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Copyright 2011 Pearson Prentice Hall.All rights reserved.

Chapter 2

The FinancialMarkets and

Interest Rates

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2-2 2011 Pearson Prentice Hall. All rights reserved.

Learning Objectives

Describe key components of the U.S. financial market systemand the financing of business.

Understand the role of the investment-banking business in

the context of raising corporate capital. Understand private debt placement and floatation costs.

Be acquainted with recent interest rate levels and thefundamentals of interest rate determination.

Explain the fundamentals of interest rate determination andthe popular theories of the term structure of interest rates.

Understand the relationships among the multinational firm,efficient financial markets, and intercountry risk.

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Slide Contents

Principles Applied in this chapter

1. Components of the US Financial Market System

2. The Investment Banking Function

3. Private Debt Placements

4. Rates of Return in Financial Market

5. Interest Rate Determinants

6. Finance and the Multinational Firm

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Principles applied

in this Chapter

Principle 3:Risk requires a reward

Principle 4:Market prices are generally right.

Principle 5:Conflicts of interest causes agency problems.

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Transfer of Capital

Public Offering Versus Private Placement

Primary Versus Secondary Market

Money Versus Capital Market

Organized Exchange Versus OTC market

Spot Versus Futures Market

1. Components of the U.S.Financial Market System

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Financial Markets:

Transfer of Capital

Financial markets play a critical role in capitalisteconomy. Financial markets help facilitate thetransfer of funds from saving surplus units to

saving deficit units i.e. transfer money from thosewho have the money to those who need it.

See Figure 2-1 for three ways to transfer capital inthe economy:

Direct transfer Indirect transfer using the investment banker Indirect transfer using a financial intermediary

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7/522-7 2011 Pearson Prentice Hall. All rights reserved.

Figure 2-1

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Direct Transfer

Direct transfer

Firm seeking funds directly approaches awealthy investor. For example, a newbusiness venture seeking funding from

venture capitalist.

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Role of Venture capitalist

Venture capitalist are the prime source offunding for start-up companies andcompanies in turnaround situations.Funding for such ventures are very risky, butcarry the potential for high returns.

The borrowing firm may not have the optionof pursuing public offering due to: small size,no record of profits, and uncertain futuregrowth prospects.

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Indirect Transfer

Indirect transfer(using investmentbanks)

Here the investment bank acts as a linkbetween the firm (needing funds) and the

investors (with surplus funds)

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Transfer Using

investment banks (IB)

Corporation sells shares to IB.ex: 5m shares at $10 per share

Investment BankPays $50m to the Corporation

IPO Investment Bank tries to sell those shares

in the Stock market for more than $50m

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Indirect Transfer

Indirect transfer(using financialintermediary):

Here the financial intermediary (such as

mutual funds) collects funds from savers inexchange of its own securities (indirect).

The collected funds are then used toacquire securities (such as stocks andbonds, direct) from firm.

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Indirect transfer using

financial intermediary (FI)

Investors (Savers)transfer savings to Mutual fund companies

Mutual fund (FI) companies issue securities to investors.

Mutual funds use the funds to buy securities from corporations.

Corporations (Users) issue stocks and bonds forfunds received from Mutual funds

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Public Offering Both individuals andinstitutional investors have the opportunity topurchase securities. The securities are initially

sold by the managing investment bank firm. Theissuing firm never actually meets the ultimatepurchaser of securities.

Private Placement The securities are offered

and sold to a limited number of investors.

Public Offerings VersusPrivate Placements

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Primary Market (initial issue) Market in which new issues of a securities are sold to initial

buyers. This is the only time the issuing firm ever gets any

money for the securities. Example: Google raised $1.76 billion through sale of shares

to public in August 2004.

Seasoned Equity Offering: It refers to sale of additionalshares by a company whose shares are already publiclytraded.

Example: Google raised $4.18 billion in September 2005

Primary versussecondary markets

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Primary versus

secondary markets (cont.)

