1 Chapter 2 – Role of Financial Markets and Interest Rates Key sections: Sources of funds used by corporations Role and types of financial markets Investment banking Private placements Long-term rates of return

2 Federal Reserve System (Fed) The US central bank – oversees financial system and controls monetary policy. Objectives: Full employment of resources Reasonable price stability Sustainable economic growth Stable balance of payments

3 Fed Funds Rate - A Benchmark Rate Rate on overnight loans between banks Influences other rates Increase in rates tend to slow growth and inflation

4 Where Companies Get Money Externally generated (stocks, bonds, bank loans) –External – 28%; internal 72% (from profits and depreciation) Mix of new corporate securities – about 75% from debt, 25% from equity –Debt is more tax efficient

5 Internal/External Mix

6 Debt/Equity Mix

7 Why Financial Markets Exist Markets – institutions and procedures facilitating transactions in financial assets Some sectors are net suppliers of funds; others are net users –Markets allocate the supply of savings These institutions bridge gap between savers/borrowers

8 Corporate Financial System Public offerings versus private placements Primary markets trade new securities; secondary markets trade existing ones Money and capital markets (MM under one year; CM one year plus) –MM – treasury bills, commercial paper, CD’s –CM – long-term (stocks, bonds, mortgages)

9 Types of Markets Organized exchanges such as NYSE – Has trading facilities. Members, listing requirements Over-the-counter markets - decentralized –Electronic trading between dealers –More OTC stocks; more $ on exchanges –NASDAQ – shows bid and offer prices

10 Investment Banks Intermediaries – raise funds for users, sell new securities to investors. Activities: Underwriting – buy whole issue at a fixed price; may use syndicate to reduce risk Distribution – sale of the new securities Advising – capital structure, M&A Make secondary markets Major players: Citi, Merrill, CS/FB, M-S, GS

11 Private Placements Purchased by small number of large, sophisticated investors –Life insurance companies and pension funds –Limited trading Advantages: speed (no SEC), lower flotation costs; flexible structures Disadvantages: higher interest cost, restrictive covenants, illiquid

12 Flotation Costs Underwriter’s spread and out-of-pocket costs Paid for risk and efforts Difference between what investors pay and what company receives Higher on stocks – greater risk –7½% on IPO’s –% declines with issue size

13 Securities and Exchange Commission (SEC) Federal regulatory body governing operation of securities markets and securities sold to public Areas covered: Sale of new securities Registration statement and prospectus Requires reports from securities issuers Operation of markets - underwriting, trading (including insiders) and broker activities

14 Market Regulation Securities Act of 1933 Requires investors receive accurate and truthful info about issuer and security SEC does not evaluate quality nor prevent sale of risky securities Registration can be a time-consuming process –Exemptions: short-term issues and PP’s

15 Other Legislation Securities Act of 1934 – regulates secondary markets Investment Company Act of 1940 –Covers mutual funds and advisors Securities Act Amendments – 1975 –National Market System – “consolidated tape” Rule 415 (shelf registration) and 144A

16 SIPC Securities Investor Protection Corp. Federal agency but not like FDIC Does not protect against loss of value Replaces securities stolen by a broker or loss through failure of a brokerage holding your securities. –Up to $500,000; 99% recovery rate.

17 Returns Over Long Periods Understand relative returns and relative risk Inflation’s impact Standard deviation measures risk Trends in interest rates

18 Risks and Returns

19 Annual Rates of Return 1926 to 2000 Avg Ann Stand Risk Security Returns Dev Prem Small Co Stocks 17.3% 33.4% 13.4% Common Stock L-T Corp Bonds L-T Govt Bonds Med-term Govt US T-Bills Inflation

Dow – 30 Industrials+3.15% S&P S&P small cap Treasury bondsflat Dollardown

My guess – stocks up modestly (5 to 10%); bonds down Wild cards –Inflation –Corporate earnings –Interest rates –Exchange rates

22 Returns Affected By Starts with risk free rate (no inflation); adds premiums for: Inflation risk Default risk Maturity premium Liquidity premium =s Nominal or quoted rate

23 Term Structure Relation between bond’s interest rate and its maturity –Securities that are exactly the same (Treasuries) Yield curve – graphic representation of YTM –Most often has positive slope – long-term rates higher than short-term

24 Yield Curves

25 Financial Markets & MNC’s Markets increasingly globalized –More sources of funds and liquidity –US companies can borrow in Japan to invest in Europe –Under developed economies lack financial markets; cost of capital is high