The Financial Markets and Interest Rates

1. Chapter 2 The Financial Markets and Interest Rates FINN 3120

2. Outline Components of US financial market The investment banking function Private debt placements Rates of return in the financial market Interest rate determinants FINN 3120

3. FINANCING OF BUSINESS: THE MOVEMENT OF FUNDS THROUGH THE ECONOMY FINN 3120

4. Transfer of Capital • Financial markets play a critical role in capitalist economies. • Financial markets help facilitate the transfer of funds from “saving surplus” units to “saving deficit” units, • i.e. transfer money from those who have the money to those who need it. • Three ways to transfer capital (fig.2-1) FINN 3120

5. Transfer of Capital • Financial markets exist in order to facilitate the transfer of funds from “saving surplus” units to “saving deficit” units, i.e. transfer money from those who have the money to those who need it. • Three ways to transfer capital in the economy: • Direct transfer • Indirect transfer using the investment banker • Indirect transfer using the financial intermediary FINN 3120

6. Transfer of Capital • Direct transfer • Firm seeking funds directly approaches a wealthy investor. • For example, a new business venture seeking funding from venture capitalists or a wealthy private investor (angel investor). FINN 3120

7. Role of Venture capitalists • Venture capitalists are the prime source of funding for start-up companies and companies in “turnaround” situations. • Funding for such ventures are very risky, but carry the potential for high returns. • The borrowing firm may not have the option of pursuing public offering due to: –small size – no record of profits – uncertain future growth prospects FINN 3120

8. Transfer of Capital • Indirect transfer Using investment banks (IB) • Investment bank acts as a link between the firm (needing funds) and the investors (with surplus funds) FINN 3120

9. Example of Transfer Using Investment Banks (IB) Corporation XYZ sells 5 million shares to Morgan Stanley (IB) at $10 per share Morgan Stanley pays $50m to XYZ IPO – Morgan Stanley tries to sell those shares in the stock market (savers) for more than $50m FINN 3120

10. Transfer of Capital • Indirect transfer using financial intermediary (FI) • Here the financial intermediary (such as mutual funds) collects funds from savers in exchange of its own securities (indirect). • The collected funds are then used to acquire securities (such as stocks and bonds, direct) from firms. FINN 3120

11. 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 for funds received from mutual funds FINN 3120

12. 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 • The securities are offered and sold to a limited number of investors • Issuing firms and buyers usually hammer out, face-to-face, the details of offerings. FINN 3120

13. 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. • Initial Public Offering (IPO): securities are issued to the public for the first time. • Seasoned Equity Offering (SEO): the sale of additional shares by a public firm whose shares are already publicly traded. • Example: Google raised $4.18 billion in September 2005 FINN 3120

14. Primary Versus Secondary Market • 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. • Primary and secondary markets are regulated by Security and Exchange Commission (SEC): • Firms have to get approval from SEC before the sale of securities in primary market • Protect investors (make sure that investors are provided adequate and accurate information for their wise decision) FINN 3120

15. Primary or Secondary Market? • Example: True or false: Seasoned secondary offerings occur in the secondary market.? • True • False FINN 3120

16. 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 certificates of deposits… • Capital Market • Market for long-term securities (maturity greater than one year). • Examples: Corporate Bonds, Common stocks, Treasury Bonds, term loans and financial leases FINN 3120

17. Money vs. Capital MarketPrimary vs. secondary market Which of the following is an example of both a capital market and a primary market transaction? • A) The U.S. Government sells 3-month Treasury Bills. • B) Microsoft common stock owned by an individual investor is sold to another investor. • C) Ford Motor Company sells a new issue of common stock to raise funds through a public offering. • D) No transactions occur in both primary and capital markets at the same time. FINN 3120

18. Organized security Exchanges versus OTC Markets • Organized security Exchanges are tangible entities: they physically occupy space (a building or part of a building); and financial instruments are traded on the premises. • There are national and regional stock exchanges in the United States. NYSE and AMEX are national stock exchanges. • Firms listed on the exchanges must comply with the listing requirements of the exchange and SEC. • For example: NYSE listing requirements encompass profitability, size, market value and public ownership. • Stock exchange benefits: Provides a continuous market, establishes and publicizes fair security prices, helps business raise new capital. FINN 3120

19. Organized security Exchanges versus OTC Markets • If firms do not meet the listing requirements of the exchanges or/and wish to avoid higher reporting requirements and fees of exchanges, they can trade on OTC • 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. • E.g. NASDAQ (“screen based, floorless market) that lists around 3,900 securities (including Google, Microsoft, Starbucks). Most corporate bond transactions are also conducted on OTC markets FINN 3120

