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

2. 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.

3. 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.

4. 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

5. The Capital Formation Process

6. 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

7. 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.

8. 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

9. 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

10. Stock Market Listing Requirements

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

12. 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

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

14. 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

15. 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

16. 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

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

18. 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.

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

20. 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

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

22. 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

23. 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

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

25. Realized Returns (Yields)5

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

27. 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

28. Interest Rate Levels

29. 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

30. “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

31. 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

32. 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

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

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

35. 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.

36. 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.

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

38. 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 = [ (8)] / 10 = 7.5%
IP20 = [ (18)] / 20 = 7.75%
Must earn these IPs to break even vs. inflation; these IPs would permit you to earn r* (before taxes). 18

39. 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

40. 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% % + 1.9% = 12.7% 21

41. 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

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

43. 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

44. The Cost of Money as a Determinant of Value