1. Securities Markets

2. In this section, you will learn:  the main participants in securities markets  the difference between primary and secondary markets  factors that affect firms’ decisions about which securities to sell and savers’ decisions about which securities to buy  the Efficient Markets Hypothesis  how people can use derivatives for hedging or speculation

3. Securities Firms  Mutual funds: hold a diverse set of securities, sell shares to savers  Hedge funds: buy assets with funds raised from wealthy savers and with borrowed funds, largely unregulated  Brokers: buy and sell securities for their clients  Dealers: buy and sell securities for themselves  Investment banks: underwrite and market new securities, assist in mergers and acquisitions, engineer new types of securities

4. Other financial institutions  Pension funds  Accept payments from workers and employers, use the funds to buy securities  Provide payments when workers retire  Insurance companies  Use premiums to buy securities  Commercial banks  Buy securities (though most deposited funds are used to make loans)

5. Financial industry consolidation  Many financial firms engage in several businesses, e.g. Merrill Lynch is an investment banker and broker.  Two key events leading to consolidation:  1999 Repeal of Glass-Steagall Act, which had separated commercial and investment banking  2007-2009 financial crisis, during which healthy institutions bought weak ones

6. The upheaval in investment banking  Early 2000s: Leading investment banks began issuing mortgage-backed securities (MBS) backed by subprime mortgages (made to borrowers with poor credit). These borrowers had to pay high interest rates, so MBS promised high returns.  2006: Housing prices fell, sharply increasing defaults among subprime borrowers. Subprime MBS lost value, causing huge losses for the institutions that owned these securities.

7. The upheaval in investment banking  Early 2008: Investment bank Bear Stearns was nearly bankrupt, couldn’t raise funds it needed to pay its obligations, was purchased by JP Morgan Chase.  September 2008: Lehman Brothers in trouble, couldn’t raise funds, couldn’t find a buyer, so Lehman declared bankruptcy and defaulted on its bonds and loans.

8. The upheaval in investment banking  Goldman Sachs and Morgan Stanley held fewer MBS, so they sustained fewer losses. They reorganized and received emergency loans from the Federal Reserve.  Merrill Lynch was purchased by Bank of America, though it still operates as broker and investment bank.

9. Primary vs. secondary markets  Public company: a firm that issues stock and bonds that are traded in financial markets  Primary markets: markets in which firms and governments issue new securities  Initial public offering (IPO): the sale of new securities  Secondary markets: markets in which existing securities are traded

10. Primary markets  Investment banks underwrite IPOs  thoroughly screen the issuing companies  buy the initial shares, resell to other institutions, earn huge fees  Investment banks’ reputations are important, especially when the issuing firms are unknown  Buyers of IPOs often resell the securities in secondary markets, where they are subsequently traded

11. Secondary markets  Exchange: a physical location where brokers and dealers meet, e.g. New York Stock Exchange  Over-the-counter (OTC) market: a secondary market with no physical location  Dealer market: an OTC market in which all trades are made with dealers over computer networks, e.g. NASDAQ  Electronic communications network (ECN): an OTC market where buyers and sellers trade directly, without a dealer taking a cut

12. Stock market indexes  Stock market index: the average price of a group of stocks.  Examples:  Dow Jones Industrial Average (DJIA), includes 30 “blue-chip stocks”  Standard & Poor’s (S&P) 500, includes the 500 largest U.S. companies  NASDAQ index, includes all stocks traded in the NASDAQ

13. Three U.S. Stock Market Indexes, 1970-2010 growth rate DJIA S&P 500, NASDAQ

14. What securities should a firm issue?  Should a firm issue stocks or bonds? If bonds, should it issue short-term or long-term bonds?  Capital structure: the mix of stocks and bonds that a firm issues

15. Does capital structure matter?  Modigliani and Miller (M and M) theorem: the proposition that a firm’s capital structure does not matter  To raise $100, a firm could sell new bonds or new shares of stock; in either case, the firm sacrifices future income to the buyer of the asset.  According to the classical theory of asset prices, the present value of these payments must equal $100, whether the asset is stock or bonds.  So, the firm should be indifferent between issuing stock or bonds.

