study guide chapter 3

OVERVIEW

Financial markets are extremely important to the economic well-being of our country. Thus, it is important that both investors and financial managers understand the environ-ment and markets within which securities are traded and

businesses operate. Therefore, in this chapter, we examine the markets where firms raise funds, securities are traded, and the prices for stocks and bonds are established.

OUTLINE

Businesses, individuals, and government units often need to raise capital (funds). People and organizations that need money are brought together with those having surplus funds in the financial markets.

There are a great many different financial markets, each one consisting of many institutions and individuals, in a developed economy.

Financial asset markets deal with stocks, bonds, mortgages, and other claims on real assets with respect to the distribution of future cash flows.

In a general sense, the term financial market refers to a conceptual mechanism rather than a physical location or a specific type of organization or structure. Financial markets are usually described as a system comprised of individuals and

institutions, instruments, and procedures that bring together borrowers and savers, no matter the location.

The primary role of financial markets is to help bring together borrowers and savers (lenders) by facilitating the flow of funds. In developed economies, financial markets help efficiently allocate excess funds of savers to individuals and organizations in need of funds for investment or consumption. Financial markets provide us with the ability to transfer income through time. Funds are transferred by three different processes.

CHAPTER 3FINANCIAL MARKETS AND THE INVESTMENT

BANKING PROCESS

FINANCIAL MARKETS, THE INVESTMENT BANKING PROCESS, AND INTEREST RATES2 - 2

A direct transfer of money and securities occurs when a business sells its stock or bonds directly to savers (investors), without going through any type of intermediary, or financial institution.

Transfers through an investment banking house occur when a brokerage firm serves as a middleman and facilitates the issuance of securities.

Transfers through a financial intermediary occur when a bank or mutual fund obtains funds from savers, issues its own securities in exchange, and then uses these funds to purchase other securities. The existence of intermediaries greatly increases the efficiency of the financial

markets.

The financial markets provide efficient funds transfers. The types of market efficiency include economic efficiency and informational efficiency. The financial markets are said to have economic efficiency if funds are allocated to

their optimal use at the lowest costs. Commissions and other costs associated with transactions are called transaction costs. When these costs are very high, investments will not be as attractive as when transaction costs are low.

If the prices of investments reflect existing information and adjust very quickly when new information becomes available, then the financial markets have achieved informational efficiency. Informational efficiency generally is divided into three categories:

Weak-form efficiency states that all information contained in past price movements is fully reflected in current market prices. Semistrong-form efficiency states that current market prices reflect all publicly available information. Strong-form efficiency states that current market prices reflect all pertinent information, whether publicly available or privately held.

The results of most of the market efficiency studies suggest that the financial markets are highly efficient in the weak form and reasonably efficient in the semistrong form, but strong-form efficiency does not hold.

Financial markets that are informationally efficient also tend to be economically efficient because investors can expect prices to reflect appropriate information and thus make intelligent choices about which investments are expected to provide the highest returns.

There are a number of different types of financial markets. Financial markets are differentiated according to the types of investments, maturities of investments, types of borrowers and lenders, locations of the markets, and types of transactions.


The markets for short-term financial instruments are termed the money markets, while the markets for long-term financial instruments are termed the capital markets. Money markets include instruments with maturities equal to one year or less when

originally issued. Money markets include only debt instruments, because equity instruments have no specific maturity. The primary function of the money markets is to provide liquidity to businesses, governments, and individuals to meet short-term needs for cash.

Capital markets include instruments with original maturities greater than one year. Capital markets include both equity instruments and long-term debt instruments, such as mortgages, corporate bonds, and government bonds. The primary function of the capital markets is to provide us with the opportunity to transfer cash surpluses or deficits to future years—to transfer income through time.

The debt markets are the markets where loans are traded, while the equity markets are the markets where stocks of corporations are traded. Equity markets are also called stock markets. Debt markets generally are described according to the characteristics of the debt that

is traded. The segmentation of the debt markets is based on the maturity of the instrument, the issuer, and the investor. The largest segment of the debt markets is represented by the bond markets, where government, corporate, and foreign bonds are traded.

The primary markets are the markets where “new” securities are traded, while the secondary markets are the markets where “used” securities are traded. The primary markets are the markets in which corporations raise new capital. Secondary markets are markets in which securities and other financial assets are

traded among investors after they have been issued by corporations and public agencies such as municipalities.

The corporation whose securities are being traded in the secondary market is not involved in the transaction and, thus, does not receive any funds from such a sale.

Options, futures, and swaps are some of the securities traded in the derivatives markets. These securities are called derivatives because their values are determined, or “derived,” directly from other assets. Although derivatives often are used to speculate about the movements of prices in the

financial markets and the markets for commodities, they typically are used to help manage risk.


