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Ch. 2 - The Financial Marketsand Interest Rates
2000, Prentice Hall, Inc.
Q: What are SECURITIES?
A:A: Financial Assets that Financial Assets that Investors purchase hoping to Investors purchase hoping to
earn a earn a high rate of return.high rate of return.
Types of Securities
Treasury Bills and Treasury BondsTreasury Bills and Treasury Bonds Municipal BondsMunicipal Bonds Corporate BondsCorporate Bonds Preferred StocksPreferred Stocks Common StocksCommon Stocks
Which of these are Which of these are RISKYRISKY??
Which promise Which promise HIGH RETURNSHIGH RETURNS??
Is there a relationship betweenIs there a relationship between RISKRISK and and RETURNRETURN??
Corporate FinancingSources
In 1996, over $500 billion in external In 1996, over $500 billion in external corporate financing was raised.corporate financing was raised.
From 1981 through 1996, capital has been From 1981 through 1996, capital has been raised through the following sources:raised through the following sources:
Corporate Bonds and NotesCorporate Bonds and Notes 75.6%75.6% Preferred StockPreferred Stock 4.2%4.2% Common StockCommon Stock 20.2%20.2%
Movement of Savings
Direct Transfer of FundsDirect Transfer of Funds
Movement of Savings
Direct Transfer of FundsDirect Transfer of Funds
saver
Movement of Savings
Direct Transfer of FundsDirect Transfer of Funds
saverfirm
Movement of Savings
Direct Transfer of FundsDirect Transfer of Funds
cashcash
saverfirm
Movement of Savings
Direct Transfer of FundsDirect Transfer of Funds
cashcash
securitiessecurities
saverfirm
Movement of Savings
Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker
Movement of Savings
Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker
investmentbanker
Movement of Savings
Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker
investmentbanker firm
Movement of Savings
Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker
fundsfunds
investmentbanker firm
Movement of Savings
Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker
fundsfunds
securitiessecurities
investmentbanker firm
Movement of Savings
Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker
fundsfunds
securitiessecurities
saver
investmentbanker firm
Movement of Savings
Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker
fundsfundsfundsfunds
securitiessecurities
saver
investmentbanker firm
Movement of Savings
Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker
securitiessecurities
fundsfundsfundsfunds
securitiessecurities
saver
investmentbanker firm
Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary
Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary
financialintermediary
Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary
financialintermediary firm
Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary
fundsfunds
financialintermediary firm
Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary
fundsfunds
firmfirmsecuritiessecurities
financialintermediary firm
Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary
fundsfunds
firmfirmsecuritiessecurities
financialintermediary firm
saver
Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary
fundsfunds fundsfunds
firmfirmsecuritiessecurities
financialintermediary firm
saver
Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary
fundsfunds
intermediaryintermediarysecuritiessecurities
fundsfunds
firmfirmsecuritiessecurities
financialintermediary firm
saver
Financial Market Components
Public OfferingPublic Offering
Financial Market Components
Public OfferingPublic Offering Firm issues securities, which are Firm issues securities, which are
made available to both individual made available to both individual and institutional investors.and institutional investors.
Financial Market Components
Public OfferingPublic Offering Firm issues securities, which are Firm issues securities, which are
made available to both individual made available to both individual and institutional investors.and institutional investors.
Private PlacementPrivate Placement
Financial Market Components
Public OfferingPublic Offering Firm issues securities, which are Firm issues securities, which are
made available to both individual made available to both individual and institutional investors.and institutional investors.
Private PlacementPrivate Placement Securities are offered and sold to a Securities are offered and sold to a
limited number of investors.limited number of investors.
Financial Market Components
Primary MarketPrimary Market
Financial Market Components
Primary MarketPrimary Market Market in which new issues of a Market in which new issues of a
security are sold to initial buyers.security are sold to initial buyers.
Financial Market Components
Primary MarketPrimary Market Market in which new issues of a Market in which new issues of a
security are sold to initial buyers.security are sold to initial buyers.
Secondary MarketSecondary Market
Financial Market Components
Primary MarketPrimary Market Market in which new issues of a Market in which new issues of a
security are sold to initial buyers.security are sold to initial buyers.
Secondary MarketSecondary Market Market in which previously issued Market in which previously issued
securities are traded.securities are traded.
Financial Market Components
Money MarketMoney Market
Financial Market Components
Money MarketMoney Market Market for short-term debt Market for short-term debt
instruments (maturity periods of instruments (maturity periods of one year or less).one year or less).