16. Why capital structure does matter  Taxes Interest payments are deductible, so the more bonds a firm issues, the lower its tax bill. Issuing stock does not affect its tax bill.  Bankruptcy In a bad year with low earnings, debt-financed firms at risk of bankruptcy if they cannot make payments on their bonds. Equity-financed firms at lower risk of bankruptcy, since not obligated to pay dividends.

17. Why capital structure does matter  Adverse selection  Some firms have strong prospects, others do not, savers lack information to tell the difference.  Weak firms may exploit this and offer shares at a price that exceeds the p.v. of future earnings.  Fearing this, savers may avoid buying any shares.  Then, strong firms cannot sell shares at a fair price.  Less of a problem for bond finance: As long as the firm remains solvent, it will pay bond buyers their fixed payments, so people more comfortable buying bonds than stock.

18. Debt maturity  Firms choose bond maturities based their ability to pay off the bonds  Long-term debt appropriate for financing projects that will generate income over the long term, e.g. factories  Short-term debt (e.g. commercial paper) better for short-term needs, e.g. bridging the gap between costs from production and revenue from sales

19. What mix of stocks and bonds should savers buy?  Stocks have higher average returns than bonds:  During 1900-2009, annual real return was 8% on stocks and 2% on bonds  Stocks are riskier than bonds:  During 1900-2009, stock returns were less than –10% in 17 years and near –40% in two years. Returns on Treasury bonds were never this low.

20. The risk-return tradeoff: example Setup:  Real return on bonds = 2% every year  Half the time, the real return on stocks is 22%, half the time, it is –6%  s = fraction of wealth in stocks, (1 – s) = fraction of wealth in bonds Let’s see how return and risk depend on s….

21. The risk-return tradeoff: example scenarioreturn on wealth in general s(return on stocks) + (1 – s)(return on bonds) if stock returns high s(22%) + (1 – s)(2%) = 2% + s(20%) if stock returns low s(–6%) + (1 – s)(2%) = 2% – s(8%) on average½ [2% + s(20%)] + ½ [2% – s(8%)] = 2% + s(6%) The higher is s, the greater the average return on wealth

22. The risk-return tradeoff: example  Average return depends on s. What about risk?  A simple way to measure risk: difference between return on wealth when stock return is high and return on wealth when stock return is low: [2% + s(20%)] [2% – s(8%)] – = s(28%) Risk is higher when s is higher

23. The risk-return tradeoff: example sreturn = 2% + s(6%)risk = s(28%) Return and risk for different values of s: 0.002.0%0% 0.253.5%7% 0.505.0%14% 0.756.5%21% 1.008.0%28%

24. The risk-return tradeoff: example Average rate of return (%) Risk, difference between high and low return (%) s = 0 s =.25 s =.5 s =.75 s = 1

25. Which stocks?  One view: pick randomly!  Efficient Markets Hypothesis (EMH): no stock is a better buy than any other.  EMH is based on the classical theory of asset prices and rational expectations: every stock’s price equals the p.v. of its expected future dividends, and expected dividends are the best possible forecasts of future dividends.

26. Which stocks?  EMH implies stock prices follow a random walk: stock price movements are unpredictable.  Prices respond only to news (new information) that changes expectations of future earnings/dividends.  News, by definition, is unpredictable, so price changes must also be unpredictable.

27. Prices adjust to news quickly  Price of Boeing stock = $50 = p.v. of dividends.  News: United Airlines has ordered 50 planes. This news raises the p.v. of Boeing’s expected earnings and dividends to $52.  At the $50 price, Boeing stock is undervalued.  Large buyers (e.g., mutual funds, pensions) buy as much Boeing stock as they can (which drives up its price), until it is no longer undervalued.  This process happens very quickly, before most people learn of the news.

28. Index vs. Actively Managed Funds  Actively managed mutual fund: buys and sells stocks based on its analysts’ research and its managers’ expertise  Index fund: buys all the stocks in a broad market index, matches the market return and does not employ analysts  Actively managed funds try to “beat the market,” which according to EMH is impossible to do consistently.