Individuals, corporations, and governments use derivatives to hedge risk by offsetting exposures to uncertain price changes in the future.

The stock market is one of the most important markets to financial managers because it is here that the price of each stock, and hence the value of all publicly-owned firms, is established. Stock market transactions can be classified into three distinct types:

Trading in the outstanding, previously issued shares of established, publicly owned companies: the secondary market.

Additional shares sold by established, publicly owned companies: the primary market.

New public offerings by privately held firms: the initial public offering (IPO) market: the primary market. Whenever stock in a privately held corporation is offered to the public for the first

time, the company is said to be going public. The market for stock that has recently gone public is called the initial public offering

(IPO) market.

There are two basic types of stock markets in the United States: organized exchanges and the over-the-counter market.

The organized exchanges, typified by the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX), are tangible, physical entities. Companies whose stock trade on an organized exchange are said to be listed. Exchange members are charged with different trading responsibilities, depending on

the type of seat that is owned. Commission brokers are individuals employed by brokerage firms that are members of the exchange. Independent brokers, sometimes called floor brokers, are independent, freelance brokers who work for themselves rather than for a brokerage firm. Competitive traders, also known as registered floor traders, represent a small group of individuals who trade only for their own accounts. Specialists are considered the most important participants in NYSE transactions because their role is to bring buyers and sellers together.

For a stock to be traded on an exchange, it must be listed. Each exchange has established listing requirements, the quantitative and qualitative characteristics a firm must possess to be listed. The primary purpose for the listing requirements is to ensure that investors have some interest in the company so its stock will be actively traded on the exchange.


The over-the-counter (OTC) market is an intangible organization that consists of a network of dealers and brokers that provide for security transactions not conducted on the organized exchanges. The stocks of smaller publicly owned firms are traded in the OTC market and are

said to be unlisted. Many of the brokers and dealers who make up the over-the-counter market are

members of a self-regulating body known as the National Association of Security Dealers (NASD), which licenses brokers and oversees trading practices.

Today, the NASDAQ is considered a sophisticated market of its own, separate from the OTC. The NASDAQ has market makers who continuously monitor trading activities in various stocks to ensure stocks are available to traders who want to buy, and vice versa.

The financial manager must have knowledge of the investment banking process, the process by which new securities are issued. Investment bankers help corporations design securities with the features that are most attractive to investors given existing market conditions, buy these securities from the corporations, and then resell them to investors. Investment banking decisions take place in two stages.

At Stage I, the firm makes some preliminary decisions on its own. The dollar amount of new capital required is established. The type of securities to be offered is specified. The basis on which to deal with the investment bankers, either by a competitive bid or

a negotiated deal, is determined. Only a handful of the largest firms on the NYSE, whose securities are already well known to the investment banking community, are in a position to use the competitive bid process. The vast majority of offerings of stocks or bonds are made on a negotiated basis.

The investment banking firm must be selected.

The Stage II decisions are made jointly by the firm and the selected investment banker. First, the two parties will reevaluate the Stage I decisions. The firm and its investment banker must decide whether the banker will work on a

“best efforts” basis or will “underwrite” the issue. On a best efforts sale, the banker does not guarantee that the securities will be sold or that the company will get the cash it needs. The securities are handled on a contingency basis, and the investment banker is paid a commission based on the amount of the issue that is sold. On an underwritten issue, the company does get a guarantee. Essentially, the banker purchases the issue, then resells the securities at a higher price. The banker bears significant risks in underwritten offerings.


The costs associated with a new security issue are termed issuance (flotation) costs. These costs include compensation to the investment banker plus legal, accounting, printing and engraving, and other costs borne by the issuer. The underwriter’s spread is the difference between the price at which the investment banking firm buys an issue from a company and the price at which the securities are sold in the primary market. Flotation costs depend on the type of security issued and the size of the issue.

Several factors must be considered when setting the offering price. If the firm is already publicly owned, the offering price will be based on the existing market price of the stock or the yield on the bonds. The investment banker will have an easier job if the issue is priced relatively low, while the issuer naturally wants as high a price as possible. It is important that the equilibrium price be approximated as closely as possible.

The registration statement provides financial, legal, and technical information about the company, while the prospectus summarizes the information in the registration statement and is provided to prospective investors for use in selling the securities.

Because of potential losses from price declines caused by a falling market, underwriters do not generally handle issues single-handedly. Groups of investment bankers form an underwriting syndicate to spread the risk and

minimize individual losses. Syndicates are also useful because an individual banker’s clients may not be able to absorb a large issue.

The investment banking house that sets up the deal is called the lead, or managing, underwriter.

A selling group may handle the distribution of securities to individual investors. The underwriters act as wholesalers and bear the risk associated with the issue,

whereas the members of the selling group act as retailers.

