Chapter 2Chapter 2

The Financial Markets and The Financial Markets and Interest RatesInterest Rates

Chapter ObjectivesChapter Objectives

Internal and external source of funds

Mix of corporate securities sold

Why financial markets exist

Financing of business U.S. financial market

system Investment banker Private Placements

Flotation costs Regulation Rates of Return and

interest rate determination Term structure of interest

rates Multinational firms,

efficient markets and inter-country risk

Federal Reserve ActionsFederal Reserve Actions

--From Feb 4, 1994 and Dec 11, 2001, the Federal Reserve System (Fed) voted to change the target funds rate on 31 occasions

--Rates were moved upward 14 times--Rates were moved downward 17 times--Rates moved downward 11 consecutive

times in 2001

Federal Funds RateFederal Funds Rate

Short-term market rate of interestServes as a sensitivity indicator of the

direction of future changes in interest rates

Objectives of the FedObjectives of the Fed

Maximum sustainable employmentPrice stability

Recent Interest Rate CyclesRecent Interest Rate CyclesEarly 1994 and 1997

Inflation Raise interest Rates

Fall 1998 International Pressures

Lower interest rates

Summer 1999 Tight labor markets, aggregate real growth, inflation

Raise interest rates

Early 2001 Slower business capital spending, equity market sell-off, recession

Lower interest rates

Market Conditions and Market Conditions and External FundsExternal Funds

Changes in market conditions influence the way corporate funds are raised.

Example:High interest costs discourage the use of

debt.

The Mix of Corporate The Mix of Corporate Securities in The Capital Securities in The Capital

MarketMarket Corporate Stock is

NOT the financing method most relied upon.

Corporate Debt is the dominant financing method

Bonds and

Notes73.60%

Equities26.40%

Debt/Equity MixDebt/Equity Mix

U.S. tax system favors debt as means of raising capital—

--Interest Expense is deductible

--Dividends paid are not deductible

Financial MarketsFinancial Markets

Financial markets are institutions and procedures that facilitate transactions in all types of financial claims—facilitate the transfer of savings from economic units with a surplus to economic units with a deficit.

Real and Financial AssetsReal and Financial Assets

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

Financial Assets—Claims for future payment on other economic units—common and preferred stocks

Underwriting — the purchase of financial claims of borrowing units and re-sell at a higher price to other investors.

Secondary Markets—trading in already existing financial claims

Financial Intermediaries—Major financial institutions i.e. Commercial banks, savings and loans, credit unions, life insurance companies, mutual funds etc.

Financial MarketsFinancial Markets

Exist to facilitate the efficient flow of savings from the surplus sectors to deficit sectors

Movement of Funds Through Movement of Funds Through the Economythe Economy

Direct Transfer of Funds

Indirect Transfer of Funds using an Investment Banker

Indirect Transfer of Funds Using the Financial Intermediary

Structure of U.S. Financial Structure of U.S. Financial MarketsMarkets

When a corporation needs to raise external capital, funds can be obtained by a:

– Public Offering -where individuals and institutional investors have the opportunity to purchase securities

or– Private Placement - where securities are sold

to a limited number of investors

Primary and Secondary Primary and Secondary MarketsMarkets

Primary Markets Securities are offered for the first time to investors – a new issue of stock. Increases the total stock of financial assets outstanding in the economy.

Secondary Markets Transactions in currently outstanding securities. All transactions after the initial purchase. Sales do not affect the total stock of financial assets that exist in the economy.

Money Market and Capital Money Market and Capital MarketMarket

Money Market – Short-term debt instruments with maturities of one year or less– Treasury Bills, Federal Agency Securities, Bankers

Acceptances, Negotiable Certificates of Deposit, Commercial Paper.

Capital Market—Long Term financial instruments with maturities than extend beyond one year.

– Term Loans, Financial Leases, Corporate Equities and Bonds

Organized Security Organized Security Exchanges and Over-The –Exchanges and Over-The –

Counter MarketsCounter Markets

Organized Security Exchanges—Tangible entities where financial instruments are traded on the premises– National and regional exchanges

New York Stock Exchange American Stock Exchange Chicago Stock Exchange

Over-The-Counter Markets—All security markets except the organized exchanges– Money Market

Benefits of Organized Benefits of Organized ExchangesExchanges

Provides a continuous market

Establishes and publicizes fair security prices

Helps businesses raise new capital

Listing RequirementsListing Requirements

Listing criteria varies from exchange to exchange. General requirements include:

ProfitabilitySizeMarket ValuePublic Ownership

Investment BankerInvestment Banker

A financial specialist involved as an intermediary in the merchandising of securities—facilitates flow of savings from economic units that want to invest to those units that want to raise funds.

Functions of an Investment Functions of an Investment BankerBanker

UnderwritingDistributingAdvising

Distribution MethodsDistribution Methods

Negotiated PurchaseCompetitive BidCommission or Best Efforts BasisPrivileged SubscriptionDirect Sales

Private PlacementsPrivate Placements

Advantages– Speed– Reduced Flotation Costs– Financing Flexibility

Disadvantages– Interest Costs– Restrictive Covenants– Possible Future SEC Registration

Market RegulationMarket Regulation

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

Securities Exchange Act of 1934—Created SEC to enforce federal securities laws

Securities Acts Amendments of 1975—Created a national market system

Securities Exchange Act of Securities Exchange Act of 19341934

Major security exchanges must register with the SEC– Insider trading is regulated – Prohibits manipulative trading– SEC control over proxy procedures– Gives Board of Governors of Federal Reserve System

responsibility for setting margin requirements

Rates of Return in Financial Rates of Return in Financial MarketsMarkets

Opportunity Cost—rate of return on next best investment alternative to the investor

Standard Deviation—Dispersion or variability around the mean or average rate of return

Maturity Premium—Additional return required by investors in long-term securities to compensate them for the increased 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.

Real Return—Return earned above the rate of increase in the general price level for goods and services in the economy (the inflation rate)

Real Rate of Interest—Rate of increase in actual purchasing power—after adjusting for inflation

Term Structure of Interest Term Structure of Interest RatesRates

The relationship between a debt security’s rate of return and the length of time until the debt matures.

Also called: Yield to Maturity

Term Structure of Interest Term Structure of Interest RatesRates

Explained by:

Unbiased Expectations TheoryLiquidity Preference TheoryMarket Segmentation Theory

Unbiased Expectations Unbiased Expectations TheoryTheory

The term structure is determined by an investor’s expectations about future interest rates

Liquidity Preference TheoryLiquidity Preference Theory

Investors require maturity premiums to compensate them for buying securities that expose them to the risks of fluctuating interest rates

Market Segmentation TheoryMarket Segmentation Theory

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

Intercountry RiskIntercountry Risk

Financial System Risk

Political System Risk

Exchange Rate Risk