-chapter two

The Financial Markets and Interest Rates

Chapter 2

Keown, Martin, Petty - Chapter 2

Chapter Objectives

U.S. Financial markets and how American firms use them

Investment banking process

How interest rates are determined

Long–term pattern of rates of return on securities

Real and Financial Assets

Real Assets—Tangible assets such as houses, equipment and inventories

Financial Assets—Claims for future payment on other economic units … Cash, Bonds, Stock, etc.

Securities ?

Financial Assets that Investors purchase hoping to earn a “high” rate of return.

Types of Securities Treasury Bills and Bonds Municipal Bonds Corporate Bonds Preferred Stocks Common Stocks

Which of these are Most RISKY? Which promise HIGHEST RETURNS? What is the relationship between RISK and

RETURN?

Financial Markets

Financial markets exist in order to allocate the supply of savings in the economy to the demanders of those savings.

Financial markets are institutions and procedures that facilitate transactions in all types of financial claims.

A securities market is simply a place where you can buy and sell securities (example, New York Stock Exchange)

Keown, Martin, Petty - Chapter 2Keown, Martin, Petty - Chapter 2 77

Movement of SavingsMovement of SavingsDirect Transfer of FundsDirect Transfer of Funds

cashcash

securitiessecurities

saverfirm

Movement of SavingsMovement of Savings

Indirect Transfer using MiddlemenIndirect Transfer using Middlemen

fundsfundsfundsfunds

investmentbanker firm

Movement of SavingsMovement of SavingsIndirect Transfer using a Financial IntermediaryIndirect Transfer using a Financial Intermediary

fundsfunds

intermediaryintermediarysecuritiessecurities

fundsfunds

firmfirmsecuritiessecurities

financialintermediary firm

The Financing ProcessThe Financing Process

SectorSector Funds Funds Raised Raised ($)($)

Funds Funds Supplied ($)Supplied ($)

Net Funds Net Funds Supplied ($)Supplied ($)

HouseholdsHouseholds 447.4447.4 397.1397.1 (50.3)(50.3)

Nonfinancial Corporate Nonfinancial Corporate BusinessBusiness

447.5447.5 383.8383.8 (63.7)(63.7)

U.S. Gov’tU.S. Gov’t 73.973.9 62.962.9 (11.0)(11.0)

State and Local Gov’tsState and Local Gov’ts 56.456.4 48.448.4 ( 8.0)( 8.0)

ForeignForeign 320.2320.2 561.7561.7 241.5241.5Source: Flow of Funds Accounts, First Quarter 2000, Flow if Funds Section, Statistical Release Z.1 (Washington, D.C.; Board of Governors of the Federal Reserve System, June 9,2000).

Keown, Martin, Petty - Chapter 2Keown, Martin, Petty - Chapter 2

Corporate Financing SourcesCorporate Financing Sources

Historical (1981 – 2000) Internal vs. External:Historical (1981 – 2000) Internal vs. External:– Internal Internal … 72%… 72%– External External … 28%… 28%

From 1998-2000, over $1.1 trillion in external corporate From 1998-2000, over $1.1 trillion in external corporate financing was raised.financing was raised.– Debt (Corporate Bonds and Notes) Debt (Corporate Bonds and Notes) … … 73.6%73.6%– Equities (Preferred & Common Stock) Equities (Preferred & Common Stock) … … 26.4%26.4%

(Interest is tax deductible and dividends are not)(Interest is tax deductible and dividends are not)

Components of U.S. Financial Market System

Public Offering Versus Private PlacementPrimary Versus Secondary Market

Money Versus Capital MarketOrganized Exchange Versus OTC market

Spot Versus Futures Market

Public Offerings Versus Private Placements

Public Offering – Both individuals and institutional investors have the opportunity to purchase securities. The securities are initially sold by the managing investment bank firm. The issuing firm never actually meets the ultimate purchaser of securities

Private Placement (direct placement) – The securities are offered and sold to a limited number of investors

Primary Versus Secondary Market

Primary Market (initial issue)

Market in which new issues of a security 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.

Secondary Market (subsequent trading)

Market in which previously issued securities are traded. The issuing corporation does not get any money for stocks traded on the secondary market.

