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  • 1. The Financial System, Corporate Governance, and Interest
  • 2. The Financial System
    • The economy is divided into sectors
      • Consumption
      • Production (includes government)
      • Most people are in both sectors
        • as workers in production and as consumers at home
    • Services, products, and money flow between the sectors every day
      • Producers pay wages to workers for labor services
      • Workers spend incomes as consumers on production sector’s output
      • Producers spend revenues on materials and more labor to make more product
      • Creates a cyclical flow of money
    2
  • 3. BUT, Diagram Omits Two Things
    • Consumption sector
      • Most people do not consume all of their income—they save a portion
      • They deposit those savings and earn a return
    • Production sector
      • Companies need to raise money from time to time to finance large, infrequent projects
        • New factories, additional equipment, new enterprises
    • Economy has a need for and a source of $
    3
  • 4. Savings and Investment
    • Financial markets channel consumer savings to companies through the sale of financial assets
      • Companies issue securities to raise money usually to spend on big assets or projects
      • Consumers purchase securities to earn a return on their savings
    4
  • 5. The Term Invest
    • Using a resource to better one’s position in the future rather than for current consumption
      • Individuals invest by putting savings into financial assets: stocks, bonds, etc.
      • Companies invest by buying assets used in production
    • Funds available for business investment come from savings put into financial assets by individuals
    • Hence: SAVINGS EQUALS INVESTMENT
      • More precisely :
      • (Consumer) Savings Equals (Business) Investment
    5
  • 6. Raising and Spending Money in Business
    • Firms spend two kinds of money
      • Day-to-day funds – come from normal profits, support routine activities
      • Large sums needed for major projects and to get businesses started - comes from selling financial assets
          • Borrowing money: Debt Financing
          • Selling stock: Equity Financing
    6
  • 7. Term
    • The length of time between now and the end (or term ination ) of something
      • Long-term projects (lasting over 5-10 years) are financed with long-term funds
        • Debt (bonds)
        • Equity
      • Short-term projects (lasting less than 1 year) are financed with short-term funds
        • Bank loans
      • Process is known as maturity matching
    7
  • 8. Financial Markets
    • Capital Markets
      • Trade in stocks and long-term debt
    • Money Markets
      • Trade in short term debt securities
        • Federal government issues a great deal of short-term debt
    8
  • 9. Financial Markets: Primary and Secondary Markets
    • Primary Market: Initial sale of a security
      • Proceeds go to the issuer
    • Secondary Market: Subsequent sales of the security
      • Between investors
      • Company not involved
    9
  • 10. Primary and Secondary Markets
    • Corporations care about a stock’s price in the secondary market
      • Influences how much money can be raised in future stock issues
      • Senior management’s compensation is usually tied to stock price
    10
  • 11. Direct and Indirect Transfers, Financial Intermediaries
      • Directly
      • Issuer sells directly to buyers or through an investment bank
      • Investment bank lines up investors and functions as a broker
    • Indirectly
    • Financial intermediary sells shares in itself and invests the funds collectively on behalf of investors
    • Mutual fund is an example
    • Portfolio is collectively owned
    11 Primary market transactions can occur
  • 12. Transfer of Funds From Investors to Businesses Figure 5.3 12
  • 13. Direct and Indirect Transfers, Financial Intermediaries
    • Institutional investors play a major role in today’s financial markets
      • Own ¼ of all stocks, make over ¾ of all trades
      • Examples include:
        • Mutual funds
        • Pension funds
        • Insurance companies
        • Banks
    13
  • 14. The Stock Market and Stock Exchanges
    • Stock market—a network of exchanges and brokers
      • Exchange —a physical marketplace such as NYSE, AMEX, regional exchanges
      • Brokerage houses employ licensed brokers to assist individuals with securities transactions
    14
  • 15. Trading—The Role of Brokers
    • What brokers do…
      • An investor opens an account with a broker and place trades via phone or online
      • Local broker forwards order to floor broker on the exchange trading floor
        • Each stock trades in a particular spot on the exchange floor in an auction-like process
        • Trading supervised by a specialist who makes markets in designated securities
      • Trade confirmation is forwarded to local broker and investor
    15
  • 16. Exchanges
    • New York Stock Exchange (NYSE)
      • Trades securities for  2800 US
      • issuers and  480 foreign companies
    • American Stock Exchange (AMEX)
      • Handles slightly smaller, younger firms than NYSE
    • Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc .)
