Financial markets Financial institutions Stock Market Efficiency CHAPTER 3 The Financial Environment: Markets, Institutions, and Investment Banking Financial markets Financial institutions Stock Market Efficiency

The Financial Market A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds. In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it.

The Financial Markets Suppliers of capital – individuals and institutions with “excess funds”. These groups are saving money and looking for a rate of return on their investment. Demanders or users of capital – individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

Flow of Funds Three financial phases Young adults borrow Older working adults save Retired adults use savings Funds transferred from savers to borrowers Direct transfer Investment banking house Financial intermediary

The Capital Formation Process

Market Efficiency Economic Efficiency - Funds are allocated to their optimal use at the lowest costs Informational Efficiency - Investment prices are adjusted quickly to reflect current information Weak-form - all information contained in past price movements is reflected in current market prices Semistrong-form - current prices reflect all publicly available information Strong-form current prices reflect all pertinent information, both public and private

Types of financial markets Money versus capital markets Debt versus equity markets Primary versus secondary markets Derivatives markets Physical assets market a.k.a tangible or real assets markets are for real goods (ex. Wheat, auto, real estate, etc). Financial markets deal with stocks, bonds, notes, and mortgages. Money markets are for short term, highly liquid debt securities (Ex – 6 month CD). Capital markets are for intermediate or long term debt and corporate stocks (30 yr treasury bond). Primary markets are in which new capital is raised (New stock issue). Secondary market is one in which existing, already out standing securities are traded. Spot market – assets are bought and sold for “on the spot” delivery (Exchange $10,000 for euros today). Futures market, the assets are bought for a future delivery (promise to buy $10,000 worth of euros at a future date for a price decided today). Private markets – transactions are negotiated directly between two parties. Public market – standardized contracts are traded on organized exchanges.

General Stock Market Activities The secondary market - trading in the outstanding, previously issued shares of established, publicly owned companies The primary market - additional shares sold by established, publicly owned companies IPO market - new public offerings by privately held firms

Stock Markets Physical stock exchanges Exchange members NYSE, AMEX, and regional exchanges Exchange members Floor brokers Specialists To have a stock listed Apply to the exchange Pay a relatively small fee Meet the exchange’s minimum requirements

Stock Market Listing Requirements

Stock Markets Over-the-Counter Markets and the Nasdaq Network of brokers and dealers Auction market Organized Investment Network Electronic Communications Networks Nasdaq

Regulation of Securities Markets Securities and Exchange Commission (SEC) Jurisdiction over most interstate offerings of new securities to the general public Regulation of national securities exchanges Power to prohibit manipulation of securities’ prices Control over stock trades by corporate insiders 4

The Investment Banking Process Investment Banker Helps corporations design securities attractive to investors Buys these securities from the corporation Resells the securities to investors

The Investment Banking Process Raising Capital: Stage I Decisions Dollars to be raised Type of securities used Competitive bid versus negotiated deal Selection of an investment banker

The Investment Banking Process Raising Capital: Stage II Decisions Reevaluating the initial decisions Best efforts or underwritten issues Underwritten Arrangement - investment bank guarantees the sale by purchasing the securities from the issuer Best Effort Arrangement - investment bank gives no guarantee that the securities will be sold Issuance (flotation) Costs Setting the offering price

The Investment Banking Process Selling Procedures Underwriting Syndicate: A syndicate of investment firms formed to spread the risk associated with the purchase and distribution of a new issuance of securities Lead or Managing Underwriter: The member of an underwriting syndicate who actually manages the distribution and sale of a new security offering Selling Group: A network of brokerage firms formed for the purpose of distributing a new issuance of securities

The Investment Banking Process Shelf Registrations Securities registered with the SEC for sale at a later date Held “on the shelf” until the sale

The Investment Banking Process Maintenance of the Secondary Market When a company is going public for the first time, the investment banker is obligated to maintain a market for the shares after the issue has been completed. The lead underwriter agrees to “make a market” in the stock and keep it reasonably liquid.