Example: Trading among investors today of Google stocks.

Money versus Capital Market Money Market

Market for short-term debt instruments (maturity periods of one year or less). Money market is typically a telephone and computer 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 securities (maturity greater than one year).

Examples: Corporate Bonds, Common stocks, Treasury Bonds, term loans and financial leases

Exchanges Versus OTC Exchanges are tangible entities and financial

instruments are traded on the premises. There are 7 organized exchanges in the United States

(ex. NYSE). Firms listed on the exchanges must comply with the listing requirements of the exchange and SEC.

OTC (Over-the-Counter) market refers to all securities markets except organized exchanges. There is no specific geographic location for OTC market. Most transactions are done through a loose network of security dealers who are known as broker-dealers and brokers.

Most prominent for stocks is NASDAQ (“screen based, floorless market) that lists more securities than NYSE (including Google, Microsoft, Starbucks)

Spot Versus Futures Market

Spot market refers to the cash market, where transaction takes place on the spot/today at the current market price (called spot rate)

Futures market refers to the creation of an agreement to buy/sell in the future at a price set today.

Investment Banker

Investment Banker They are financial specialists involved as an

intermediary in the sale of securities (stocks and bonds). They buy the entire issue of securities from the issuing firm and then resell it to the general public.

Prominent investment banks in the US include Goldman Sachs, Merrill Lynch, Lehman Brothers, Citigroup/Salomon Smith Barney (See table 2-2).

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 the investment 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.

Distribution Methods

Negotiated Purchase Competitive Bid Purchase Commission or Best Efforts Basis Privileged Subscription Dutch Auction Direct Sales

Negotiated Purchase Issuing firm selects an investment banker to

underwrite the issue. The firm and the investment banker

negotiate the terms of the offer. Competitive Bid

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

The firm selects the banker offering the highest price.

Best Efforts Issue is not underwritten i.e. no money is

paid upfront 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 to a select group of investors. Usually targeted to current stockholders,

employees, or customers.

Dutch Auction Investors place bids indicating how many

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

See figure 2-2

Direct Sale Issuing firm sells the securities directly to

the investing public. No investment banker is involved. Example: Private placement

Flotation Costs

Transaction costs incurred when a firm raises funds by issuing securities:

1. Underwriter’s spread (Difference between gross and net proceeds)

2. Issuing costs(printing and engraving of security certificates, legal fees, accounting fees, trustee fees, other miscellaneous expenses)

Stock Issue Example:Stock Issue Example:

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

$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?

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

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

Underwriting spreadUnderwriting spread: 2% of $100 million : 2% of $100 million = $2 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?

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

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, the $20 per share. If the stock price falls, the investment bank could lose money.investment bank could lose money.

Government Intervention Fiscal Policy – Taxes

Monetary Policy - The Federal Reserve Board

Regulations

Market RegulationMarket RegulationSecurities Act of 1933 Securities Act of 1933 — Aims to provide potential investors — Aims to provide potential investors with accurate, truthful disclosure about the firm and new with accurate, truthful disclosure about the firm and new securities being offered … Primary Market.securities being offered … Primary Market.

Securities Securities ExchangeExchange Act of 1934 Act of 1934 — Created SEC to enforce — Created SEC to enforce federal securities laws ; truthful disclosure … Secondary Market.federal securities laws ; truthful disclosure … Secondary Market.

Securities Acts Amendments of 1975 Securities Acts Amendments of 1975 —Created a national —Created a national market system.market system.

Sarbanes-Oxley Act of 2002 – revisited truthful disclosure.Sarbanes-Oxley Act of 2002 – revisited truthful disclosure.

Role of the “Independent 3Role of the “Independent 3rdrd Party Auditor”??? Party Auditor”???

Rates of Return in Financial Markets

Rates of Return in Financial Markets Opportunity Cost — Rate of return on

next best investment alternative to the investor

Standard Deviation — Dispersion or variability … One way we measure Risk.

Real Return — Return earned above the rate of inflation

Figure 2-3 shows that investors demand compensation for inflation and other elements of risk (such as default). Thus higher risk securities (common stocks) offer higher return in the long-run.

