Chap 2

Foundations of FinanceArthur Keown

John D. Martin

J. William Petty

The Financial Markets and Interest Rates

Chapter 2

Keown, Martin, Petty - Chapter 2

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Learning Objectives

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

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

3. Distinguish between privately placed securities and publicly offered securities.

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


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Learning Objectives5. Understand the rate-of-return relationships

among various classes of financing vehicles that persist in the financial markets.

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

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

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


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Slide Contents

1. Principles Used in this chapter2. Components of US Financial Market3. Investment Banker4. Sarbanes-Oxley Act5. Rates of Return in Financial Market6. Interest Rate Determinants7. Term Structure of Interest Rates8. Finance and the Multinational Firm

1. Principles Used in this Chapter


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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.

2. Components of U.S. Financial Market System

Public Offering Versus Private PlacementPrimary Versus Secondary Market

Money Versus Capital MarketOrganized Exchange Versus OTC market

Spot Versus Futures Market


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Financial Markets

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

Financial markets are institutions and procedures that facilitate transactions in all types of financial claims. A securities market is simply a place where you can buy and sell securities (example, New York Stock Exchange)


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Benefits of Financial Markets example

If you have $200,000 to invest, what would be the benefit of buying shares in 20 corporations rather than opening your own business?


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Benefits of investing in financial assets (like stocks) rather than investing in own business

1. Reduced risk through diversification.

With $200,000 you can perhaps invest in only one business whereas with $200,000 you can invest $10,000 each in stocks of 20 Companies. Such diversification reduces risk as not all companies will fail at the same time!

2. Low time commitment

3. Limited liability

4. No or low expertise needed

5. Easy to exit/enter

6. Continuous valuation of your wealth


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Figure 2-1

Examines the relationship between financial markets and the corporation


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Public Offerings Versus Private Placements

Public Offering – Both individuals and institutional investors have the opportunity to purchase securities. The securities are initially sold by the managing investment bank firm. The issuing firm never actually meets the ultimate purchaser of securities

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


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Role of Venture capitalist Venture capitalists play a leading role in the

private placement market. They are a prime source of funding for start-up companies and companies in “turnaround” situations. Funding for such ventures are risky, but carry the potential for high returns.

The borrowing firm may not have the option of pursuing public offering due to: small size, no record of profits, and uncertain future growth prospects.


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Primary Versus Secondary Market

Primary Market (initial issue)

Market in which new issues of a security are sold to initial buyers. This is the only time the issuing firm ever gets any money for the securities.

Example: Google raised $1.76 billion through sale of shares to public in August 2004.

Secondary Market (subsequent trading)

Market in which previously issued securities are traded. The issuing corporation does not get any money for stocks traded on the secondary market.

Example: Trading among investors today of Google stocks.


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Money versus Capital Market Money Market

Market for short-term debt instruments (maturity periods of one year or less). Money market is typically a telephone and computer market (rather than a physical building)

Examples: Treasury bills (issued by federal government), commercial paper, negotiable CDs, bankers’ acceptances.

Capital Market

Market for long-term securities (maturity greater than one year).

Examples: Corporate Bonds, Common stocks, Treasury Bonds, term loans and financial leases


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Exchange Versus OTC

Exchanges are tangible entities and financial instruments are traded on the premises.

There are 7 organized exchanges in the United States (ex. NYSE). Firms listed on the exchanges must comply with the listing requirements of the exchange and SEC.

For example: NYSE listing requirements encompass profitability, size, market value and public ownership. (see table 2-1)

Stock exchange benefits: Provides a continuous market, establishes and publicizes fair security prices, helps business raise new capital


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OTC OTC (Over-the-Counter) market refers to all

securities markets except organized exchanges. There is no specific geographic location for OTC market. Most transactions are done through a loose network of security dealers who are known as broker-dealers and brokers.

Most prominent for stocks is NASDAQ (“screen based, floorless market) that lists more securities than NYSE (including Google, Microsoft, Starbucks)

Most corporate bond transactions are also conducted on OTC markets.


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Spot Versus Futures Market

Spot market refers to the cash market, where transaction takes place on the spot/today at the current market price (called spot rate)

Futures market refers to the creation of an agreement to buy/sell in the future at a price set today.

3. Investment Banker


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Investment Banker They are financial specialists involved as an

intermediary in the sale of securities (stocks and bonds). They buy the entire issue of securities from the issuing firm and then resell it to the general public.

