Chapter 2

The Financial Markets and Interest Rates

Real and Financial Assets n Real Assets—Tangible assets such as houses, equipment and inventories n Financial Assets—Claims for future payment on other economic units— common and preferred stocks

Q: What are SECURITIES? A: Financial Assets that Investors purchase hoping to earn a high rate of return.

Types of Securities n Treasury Bills and Treasury Bonds n Municipal Bonds n Corporate Bonds n Preferred Stocks n Common Stocks Which of these are RISKY? Which promise HIGH RETURNS? Is there a relationship between RISK and RETURN?

Corporate Financing Sources n From , over $1.1trillion in external corporate financing was raised. n From 1998 through 2000, capital has been raised through the following sources: n Corporate Bonds and Notes 73.6% n Equities (Preferred & 26.4% Common Stock) Common Stock) (Interest is deductible and dividends are not)

Movement of Savings n Direct Transfer of Funds cash securities saver firm

Movement of Savings n Indirect Transfer using Investment Banker securities fundsfunds securities saver investment banker firm

Movement of Savings n Indirect Transfer using a Financial Intermediary funds intermediarysecurities funds firmsecurities financial intermediary firm saver

Financial Market Components n Public Offering u Firm issues securities, which are made available to both individual and institutional investors. n Private Placement u Securities are offered and sold to a limited number of investors.

Financial Market Components n Primary Market u Market in which new issues of a security are sold to initial buyers. n Secondary Market u Market in which previously issued securities are traded.

Financial Market Components n Money Market u Market for short-term debt instruments (maturity periods of one year or less). n Capital Market u Market for long-term securities (maturity greater than one year). FedFundsRate

Financial Market Components n Organized Exchanges u Buyers and sellers meet in one central location to conduct trades. n Over-the-Counter (OTC) u Securities dealers operate at many different locations across the country. u Connected by Nasdaq system (National Association of Securities Dealers Automated Quotation system).

Investment Banking How do investment bankers help firms issue securities? Underwriting the issue. Distributing the issue. Advising the firm.

Distribution Methods n Negotiated Purchase u Issuing firm selects an investment banker to underwrite the issue. u The firm and the investment banker negotiate the terms of the offer. n Competitive Bid u Several investment bankers bid for the right to underwrite the firm’s issue. u The firm selects the banker offering the highest price.

Distribution Methods n Best Efforts u Issue is not underwritten. u Investment bank attempts to sell the issue for a commission. n Privileged Subscription u Investment banker helps market the new issue to a select group of investors. u Usually targeted to current stockholders, employees, or customers.

Distribution Methods n Direct Sale u Issuing firm sells the securities directly to the investing public. u No investment banker is involved.

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. n What type of issue is this? n It’s a negotiated purchase.

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. n How many shares will be sold?

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. n How many shares will be sold? n $100,000,000 / $20 = 5 million new shares of common stock.

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. n What are the flotation costs?

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. n What are the flotation costs? n Underwriting spread: 2% of $100 million = $2 million.

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. n What are the flotation costs? n Underwriting spread: 2% of $100 million = $2 million. n Issuing costs: printing and engraving costs; legal, accounting and trustee fees.

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. n What are the risks?

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. n What are the risks? n 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.

Regulations: The Primary Market The Securities Act of 1933 n Firms register with the Securities Exchange Commission (SEC). n SEC has 20 days to review. u SEC may ask for more information. u The firm can not solicit buyers during the review period but can advertise.

Regulations: The Secondary Market The Securities Exchange Act of 1934 n Established the SEC. n Exchanges must register with SEC. n Company information must be available to the public. n Insider trading is regulated.

Regulations: Recent Developments Securities Acts Amendments of 1975 n Created National Market System. n Eliminated fixed brokerage commissions. SEC Rule 415 n Allows Shelf Registration

Interest Rate Determinants Interest Rates

INFERRED REAL RATE OF INTEREST (Nominal less inflation = Real Rate) Nom. Infl. Real Nom. Infl. Real Yld Rate Rate Treasury Bills 4.5% 3.0% 1.5% Treasury Bonds 7.0% 3.0% 4.0% Corporate Bonds 9.0% 3.0% 6.0%

Interest Rate Determinants n k= k* + IRP + DRP + MP + LP n k = nominal or observed rate of interest n k* = real risk-free rate of interest n IRP = inflation risk premium n MP=maturity premium n DRP=default-risk premium

Description of Premiums Nominal rate = Inflation rate (Can be CPI) Inflation rate (Can be CPI) Real Risk Free Interest (k*) 3 mo. Treasury Bills 3 mo. Treasury Bills Maturity Rate Premium (MP) 30 yr. Treasury Bonds Default Rate Premium (DRP) 30 yr. Treasury Bonds Default Rate Premium (DRP) AAA Corporate Bonds AAA Corporate Bonds

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%. What are the k*, IRP, DRP, and the MP? What are the k*, IRP, DRP, and the MP? What is the nominal rate of this bond for Company X?

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 AAAbonds - LP) k=9.0% NOMINAL RATE OF INTEREST ON THIS BOND

Term Structure of Interest Rates n The pattern of rates of return for debt securities that differ only in the length of time to maturity. yieldtomaturity time to maturity (years)

Term Structure of Interest Rates yieldtomaturity time to maturity (years) n The yield curve may be downward sloping or “inverted” if rates are expected to fall.

Term Structure Theories n Unbiased Expectations Theory u the term structure is determined by expectations of future rates. n Liquidity Preference Theory u investors require maturity premiums to invest in longer term securities. n Market Segmentation Theory u there are separate markets for long and short term investments.