the financial system and interest
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The Financial System and Interest. Chapter 5. Read Ch. 5 ( ch. 4 in the 4 th edition) Possible test questions handed out in lab Interesting books on investing One Up On Wall Street : How To Use What You Already Know To Make Money In The Market by Peter Lynch, John Rothchild - PowerPoint PPT PresentationTRANSCRIPT
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Read Ch. 5 (ch. 4 in the 4th edition) Possible test questions handed out in lab Interesting books on investing
One Up On Wall Street : How To Use What You Already Know To Make Money In The Market by Peter Lynch, John Rothchild
Take On the Street: What Wall Street and Corporate America Don't Want You to Know by Arthur Levitt
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Primary and Secondary Markets
Purpose of a financial market is to facilitate the flow of funds from savers to production sector (investment in business projects) This occurs in the:
Primary market (market in which securities are initially sold)
Investors trade securities between each other in the Secondary market
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Primary and Secondary Markets
Corporations, even though they do not raise money in the secondary market, are interested in the stock’s price in the secondary market Goal: Max. Stock Price Influences how much money can be
raised in future stock issues Senior management’s compensation is
usually tied to the stock price
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The Stock Market and Stock Exchanges
Stock market—a network of exchanges and brokers Exchange—a physical marketplace
(NYSE, AMEX, regional exchanges) Broker—individual whose job is to assist
people in buying and selling securities Work for brokerage firms Members of stock exchange
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Exchanges
New York Stock Exchange (NYSE) Trades securities for 1,200 of largest, strongest
companies in U.S. Handles about 85% of trading activity
American Stock Exchange (AMEX) Handles slightly smaller, younger firms than NYSE
NASDAQ Regional stock exchanges (Philadelphia,
Chicago, San Francisco, etc.) Exchanges are linked electronically
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Exchanges The Market
The stock market refers to the entire interconnected set of places, organizations and processes involved in trading stocks
Regulation Securities are regulated under state and federal
laws Securities Act of 1933
Required companies to disclose certain information Securities Act of of 1934
Set up Securities and Exchange Commission Securities law is primarily aimed at disclosure
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Private, Public, and Listed Companies, and the NASDAQ Market
Assume a business is successful and the owner decides to raise money for expansion by incorporating and selling stock to others Privately held companies—can’t sell securities to
the general public (also, sale of securities is severely restricted by regulation)
Publicly traded companies—have received approval of the SEC to offer securities to the general public Process of obtaining approval and
registration is known as ‘going public’
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Private, Public, and Listed Companies, and the NASDAQ Market
Process of ‘going public’ Use an investment banking firm (e.g., Goldman
Sachs or Morgan Stanley), to determine If a market exists for shares of your company The likely price for your firm’s stock
Develop a prospectus—provides detailed information about company Financial statements Key executives/background
SEC reviews prospectus An unapproved prospectus is call a ‘red herring’
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Private, Public, and Listed Companies, and the OTC Market
The IPO Once prospectus is approved by SEC securities
can be sold to public Initial sale is known as an IPO or initial public
offering Market for IPOs is very volatile and risky
Prices can rise (or fall) very dramatically Investment banks usually line up buyers prior to
the actual sale of securities Buyers are usually institutional investors
IPO occurs in primary market, but once securities are placed with investors, trading begins in the secondary market
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Company Name
Offer Date Exchange Industry UnderwriterDeal Size(US$MM)
Visa 03/18/08 NYSE Financial J.P. Morgan $17,864
ENEL SpA 11/01/99 NYSE Utilities Merrill Lynch $16,452
Facebook 05/17/12 NASDAQ Technology Morgan Stanley $16,007
General Motors
11/17/10 NYSE Capital Goods & Services
Morgan Stanley $15,774
Deutsche Telekom
11/17/96 NYSE Communications
Goldman Sachs $13,034
AT&T Wireless Group
04/26/00 NYSE Communications
Goldman Sachs $10,620
Kraft Foods 06/12/01 NYSE Consumer Credit Suisse $8,680
France Telecom
10/17/97 NYSE Communications
Merrill Lynch $7,289
Telstra Corporation
11/17/97 NYSE Communications
Credit Suisse $5,646
Swisscom 10/04/98 NYSE Communications
Warburg Dillon Read
$5,582
Largest all time IPOs. 2/7/2014
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myths about IPOs The general perception is that IPOs are a
fail-safe way to make money and that if one invests money in an IPO returns are guaranteed. This is the greatest myth about IPOs. Many IPOs will result in losses for the investors, the prices of the same will go down because of several reasons like a weak company, over pricing, weak management or simply because the price fell along with the general markets.
