1. Chapter 5 – The Financial System, Corporate Governance, and Interest

2. The Financial System The economy is divided into sectors
Consumption
Production (includes government)
Services, products, and money flow between the sectors every day
Producers pay wages
Workers spend incomes
Producers spend revenues
Creates a cyclical flow of money

3. Figure 5-1 Cash Flows Between Sectors

4. Diagram Omits Two Things
Consumption sector
Most people do not consume all of their income—they deposit savings and earn a return
Production sector
Companies need to raise money to finance large, infrequent projects
Economy has a need for and a source of $

5. Savings and Investment
Financial markets channel consumer savings to companies through the sale of financial assets
Companies issue securities
Consumers purchase securities

6. Figure 5- 2 Flows Between Sectors

7. This makes funds available for business investment
The Term “Invest”
Individuals invest by putting savings into financial assets: stocks, bonds, etc.
This makes funds available for business investment
Hence: SAVINGS = INVESTMENT
(Consumer) Savings = (Business) Investment

8. Raising and Spending Money in Business
Firms spend two kinds of money
Day-to-day funds
Large sums needed for major projects

9. Raising and Spending Money in Business
Firms to raise money by:
Borrowing money: Debt Financing
Selling stock: Equity Financing

10. Term Long-term projects
The length of time between now and the end (or termination) of something
Long-term projects
last over 5-10 years
financed with debt (bonds) and equity (earnings/stocks)
Short-term projects
last less than 1 year
financed with short-term funds (bank loans)
Process is known as maturity matching

11. Financial Markets Capital Markets Money 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

12. 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

13. 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

14. Direct and Indirect Transfers, Financial Intermediaries
Primary market transactions can occur
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

15. Figure 5-3 Transfer of Funds

16. 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

17. The Stock Market and Stock Exchanges
Stock market—a network of exchanges and brokers
Exchange—a marketplace such as NYSE, AMEX, NASDAQ, & regional exchanges
Brokerage houses employ licensed brokers to make securities transactions for investors

18. 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
Trade confirmation is forwarded to local broker and investor

19. Figure 5-4 Schematic Representation of a Stock Market Transaction

20. Exchanges New York Stock Exchange (NYSE) NYSE MKT (Previously AMEX)
(NASDAQ)
Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc.)
Exchanges are linked electronically

21. Stock Market and Exchanges
Stock Market refers to the entire interconnected set of places, organizations and processes involved in trading stocks
Regulation
Securities Act of 1933
Required companies to disclose certain information
Securities Exchange Act of 1934
Set up Securities and Exchange Commission (SEC)
Securities law is primarily aimed at disclosure

22. Private, Public, and Listed Companies, and the OTCBB Market
Privately Held Companies
Can’t sell securities to the general public
Sale of securities is strictly regulated
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’

23. Private, Public, and Listed Companies, and the NASDAQ Market
Public Companies
Use an investment banking firm to “go public”
Prospectus—provides detailed information about company
SEC reviews prospectus
Red Herring - an unapproved, or preliminary, prospectus

24. Private, Public, and Listed Companies, and the OTC Market
The IPO
Initial public offering (IPO) is the initial sale
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
IPOs are discussed in detail in Chapter 8

25. The OTCBB Market
After a company goes public, its shares can trade in the over-the-counter (OTC) market
Firms not listed on an exchange trade through the OTCBB overseen by the NASD
Eventually a firm may list on an exchange

26. Figure 5-7 Stock Market Quotation for Microsoft Corp.

27. Corporate Governance
Corporate governance refers to the relationships, rules and procedures under which businesses are organized and run.
Focused on ethics and legality of financial relationships between top managers and the corporations they serve.
The idea is connected to the agency problem, which refers to a conflict of interest between executives and stockholders
Two major financial crises thus far in the 21st century
Stock market crash of 2000 caused by financial reporting fraud
Financial crisis of 2008 caused by the subprime mortgage market

28. Corporate Governance: Executive Compensation
The personal wealth of corporate executives is closely tied to stock price
The stock market bids prices up and down
Current financial performance is the best indication of future performance

29. Concept Connection Example 5-1 Executive Stock Options
Harry Johnson, CEO
Salary $2,500,000
Bonus ,500,000
$4,000,000
Plus: Stock option:
200,000 $20, Market Price now $48.65
Option Value:
200,000 x ($ $20.00) = $5,730,000
Total comp = $9,730,000; 59% from options