Secondary Market (subsequent trading) Market in which previously issued securities are traded. The

issuing corporation does not get any money for stockstraded on the secondary market.

Example: Trading among investors today of Google stocks.

Primary and secondary markets are regulated bySEC. Firms have to get approval from SEC before

the sale of securities in primary market. Firms mustprovide financial information to SEC on a regularbasis (ex. Financial statements) to protect investors.

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Money versus Capital Market

Money Market

Market for short-term debt instruments (maturity periods ofone year or less). Money market is typically a telephone andcomputer market (rather than a physical building)

Examples: Treasury bills (issued by federal government),commercial paper, negotiable CDs, bankers acceptances.

Capital Market

Market for long-term financial securities (maturity greater

than one year).Examples: Corporate Bonds, Common stocks, TreasuryBonds, term loans and financial leases.

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Exchanges are tangible entities and financialinstruments are traded on the premises. New York Stock Exchange (NYSE, also known as big

board) is the most prominent exchange. In 2009,NYSE listed more than 4,000 US and Non-USsecurities with total value of around $10 trillion. Firmslisted on the exchanges must comply with the listingrequirements of the exchange (such as for profitability,size, market value and public ownership).

Stock exchange benefits: Provides a continuousmarket, establishes and publicizes fair security prices,helps business raise new capital.

Exchange Versus OTC

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OTC

If firms do not meet the listing requirements of the exchange,and/or wish to avoid higher reporting requirements and feesof exchanges, it may choose to trade on OTC.

OTC (Over-the-Counter) market refers to all securitiesmarket except organized exchanges. There is no specificgeographic location for OTC market. Most transactions aredone through a network of security dealers who are knownas broker-dealers and brokers. Their profit depends on theprice at which they are willing to buy (bid price) and the price

at which they are willing to sell (ask price). Most prominent OTC market for stocks is NASDAQ.

NASDAQ lists around 3,900 securities (including Google,Microsoft, Starbucks). Most corporate bond transactions arealso conducted on OTC markets.

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Spot Versus Futures Market

Spot market refers to the cash market, wheretransaction takes place on the spot/today at

the current market price (called spot rate).

Futures market is where you make anagreement to buy/sell in the future at a pricethat is set today.

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2. Investment

Banking Function

Investment Banker

They are financial specialists involved as an intermediaryin the sale of securities (stocks and bonds). They buy theentire issue of securities from the issuing firm and thenresell it to the general public.

Prominent investment banks in the US include GoldmanSachs, JP Morgan, Morgan Stanley (See Table 2-1)

Note, Merrill Lynch is now part of Bank of America,Wachovia was absorbed by Wells Fargo; LehmanBrothers and Bear Sterns went out of business.

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Table 2-1

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Functions of an

Investment Banker

Underwriting: Underwriting means assuming risk. Since money

for securities is paid to the issuing firm before the

securities are sold, there is a risk to theinvestment bank(s).

Distributing: Once the securities are purchased from issuing

firm, they are distributed to ultimate investors. Advising:

On timing of sale, type of security etc.

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Distribution Methods

Negotiated Purchase

Competitive Bid Purchase

Commission or Best Efforts Basis Privileged Subscription

Dutch Auction

Direct Sales

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Distribution Methods (cont.)

Negotiated Purchase

Issuing firm selects an investment banker to

underwrite the issue. The firm and the investmentbanker negotiate the terms of the offer.

Competitive Bid

Several investment bankers bid for the right to

underwrite the firms issue. The firm selects thebanker offering the highest price.

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Best Efforts

Issue is not underwritten i.e. no money is paidupfront for the stocks ==> No risk for the

Investment banks Investment bank attempts to sell the issue for a

commission. Privileged Subscription

Investment banker helps market the new issue toa select group of investors. Usually targeted to current stockholders,

employees, or customers.

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Dutch Auction

Investors place bids indicating how many shares

they are willing to buy and at what price. The pricethe stock is then sold for becomes the lowest priceat which the issuing company can sell all theavailable shares.

See Figure 2-2

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Figure 2-2

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Direct Sale

Issuing firm sells the securities directly to theinvesting public.

