the final investors and these final users in public markets.

In the markets in which private information does exist,

but in sort of a little bit other forms and as we will see throughout

this week it still keeps playing an extremely important role in this process,

but in somewhat different way.

So now, we have come to a point,

after having analyzed public capital markets,

to pose a question.

So, what do investment banks do and we will talk about that in our next episode.

5.2. Public capital markets. The demand for investment banking services

Capital Markets and Financial Institutions – How to Survive Them

Meet the Instructors