30. Moral Hazard
A situation that tempts people to act in immoral or unethical ways

31. Concept Connection Example 5-1 Moral Hazard of Stock Based Compensation
What if Harry can’t exercise his option for another six months?
AND some disturbing financial information comes 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

32. Holding Performance Up
Company financial statements - Income Statement and Balance Sheet are actually easy to manipulate by “bending” accounting rules

33. Responsibility for Financial Statements
Responsibility for the contents of financial statements primarily falls to top management
Top execs have the power to enhance their own wealth by cheating on financial reporting

34. Stock prices skyrocketed Top management was willing to bend rules
Events of the 1990s
Stock prices skyrocketed
Top management was willing to bend rules
Some accountants partnered with unethical executives in deceiving the public
Enron

35. Public Accounting Reform Regulation
SOX (§§ ) creates the Public Accounting Oversight Board (PCAOB) to oversee and regulate the accounting industry
Accounting will never be self-regulated again
Requires firms to register
Sets standards of performance & compliance
Inspections and disciplinary procedures

36. Resulted in the Sarbanes-Oxley (SOX)Act:
Events of the 1990s
Resulted in the Sarbanes-Oxley (SOX)Act:
Title I: Oversight of the Public Accounting Industry.
Title II: Auditor Independence.
Title III: Corporate Responsibility.
Title IV: Enhanced Financial Disclosure.
Title V: Wall Street Reforms—Securities Analyst Conflicts of Interest.

37. Executives Profit While Others Go Broke
Executives often received huge incentive compensation while the stock tanked and investors/employees lost everything
SOX (§304) requires CEOs & CFOs to repay such gains to corporation

38. Stock Analyst Conflicts
SOX (§501) directs the SEC to issue rules insulating analysts from investment banking pressure
SEC adopted Regulation Analyst Certification (Reg AC): Analysts must certify:
They actually believe in their recommendations
Their compensation is not linked to specific recommendations

39. The Financial Crisis of 2008
Home Ownership, Mortgages, and Risk
Securitization
Subprime markets
Credit Default Swap (CDS)

40. Home Ownership, Mortgages, and Risk
Loans are secured by a House
Failure to make payment leads to Foreclosure

41. Securitization
Bundle of Loans and Securitization
Collateralized debt obligations (CDO)
CDO tranche
Flaw in Risk Allocation Method

42. Subprime Mortgage Market
Institutions borrowed at short-term rates to invest in CDOs
Needed money to invest
Banks ran out of qualified borrowers

43. Loans made to unqualified borrowers Types of loans
Subprime Loans
Loans made to unqualified borrowers
Types of loans
Zero down
Adjustable Rate Mortgages (ARM)
Negative Amortization (NegAm)
Alt-A loans

44. Credit Default Swaps (CDS)
Contract between buyer and seller in which the seller agrees to repay losses the buyer suffers

45. The Trigger- Interest Rates Rise
Concern about inflation
Federal reserve raised rates
Resulting in mortgage rates going up and an end to rising real estate prices

46. Effect on CDO Market and CDO Owners
CDO market froze
2008 staggering losses and equity reductions by financial institutions
Bailouts arrived

47. Federal Government Actions in 2008
Intervention
Government takeover
Officials brokered merger of at risk institutions
Bail outs by the federal government

48. Federal Government Actions in 2008
Two actions were particularly important to the financial crisis
Bear- Stearns
Lehman Brothers

49. The Crisis is a Governance Issue
The financial system created an incentive for dishonesty
Make loans regardless of ability to pay
The “too big to fail” concept creates a Moral Hazard in banking
Executives are rewarded if high risk projects go well
But government (taxpayers) pay for failures

50. The Dodd-Frank Act
Signed in 2010
Designed to fix the problem through legislation
Governs conduct on more than 240 issues

51. 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

52. The Relationship Between Interest and the Stock Market
Stock returns and interest on debt instruments are related
Stocks and bonds compete for investor’s dollars
Stocks offer higher returns but have more risk
Investors prefer debt if the expected return is equal
Interest rates and security prices move in opposite directions

53. 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

54. Debt Markets: 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

55. Debt Markets: Supply and Demand A Brief Review
A supply curve relates prices with quantities supplied by producers
Generally upward sloping to the right since firms will to produce more at higher prices
Equilibrium – intersection of supply and demand curves
Sets market price and quantity
Changing conditions shift supply and demand curves for a new equilibrium

56. Figure 5-8 Supply & Demand Curves for a Product or Service

57. Supply and Demand for Money
In the debt market
Lenders represent supply
Borrowers represent demand
The price represents the interest rate
Debt securities are bills, notes and bonds