Prominent investment banks in the US include Goldman Sachs, Merrill Lynch, Lehman Brothers, Citigroup/Salomon Smith Barney (See table 2-2).


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Functions of an Investment Banker

Underwriting:

Underwriting means assuming risk. Since money for securities is paid to the issuing firm before the securities are sold, there is a risk to the investment bank(s).

Distributing:

Once the securities are purchased from issuing firm, they are distributed to ultimate investors.

Advising:

On timing of sale, type of security etc.


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Distribution Methods

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


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Negotiated Purchase Issuing firm selects an investment banker to

underwrite the issue. The firm and the investment banker

negotiate the terms of the offer. Competitive Bid

Several investment bankers bid for the right to underwrite the firm’s issue.

The firm selects the banker offering the highest price.



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Best Efforts Issue is not underwritten i.e. no money is

paid upfront for the stocks ==> No risk for the Investment banks

Investment bank attempts to sell the issue for a commission.

Privileged Subscription Investment banker helps market the new

issue to a select group of investors. Usually targeted to current stockholders,

employees, or customers.



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Dutch Auction Investors place bids indicating how many

shares they are willing to buy and at what price. The price the stock is then sold for becomes the lowest price at which the issuing company can sell all the available shares.

See figure 2-2



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Direct Sale Issuing firm sells the securities directly to

the investing public. No investment banker is involved. Example: Private placement



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Private Placements Trade-offs

Advantages Faster to raise money Reduced Floatation Costs Financing Flexibility

Disadvantages Interest Costs higher than public issues Restrictive Covenants Possible Future SEC Registration


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Floatation Cost

Transaction cost incurred when a firm raises funds by issuing securities:

1. Underwriter’s spread (Difference between gross and net proceeds)

2. Issuing costs(printing and engraving of security certificates, legal fees, accounting fees, trustee fees, other miscellaneous expenses)

4. Sarbanes-Oxley Act


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Sarbanes-Oxley Act

In response to corporate scandals, Congress passed this Act in 2002.

This Act holds senior corporate advisors (such as accountants, lawyers, board of directors, officers) responsible for any instances of misconduct.

Thus the Act attempts to protect the interest of investors by improving transparency and accuracy of corporate disclosures.

5. Rates of Return in Financial Markets


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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 rate of return in the financial markets

Real Return — Return earned above the rate of inflation

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.


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Figure 2-3 shows that investors demand compensation for inflation and other elements of risk (such as default). Thus higher risk securities (common stocks) offer higher return in the long-run.

Rates of Return in Financial Markets


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6. Interest Rate Determinants


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Interest Rate Determinants Nominal Rate = Real rate + Inflation risk

premium + Default Risk premium + Maturity Premium + Liquidity Premium

Thus the nominal rate or quoted rate for securities is driven by all of the above risk premium factors. Such knowledge is critical when companies set an interest rate for their issues.

Review the example on pages 48-49.


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Real and Nominal Rates

k = k* + IRP + (k*xIRP)

Where k= nominal rate of returnk* = real rate of returnIRP = Inflation risk

premium


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Example

What is the real rate of return, if the inflation is 5% and the quoted rate is 11.3%

.113 = k* + .05 + .05xk* .063 = 1.05k*==>k* = .06 or 6%

7. Term Structure of Interest Rates or Yield-to-Maturity


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Term Structure of Interest Rates or Yield to Maturity

The graph shows the relationship between a debt security’s rate of return and the length of time until the debt matures, where the risk of default is held constant.

The graph could be upward sloping (indicating longer term securities command higher returns), flat or inverted (longer term securities command lower returns compared to short-term securities).

The graph changes over time. Upward sloping curve is most commonly observed.

Figure 2-5


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Theories to explain the shape

1. Unbiased Expectations Theory

2. Liquidity Preference Theory

3. Market Segmentation Theory


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Unbiased Expectations Theory

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


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Liquidity Preference Theory

Investors require maturity premiums to compensate them for risks of uncertain future interest rates.


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Market Segmentation Theory

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

8. Finance and The Multinational Firm


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Finance and The Multinational Firm Well developed financial markets contribute to the

overall growth of an economy.

US has a well developed financial market that allows for efficient transfer of capital from “savers” to “users” leading to timely financing of investments.

Multinational firms with excess cash will prefer to invest in countries that have well developed financial markets and stable political environments.

Developing countries, with less developed financial markets, attract less investment from multinational firms, which contributes to their slower pace of development.

Documents

Chap 2