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Principles of Managerial Finance

Brief Edition

Chapter 2

Institutions, Markets, and

Interest Rates

Learning Objectives• Identify key participants in financial transactions and

the basic activities and changing role of financial

institutions.

• Understand the relationship between financial

institutions and markets, and the basic function and

operation of the money market.

• Describe the capital market, the securities traded

there, and the role of the securities exchanges in the

capital market.

Learning Objectives

• Be able to interpret bond & stock quotations.

• Understand the role of the investment banker in

securities offerings.

• Describe the fundamentals of interest rates and

required returns: inflation, term structure, risk

premiums, and the basic relationship between risk and

rates of return.

• Explain the fundamentals of business taxation, and

the role of S corporations.

Effective Financial Systems• An effective financial system must posses three

characteristics:

– monetary systems that provide an efficient medium for exchanging goods and services,

– facilitate capital formation whereby excess capital from savers is made available to borrowers (investors), and

– efficient and complete financial markets which provide for the transfer of financial assets (such as stocks and bonds), and for the conversion of such assets into cash.

Financial Intermediaries in the U.S.

Depository Institutions Finance Companies

Commercial Banks Sales Finance Companies

S&Ls Sconsumer Finance Companies

Savings Banks Commercial Finance Companies

Credit Unions

Selected Securities Market Institutions

Contractual Savings Institutions Mortgage Banking Companies

Life Insurance Companies Investment Bankers & Brokerage Companies

Private Pension Funds Organized Securities Markets

State & Local Government Retirement Funds Credit Reporting Organizations

Government Credit-Related Agencies

Investment Institutions

Investment Companies and Mututal Funds

Real Estate Investment Trusts

Money Market Funds

Major Intermediaries in the U.S. Financial System

• Intermediation is the process by which savings are

accumulated in depository institutions and then lent or

invested.

• During periods of disintermediation,such as during the

late 1970s and early 1980s, funds actually flow out

of depository institutions.

• This impedes the flow of funds to demanders such as

businesses or individuals wishing to finance homes or

cars.

Financial Intermediation

Banking Legislation

• DIDMCA (1980) actually consisted of two parts:

Depository Institutions Deregulation and Monetary

Control.

• DID was designed to do a number of things:

– curtail regulation Q (interest rate ceilings)

– increase various sources of funding available to

banks

– expand the scope and activity of S&Ls by allowing

them to invest in other than home mortgages

Depository Institutions Deregulation and Monetary Control Act (DIDMCA)

Banking Legislation

• The monetary control (MC) portion of DIDMCA was

designed to extend the Fed’s control to thrifts and

nonmember banks by extending reserve requirements

and other controls to them.

• This permitted both greater competition for deposits

and more flexibility in terms of the types of investments

various institutions could make.

Depository Institutions Deregulation and Monetary Control Act (DIDMCA)

Banking Legislation

• The principal focus of the Garn-St. Germain Act (1982)

was to assist the ailing S&L industry.

• This was in direct response to the dramatic increase in

inflation and interest rates in 1980-81 which caused

massive withdrawals from S&Ls to MMMFs which

could pay market interest rates on short term deposits.

• Specifically, it authorized S&Ls to issue MMDAs with

no regulated interest rate ceiling, and allowed them to

make non-residential real estate loans.

Garn-St. Germain Depository Institutions Act

The S&L Crisis• The extensive deregulation of the early 1980s allowed

S&Ls to invest in assets in which they had little prior

experience - particularly risky commercial real estate.

• Because many of these investments were ill conceived

resulting in large default rates, many S&Ls became

insolvent.

• Because depositors were insured by the FDIC, the

federal government had an obligation to provide

reimbursement to depositors to the tune of $500 billion.

Deposit Insurance• Federal deposit insurance was first established during

the Great Depression.

• Three separate institutions provided insurance for the

three main types of institutions:

– FDIC for Banks

– FSLIC for S&Ls

– NCUSIF for Credit Unions

• The level of insurance per account was increased over

the years until it stood at $100,000 by 1980.

Deposit Insurance• In 1989, the FSLIC was absorbed into the FDIC

because the high S&L bankruptcy rate during the

1980s also resulted in the bankruptcy of the FSLIC.

