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Chapter 2. The Financial Markets and Interest Rates.

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Presentation on theme: "Chapter 2. The Financial Markets and Interest Rates."— Presentation transcript:

1 Chapter 2

2 The Financial Markets and Interest Rates

3 Chapter Objectives Internal and external source of funds Mix of corporate securities sold Why financial markets exist Financing of business U.S. financial market system Investment banker Private Placements Flotation costs Regulation Rates of Return and interest rate determination Term structure of interest rates Multinational firms, efficient markets and inter-country risk

4 Federal Reserve Actions --From Feb 4, 1994 and Dec 11, 2001, the Federal Reserve System (Fed) voted to change the target funds rate on 31 occasions --Rates were moved upward 14 times --Rates were moved downward 17 times --Rates moved downward 11 consecutive times in 2001

5 Federal Funds Rate Short-term market rate of interest Serves as a sensitivity indicator of the direction of future changes in interest rates

6 Objectives of the Fed Maximum sustainable employment Price stability

7 Recent Interest Rate Cycles Early 1994 and 1997 InflationRaise interest Rates Fall 1998International Pressures Lower interest rates Summer 1999Tight labor markets, aggregate real growth, inflation Raise interest rates Early 2001Slower business capital spending, equity market sell- off, recession Lower interest rates

8 Market Conditions and External Funds Changes in market conditions influence the way corporate funds are raised. Example: High interest costs discourage the use of debt.

9 The Mix of Corporate Securities in The Capital Market Corporate Stock is NOT the financing method most relied upon. Corporate Debt is the dominant financing method

10 Debt/Equity Mix U.S. tax system favors debt as means of raising capital— --Interest Expense is deductible --Dividends paid are not deductible

11 Financial Markets Financial markets are institutions and procedures that facilitate transactions in all types of financial claims—facilitate the transfer of savings from economic units with a surplus to economic units with a deficit.

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

13 Underwriting — the purchase of financial claims of borrowing units and re-sell at a higher price to other investors. Secondary Markets—trading in already existing financial claims Financial Intermediaries—Major financial institutions i.e. Commercial banks, savings and loans, credit unions, life insurance companies, mutual funds etc.

14 Financial Markets Exist to facilitate the efficient flow of savings from the surplus sectors to deficit sectors

15 Movement of Funds Through the Economy Direct Transfer of Funds Indirect Transfer of Funds using an Investment Banker Indirect Transfer of Funds Using the Financial Intermediary

16 Structure of U.S. Financial Markets When a corporation needs to raise external capital, funds can be obtained by a: – Public Offering -where individuals and institutional investors have the opportunity to purchase securities or – Private Placement - where securities are sold to a limited number of investors

17 Primary and Secondary Markets Primary MarketsSecurities are offered for the first time to investors – a new issue of stock. Increases the total stock of financial assets outstanding in the economy. Secondary Markets Transactions in currently outstanding securities. All transactions after the initial purchase. Sales do not affect the total stock of financial assets that exist in the economy.

18 Money Market and Capital Market Money Market – Short-term debt instruments with maturities of one year or less – Treasury Bills, Federal Agency Securities, Bankers Acceptances, Negotiable Certificates of Deposit, Commercial Paper. Capital Market—Long Term financial instruments with maturities than extend beyond one year. – Term Loans, Financial Leases, Corporate Equities and Bonds

19 Organized Security Exchanges and Over-The – Counter Markets Organized Security Exchanges—Tangible entities where financial instruments are traded on the premises – National and regional exchanges New York Stock Exchange American Stock Exchange Chicago Stock Exchange Over-The-Counter Markets—All security markets except the organized exchanges – Money Market

20 Benefits of Organized Exchanges Provides a continuous market Establishes and publicizes fair security prices Helps businesses raise new capital

21 Listing Requirements Listing criteria varies from exchange to exchange. General requirements include: Profitability Size Market Value Public Ownership

22 Investment Banker A financial specialist involved as an intermediary in the merchandising of securities—facilitates flow of savings from economic units that want to invest to those units that want to raise funds.

23 Functions of an Investment Banker Underwriting Distributing Advising

24 Distribution Methods Negotiated Purchase Competitive Bid Commission or Best Efforts Basis Privileged Subscription Direct Sales

25 Private Placements Advantages – Speed – Reduced Flotation Costs – Financing Flexibility Disadvantages – Interest Costs – Restrictive Covenants – Possible Future SEC Registration

26 Market Regulation Securities Act of 1933—Aims to provide potential investors with accurate, truthful disclosure about the firm and new securities being offered. Securities Exchange Act of 1934—Created SEC to enforce federal securities laws Securities Acts Amendments of 1975—Created a national market system

27 Securities Exchange Act of 1934 Major security exchanges must register with the SEC – Insider trading is regulated – Prohibits manipulative trading – SEC control over proxy procedures – Gives Board of Governors of Federal Reserve System responsibility for setting margin requirements

28 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 or average rate of return Maturity Premium—Additional return required by investors in long-term securities to compensate them for the increased risk of price fluctuations on those securities caused by interest rate changes

29 Liquidity Premium—Additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price. Real Return—Return earned above the rate of increase in the general price level for goods and services in the economy (the inflation rate) Real Rate of Interest—Rate of increase in actual purchasing power—after adjusting for inflation

30 Term Structure of Interest Rates The relationship between a debt security’s rate of return and the length of time until the debt matures. Also called: Yield to Maturity

31 Term Structure of Interest Rates Explained by: Unbiased Expectations Theory Liquidity Preference Theory Market Segmentation Theory

32 Unbiased Expectations Theory The term structure is determined by an investor’s expectations about future interest rates

33 Liquidity Preference Theory Investors require maturity premiums to compensate them for buying securities that expose them to the risks of fluctuating interest rates

34 Market Segmentation Theory Legal restrictions and personal preferences limit choices for investors to certain ranges of maturities

35 Intercountry Risk Financial System Risk Political System Risk Exchange Rate Risk

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