Financial markets and interest rate

Chapter 2

The Financial Markets and Interest Rates

Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr.

Chapter 2 The Financial Markets and Interest Rates

Pearson Prentice HallFoundations of Finance2 - 2

Chapter Objectives

• Understanding the historical relationship between internally generated and externally generated sources of funds.

• Understand the financing mix that tends to be used by the firms raising long-term capital.

• Explain why the financial markets exist in a developed country.

• Explain the financing process by which savings are supplied and raised by major sectors in the economy.



Chapter Objectives

• Describe key components of the U.S. financial market system.

• Understand the role of the investment-banking business in the context of raising corporate capital.

• Distinguish between privately placed securities and publicly offered securities.

• Be acquainted with securities floatation costs and securities markets regulations.



Chapter Objectives

• Understand the rate-of-return relationships among various classes of financing vehicles that persist in the financial markets.

• Be acquainted with recent interest rate levels and the fundamentals of interest rate determination.

• Explain the popular theories of the term structure of interest rates.

• Understand the relationships among the multinational firm, efficient financial markets, and the inter-country risk.



Principles Used in this Chapter

Principle 1: The Risk-Return Tradeoff - We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return.

Principle 6: Efficient Capital Markets - The Markets are Quick and the Prices Are Right.

Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance.



Federal Funds Rate

• Short-term market rate of interest

• Serves as a sensitivity indicator of the direction of future changes in interest rates



Objectives of the Fed

• Maximum sustainable employment

• Price stability



Recent Interest Rate Cycles

Early 1994 & 1997

Inflation Raise interest Rates

Fall 1998 International Pressures Lower interest rates

Summer 1999

Tight labor markets, aggregate real growth, inflation

Raise interest rates

Early 2001 Contracting manufacturing output, slower business capital spending, equity market sell-off, recession

Lower interest rates

Summer 2004

Firming Labor market, stronger retail sales, improving industrial production, hot housing market, increases in energy prices, all suggesting unacceptable future rates of inflation.

Raise interest rates



Nonfinancial Corporate Business Sources of Funds, 1981-2000

• Changes in market conditions influence the way corporate funds are raised

• Example: High interest costs discourage the use of debt.

Internal Funds72.30%

External Funds27.70%



Corporate Securities Offered for Cash

• Nonfinancial Corporations- 3yr. Cash Weighted Average, 2001-2003

• Total Volume($M)– $1,288,515

Bonds and

Notes85.70%

Equities14.30%

Source:Statistical Supplement to the Federal Reserve Bulletin, Table 1.46, October 2004, A29.



Debt/Equity Mix

• U.S. tax system favors debt as means of raising capital

• Interest expense is deductible

• Dividends paid are not deductible



Financial Markets

• Financial markets are institutions and procedures that facilitate transactions in all types of financial claims

• Financial markets exist in order to allocate the supply of savings in the economy to the demanders of those savings.



Financial Markets

• Real assets are tangible assets such as houses, equipment, and inventories.

• Financial assets represent claims for future payments in other economic units.



• Underwriting — the purchase of financial claims of borrowing units and reselling them at a higher price to other investors.

• Secondary Markets — trading in already existing financial claims

• Financial Intermediaries — major financial institutions i.e. commercial banks, savings and loans, credit unions, life insurance companies, mutual funds etc.

Financial Markets



• Indirect Securities – financial claims offered by financial intermediaries to economic units with excess savings

• Direct Securities – financial claims purchased by financial intermediaries with proceeds from the sale of indirect securities

Financial Markets



The Financing Process

Sector Funds Raised ($)

Funds Supplied ($)

Net Funds Supplied ($)

Households 447.4 397.1 (50.3)

Nonfinancial Corporate Business

447.5 383.8 (63.7)

U.S. Gov’t 73.9 62.9 (11.0)State and Local Gov’ts

56.4 48.4 ( 8.0)

Foreign 320.2 561.7 241.5Source: Flow of Funds Accounts, First Quarter 2000, Flow if Funds Section, Statistical Release Z.1 (Washington, D.C.; Board of Governors of the Federal Reserve System, June 9,2000).