20. 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. • Difference between spot and futures markets: when you deliver and when you pay. FINN 3120

21. SELLING SECURITIES TO THE PUBLIC FINN 3120

22. 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, JP Morgan, Morgan Stanley FINN 3120

23. Table 2-1 FINN 3120

24. 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. FINN 3120

25. Distribution Methods • Issuing firms can use several methods to distribute new securities to investment bankers followed by final investors FINN 3120

26. Distribution Methods • Negotiated Purchase • Competitive Bid • Best Efforts • Privileged Subscription • Direct Sale FINN 3120

27. Distribution Methods 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. FINN 3120

28. Distribution Methods (cont.) Best Efforts • Issue is not underwritten, i.e., no money is paid upfront for the stocks. Investment bank, acting as an agent, attempt to sell the stocks in return for a commission. Privileged Subscription • Investment banker helps market the new issue to a select group of investors such as current stockholders, employees, or customers. FINN 3120

29. Distribution Methods (cont.) Direct Sale • Issuing firm sells the securities directly to the investing public. • No investment banker is involved. FINN 3120

30. Private Debt Placements • Private Placement (debt contract, seasoned) • Private placements of debt refers to raising money directly from prominent investors such as life insurance companies, pension funds. • It can be accomplished with or without the assistance of investment bankers FINN 3120

31. Private Debt Placements • Advantages • Faster to raise money (registration with SEC is not required) • Reduced Flotation Costs • See next slide for definition of flotation cost • Financing Flexibility (face-to-face with investors) • Disadvantages • Interest Costs higher than public issues • Restrictive Covenants FINN 3120

32. Flotation Cost • Transaction cost incurred when a firm raises funds by issuing securities: • Underwriter’s spread (Difference between gross and net proceeds) • Issuing costs (printing and engraving of security certificates, legal fees, accounting fees, other miscellaneous expenses) FINN 3120

33. RATES OF RETURN IN THE FINANCIAL MARKETS FINN 3120

34. Terminologies • Opportunity Cost— Rate of return on next best investment alternative 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. • Inflation risk premium – a premium to compensate for anticipated inflation that is equal to the price change expected to occur over the life of the bond or investment instrument. FINN 3120

35. Terminologies • Maturity Premium — Additional return required by investors in long-term securities to compensate them for greater risk of price fluctuations on those securities caused by interest rate changes • Liquidity Premium — Additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price. • Default risk premium – additional return required by investors to compensate them for the risk of default. FINN 3120

36. An example • What if the question changes to: • Highest Liquidity risk premium? • Highest Maturity risk premium? FINN 3120

37. Rates of Return over long periods FINN 3120

38. Interest rate levels and inflation • There is a direct relationship between inflation and interest rates. • The returns are affected by the degree of inflation, default premium, maturity premium and liquidity premium. FINN 3120

39. INTEREST RATE DETERMINANTS FINN 3120

40. What factors determine the interest rate? • Nominal interest rate = Real risk-free rate + Inflation premium + Default-risk premium + Maturity-risk Premium + Liquidity-risk 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. FINN 3120

41. An example FINN 3120

42. Real and Nominal Rates • The real rate of interest includes default risk, maturity risk and liquidity premiums. • Real risk-free interest rate = risk-free rate – inflation premium • Fisher effect model: • Nominal (quoted) rate of interest = real rate of interest + inflation rate + product of the real rate of interest and the inflation rate. • Eg: The nominal interest rate is 7% and the expected inflation rate is 2%. Based on the Fisher effect, the real rate of interest is • A) 5.0%. • B) 6.86%. • C) 5.1%. • D) 4.9%. FINN 3120

43. The Term Structure of Interest Rates • Figure 2-5 shows the relationship between a debt security’s rate of return and the length of time until the debt matures, where the risk of default is held constant. • The graph could be upward-sloping (indicating longer-term securities command higher returns), flat (equal returns for long- and short-term securities), or inverted (longer-term securities command lower returns compared to short-term securities). • The graph changes over time. Upward-sloping curve is most commonly observed. FINN 3120

44. Upward sloping curve FINN 3120

45. Flat and inverted shapes FINN 3120

46. Theories of the term structure interest rates • Unbiased Expectations Theory: The term structure is determined by an investor’s expectations about future interest rates. • See the example on page 43. • Liquidity Preference Theory: Investors require liquidity premium to compensate them for risks of holding longer term securities • Upward slopping curve. • Market Segmentation Theory: Legal restrictions and personal preferences limit choices for investors to certain ranges of maturities. • The interest rate for a particular maturity depends on the supply and demand for that security. FINN 3120

47. Question? FINN 3120