Financial Market Components
Money MarketMoney Market Market for short-term debt Market for short-term debt
instruments (maturity periods of instruments (maturity periods of one year or less).one year or less).
Capital MarketCapital Market
Financial Market Components
Money MarketMoney Market Market for short-term debt Market for short-term debt
instruments (maturity periods of instruments (maturity periods of one year or less).one year or less).
Capital MarketCapital Market Market for long-term securities Market for long-term securities
(maturity greater than one year).(maturity greater than one year).
Financial Market Components
Organized ExchangesOrganized Exchanges
Financial Market Components
Organized ExchangesOrganized Exchanges Buyers and sellers meet in one central Buyers and sellers meet in one central
location to conduct trades.location to conduct trades.
Financial Market Components
Organized ExchangesOrganized Exchanges Buyers and sellers meet in one central Buyers and sellers meet in one central
location to conduct trades.location to conduct trades.
Over-the-Counter (OTC)Over-the-Counter (OTC)
Financial Market Components
Organized ExchangesOrganized Exchanges Buyers and sellers meet in one central Buyers and sellers meet in one central
location to conduct trades.location to conduct trades.
Over-the-Counter (OTC)Over-the-Counter (OTC) Securities dealers operate at many Securities dealers operate at many
different locations across the country.different locations across the country.
Financial Market Components
Organized ExchangesOrganized Exchanges Buyers and sellers meet in one central Buyers and sellers meet in one central
location to conduct trades.location to conduct trades.
Over-the-Counter (OTC)Over-the-Counter (OTC) Securities dealers operate at many Securities dealers operate at many
different locations across the country.different locations across the country. Connected by Connected by NasdaqNasdaq system (National system (National
Association of Securities Dealers Association of Securities Dealers Automated Quotation system).Automated Quotation system).
Investment Banking
How do investment bankers help How do investment bankers help firms issue securities?firms issue securities?
Underwriting the issue.Underwriting the issue.
Distributing the issue.Distributing the issue.
Advising the firm.Advising the firm.
Distribution Methods Distribution Methods
Negotiated PurchaseNegotiated Purchase
Distribution Methods Distribution Methods
Negotiated PurchaseNegotiated Purchase Issuing firm selects an investment Issuing firm selects an investment
banker to underwrite the issue.banker to underwrite the issue.
Distribution Methods Distribution Methods
Negotiated PurchaseNegotiated Purchase Issuing firm selects an investment Issuing firm selects an investment
banker to underwrite the issue.banker to underwrite the issue. The firm and the investment banker The firm and the investment banker
negotiate the terms of the offer.negotiate the terms of the offer.
Distribution Methods Distribution Methods
Negotiated PurchaseNegotiated Purchase Issuing firm selects an investment Issuing firm selects an investment
banker to underwrite the issue.banker to underwrite the issue. The firm and the investment banker The firm and the investment banker
negotiate the terms of the offer.negotiate the terms of the offer. Competitive BidCompetitive Bid
Distribution Methods Distribution Methods
Negotiated PurchaseNegotiated Purchase Issuing firm selects an investment Issuing firm selects an investment
banker to underwrite the issue.banker to underwrite the issue. The firm and the investment banker The firm and the investment banker
negotiate the terms of the offer.negotiate the terms of the offer. Competitive BidCompetitive Bid
Several investment bankers bid for the Several investment bankers bid for the right to underwrite the firm’s issue.right to underwrite the firm’s issue.
Distribution Methods Distribution Methods
Negotiated PurchaseNegotiated Purchase Issuing firm selects an investment Issuing firm selects an investment
banker to underwrite the issue.banker to underwrite the issue. The firm and the investment banker The firm and the investment banker
negotiate the terms of the offer.negotiate the terms of the offer. Competitive BidCompetitive Bid
Several investment bankers bid for the Several investment bankers bid for the right to underwrite the firm’s issue.right to underwrite the firm’s issue.
The firm selects the banker offering The firm selects the banker offering the highest price. the highest price.
Distribution Methods Distribution Methods
Best EffortsBest Efforts
Distribution Methods Distribution Methods
Best EffortsBest Efforts Issue is not underwritten.Issue is not underwritten.
Distribution Methods Distribution Methods
Best EffortsBest Efforts Issue is not underwritten.Issue is not underwritten. Investment bank attempts to sell the Investment bank attempts to sell the
issue for a commission. issue for a commission.
