Ch. 2 - The Financial Markets and Interest Rates  2000, Prentice Hall, Inc.

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 In 1996, over $500 billion in external corporate financing was raised. n From 1981 through 1996, capital has been raised through the following sources: n Corporate Bonds and Notes75.6% n Preferred Stock 4.2% n Common Stock20.2%

Movement of Savings n Direct Transfer of Funds

Movement of Savings n Direct Transfer of Funds saver

Movement of Savings n Direct Transfer of Funds saver firm

Movement of Savings n Direct Transfer of Funds cash saver firm

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

Movement of Savings n Indirect Transfer using Investment Banker

Movement of Savings n Indirect Transfer using Investment Banker investment banker

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

Movement of Savings n Indirect Transfer using Investment Banker funds investment banker firm

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

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

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

Movement of Savings n Indirect Transfer using a Financial Intermediary financial intermediary

Movement of Savings n Indirect Transfer using a Financial Intermediary financial intermediary firm

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

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

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

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

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

Financial Market Components n Public Offering

Financial Market Components n Public Offering u Firm issues securities, which are made available to both individual and institutional investors.

Financial Market Components n Public Offering u Firm issues securities, which are made available to both individual and institutional investors. n Private Placement

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

Financial Market Components n Primary Market u Market in which new issues of a security are sold to initial buyers.

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

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

Financial Market Components n Money Market u Market for short-term debt instruments (maturity periods of one year or less).

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

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).

Financial Market Components n Organized Exchanges

Financial Market Components n Organized Exchanges u Buyers and sellers meet in one central location to conduct trades.

Financial Market Components n Organized Exchanges u Buyers and sellers meet in one central location to conduct trades. n Over-the-Counter (OTC)

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.

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

Distribution Methods n Negotiated Purchase u Issuing firm selects an investment banker to underwrite the issue.

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.

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

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.

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

Distribution Methods n Best Efforts u Issue is not underwritten.

Distribution Methods n Best Efforts u Issue is not underwritten. u Investment bank attempts to sell the issue for a commission.

Distribution Methods n Best Efforts u Issue is not underwritten. u Investment bank attempts to sell the issue for a commission. n Privileged Subscription

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.

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

Distribution Methods n Direct Sale u Issuing firm sells the securities directly to the investing public.

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.

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.

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

Interest Rates Conceptually:

Interest Rates Conceptually: Nominalrisk-freeInterestRate k rf

Interest Rates Conceptually: Nominalrisk-freeInterestRate k rf =

Interest Rates Conceptually: Nominalrisk-freeInterestRate k rf = Realrisk-freeInterestRatek*

Interest Rates Conceptually: Nominalrisk-freeInterestRate k rf = Realrisk-freeInterestRatek* +

Interest Rates Conceptually: Nominalrisk-freeInterestRate k rf = Realrisk-freeInterestRatek* + Inflation-riskpremiumIRP

Conceptually: Nominalrisk-freeInterestRate k rf = Realrisk-freeInterestRatek* + Inflation-riskpremiumIRP Mathematically: Interest Rates

Conceptually: Nominalrisk-freeInterestRate k rf = Realrisk-freeInterestRatek* + Inflation-riskpremiumIRP Mathematically: (1 + k rf ) = (1 + k*) (1 + IRP) Interest Rates

Conceptually: Nominalrisk-freeInterestRate k rf = Realrisk-freeInterestRatek* + Inflation-riskpremiumIRP Mathematically: (1 + k rf ) = (1 + k*) (1 + IRP) This is known as the “Fisher Effect” Interest Rates

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.

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 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 Ratesyieldtomaturity time to maturity (years) n The yield curve may be downward sloping or “inverted” if rates are expected to fall.

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.