Ch. 2 - The Financial Markets and Interest Rates 2000, Prentice Hall, Inc

Ch. 2 - The Financial Marketsand Interest Rates

2000, Prentice Hall, Inc.

Q: What are SECURITIES?

A:A: Financial Assets that Financial Assets that Investors purchase hoping to Investors purchase hoping to

earn a earn a high rate of return.high rate of return.

Types of Securities

Treasury Bills and Treasury BondsTreasury Bills and Treasury Bonds Municipal BondsMunicipal Bonds Corporate BondsCorporate Bonds Preferred StocksPreferred Stocks Common StocksCommon Stocks

Which of these are Which of these are RISKYRISKY??

Which promise Which promise HIGH RETURNSHIGH RETURNS??

Is there a relationship betweenIs there a relationship between RISKRISK and and RETURNRETURN??

Corporate FinancingSources

In 1996, over $500 billion in external In 1996, over $500 billion in external corporate financing was raised.corporate financing was raised.

From 1981 through 1996, capital has been From 1981 through 1996, capital has been raised through the following sources:raised through the following sources:

Corporate Bonds and NotesCorporate Bonds and Notes 75.6%75.6% Preferred StockPreferred Stock 4.2%4.2% Common StockCommon Stock 20.2%20.2%

Movement of Savings

Direct Transfer of FundsDirect Transfer of Funds

Movement of Savings


saver

Movement of Savings


saverfirm

Movement of Savings


cashcash

saverfirm

Movement of Savings


cashcash

securitiessecurities

saverfirm

Movement of Savings

Indirect Transfer using Investment BankerIndirect Transfer using Investment Banker

Movement of Savings


investmentbanker

Movement of Savings


investmentbanker firm

Movement of Savings


fundsfunds


Movement of Savings


fundsfunds



Movement of Savings


fundsfunds


saver


Movement of Savings


fundsfundsfundsfunds


saver


Movement of Savings



fundsfundsfundsfunds


saver


Movement of Savings Indirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary


financialintermediary


financialintermediary firm


fundsfunds



fundsfunds

firmfirmsecuritiessecurities



fundsfunds



saver


fundsfunds fundsfunds



saver


fundsfunds

intermediaryintermediarysecuritiessecurities

fundsfunds



saver

Financial Market Components

Public OfferingPublic Offering


Public OfferingPublic Offering Firm issues securities, which are Firm issues securities, which are

made available to both individual made available to both individual and institutional investors.and institutional investors.




Private PlacementPrivate Placement




Private PlacementPrivate Placement Securities are offered and sold to a Securities are offered and sold to a

limited number of investors.limited number of investors.


Primary MarketPrimary Market


Primary MarketPrimary Market Market in which new issues of a Market in which new issues of a

security are sold to initial buyers.security are sold to initial buyers.




Secondary MarketSecondary Market




Secondary MarketSecondary Market Market in which previously issued Market in which previously issued

securities are traded.securities are traded.


Money MarketMoney Market


Money MarketMoney Market Market for short-term debt Market for short-term debt

instruments (maturity periods of instruments (maturity periods of one year or less).one year or less).




Capital MarketCapital Market




Capital MarketCapital Market Market for long-term securities Market for long-term securities

(maturity greater than one year).(maturity greater than one year).


Organized ExchangesOrganized Exchanges


Organized ExchangesOrganized Exchanges Buyers and sellers meet in one central Buyers and sellers meet in one central

location to conduct trades.location to conduct trades.




Over-the-Counter (OTC)Over-the-Counter (OTC)




Over-the-Counter (OTC)Over-the-Counter (OTC) Securities dealers operate at many Securities dealers operate at many

different locations across the country.different locations across the country.




Over-the-Counter (OTC)Over-the-Counter (OTC) Securities dealers operate at many Securities dealers operate at many

different locations across the country.different locations across the country. Connected by Connected by NasdaqNasdaq system (National system (National

Association of Securities Dealers Association of Securities Dealers Automated Quotation system).Automated Quotation system).

Investment Banking

How do investment bankers help How do investment bankers help firms issue securities?firms issue securities?

Underwriting the issue.Underwriting the issue.

Distributing the issue.Distributing the issue.

Advising the firm.Advising the firm.

Distribution Methods Distribution Methods

Negotiated PurchaseNegotiated Purchase


Negotiated PurchaseNegotiated Purchase Issuing firm selects an investment Issuing firm selects an investment

banker to underwrite the issue.banker to underwrite the issue.



banker to underwrite the issue.banker to underwrite the issue. The firm and the investment banker The firm and the investment banker

negotiate the terms of the offer.negotiate the terms of the offer.




negotiate the terms of the offer.negotiate the terms of the offer. Competitive BidCompetitive Bid





Several investment bankers bid for the Several investment bankers bid for the right to underwrite the firm’s issue.right to underwrite the firm’s issue.





Several investment bankers bid for the Several investment bankers bid for the right to underwrite the firm’s issue.right to underwrite the firm’s issue.

The firm selects the banker offering The firm selects the banker offering the highest price. the highest price.


Best EffortsBest Efforts


Best EffortsBest Efforts Issue is not underwritten.Issue is not underwritten.


Best EffortsBest Efforts Issue is not underwritten.Issue is not underwritten. Investment bank attempts to sell the Investment bank attempts to sell the

issue for a commission. issue for a commission.



issue for a commission. issue for a commission. Privileged SubscriptionPrivileged Subscription




Investment banker helps market the Investment banker helps market the new issue to a select group of investors.new issue to a select group of investors.




