Foundations of Finance Arthur Keown John D. Martin J. William Petty

The Financial Markets and Interest Rates Chapter 2

Keown, Martin, Petty - Chapter 23 Learning Objectives 1. Describe key components of the U.S. financial market system. 2. Understand the role of the investment-banking business in the context of raising corporate capital. 3. Distinguish between privately placed securities and publicly offered securities. 4. Be acquainted with securities floatation costs and securities markets regulations.

Keown, Martin, Petty - Chapter 24 Learning Objectives 5. Understand the rate-of-return relationships among various classes of financing vehicles that persist in the financial markets. 6. Be acquainted with recent interest rate levels and the fundamentals of interest rate determination. 7. Explain the popular theories of the term structure of interest rates. 8. Understand the relationships among the multinational firm, efficient financial markets, and the inter-country risk.

Keown, Martin, Petty - Chapter 25 Slide Contents 1. Principles Used in this chapter 2. Components of US Financial Market 3. Investment Banker 4. Sarbanes-Oxley Act 5. Rates of Return in Financial Market 6. Interest Rate Determinants 7. Term Structure of Interest Rates 8. Finance and the Multinational Firm

1. Principles Used in this Chapter

Keown, Martin, Petty - Chapter 27 Principles Used in this Chapter Principle 1: The Risk-Return Tradeoff — We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return. Principle 6: Efficient Capital Markets — The Markets are Quick and the Prices Are Right. Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance.

2. 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

Keown, Martin, Petty - Chapter 29 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)

Keown, Martin, Petty - Chapter 210 Benefits of Financial Markets example If you have $200,000 to invest, what would be the benefit of buying shares in 20 corporations rather than opening your own business?

Keown, Martin, Petty - Chapter 211 Benefits of investing in financial assets (like stocks) rather than investing in own business 1. Reduced risk through diversification. With $200,000 you can perhaps invest in only one business whereas with $200,000 you can invest $10,000 each in stocks of 20 Companies. Such diversification reduces risk as not all companies will fail at the same time! 2. Low time commitment 3. Limited liability 4. No or low expertise needed 5. Easy to exit/enter 6. Continuous valuation of your wealth

Keown, Martin, Petty - Chapter 212 Figure 2-1 Examines the relationship between financial markets and the corporation

Keown, Martin, Petty - Chapter 213

Keown, Martin, Petty - Chapter 214 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

Keown, Martin, Petty - Chapter 215 Role of Venture capitalist Venture capitalists play a leading role in the private placement market. They are a prime source of funding for start-up companies and companies in “turnaround” situations. Funding for such ventures are risky, but carry the potential for high returns. The borrowing firm may not have the option of pursuing public offering due to: small size, no record of profits, and uncertain future growth prospects.

Keown, Martin, Petty - Chapter 216 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 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.

Keown, Martin, Petty - Chapter 217 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

Keown, Martin, Petty - Chapter 218 Exchange 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. For example: NYSE listing requirements encompass profitability, size, market value and public ownership. (see table 2-1) Stock exchange benefits: Provides a continuous market, establishes and publicizes fair security prices, helps business raise new capital

Keown, Martin, Petty - Chapter 219 OTC 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) Most corporate bond transactions are also conducted on OTC markets.

Keown, Martin, Petty - Chapter 220 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.

3. Investment Banker

Keown, Martin, Petty - Chapter 222 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).

Keown, Martin, Petty - Chapter 223 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.

