Chapter 2

The Creation of

Financial Assets

Forms of Business

• Sole proprietorships

• Partnerships

• Limited partnerships– General partners

– Limited partners

Corporations

• Charter from a state

• Bylaws– Relationship between firm and

stockholders (owners)

Corporations

• Advantages of– Limited liability

– Permanence

– Transfer of title

• S corporations and limited liability companies (LLC)

The Role of Money

• Medium of exchange

• Importance of liquidity

Money Supply

• M-1 sum of cash, coin, and checking accounts

• M-2 sum of cash, coin, checking accounts, plus savings accounts

Money Supply

• M-2 is a broader definition

• M-2 is not affected by shifting funds between checking and savings accounts

The Role of Interest Rates

• Allocate scarce credit

• Short-term / Money market

• Long-term / Capital market

Structure of Yield

• Yield curve

• Generally long-term implies higher rates (positively sloped yield curve)

Time and Yields

• Positively sloped yield curve

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Time and Yields

• Negatively sloped yield curve

The Transfer of Funds from Savers to Business

• Income that is saved is subsequently invested

• The process of investing creates financial claims

• Financial claims are either–debt–equity

The Direct Transfer

• The saver has a claim (debt or equity) on the issuer

• The issuer receives the money

CorporationGeneral Public(Savers)

Security

Money

The Indirect Transfer through a Financial Intermediary

• The saver has a claim on the financial intermediary

• The financial intermediary has a claim on the ultimate user of the funds

Financial Intermediary

General Public(Savers)

Account

Money

Issuing and Selling New Securities

• Difference between– Primary markets - the first sale

– Secondary markets - subsequent sales

The Sale of New Securities to the General Public

• Initial public offerings (IPOs)

• The role of investment bankers

Underwriting

• Firm commitment

• The guaranteed sale

• Underwriter bears the risk

The Sale of New Securities To the General Public

• Best effort agreements– issuing firm bears the risk

The Sale of New Securities to the General Public

• The mechanics of security underwriting

– the originating house or managing undewriter

– the syndicate

– the underwriting disconnect

Regulation of Initial Public Offerings

• Registration of new securities

• The prospectus

• Securities and Exchange Commission (SEC)

• The shelf-registration

Pricing an IPO

• Underpricing leads to windfall gains to initial buyers

• Overpricing inflicts losses on initial buyers and the investment bankers

• Tendency to underprice to assure a successful sale

The Price Volatility of IPOs

• Prices can rise dramatically

• Many firms eventually fail

• Few investors get to participate in an IPO

Financial Intermediaries and Investment Bankers Differ

• Financial Intermediaries create claims on themselves (e.g. a savings account)

• Investment bankers– facilitate the sale of new securities– do not create claims on themselves

Shelf Registration

• Information filed with the SEC– Flexibility

– Securities sold when funds are needed

The Private Placement

• Direct sale of securities

• Reduces selling costs

• Features can be tailor made for both parties

Financial Intermediaries

• Middleman

• Creation of Claims

Financial Intermediaries

• Each financial intermediary creates claims on itself and transfers funds from savers to – firms

– governments

– people who need funds

The Variety of Financial Intermediaries

•Commercial Banks•Savings and loan associations•Mutual savings banks•Credit unions•Life insurance companies •Pension plans•Money market mutual funds

Commercial Bank’s

• Assets and Liabilities– Importance of loans

– Importance of deposit liabilities

– Small equity base

Variety of Deposits

• Demand deposits (checking accounts)

• Savings account

• Certificates of deposits

• Negotiable CDs

Reserves

• Required reserves

• Excess reserves

• Secondary reserves

Regulation of Depository Institutions

• The Depository Institutions Deregulation and Monetary Control Act of 1980

• Subject to the Regulation of the Federal Reserve

Federal Deposit Insurance Corporation (FDIC)

• Insures accounts up to specified limit

• Another source of regulation of banks

• Add stability to the banking system

Regulatory Trends

• The consolidation of regulation through the Federal Reserve

• Reduced or blurred the distinctions among the different types of depository institutions and other financial institutions (e.g., brokerage and insurance firms)

Life Insurance Companies and Pension Plans

• Alternatives for savings

• May serve as financial intermediaries

Money Market Mutual Funds

• A specialized investment company

• Makes only short-term investments

• Acquires money market instruments

• Shares in money funds have become popular investments

The Money Market Instruments

•Certificates of deposit (CDs)

•Negotiable CDs

•U.S. Treasury bills

The Money Market Instruments

• Commercial Paper• Repurchase agreements (repos)• Bankers' acceptances• Tax (or revenue) anticipation notes• Eurodollar CDs

The Money Market Instruments

• These instruments are–safe–liquid

• Offer competitive short-term rates