58. Figure 5-9 Supply and Demand Curves for Money (Debt)

59. 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

60. The Determinants of Supply and Demand
Supply of loanable funds depends on the time preference for consumption of individuals
A decrease in the preference for consumption will lead to an increase in loanable funds
Constant changes shift supply and demand curves

61. The Components of an Interest Rate
Interest rates include base rates and risk premiums
Interest rate represented by the letter k
k = base rate + risk premium

62. The Components of an Interest Rate
Components of the Base Rate
Base rate = kPR + INFL
The pure interest rate plus expected inflation
Rate people lend money when no risk is involved
Pure interest rate (kPR) = earning power of money
Would exist in the real world if no inflation

63. 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

64. Risk Premiums
Risk in loans is the chance that the lender will not receive the full amount of principal and interest payments
Lenders demand risk premiums of extra interest for risky loans

65. 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

66. Different Kinds of Lending Risk
Default Risk (DR)
The chance the lender won't pay principal or interest
Losses can be as much as the entire amount
Investors demand a default risk premium based on the their perception of the borrower’s creditworthiness
Considers firm's financial condition and credit record

67. Different Kinds of Lending Risk
Liquidity Risk (LR)
Associated with being unable to sell the bond of an little known issuer
Debt of small, hard to market firms is “illiquid”
Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk

68. 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

69. Putting the Pieces Together: The Interest Rate Model
k = kPR + INFL + DR + LR + MR
k is the nominal or quoted interest rate
Model tells what theoretically should be in an interest rate
Setting Interest Rates
set by supply and demand
No one uses the model to set rates

70. Federal Government Securities, the Risk Free Rate
The Federal government issues long-term bonds as well as shorter-term securities
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

71. The Risk-Free Rate
Very short term federal securities, Treasury Bills, pay the risk free rate
The risk-free rate is approximately the yield on short-term Treasury bills
Denoted as kRF
Conceptual floor for interest rates

72. The Real Rate of Interest
The Real Rate of Interest implies the effects of inflation removed
Tells investors whether or not they are getting ahead
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

73. Concept Connection Example 5-3 Using the Interest Rate Model
Using the Interest Rate Model, Sunshine Inc. is planning to borrow by issuing three year bonds (notes).
The following information is available.
1. The pure interest rate is 2.0%.
2. Inflation will be 3% next year and 4% thereafter.
3. Sunshine’s debt carries a default risk premium of 1.5%.
4. The firm carries a liquidity risk premium of .5%.
5. Maturity risk premiums on three-year debt are 1.0%.
a. Estimate the interest rate Sunshine will have to offer.
b. Moonlight Ltd. recently issued three-year debt paying 11%. What does the interest rate model imply about Moonlight’s risk relative to Sunshine’s?

74. Concept Connection Example 5-3 Using the Interest Rate Model
SOLUTION: To estimate the interest rate Sunshine will have to offer to sell the bonds (ks).
Calculate INFL, the average inflation rate over the life of the loan.
INFL = ( )/3 = 11/3 = = 3.7
are the inflation rates for the three years, or the life of this project. Add them together
The 3 is the number of years, or life of the project
Then write the interest rate model and substitute for kS.
kS = kPR + INFL + DR + LR + MR =
= 8.7%

75. Concept Connection Example 5-3 Using the Interest Rate Model
b. Write the interest rate model for Moonlight treating DR as an unknown, then substitute, and solve for DR.
kM = kPR + INFL + DR + LR + MR
11.0 = DR
DR = 3.8
Sunshine’s risk premium from assumptions
The debt market seems to be assigning Moonlight a default risk premium of 3.8%, which is (3.8/1.5 ) = 2.5 times as large as Sunshine’s. This implies more risk.

76. Yield Curves—The Term Structure of Interest Rates
A graphic relation between interest rates term
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

77. Inverted Yield Curve- An Economic Predictor
Inversion Period Recession Date July January 2001 March 2001 May August 1989 July 1990 October September 1981 July 1981 November May 1980 January 1980 June November 1974 November 1973 December February 1970 December 1969

78. Figure 5-10 Yield Curves

79. Yield Curves—The Term Structure of Interest Rates
Theories attempt to explain the term structure of interest rates
Expectations Theory
Today's rates rise or fall with term as future rates are expected to rise or fall
Liquidity Preference Theory
Investors prefer shorter term securities and must be induced to make longer loans
Market Segmentation Theory
Loan terms define independent segments of the debt market which set separate rates