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  • 1. The Financial Markets and Interest Rates Chapter 2
  • 2. Chapter Objectives
    • U.S. Financial markets and how American firms use them
    • Investment banking process
    • How interest rates are determined
    • Long–term pattern of rates of return on securities
  • 3. Real and Financial Assets
    • Real Assets —Tangible assets such as houses, equipment and inventories
    • Financial Assets —Claims for future payment on other economic units … Cash, Bonds, Stock, etc.
  • 4. Securities ?
    • Financial Assets that Investors purchase hoping to earn a “high” rate of return.
  • 5. Types of Securities
    • Treasury Bills and Bonds
    • Municipal Bonds
    • Corporate Bonds
    • Preferred Stocks
    • Common Stocks
    • Which of these are Most RISKY?
    • Which promise HIGHEST RETURNS?
    • What is the relationship between RISK and RETURN?
  • 6. 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)
  • 7. Movement of Savings
    • Direct Transfer of Funds
    cash securities saver firm
  • 8. Movement of Savings
    • Indirect Transfer using Middlemen
    securities funds funds securities saver investment banker firm
  • 9. Movement of Savings
    • Indirect Transfer using a Financial Intermediary
    funds intermediary securities funds firm securities financial intermediary firm saver
  • 10. The Financing Process Source: 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). 241.5 561.7 320.2 Foreign ( 8.0) 48.4 56.4 State and Local Gov’ts (11.0) 62.9 73.9 U.S. Gov’t (63.7) 383.8 447.5 Nonfinancial Corporate Business (50.3) 397.1 447.4 Households Net Funds Supplied ($) Funds Supplied ($) Funds Raised ($) Sector
  • 11. Corporate Financing Sources
    • Historical (1981 – 2000) Internal vs. External:
      • Internal … 72%
      • External … 28%
    • From 1998-2000, over $1.1 trillion in external corporate financing was raised.
      • Debt (Corporate Bonds and Notes) … 73.6%
      • Equities (Preferred & Common Stock) … 26.4%
    • (Interest is tax deductible and dividends are not)
  • 12. Components of U.S. Financial Market System Public Offering Versus Private Placement Primary Versus Secondary Market Money Versus Capital Market Organized Exchange Versus OTC market Spot Versus Futures Market
  • 13. 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
  • 14. 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.
  • 15. 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
  • 16. Exchanges 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.
    • 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)
  • 17. 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.
  • 18. Investment Banker
  • 19. 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).
  • 20. 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.
  • 21. Distribution Methods
    • Negotiated Purchase
    • Competitive Bid Purchase
    • Commission or Best Efforts Basis
    • Privileged Subscription
    • Dutch Auction
    • Direct Sales
  • 22.
    • 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.
    Distribution Methods
  • 23.
    • 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.
    Distribution Methods
  • 24.
    • 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 highest price at which the issuing company can sell all the available shares.
      • See figure 2-2
    Distribution Methods
  • 25.  
  • 26.
    • Direct Sale
      • Issuing firm sells the securities directly to the investing public.
      • No investment banker is involved.
      • Example : Private placement
    Distribution Methods
  • 27. Flotation Costs
    • Transaction costs incurred when a firm raises funds by issuing securities:
      • Underwriter’s spread
        • (Difference between gross and net proceeds)
      • Issuing costs
      • ( printing and engraving of security certificates, legal fees, accounting fees, trustee fees, other miscellaneous expenses)
  • 28. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
  • 29. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
    • What type of issue is this?
  • 30. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
    • What type of issue is this?
    • It’s a negotiated purchase .
  • 31. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
    • How many shares will be sold?
  • 32. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
    • How many shares will be sold?
    • $100,000,000 / $20 = 5 million new shares of common stock.
  • 33. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
    • What are the flotation costs?
  • 34. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
    • What are the flotation costs?
    • Underwriting spread : 2% of $100 million = $2 million.
    • Issuing costs : printing and engraving costs; legal, accounting and trustee fees.
  • 35. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
    • What are the risks?
  • 36. Stock Issue Example:
    • Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
    • What are the risks?
    • The investment bank accepts the risk of being able to sell the new stock issue for $20 per share. If the stock price falls, the investment bank could lose money.
  • 37. Government Intervention
    • Fiscal Policy – Taxes
    • Monetary Policy - The Federal Reserve Board
    • Regulations
  • 38. Market Regulation
    • Securities Act of 1933 — Aims to provide potential investors with accurate, truthful disclosure about the firm and new securities being offered … Primary Market.
    • Securities Exchange Act of 1934 — Created SEC to enforce federal securities laws ; truthful disclosure … Secondary Market.
    • Securities Acts Amendments of 1975 —Created a national market system.
    • Sarbanes-Oxley Act of 2002 – revisited truthful disclosure.
    • Role of the “Independent 3 rd Party Auditor”???
  • 39. Rates of Return in Financial Markets
  • 40. Rates of Return in Financial Markets
    • Opportunity Cost — Rate of return on next best investment alternative to the investor
    • Standard Deviation — Dispersion or variability … One way we measure Risk.
    • Real Return — Return earned above the rate of inflation
  • 41.
    • 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
  • 42.  
  • 43. Interest Rate Determinants
  • 44. 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.
  • 45. Interest Rate Determinants
    • k= k* + IRP + DRP + LP + MP
    • k = nominal or observed rate of interest
    • k* = real risk-free rate of interest
    • IRP = inflation risk premium
    • MP=maturity premium
    • DRP=default-risk premium
    • LP=liquidity premium
  • 46. Description of Premiums Nominal rate = Inflation rate + Real Risk Free Rate (k*) 3 mo. Treasury Bills Rate - Inflation Rate + Maturity Premium (MP) 30 yr. Treasury Bonds Rate - 3 mo. Treasury Bills Rate + Default Premium (DRP) AAA Corporate Bonds Rate - 30 yr. Treasury Bonds Rate + Liquidity Prem. (LP) How easy to trade or convert to cash?
  • 47. Example: Inflation rate is 1.5%, real risk free rate is 3%, AAA corporate bonds are 9%, 3 month treasury bills are 4.5% and 30 year treasury bonds are 7%. Given the LP is 3 basis points (.03%) What are the k*, IRP, DRP, liquidity premium, and the MP? What is the nominal rate of this bond for Company X?
  • 48. Solution k = k* +IRP+DRP+MP+LP k* = 3% (4.5%-1.5%)(real risk free rate-diff to treasury bills) IRP = 1.5% (given) MRP = 2.5% (7.0%-4.5%) (diff to treasury notes) DRP = 2.0% (9%-7%) (diff to AAA bonds - LP) LP = .03% (given) (diff to a particular AAA bond) k=9.03% NOMINAL RATE OF INTEREST ON THIS BOND
  • 49. Term Structure of Interest Rates or Yield-to-Maturity
  • 50.  
  • 51. Theories to explain the shape
    • Unbiased Expectations Theory
    • Liquidity Preference Theory
    • Market Segmentation Theory
  • 52. Unbiased Expectations Theory
    • Term Structure is determined by an Investor’s expectations about future interest rates.
  • 53. Liquidity Preference Theory
    • Investors require maturity premiums to compensate them for risks of uncertain future interest rates.
  • 54. Market Segmentation Theory
    • Legal restrictions and personal preferences limit choices for investors to certain ranges of maturities.
  • 55. Finance and The Multinational Firm
  • 56. Intercountry Risk
    • Financial System Risk
    • Political System Risk
    • Exchange Rate Risk