• One special problem with deposit insurance is the “too

big to fail” assumption meaning that banks would

always be bailed out in crisis due to the far reaching

effects caused by failure.

• This problem was addressed by the Federal Deposit

Insurance Corporation Improvement Act (FDICIA) in

1991.

The Relationship between Financial Institutions and Financial Markets

• While real assets include the direct ownership of

tangible assets such as land or buildings, financial

assets represent claims against the income and

assets of those who issued the claims.

• Types of financial assets include stocks, bonds, and

bank deposits.

• Some financial assets, such as stocks and bonds, can

be traded in the secondary markets while others, such

as bank deposits, cannot.

Claims to Wealth

• Marketable financial assets can be further

categorized according to whether they trade in the

primary market or the secondary market.

• Primary markets are where new securities are

issued.

• Secondary markets are where securities are bought

and sold after initially issued in the primary

markets.

• In addition, financial assets may be money market

instruments or capital market instruments.

Claims to Wealth

Claims to Wealth

Money Market Instruments Capital Market InstrumentsU.S. Treasury Bills U.S. Treasury Notes & Bonds

Negotiable CDs U.S. Government Agency Bonds

Bankers Acceptances State & Local Government Bonds

Federal Funds Corporate Bonds

Commercial Paper Corporate Stocks

Repurchase Agreements Real Estate Mortgages

• Examples of money market and capital market

instruments include the following:

Capital MarketsBonds

• Bonds are long-term debt instruments issued by

corporations and government.

• Corporate bonds typically pay interest

semiannually, pay fixed coupon interest, have a par or

face value of $1,000 and have an original maturity of

10 to 30 years.

• Furthermore, bonds have a prior claim on the firm’s

assets but do not represent ownership in the firm.

Capital MarketsStocks

• Unlike bonds, common stock represents ownership

in a business, expect to receive periodic dividends,

and hope to profit through an increase in share price.

• Preferred stock possesses features of both common

stocks and bonds and are sometimes referred to as

hybrid securities.

• Like bonds, they provide fixed payments to holders.

• Like common stock, they have no maturity date.

Securities ExchangesOrganized Exchanges

• Organized securities exchanges are tangible

secondary markets where outstanding securities are

bought and sold.

• They account for over 60% of the dollar volume of

domestic shares traded.

• Only the largest and most profitable companies meet

the requirements necessary to be listed on the New

York Stock Exchange.


• Only those that own a seat on the exchange can make

transactions on the floor (there are currently 1,366

seats).

• Trading is conducted through an auction process

where specialists “make a market” in selected

securities.

• As compensation for executing orders, specialists

make money on the spread (bid price - ask price).


Requirements NYSE AMEX

shares held by public 1,100,000 400,000

stockholders with 100+ shares 2,000 1,200

pretax income (latest year) $2,500,000

$750,000

pretax income (prior 2 years) $2,000,000 N/A

MV of public shares held $18,000,000 $300,000

tangible assets $16,000,000 $4,000,000

Securities ExchangesOver-the-Counter Exchange

• The over-the-counter (OTC) market is an intangible

market for securities transactions.

• Unlike organized exchanges, the OTC is both a

primary market and a secondary market.

• The OTC is a computer-based market where dealers

make a market in selected securities and are linked to

buyers and sellers through the NASDAQ System.

• Dealers also make money on the “spread”.

Securities Price

Quotations

Bond Quotations

Securities Price Quotations

Stock Quotations

Functions of Investment BankersUnderwriting, Private Placement & Best Efforts

• Corporations typically raise debt and equity capital

using the services of investment bankers through

public offerings.

• When underwriting a security issue, an investment

bankers guarantees the issuer will receive a

specified amount of money from the issue.

• The investment banker purchases the securities from

the firm at a lower price than the planned resale price.

Functions of Investment Bankers

• When underwriting an issue, the investment banker

bears the risk of price changes between the time of

purchase and the time of resale.

• With a private placement, the investment banker

arranges for the direct sale of the issue to one or

more individuals or firms and receives a commission

for acting as the intermediary in the transaction.

• When a firm issues securities on a best efforts basis,

compensation is based on the number of securities

sold.