http://www.19.5degs.com/element/19427.php
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The NASDAQ Market After a company goes public, its
shares are usually traded in the over-the-counter (OTC) market
Eventually a firm may wish to be listed on an exchange Loosely organized network of brokers
The National Association of Securities Dealers Automated Quotation System (NASDAQ) is the market’s computer system
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The NASDAQ Market
The Nasdaq Stock Market is a computerized communication system that provides the bid and asked prices of more than 5,000 over-the-counter (OTC) stocks that have met the market's registration requirements.
Update. The current thinking is that Nasdaq is considered a stock exchange and its stocks are not OTC stocks.
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Interest
Interest rates typically refer to the rate charged on a debt instrument There are MANY interest rates, including
the prime rate, the federal funds rate, etc. Interest rates tend to move in tandem
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The Relationship Between Interest and the Stock Market
The stock market reacts to changes in interest rates (even though interest rates are related to the bond market) Stocks (equity) and bonds (debt) compete for
investor’s dollars Stocks offer higher returns but have more risk
If you could earn 10% by investing in a bond of IBM, what return would you want to invest in IBM’s stock? ANS. More than 10% because the stock is more
risky
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The Relationship Between Interest and the Stock Market
If interest rates were to rise to 12% on IBM’s bonds, what would happen to your required rate of return on IBM’s stock? Your required return on IBM’s stock would rise
and therefore, the value of IBM’s stock would drop in the market
Interest rates and security prices move in opposite directions Good reason for us to have an interest in interest
rates
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Interest and the Economy Would you be more likely to buy a
house/car when interest rates are high or low?
Interest rates have a significant effect on the economy Lower interest rates stimulate business and
economic activity Businesses and individuals use credit a great
deal Interest rates represent the cost of borrowing money
(credit)
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This is a copy of a later slide (#33) Putting the Pieces Together
The factors that make up an interest rate, k, can be expanded to include the particular types of risk
K = KPure Interest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium
k = kpr + INFL + DR + LR + MR K is known as the nominal or quoted interest rate
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The Components of an Interest Rate
Interest rates include base rates and risk premiums
Interest rate will be represented by the letter k k = base rate + risk premiums k = kpr + INFL + DR + LR + MR
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Conceptual View for Interest Rates k = kpr + INFL + DR + LR + MR
Components of the Base Rate The base rate is pure interest plus expected
inflation The rate at which people lend money when
no risk is involved Pure interest rate is AKA earning power of money
An unobservable rate that would exist in the real world if there were no inflation and no risk
Generally considered to be between 2% and 4%
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The Components of an Interest Rate
The Inflation Adjustment Inflation refers to a general increase in prices Refers to the fact that, if prices rise, $100 at the
beginning of the year will not buy as much at the end of the year
If you lent someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year Interest rates include estimates of average
annual inflation over loan periods
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Risk Premiumsk = kpr + INFL + DR + LR + MR
Default risk in loans refers to the chance that the lender will not receive the full amount of principal and interest payments agreed upon
Some loans are more risky than others
Lenders demand a risk premium of extra interest for making risky loans
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Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR
Bond losses can be associated with fluctuations in the prices of bonds as well as with the failure of borrowers to repay the loans
Default Risk The chance the borrower won't pay principal or
interest Losses can be the entire amount or anywhere in
between Investors demand a default risk premium which
depends on the investor's perception of the creditworthiness of the borrower Perception is based on the firm's financial
condition and credit record
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Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR
Default Risk (continued) Premiums range from 0% to 6 or 8 %
Once a company's default risk becomes too high, they will be unable to borrow at any interest rate