Distribution Methods Distribution Methods
Best EffortsBest Efforts Issue is not underwritten.Issue is not underwritten. Investment bank attempts to sell the Investment bank attempts to sell the
issue for a commission. issue for a commission. Privileged SubscriptionPrivileged Subscription
Distribution Methods Distribution Methods
Best EffortsBest Efforts Issue is not underwritten.Issue is not underwritten. Investment bank attempts to sell the Investment bank attempts to sell the
issue for a commission. issue for a commission. Privileged SubscriptionPrivileged Subscription
Investment banker helps market the Investment banker helps market the new issue to a select group of investors.new issue to a select group of investors.
Distribution Methods Distribution Methods
Best EffortsBest Efforts Issue is not underwritten.Issue is not underwritten. Investment bank attempts to sell the Investment bank attempts to sell the
issue for a commission. issue for a commission. Privileged SubscriptionPrivileged Subscription
Investment banker helps market the Investment banker helps market the new issue to a select group of investors.new issue to a select group of investors.
Usually targeted to current Usually targeted to current stockholders, employees, or customers.stockholders, employees, or customers.
Distribution Methods Distribution Methods
Direct SaleDirect Sale
Distribution Methods Distribution Methods
Direct SaleDirect Sale Issuing firm sells the securities directly Issuing firm sells the securities directly
to the investing public.to the investing public.
Distribution Methods Distribution Methods
Direct SaleDirect Sale Issuing firm sells the securities directly Issuing firm sells the securities directly
to the investing public.to the investing public. No investment banker is involved. No investment banker is involved.
Stock Issue Example:
Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.
What type of issue is this?What type of issue is this? It’s a It’s a negotiated purchasenegotiated purchase..
Stock Issue Example:
Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.
How many shares will be sold?How many shares will be sold?
Stock Issue Example:
Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.
How many shares will be sold?How many shares will be sold? $100,000,000 / $20 = $100,000,000 / $20 = 5 million5 million new new
shares of common stock.shares of common stock.
Stock Issue Example:
Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.
What are the flotation costs?What are the flotation costs?
Stock Issue Example:
Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.
What are the flotation costs?What are the flotation costs? Underwriting spreadUnderwriting spread: 2% of $100 : 2% of $100
million = $2 million.million = $2 million.
Stock Issue Example:
Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.
What are the flotation costs?What are the flotation costs? Underwriting spreadUnderwriting spread: 2% of $100 : 2% of $100
million = $2 million.million = $2 million. Issuing costsIssuing costs: printing and engraving : printing and engraving
costs; legal, accounting and trustee fees.costs; legal, accounting and trustee fees.
Stock Issue Example:
Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.
What are the risks?What are the risks?
Stock Issue Example:
Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.
What are the risks?What are the risks? The investment bank accepts the risk of The investment bank accepts the risk of
being able to sell the new stock issue for being able to sell the new stock issue for $20 per share. If the stock price falls, $20 per share. If the stock price falls, the investment bank could lose money.the investment bank could lose money.
Regulations:Regulations:The Primary MarketThe Primary Market
The Securities Act of 1933The Securities Act of 1933 Firms register with the Securities Firms register with the Securities
Exchange Commission (SEC).Exchange Commission (SEC). SEC has 20 days to review.SEC has 20 days to review.
Regulations:Regulations:The Primary MarketThe Primary Market
The Securities Act of 1933The Securities Act of 1933 Firms register with the Securities Firms register with the Securities
Exchange Commission (SEC).Exchange Commission (SEC). SEC has 20 days to review.SEC has 20 days to review.
SEC may ask for more information.SEC may ask for more information.
Regulations:Regulations:The Primary MarketThe Primary Market
The Securities Act of 1933The Securities Act of 1933 Firms register with the Securities Firms register with the Securities
Exchange Commission (SEC).Exchange Commission (SEC). SEC has 20 days to review.SEC has 20 days to review.
SEC may ask for more information.SEC may ask for more information. The firm can not solicit buyers during The firm can not solicit buyers during
the review period but can advertise.the review period but can advertise.
Regulations:The Secondary Market
The Securities Exchange Act of 1934The Securities Exchange Act of 1934 Established the SEC.Established the SEC. Exchanges must register with SEC.Exchanges must register with SEC. Company information must be Company information must be
available to the public.available to the public. Insider trading is regulatedInsider trading is regulated..