Investment banker helps market the Investment banker helps market the new issue to a select group of investors.new issue to a select group of investors.

Usually targeted to current Usually targeted to current stockholders, employees, or customers.stockholders, employees, or customers.


Direct SaleDirect Sale


Direct SaleDirect Sale Issuing firm sells the securities directly Issuing firm sells the securities directly

to the investing public.to the investing public.


Direct SaleDirect Sale Issuing firm sells the securities directly Issuing firm sells the securities directly

to the investing public.to the investing public. No investment banker is involved. No investment banker is involved.

Stock Issue Example:

Our firm needs to raise approximately Our firm needs to raise approximately $100 million for expansion. Our stock $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwrite the issue for a 2% underwriting spread.underwriting spread.

What type of issue is this?What type of issue is this? It’s a It’s a negotiated purchasenegotiated purchase..



How many shares will be sold?How many shares will be sold?



How many shares will be sold?How many shares will be sold? $100,000,000 / $20 = $100,000,000 / $20 = 5 million5 million new new

shares of common stock.shares of common stock.



What are the flotation costs?What are the flotation costs?



What are the flotation costs?What are the flotation costs? Underwriting spreadUnderwriting spread: 2% of $100 : 2% of $100

million = $2 million.million = $2 million.



What are the flotation costs?What are the flotation costs? Underwriting spreadUnderwriting spread: 2% of $100 : 2% of $100

million = $2 million.million = $2 million. Issuing costsIssuing costs: printing and engraving : printing and engraving

costs; legal, accounting and trustee fees.costs; legal, accounting and trustee fees.



What are the risks?What are the risks?



What are the risks?What are the risks? The investment bank accepts the risk of The investment bank accepts the risk of

being able to sell the new stock issue for being able to sell the new stock issue for $20 per share. If the stock price falls, $20 per share. If the stock price falls, the investment bank could lose money.the investment bank could lose money.

Regulations:Regulations:The Primary MarketThe Primary Market

The Securities Act of 1933The Securities Act of 1933 Firms register with the Securities Firms register with the Securities

Exchange Commission (SEC).Exchange Commission (SEC). SEC has 20 days to review.SEC has 20 days to review.




SEC may ask for more information.SEC may ask for more information.




SEC may ask for more information.SEC may ask for more information. The firm can not solicit buyers during The firm can not solicit buyers during

the review period but can advertise.the review period but can advertise.

Regulations:The Secondary Market

The Securities Exchange Act of 1934The Securities Exchange Act of 1934 Established the SEC.Established the SEC. Exchanges must register with SEC.Exchanges must register with SEC. Company information must be Company information must be

available to the public.available to the public. Insider trading is regulatedInsider trading is regulated..

Regulations:Recent Developments

Securities Acts Amendments of 1975Securities Acts Amendments of 1975 Created National Market System.Created National Market System. Eliminated fixed brokerage Eliminated fixed brokerage

commissions.commissions.

SEC Rule 415SEC Rule 415 Allows Shelf RegistrationAllows Shelf Registration

Interest Rate Determinants

InterestRates

Interest RatesConceptuallyConceptually::


NominalNominalrisk-freerisk-freeInterestInterest

Rate Rate

kkrfrf



Rate Rate

kkrfrf

==



Rate Rate

kkrfrf

==

RealRealrisk-freerisk-freeInterestInterest

Rate Rate

k*k*



Rate Rate

kkrfrf

==


Rate Rate

k*k*

++



Rate Rate

kkrfrf

==


Rate Rate

k*k*

++

Inflation-Inflation-riskrisk

premiumpremium

IRPIRP

ConceptuallyConceptually::


Rate Rate

kkrfrf

==


Rate Rate

k*k*

++


premiumpremium

IRPIRP

MathematicallyMathematically::

Interest Rates



Rate Rate

kkrfrf

==


Rate Rate

k*k*

++


premiumpremium

IRPIRP


(1 + k(1 + krfrf) = (1 + k*) (1 + IRP)) = (1 + k*) (1 + IRP)

Interest Rates



Rate Rate

kkrfrf

==


Rate Rate

k*k*

++


premiumpremium

IRPIRP


(1 + k(1 + krfrf) = (1 + k*) (1 + IRP)) = (1 + k*) (1 + IRP)

This is known as the This is known as the ““Fisher EffectFisher Effect””

Interest Rates

Term Structure of Interest Rates The pattern of rates of return for debt The pattern of rates of return for debt

securities that differ only in the length of securities that differ only in the length of time to maturity.time to maturity.



yieldyieldto to

maturitymaturity

time to maturity (years)time to maturity (years)



yieldyieldto to

maturitymaturity


Term Structure of Interest Rates

yieldyieldto to

maturitymaturity


The yield curve may be downward The yield curve may be downward sloping or “inverted” if rates are sloping or “inverted” if rates are expected to fall.expected to fall.

Term Structure of Interest Rates

yieldyieldto to

maturitymaturity


The yield curve may be downward The yield curve may be downward sloping or “inverted” if rates are sloping or “inverted” if rates are expected to fall.expected to fall.

Term Structure Theories

Unbiased Expectations TheoryUnbiased Expectations Theory the term structure is determined by the term structure is determined by

expectations of future rates.expectations of future rates. Liquidity Preference TheoryLiquidity Preference Theory

investors require maturity premiums to investors require maturity premiums to invest in longer term securities .invest in longer term securities .

Market Segmentation TheoryMarket Segmentation Theory there are separate markets for long and there are separate markets for long and

short term investments.short term investments.

Documents

Ch. 2 - The Financial Markets and Interest Rates 2000, Prentice Hall, Inc