No investment banker is involved.

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Private placements of debt refers to raisingmoney directly from prominent investors such

as life insurance companies, pension funds. Itcan be accomplished with or without theassistance of investment bankers.

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Advantages

Faster to raise money

Reduces flotation costs Offers financing flexibility

Disadvantages

Interest costs are higher than public issues Restrictive covenants

Possible future SEC registration

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Floatation Cost

Floatation cost refers to transaction costincurred when a firm raises funds by issuing

securities: Underwriters spread

(Difference between gross and net proceeds)

Issuing costs

(printing and engraving of security certificates,legal fees, accounting fees, trustee fees, othermiscellaneous expenses)

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4. Rates of Return in the

Financial Markets

Rates of return over long periods See Figure 2-3

Higher returns are associated with higher risk(principle 3). Figure also shows that investorsdemand compensation for inflation and otherelements of risk (such as default).

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Some terms

Opportunity Cost Rate of return on next best investmentalternative to the investor

Standard Deviation Dispersion or variability around the mean

rate of return in the financial markets

Real Return Return earned above the rate of inflation

Maturity Premium Additional return required by investors inlong-term securities to compensate for greater risk of pricefluctuations on those securities caused by interest rate changes

Liquidity Premium Additional return required by investors insecurities that cannot be quickly converted into cash at areasonably predictable price.

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Figure 2-3

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Interest rate levels

Interest rate levels and inflation are displayedin Table 2-2 and Figure 2-4. We observe:

A direct relationship between inflation and interestrates.

The returns are affected by the degree of inflation,default premium, maturity premium and liquidity

premium.

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Figure 2-4

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5. Interest Rate Determinants

Nominal interest rate = Real risk free rate + Inflationrisk premium + Default Risk premium + MaturityPremium + Liquidity Premium

Thus the nominal rate or quoted rate for securities isdriven by all of the above risk premium factors. Suchknowledge is critical when companies set an interestrate for their issues.

Review the example in text.

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Real and Nominal Rates

Nominal interest rate = real rate of interest + inflationrisk premium

The real rate of interest includes default risk, maturityrisk and liquidity premiums.

Review example in text.

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Term Structure of Interest

Rates or Yield to Maturity

The graph shows the relationship between a debtsecuritys rate of return and the length of time untilthe debt matures, where the risk of default is heldconstant.

The graph could be upward sloping (indicating longerterm securities command higher returns), flat (equalreturns for long and short-term securities) or inverted(longer term securities command lower returnscompared to short-term securities).

The graph changes over time. Upward sloping curveis most commonly observed.

Figure 2-5

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Figure 2-5

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Figure 2-6

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Figure 2-7

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of the Term Structure:

Unbiased Expectations Theory

Liquidity Preference Theory

Market Segmentation Theory

Th U bi d

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The Unbiased

Expectations Theory

Term Structure is determined by anInvestors expectations about future

interest rates.

Th Li idit

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The Liquidity

Preference Theory

Investors require maturity premiums tocompensate them for risks of uncertain

future interest rates.

Th M k t

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The Market

Segmentation Theory

Legal restrictions and personalpreferences limit choices for investors

to certain ranges of maturities.

6 Fi d th

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6. Finance and the

Multinational firm

Well developed financial markets contribute to the overallgrowth of an economy.

US has well developed financial market that allows for

efficient transfer of capital from savers to users leadingto timely financing of investments.

Multinational firms with excess cash will prefer to invest incountries that have well developed financial market andstable political environment.

Developing countries, with less developed financialmarkets, attract less investment from multinational firms,which contributes to their slower pace of development.

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Table 2-2

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Table 2-2 (cont.)

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Key Terms

Capital markets Direct sale Dutch auction Floatation costs IPO Investment banker Liquidity preference

theory Market segmentation

theory

Money market Nominal rate of interest Opportunity cost of funds Organized security

exchanges Over-the-counter markets Primary market

Private placement Privileged subscription Public Offering

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