Underwriting, Private Placement & Best Efforts

Functions of Investment Bankers

• Underwriters also act as advisors and consultants for

corporations.

• They can assist firms in planning both the timing of

an issue and the amount and features of an issue.

• They also can assist in evaluating mergers and

acquisitions.

Advising

Other Aspects of Investment Banking

• An investment banker may be selected through

competitive bidding, where the banker or group of

bankers that bids the highest price for an issue is

chosen for the underwriting.

• With a negotiated offering, the investment

banker is merely hired rather than awarded the issue

through a competitive bid.

Selecting an Investment Banker


• Underwriting syndicates are typically formed when

companies bring large issues to the market.

• Each investment banker in the syndicate normally

underwrites a portion of the issue in order to reduce

the risk of loss for any single firm and insure wider

distribution of shares.

• The syndicate does so by creating a selling group

which distributes the shares to the investing public.

Syndicating the Underwriting

Other Aspects of Investment BankingSyndicating the Underwriting


• Before a new security can be issued, the firm must file

a registration statement with the SEC at least 20 days

before approval is granted.

• One part of the registration statement called the

prospectus details the firm’s operating and financial

position.

• However, a prospectus may be distributed to potential

investors during the approval period as long as a red

herring is printed on the front cover.

Registration Requirements


• As an alternative to filing cumbersome registration

statements, firms with more than $150 million in

outstanding stock can use a procedure called shelf

registration.

• This allows the firm to file a single document that

covers all issues during the subsequent 2 year period.

• As a result, the approved securities are kept “on the

shelf” until the need for or market conditions are

appropriate for issue.

Registration Requirements


• In general, underwriters wait until the end of the

registration period to price securities to ensure

marketability.

• If the issue is fully sold, it is considered an

oversubscribed issue; if not fully sold, it is considered

undersubscribed.

• In order to stabilize the issue at the initial offering price

as it is being offered for sale, investment bankers often

place orders to purchase the security themselves.

Pricing & Distributing an Issue


• Investment bankers earn their income by profiting on

the spread.

• The spread is difference between the price paid for the

securities by the investment banker and the eventual

selling price in the marketplace.

• In general, costs for underwriting equity is highest,

followed by preferred stock, and then bonds.

• In percentage terms, costs can be as high as 17% for

small stock offerings to as low as 1.6% for large bond

issues.

Cost of Investment Banking Services


• Although diminishing in frequency, firms can also

negotiate private placements rather than public

offerings.

• Private placements can reduce administrative and

issuance costs for firms since registration and

approval from the SEC is not required.

• However, they do pose problems for purchasers since

the securities cannot not be resold via secondary

markets.

Private Placements

Interest Rates & Required Returns

• The term structure of interest rates relates the interest

rate to the time to maturity for securities with a

common default risk profile.

• Typically, treasury securities are used to construct yield

curves since all have zero risk of default.

• However, yield curves could also be constructed with

AAA or BBB corporate bonds or other types of similar

risk securities.

Term Structure of Interest Rates

Interest Rates & Required ReturnsTerm Structure of Interest Rates

Impact of Inflation

Interest Rates & Required ReturnsTerm Structure of Interest Rates

Yield Curves

Theories of Term Structure

• This theory suggest that the shape of the yield curve

reflects investors expectations about the future

direction of inflation and interest rates.

• Therefore, an upward-sloping yield curve reflects

expectations of higher future inflation and interest

rates.

• In general, the very strong relationship between

inflation and interest rates supports this theory.

Expectations Hypothesis


• This theory contends that long term interest rates tend

to be higher than short term rates for two reasons:

– long-term securities are perceived to be riskier than

short-term securities

– borrowers are generally willing to pay more for long-

term funds because they can lock in at a rate for a

longer period of time and avoid the need to roll over

the debt.

Liquidity Preference Theory


• This theory suggests that the market for debt at any

point in time is segmented on the basis of maturity.

• As a result, the shape of the yield curve will depend on

the supply and demand for a given maturity at a given

point in time.

Market Segmentation Theory

Risk Premiums

• Default Risk

• Maturity Risk

• Liquidity Risk

• Contractual Provisions

• Tax Risk

Issue & Issuer Characteristics

Expected Risk & Required Return

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