29. Index vs. Actively Managed Funds  In the five years ending 12/31/2009,  S&P 500 outperformed 61% of actively managed large-cap funds  S&P MidCap 400 outperformed 77% of actively managed mid-cap funds  S&P SmallCap 600 outperformed 67% of actively managed small-cap funds.  Additionally, actively managed funds have higher expenses than index funds.

30. Derivatives  Derivative: an asset whose payments are tied to the prices of other assets  Three types of derivatives:  futures, options, credit default swaps  Two uses of derivatives:  hedging: reducing risk by purchasing an asset that is likely to pay a high return if an asset you already have pays a low or negative return  speculation: using financial markets to make risky bets

31. Futures  Futures contract: an agreement to trade an asset for a specified price on a specified future date, the delivery date  Example: A wheat farmer wants to hedge against the risk that wheat prices will fall before her harvest is ready, and a miller wants to hedge against the risk that wheat prices will rise before the current crop is ready. The farmer sells the miller a futures contract, and both eliminate their risk by locking in the future price today.  There are futures for securities and commodities.

32. Options  Call option: allows its owner to buy a security at a specified price, the strike price, any time until the option’s expiration date.  Put option: allows its owner to sell a security at a specified strike price on any date before the option expires.  Example: To protect yourself against a fall in stock prices, buy put options on stocks you own. If stock prices fall, exercise the option to limit your losses.

33. NOW YOU TRY: When to exercise a call option You paid $2 per share to buy a call option on Microsoft stock. The strike price is $40 and the option expires on December 30. In each of the following scenarios, would you exercise the option? Why or why not? scenariotoday’s dateMicrosoft stock price today a.Dec. 29$45 b.Dec. 29$41 c.Nov. 15$35 d.Nov. 15$45

34. ANSWERS: Exercise your call option? scenariotoday’s dateMicrosoft stock price today a. Dec. 29$43 Yes, loss is $1 per share if you exercise option, $2 per share if you do not. No, you would lose money, and price might rise before the option expires. It depends. Exercise option to lock in a quick profit, or wait if you think price will rise further. b. c. d. Yes, buy at $40, sell at $43 for quick profit. Yes, loss is $1 per share if you exercise option, $2 per share if you do not. No, you would lose money, and price might rise before the option expires. It depends. Exercise option to lock in a quick profit, or wait if you think price will rise further. Dec. 29$41 Nov. 15$35 Nov. 15$45

35. Credit Default Swaps  Credit Default Swap (CDS): pays its buyer in the event of default on a particular debt instrument (e.g. bond or mortgage)  Example: A bank hedges against the risk one of its mortgage borrowers will default by purchasing a CDS that pays off in that event  CDSs are like insurance, except that the people who trade them need not have any relation to the underlying debt instrument.  CDS are not traded on an exchange, but are negotiated privately b/w buyer and seller

36. SECTION SUMMARY  Securities firms are companies whose primary purpose is to hold securities, trade them, or help others trade them. Examples include mutual funds, hedge funds, brokers, dealers, and investment banks.  Corporations issue securities in primary markets through investment banks, whose underwriting reduces the problem of adverse selection.

37. SECTION SUMMARY  After securities are issued, they are traded in secondary markets, including exchanges, dealer markets, and electronic communication networks.  Firms can finance investment by issuing stocks or bonds. The mix of the two that a firm chooses is called its capital structure.  Savers split their wealth among classes of assets such as stocks and bonds. Stocks have higher average returns than bonds, but are riskier.

38. SECTION SUMMARY  The efficient market hypothesis states that every stock’s price is the best estimate of its true value. News that alters this true value will alter the stock’s price. But since news cannot be predicted, stock prices follow a random walk.  Derivatives are assets whose payoffs are tied to other assets. Examples include futures, options, and credit default swaps.  People and firms use derivatives to hedge against possible losses, or to speculate in hopes of earning huge profits.