Rates of Return in Financial Markets

Interest Rate Determinants

Interest Rate Determinants Nominal Rate = Real rate + Inflation risk

premium + Default Risk premium + Maturity Premium + Liquidity Premium

Thus the nominal rate or quoted rate for securities is driven by all of the above risk premium factors. Such knowledge is critical when companies set an interest rate for their issues.

Review the example on pages 48-49.

Interest Rate DeterminantsInterest Rate Determinants

k= k* + IRP + DRP + LP + MPk= k* + IRP + DRP + LP + MP

k = nominal or observed rate of interestk = nominal or observed rate of interest

k* = real risk-free rate of interestk* = real risk-free rate of interest

IRP = inflation risk premiumIRP = inflation risk premium

MP=maturity premiumMP=maturity premium

DRP=default-risk premiumDRP=default-risk premium

LP=liquidity premiumLP=liquidity premium

Description of PremiumsDescription of Premiums

Nominal rate =Nominal rate = Inflation rate Inflation rate + + Real Risk Free Rate (k*) Real Risk Free Rate (k*) 3 mo. Treasury Bills Rate - Inflation Rate3 mo. Treasury Bills Rate - Inflation Rate

+ Maturity Premium (MP) + Maturity Premium (MP) 30 yr. Treasury Bonds Rate - 3 mo. Treasury Bills Rate 30 yr. Treasury Bonds Rate - 3 mo. Treasury Bills Rate

+ Default Premium (DRP) + Default Premium (DRP) AAA Corporate Bonds Rate - 30 yr. Treasury Bonds Rate AAA Corporate Bonds Rate - 30 yr. Treasury Bonds Rate

+ Liquidity Prem. (LP)+ Liquidity Prem. (LP) How easy to trade or convert to cash? How easy to trade or convert to cash?

Example:Example:

Inflation rate is 1.5%, real risk free rate is 3%, AAA Inflation rate is 1.5%, real risk free rate is 3%, AAA corporate bonds are 9%, 3 month treasury bills are corporate bonds are 9%, 3 month treasury bills are 4.5% and 30 year treasury bonds are 7%. Given 4.5% and 30 year treasury bonds are 7%. Given the LP is 3 basis points (.03%)the LP is 3 basis points (.03%)

What are the k*, IRP, DRP, liquidity premium, and What are the k*, IRP, DRP, liquidity premium, and the MP?the MP?

What is the nominal rate of this bond for Company What is the nominal rate of this bond for Company X?X?

SolutionSolution

k = k* +IRP+DRP+MP+LPk = k* +IRP+DRP+MP+LP

k* = 3% (4.5%-1.5%)(real risk free rate-diff to treasury bills) k* = 3% (4.5%-1.5%)(real risk free rate-diff to treasury bills)

IRP = 1.5% (given)IRP = 1.5% (given)

MRP = 2.5% (7.0%-4.5%) (diff to treasury notes)MRP = 2.5% (7.0%-4.5%) (diff to treasury notes)

DRP = 2.0% (9%-7%) (diff to AAA bonds - LP)DRP = 2.0% (9%-7%) (diff to AAA bonds - LP)

LP = .03% (given) (diff to a particular AAA bond)LP = .03% (given) (diff to a particular AAA bond)

k=9.03% NOMINAL RATE OF INTEREST ON THIS BONDk=9.03% NOMINAL RATE OF INTEREST ON THIS BOND

Term Structure of Interest Rates or Yield-to-Maturity

Theories to explain the shape

1. Unbiased Expectations Theory

2. Liquidity Preference Theory

3. Market Segmentation Theory

Unbiased Expectations Theory

Term Structure is determined by an Investor’s expectations about future interest rates.

Liquidity Preference Theory

Investors require maturity premiums to compensate them for risks of uncertain future interest rates.

Market Segmentation Theory

Legal restrictions and personal preferences limit choices for investors to certain ranges of maturities.

Finance and The Multinational Firm

Intercountry RiskIntercountry Risk

Financial System RiskFinancial System Risk

Political System RiskPolitical System Risk

Exchange Rate RiskExchange Rate Risk

-chapter two

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