Default doesn't actually have to occur for problems to exist If investors realize that a firm is having difficulty making
interest payments (although it is still making them) the bond's price will probably fall
A time dimension is involved in the risk of default The longer the time period involved with the debt
instrument the more likely that the firm will face financial difficulty
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Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR
Liquidity Risk Associated with being unable to sell the bond of
an little known issuer Debt of small firms are particularly hard to
market Said to be illiquid
Sellers must reduce their prices to encourage investors to buy the illiquid securities
Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk
Very short-term securities usually bear little liquidity risk
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Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR
Maturity Risk Bond prices and interest rates move in opposite
directions Long-term bond prices change more with
interest rate swings than short-term bond prices Gives rise to maturity risk
Investors demand a maturity risk premium Ranges from 0% to 2% or more for long-term
issues
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Putting the Pieces Together The factors that make up an interest rate, k, can be
expanded to include the particular types of risk K = KPure Interest Rate + Inflation + Default Risk Premium +
Liquidity Risk Premium + Maturity Risk Premium
k = kpr + INFL + DR + LR + MR K is known as the nominal or quoted interest rate
“Setting” Interest Rates Interest rates are set by the forces of supply and
demand Thus the interest rate model above is only an economic
model of reality Represents an explanation of what generally has to be
behind the interest rate needs of investors
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Federal Government Securities, Risk Free and Real Rates
Federal Government Securities Cities, states and federal governments issue
long-term bonds Federal treasury also issues short-term securities
Known as Treasury securities Treasury bills have terms from 90 days to a year Treasury notes have terms from 1 to 10 years
No default risk associated with federal government debt Can print money to pay off all of its debt
No liquidity risk for federal government debt Always an active market
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The Risk-Free Rate
The risk-free rate is approximately the yield on short-term Treasury bills Includes the pure rate and an allowance
for inflation Same as the base rate discussed earlier
Viewed as a conceptual floor for the structure of interest rates
Denoted as kRF
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The Real Rate of Interest Real refers to values that have the effects of inflation
removed Tells investors by how much they are getting ahead
If you earn a real rate of 8% on an investment and inflation turns out to be 10%, you are losing purchasing power on your investment
There are periods in time when the real rate of interest has been negative Because we don't really know what the rate of
inflation will be at the point in time when nominal rates are set
The Real Risk-Free Rate Implies that both the inflation adjustment and the risk
premium is zero
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Yield Curves—The Term Structure of Interest Rates
The relationship between interest rates and the term of debt is known as the term structure of interest rates The yield curve is a graphical
representation of the term structure of interest rates
Most of the time short-term rates are lower than long-term rates However at times the opposite is true
Known as an inverted yield curve
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Yield Curves—The Term Structure of Interest Rates
Theories have developed attempting to explain the term structure of interest rates Expectations theory
Today's rates rise or fall with term as future rates are expected to rise or fall
Liquidity preference theory Investors prefer shorter term securities and
must be induced to make longer loans Market segmentation theory
Loan terms define independent segments of the debt market which set separate rates
27. You have been assigned to estimate the interest rates that your company may have to pay when borrowing money in the near future. The following information is available.
a. Calculate the inflation adjustment (INFL) for a 5-year loan.
b. Calculate the appropriate interest rate for a 5-year loan.
kPR = 2%
MR = .1% for a 1 year loan increasing by .1% for each additional year
35k = kpr + INFL + DR + LR + MR
LR = .05% for a 1 year loan increasing by .05% for each additional year
DR = 0 for a 1 year loan, .2% for a 2-year loan, increasing.1% for each additional year
Expected Inflation RatesYear 1 = 7%Year 2 = 5%Year 3 and thereafter = 3%
a. INFL = (7% + 5% + 3% + 3% + 3%)/5 = 4.2%
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k = kpr + INFL + DR + LR + MR
b. k= 2% + 4.2% + .5% + .25% + .5% = 7.45%