Keown, Martin, Petty - Chapter 224 Distribution Methods Negotiated Purchase Competitive Bid Purchase Commission or Best Efforts Basis Privileged Subscription Dutch Auction Direct Sales

Keown, Martin, Petty - Chapter 225 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

Keown, Martin, Petty - Chapter 226 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

Keown, Martin, Petty - Chapter 227 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 lowest price at which the issuing company can sell all the available shares. See figure 2-2 Distribution Methods

Keown, Martin, Petty - Chapter 228

Keown, Martin, Petty - Chapter 229 Direct Sale Issuing firm sells the securities directly to the investing public. No investment banker is involved. Example: Private placement Distribution Methods

Keown, Martin, Petty - Chapter 230 Private Placements Trade-offs Advantages Faster to raise money Reduced Floatation Costs Financing Flexibility Disadvantages Interest Costs higher than public issues Restrictive Covenants Possible Future SEC Registration

Keown, Martin, Petty - Chapter 231 Floatation Cost Transaction cost incurred when a firm raises funds by issuing securities: 1. Underwriter’s spread (Difference between gross and net proceeds) 2. Issuing costs ( printing and engraving of security certificates, legal fees, accounting fees, trustee fees, other miscellaneous expenses)

4. Sarbanes-Oxley Act

Keown, Martin, Petty - Chapter 233 Sarbanes-Oxley Act In response to corporate scandals, Congress passed this Act in This Act holds senior corporate advisors (such as accountants, lawyers, board of directors, officers) responsible for any instances of misconduct. Thus the Act attempts to protect the interest of investors by improving transparency and accuracy of corporate disclosures.

5. Rates of Return in Financial Markets

Keown, Martin, Petty - Chapter 235 Rates of Return in Financial Markets Opportunity Cost — Rate of return on next best investment alternative to the investor Standard Deviation — Dispersion or variability around the mean rate of return in the financial markets Real Return — Return earned above the rate of inflation Maturity Premium — Additional return required by investors in long-term securities to compensate them for greater risk of price fluctuations on those securities caused by interest rate changes Liquidity Premium — Additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price.

Keown, Martin, Petty - Chapter 236 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

Keown, Martin, Petty - Chapter 237

Keown, Martin, Petty - Chapter 238

6. Interest Rate Determinants

Keown, Martin, Petty - Chapter 240 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

Keown, Martin, Petty - Chapter 241 Real and Nominal Rates k = k* + IRP + (k*xIRP) Where k= nominal rate of return k* = real rate of return IRP = Inflation risk premium

Keown, Martin, Petty - Chapter 242 Example What is the real rate of return, if the inflation is 5% and the quoted rate is 11.3%.113 = k* xk*.063 = 1.05k* ==>k* =.06 or 6%

7. Term Structure of Interest Rates or Yield-to-Maturity

Keown, Martin, Petty - Chapter 244 Term Structure of Interest Rates or Yield to Maturity The graph shows the relationship between a debt security’s rate of return and the length of time until the debt matures, where the risk of default is held constant. The graph could be upward sloping (indicating longer term securities command higher returns), flat or inverted (longer term securities command lower returns compared to short-term securities). The graph changes over time. Upward sloping curve is most commonly observed. Figure 2-5

Keown, Martin, Petty - Chapter 245

Keown, Martin, Petty - Chapter 246 Theories to explain the shape 1. Unbiased Expectations Theory 2. Liquidity Preference Theory 3. Market Segmentation Theory

Keown, Martin, Petty - Chapter 247 Unbiased Expectations Theory Term Structure is determined by an Investor’s expectations about future interest rates.

Keown, Martin, Petty - Chapter 248 Liquidity Preference Theory Investors require maturity premiums to compensate them for risks of uncertain future interest rates.

Keown, Martin, Petty - Chapter 249 Market Segmentation Theory Legal restrictions and personal preferences limit choices for investors to certain ranges of maturities.

8. Finance and The Multinational Firm

Keown, Martin, Petty - Chapter 251 Finance and The Multinational Firm Well developed financial markets contribute to the overall growth of an economy. US has a well developed financial market that allows for efficient transfer of capital from “savers” to “users” leading to timely financing of investments. Multinational firms with excess cash will prefer to invest in countries that have well developed financial markets and stable political environments. Developing countries, with less developed financial markets, attract less investment from multinational firms, which contributes to their slower pace of development.