    • Exchanges are linked electronically
    16
  • 17. Stock Market and Exchanges
    • Stock Market refers to the entire interconnected set of places, organizations and processes involved in trading stocks
    • Stock Exchanges are the administrative and trading centers of the stock market
    • Regulation
      • Securities Act of 1933
        • Required companies to disclose certain information
      • Securities Exchange Act of 1934
        • Set up Securities and Exchange Commission
      • Securities law is primarily aimed at disclosure
    17
  • 18. Private, Public, and Listed Companies, and the NASDAQ Market
    • Privately Held Companies
    • Can’t sell securities to the general public
      • Sale of securities is severely restricted by regulation
    • Publicly Traded Companies
    • Received approval from SEC to offer securities to the general public
    • Process of obtaining approval and registration is known as ‘going public’
    18
  • 19. Private, Public, and Listed Companies, and the OTC Market
    • The IPO
      • Once prospectus is approved by SEC securities can be sold to public
      • Initial public offering (IPO) is the initial sale
        • Market for IPOs is very volatile and risky
      • Investment banks usually line up institutional buyers prior to the actual securities sale
      • IPO occurs in primary market, then trading begins in the secondary market
    19
  • 20. The NASDAQ Market
    • After a company goes public, its shares can trade in the over-the-counter (OTC) market
    • Eventually a firm may list on an exchange
    • Smaller, public companies can trade on the NASDAQ market
      • National Association of Securities Dealers Automated Quotation System
    20
  • 21. The Governance Problem
    • So top executives are personally motivated to hold financial performance up - often at any cost
    • Which in turn holds stock price up and makes them rich
    21
  • 22. Compensation: Harry Johnson, CEO
    • Salary $2,500,000
    • Bonus 1,500,000
    • $4,000,000
    • Plus: Stock option:
    • 200,000 shares @ $20, Market Price now $48.65
      • Option Value:
      • 200,000 x ($48.65 - $20.00) = $5,730,000
    • Total comp = $9,730,000; 59% from options
    22
  • 23. Moral Hazard of Stock Based Compensation
    • BUT what if Harry can’t exercise his option for another six months
      • AND some disturbing financial information has come up that will cause the stock’s price to drop by $10.
      • If released that info will cost Harry $2,000,000
    • Harry is motivated to hold stock price up at any cost until he can exercise his option.
    • Usually means suppressing the damaging information while ordinary investors buy in at inflated price
    23
  • 24. Measures of Performance
    • The market measures performance on three important financial results
      • Revenue
      • Earnings per share
      • Debt
    • Revenue and Earnings per share
      • More is better
      • Rapid growth is great
    • Debt
      • Less is better
    24
  • 25. The Crime Against Investors
    • Company executives with auditors help misstated financial statements
      • Stocks became grossly overvalued
    • When fraud discovered stock price crashes
      • Small investors who bought at high prices lose their investments
      • Executives see crash coming and cash out early
    • Some firms had forced employee retirement savings into their own stock
      • Ordinary employees lost their entire retirements
    25
  • 26. Recognition
    • In 2000 Enron, the seventh largest company in the country got caught.