Movement of Savings

• Direct Transfer of Funds

• Indirect Transfer of Funds Using an Investment Banker

• Indirect Transfer of Funds Using the Financial Intermediary



Three Ways to Transfer Financial Capital in the Economy

Three Ways to Transfer Financial Capital in the Economy



Public Offerings and Private Placements

• Public Offering – both individuals and institutional investors have the opportunity to purchase securities

• Private Placement (direct placement) – the securities are offered and sold to a limited number of investors



Primary and Secondary Markets

• Primary Markets – Securities are offered for the first time to investors – a new issue of stock. Increases the total stock of financial assets outstanding in the economy.

• Secondary Markets – Transactions in currently outstanding securities. All transactions after the initial purchase. Sales do not affect the total stock of financial assets that exist in the economy.



Money Market and Capital Market

• Money Market: all institutions and procedures that provide for transactions in short-term debt instruments

• Capital Market: all institutions and procedures that provide for transactions in long-term financial instruments



Organized Security Exchanges and Over-the-Counter Markets

• Organized Security Exchanges—Tangible entities; physically operate space, where financial instruments are traded on the premises– National and regional exchanges

• New York Stock Exchange• American Stock Exchange• Chicago Stock Exchange

• Over-The-Counter Markets—All security markets except the organized exchanges– Money Market



Stock Exchange Benefits

• Provides a continuous market

• Establishes and publicizes fair security prices

• Helps businesses raise new capital



Listing Requirements

• Listing criteria varies from exchange to exchange. General requirements include:

*Profitability*Market Value*Public Ownership



Investment Banker

• A financial specialist involved as an intermediary in the merchandising of securities; facilitates flow of savings from economic units that want to invest in those units that want to raise funds.



Functions of an Investment Banker

• Underwriting

• Distributing

• Advising



Distribution Methods

• Negotiated Purchase• Competitive Bid Purchase• Commission or Best Efforts Basis• Privileged Subscription• Direct Sales



Private Placements

• Advantages– Speed– Reduced Flotation Costs– Financing Flexibility

• Disadvantages– Interest Costs– Restrictive Covenants– Possible Future SEC Registration



Market Regulation

• Securities Act of 1933 — Aims to provide potential investors with accurate, truthful disclosure about the firm and new securities being offered.

• Securities Exchange Act of 1934 — Created SEC to enforce federal securities laws

• Securities Acts Amendments of 1975 —Created a national market system



Securities Exchange Act of 1934

• Major security exchanges must register with the SEC– Insider trading is regulated – Prohibits manipulative trading– SEC control over proxy procedures– Gives Board of Governors of Federal

Reserve System responsibility for setting margin requirements



Sarbanes-Oxley Act of 2002

• Congress passed in July 2002 the Public Accounting and Reform and Investor Protection Act

• The Act contains 11 titles which tighten significantly the latitude given corporate advisors who have access to or influence company decisions.



Sarbanes-Oxley Act of 2002Key Elements

• Public Company Accounting Oversight Board• Auditor Independence• Corporate Responsibility• Enhanced Financial Decisions• Analysts Conflicts of Interest• Commission Resources and Authority• Studies and Reports• Corporate and Criminal Fraud Accountability• White-Collar Crime Penalty Enhancements• Corporate Tax Returns• Corporate Fraud and Accountability



Rates of Return in Financial Markets

• Opportunity Cost — Rate of return on next best investment alternative to the investor

• Standard Deviation — Dispersion or variability around the mean, or average of the rate of return in the financial markets

• Maturity Premium — Additional return required by investors in long-term securities to compensate them for greater risk of price fluctuations on those securities caused by interest rate changes



• Liquidity Premium — Additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price.

• Real Return — Return earned above the rate of increase in the general price level for goods and services in the economy (the inflation rate)

• Real Rate of Interest — Rate of increase in actual purchasing power—after adjusting for inflation

Rates of Return in Financial Markets



Term Structure of Interest Rates

• The relationship between a debt security’s rate of return and the length of time until the debt matures.

• Also called “Yield to Maturity”



Term Structure of Interest Rates

Explained by:

• Unbiased Expectations Theory• Liquidity Preference Theory• Market Segmentation Theory



Unbiased Expectations Theory

• Term Structure is determined by an Investor’s expectations about future interest rates.



Liquidity Preference Theory

• Investors require maturity premiums to compensate them for buying securities that expose them to the risks of fluctuating interest rates



Market Segmentation Theory

• Legal restrictions and personal preferences limit choices for investors to certain ranges of maturities



Financial Markets and Intercountry Risk

• Financial System Risk

• Political System Risk

• Exchange Rate Risk