Types of Financial Intermediaries Commercial banks Credit unions Savings and loan associations Mutual funds Whole life insurance companies Pension funds

The Role of Financial Intermediaries Facilitate the transfer of funds from those who have funds (savers) to those who need funds (borrowers) Manufacturing a variety of financial products that take the form of either loans or savings instruments

Benefits of Financial Intermediaries Reduced costs Risk/diversification Funds divisibility/pooling Financial flexibility Related services

International Financial Markets U.S. stock markets represent less than 50% of the total value worldwide U.S. markets still dominate the stock markets in other countries U.S. investors can participate in international markets by using American Depository Receipts - mutual funds that hold stocks or foreign securities certificates issued in dollar denominations

Financial Organizations in Other Parts of the World U.S. financial institutions are more heavily regulated U.S. financial institutions face greater limitations on branching, services and relationships with non-financial businesses

CHAPTER 5 The Cost of Money (Interest Rates) Cost of Money and factors that effect cost of money How are interest rates determined

Realized Returns (Yields) 5

Factors that Affect the Cost of Money Production opportunities Time preferences for consumption Risk Inflation 5

The Cost of Money What do we call the price, or cost, of debt capital? The Interest Rate What do we call the price, or cost, of equity capital? Return on Equity = Dividends + Capital Gains 6

Interest Rate Levels

Determinants of Market Interest Rates r = Quoted or nominal rate rRF = The quoted risk-free rate RP = Risk premium RP = DRP + LP + MRP DRP = Default risk premium LP = Liquidity premium MRP = Maturity risk premium

“Real” versus “Nominal” Rates r = represents any nominal rate r* = represents the “real” risk-free rate of interest. Like a T-bill rate, if there was no inflation. Typically ranges from 2% to 4% per year. rRF = represents the rate of interest on Treasury securities. 7

Premiums Added to r* for Different Types of Debt IP = Inflation premium DRP = Default risk premium LP = Liquidity premium MRP = Maturity risk premium IP MRP DRP LP S-T Treasury  L-T Treasury S-T Corporate L-T Corporate 9

The Term Structure of Interest Rates Term structure: the relationship between interest rates (or yields) and maturities A graph of the term structure is called the yield curve. 10

U.S. Treasury Bond Interest Rates on Different Dates (Yield Curves) 11

Three Explanations for the Shape of the Yield Curve Liquidity Preference Theory Expectations Theory Market Segmentation Theory 12

Liquidity Preference Theory Lenders prefer S-T securities because they are less subject to interest rate risk and are thus more easily bought or sold in the market. Thus, S-T rates should be low, and the yield curve should be slope upward.

Expectations Theory Shape of curve depends on investors’ expectations about future inflation rates. If inflation is expected to increase, S-T rates will be low, L-T rates high, and vice versa. Thus, the yield curve can slope up OR down.

Calculating Interest Rates Expectations Theory Step 1: Find the average expected inflation rate over years 1 to N: 17

Example: Inflation for Year 1 is 5%. Inflation for Year 2 is 6%. Inflation for Year 3 and beyond is 8%. r* = 3% MRPt = 0.1% (t-1) IP1 = 5%/ 1.0 = 5.00% IP10 = [ 5 + 6 + 8(8)] / 10 = 7.5% IP20 = [ 5 + 6 + 8(18)] / 20 = 7.75% Must earn these IPs to break even vs. inflation; these IPs would permit you to earn r* (before taxes). 18

Calculating Interest Rates Expectations Theory: Step 2: Find MRP based on this equation: MRPt = 0.1% (t - 1) MRP1 = 0.1% x 0 = 0.0% MRP10 = 0.1% x 9 = 0.9% MRP20 = 0.1% x 19 = 1.9% 20

Calculating Interest Rates Expectations Theory: Step 3: Add the IPs and MRPs to r*: rRFt = r* + IPt + MRPt Assume r* = 3%. 1-Yr: rRF1 = 3% + 5.0% + 0.0% = 8.0% 10-Yr: rRF10 = 3% + 7.5% + 0.9% = 11.4% 20-Yr: rRF20 = 3% + 7.75% + 1.9% = 12.7% 21

Market Segmentation Theory Borrowers and lenders have preferred maturities Slope of yield curve depends on supply and demand for funds in both the L-T and S-T markets (curve could be flat, upward, or downward sloping) 13

Other Factors That Influence Interest Rate Levels Federal Reserve Policy Federal deficits International Business (Foreign Trade Balance) Business Activity

Interest Rate Levels and Stock Prices The higher the rate of interest, the lower a firm’s profits Interest rates affect the level of economic activity, and economic activity affects corporate profits

The Cost of Money as a Determinant of Value