      • Fraudulent reporting was discovered
      • CPA’s complicity was revealed
      • The firm collapsed along with its pension assets
      • Arthur Anderson, one of the largest accounting firms failed and disappeared completely
    • Resulting investigations revealed many companies had misstated financials
    26
  • 27. Federal Government Moves to Fix the Problem
    • Three major culpable groups were identified
      • Top management
      • Auditors
      • Wall Street financial analysts
    • Federal government creates legislation that in future will
      • Regulate the Public Accounting profession
      • Enhance accounting/reporting controls
      • Punish guilty executives severely
      • Regulate Analyst reporting
    • Sarbanes-Oxley Act (SOX)
    27
  • 28. Stock Analyst Conflicts
    • Investors buy and sell stocks based on Wall Street analysts’ recommendations
    • But many analysts worked for brokerage houses that had Investment Banking departments doing business with the firms being analyzed
      • investment banks advise companies on selling securities
    • Employers pressured analysts for favorable reports
      • pressure = compensation, threat of firing
      • of 33,000 buy/sell/hold recommendations issued in 1999, only 125 were sells (.3%)
        • While market was on the brink of collapse
    28
  • 29. Interest
    • Interest is the return on debt
      • Primary vehicle is the bond
    • Investor lends money to the bond’s issuer
    • There are MANY interest rates in debt markets
      • Depend on term and risk
      • Rates tend to move
      • together
    29
  • 30. Interest and the Economy
    • Interest rates have a significant effect on the economy
      • Lower interest rates stimulate business and economic activity
        • Debt financed projects cost less if rates are low
          • More projects are undertaken
        • Consumers purchase more houses, cars, etc. when rates are low
    30
  • 31. Supply and Demand – A Brief Review
    • Interest rates are set by supply and demand
    • Demand curve relates price and quantity of a product that consumers will buy
      • Reflects desires and abilities of buyers at a particular time
      • Usually slopes downward to the right since people buy more when the price of a product is low
    31
  • 32. The Determinants of Supply and Demand
    • Demand for borrowed funds depends on:
      • Opportunities available to use the funds
      • Attitudes of people and businesses about using credit
        • If people feel good about the economy they will spend with borrowed money and businesses will borrow for expansion and new projects
    32
  • 33. The Components of an Interest Rate
    • Interest rates include base rates rates and risk premiums
    • Interest rate represented by the letter k
      • k = base rate + risk premium
    • Components of the Base Rate
      • Base rate = k PR + INFL
      • The pure interest rate plus expected inflation
        • Rate people lend money when no risk is involved
      • Pure interest rate (k PR ) = earning power of money
        • Would exist in the real world if no inflation
        • Generally between 2% and 4%
    33
  • 34. The Components of an Interest Rate
    • The Inflation Adjustment (INFL)
      • Inflation refers to a general increase in prices
      • If prices rise, $100 at the beginning of the year will not buy as much at the end of the year
      • If you loaned someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year
        • Interest rates include estimates of average annual inflation over loan periods
    34
  • 35. Risk Premiums
    • Risk in loans is the chance that the lender will not receive the full amount of principal and interest payments
      • Some loans are more risky than others
    • Lenders demand risk premiums of extra interest for risky loans
    35
  • 36. Different Kinds of Lending Risk
    • Bond lending losses can be associated with price fluctuations and the failure of borrowers to repay loans
    • Three sources of risk, each with its own risk premium:
      • Default risk
      • Liquidity risk
      • Maturity risk
    36
  • 37. Different Kinds of Lending Risk
    • Maturity Risk (MR)
      • Bond prices and interest rates move in opposite directions
      • Long-term bond prices change more with interest rate swings than short-term bond prices
        • Larger loss possible on long term bond if rates change
        • Gives rise to maturity risk
      • Investors demand a maturity risk premium on longer term bonds
        • Generally ranges from 0% to 2%
    37
  • 38. Federal Government Securities, the Risk Free Rate
    • Federal Government Securities
      • The Federal government issues long-term bonds as well as shorter-term securities
        • Treasury bills - terms from 90 days to a year
        • Treasury notes - terms from 1 to 10 years
    • Risk in Federal Government Debt
      • No default risk: Can print money to pay off its debt
      • No liquidity risk: It’s easy to sell federal securities
      • Federal debt does have maturity risk
        • But not on very short-term debt
    • Hence very short term federal securities, Treasury Bills , pay the RISK FREE RATE
    38
  • 39. The Risk-Free Rate
    • The risk-free rate is approximately the yield on short-term Treasury bills
      • Includes the pure rate and inflation the inflation adjustment
    • Conceptual floor for interest rates
    • Denoted as k RF
    39
  • 40. The Real Rate of Interest
    • Real implies the effects of inflation removed
    • Tells investors whether or not they are getting ahead
      • Loss in purchasing power - earn a real rate of 8% when inflation is 10%
    • There are periods during which the real rate has been negative
    • The Real Risk-Free Rate implies that both the inflation adjustment and the risk premium is zero
    40
  • 41. Yield Curves—The Term Structure of Interest Rates
    • The graphic relation between interest rates and the term of debt
    • The normal yield curve
      • Short-term rates are usually lower than long-term rates – curve slopes up
    • The inverted yield curve
      • Long-term rates are lower than short-term rates – curve slopes down
    • A sustained inverted curve usually signals an economic downturn is ahead
    41
  • 42. Yield Curves Figure 5.10 42