Regulations:Recent Developments
Securities Acts Amendments of 1975Securities Acts Amendments of 1975 Created National Market System.Created National Market System. Eliminated fixed brokerage Eliminated fixed brokerage
commissions.commissions.
SEC Rule 415SEC Rule 415 Allows Shelf RegistrationAllows Shelf Registration
Interest Rate Determinants
InterestRates
Interest RatesConceptuallyConceptually::
Interest RatesConceptuallyConceptually::
NominalNominalrisk-freerisk-freeInterestInterest
Rate Rate
kkrfrf
Interest RatesConceptuallyConceptually::
NominalNominalrisk-freerisk-freeInterestInterest
Rate Rate
kkrfrf
==
Interest RatesConceptuallyConceptually::
NominalNominalrisk-freerisk-freeInterestInterest
Rate Rate
kkrfrf
==
RealRealrisk-freerisk-freeInterestInterest
Rate Rate
k*k*
Interest RatesConceptuallyConceptually::
NominalNominalrisk-freerisk-freeInterestInterest
Rate Rate
kkrfrf
==
RealRealrisk-freerisk-freeInterestInterest
Rate Rate
k*k*
++
Interest RatesConceptuallyConceptually::
NominalNominalrisk-freerisk-freeInterestInterest
Rate Rate
kkrfrf
==
RealRealrisk-freerisk-freeInterestInterest
Rate Rate
k*k*
++
Inflation-Inflation-riskrisk
premiumpremium
IRPIRP
ConceptuallyConceptually::
NominalNominalrisk-freerisk-freeInterestInterest
Rate Rate
kkrfrf
==
RealRealrisk-freerisk-freeInterestInterest
Rate Rate
k*k*
++
Inflation-Inflation-riskrisk
premiumpremium
IRPIRP
MathematicallyMathematically::
Interest Rates
ConceptuallyConceptually::
NominalNominalrisk-freerisk-freeInterestInterest
Rate Rate
kkrfrf
==
RealRealrisk-freerisk-freeInterestInterest
Rate Rate
k*k*
++
Inflation-Inflation-riskrisk
premiumpremium
IRPIRP
MathematicallyMathematically::
(1 + k(1 + krfrf) = (1 + k*) (1 + IRP)) = (1 + k*) (1 + IRP)
Interest Rates
ConceptuallyConceptually::
NominalNominalrisk-freerisk-freeInterestInterest
Rate Rate
kkrfrf
==
RealRealrisk-freerisk-freeInterestInterest
Rate Rate
k*k*
++
Inflation-Inflation-riskrisk
premiumpremium
IRPIRP
MathematicallyMathematically::
(1 + k(1 + krfrf) = (1 + k*) (1 + IRP)) = (1 + k*) (1 + IRP)
This is known as the This is known as the ““Fisher EffectFisher Effect””
Interest Rates
Term Structure of Interest Rates The pattern of rates of return for debt The pattern of rates of return for debt
securities that differ only in the length of securities that differ only in the length of time to maturity.time to maturity.
Term Structure of Interest Rates The pattern of rates of return for debt The pattern of rates of return for debt
securities that differ only in the length of securities that differ only in the length of time to maturity.time to maturity.
yieldyieldto to
maturitymaturity
time to maturity (years)time to maturity (years)
Term Structure of Interest Rates The pattern of rates of return for debt The pattern of rates of return for debt
securities that differ only in the length of securities that differ only in the length of time to maturity.time to maturity.
yieldyieldto to
maturitymaturity
time to maturity (years)time to maturity (years)
Term Structure of Interest Rates
yieldyieldto to
maturitymaturity
time to maturity (years)time to maturity (years)
The yield curve may be downward The yield curve may be downward sloping or “inverted” if rates are sloping or “inverted” if rates are expected to fall.expected to fall.
Term Structure of Interest Rates
yieldyieldto to
maturitymaturity
time to maturity (years)time to maturity (years)
The yield curve may be downward The yield curve may be downward sloping or “inverted” if rates are sloping or “inverted” if rates are expected to fall.expected to fall.
Term Structure Theories
Unbiased Expectations TheoryUnbiased Expectations Theory the term structure is determined by the term structure is determined by
expectations of future rates.expectations of future rates. Liquidity Preference TheoryLiquidity Preference Theory
investors require maturity premiums to investors require maturity premiums to invest in longer term securities .invest in longer term securities .
Market Segmentation TheoryMarket Segmentation Theory there are separate markets for long and there are separate markets for long and
short term investments.short term investments.