A shelf registration is a procedure used by large, well-established firms to issue new securities on very short notice. Large, well-known public companies that issue securities frequently file a master

registration statement with the SEC and then update it with a short-form statement just prior to each individual offering.

For new issues, the investment banker will normally maintain a market in the shares after the public offering. This is done in order to provide liquidity for the shares and to maintain a good relationship with both the issuer and the investors who purchased the shares.


Sales of new securities, such as stocks and bonds, as well as operations in the secondary markets, are regulated by the Securities and Exchange Commission (SEC) and, to a lesser extent, by each of the 50 states.

The SEC regulations are intended to ensure investors receive fair financial disclosure from publicly traded companies and to discourage fraudulent and misleading behavior by firms’ investors, owners, and employees to manipulate stock prices.

The SEC has jurisdiction over all interstate offerings of new securities to the public in amounts of $1.5 million or more.

A company wishing to issue new stock must file both a registration statement and a prospectus with the SEC. When the SEC approves the registration statement and prospectus, it only validates

that the required information has been furnished. The SEC doesn’t provide judgment concerning the quality or value of the issue.

The SEC regulates all national securities exchanges, and companies whose securities are listed on an exchange must file annual reports with both the SEC and the exchange.

The SEC has control over stock trades by corporate insiders. Officers, directors, and major stockholders must file monthly reports of changes in their holdings of the corporation’s stock.

The SEC has the power to prohibit manipulation of securities’ prices by such devices as pools or wash sales.

Financial markets have become much more global during the last few decades.

Even with the expansion of stock markets internationally, exchanges in the U.S. still conduct the greatest number of trades, both with respect to volume and value.

The international market for bonds has experienced growth similar to the international stock markets.

On January 1, 1999, the European Monetary Union (EMU) began. The EMU started with 11 countries that created a common currency, called the euro, and a common debt instrument that is denominated in the euro and is traded in a unified financial market called the Euro market.

While the globalization of financial markets continues and international markets offer investors greater opportunities, investing overseas can be difficult due to restrictions or barriers erected by foreign countries.


Most individuals interested in investing internationally do so indirectly by purchasing financial instruments that represent foreign stocks, bonds, and other investments but that are offered by institutions in the United States.

Investors can participate internationally by purchasing (1) American Depository Receipts (ADRs), (2) mutual funds that hold international stocks, or (3) foreign securities certificates issued in dollar denominations.

SELF-TEST QUESTIONS

Definitional

1. Markets for short-term debt securities are called _______ markets, while markets for long-term debt and equity are called _________ markets.

2. Firms raise capital by selling newly issued securities in the _________ markets, while existing, outstanding securities are traded in the ___________ markets.

3. An institution that issues its own securities in exchange for funds and then uses these funds to purchase other securities is called a financial ______________.

4. A(n) ____________ _________ firm facilitates the transfer of capital between savers and borrowers by acting as a middleman.

5. The two basic types of stock markets are the ___________ ___________, such as the NYSE, and the ______-_____-_________ market, which consists of a network of dealers and brokers.

6. Securities traded on the organized exchanges are known as ________ securities.

7. Before an interstate issue of stock amounting to $1.5 million or more can be sold to the public, it must be ____________ with and approved by the _____.

8. Setting the __________ price for a stock issue may present a conflict of interest between the issuer and the ____________ ________.

9. In order to spread the risk of underwriting a sizable common stock issue, investment bankers will form a(n) ______________ ___________.

10. On a(n) ______ _________ arrangement, the investment banker does not guarantee that the securities will be sold or that the company will get the cash it needs.


11. On a(n) ______________ issue the investment banker essentially purchases the issue and then resells the securities at a higher price bearing significant risks.

12. A(n) _______ ______________ is a procedure used by large, well-established firms to issue new securities on very short notice.

13. The financial markets are said to have __________ ____________ if funds are allocated to their optimal use at the lowest costs.

14. If the prices of investments reflect existing information and adjust very quickly when new information becomes available, then the financial markets have achieved _______________ ____________.

15. ____________-______ efficiency states that current market prices reflect all publicly available information.

16. Options, futures, and swaps are some of the securities traded in the _____________ markets.

17. The market for stock that has recently gone public is called the _________ ________ __________ market.

18. The primary purpose for _________ ______________ is to ensure that investors have some interest in the company so its stock will be actively traded on the exchange.

19. ___________ _______ markets deal with stocks, bonds, mortgages, and other claims on real assets with respect to the distribution of future cash flows.

20. A(n) ________ __________ of money and securities occurs when a business sells its stocks or bonds to savers (investors), without going through any type of intermediary, or financial institution.

21. ______-______ efficiency states that all information contained in past price movements is fully reflected in current market prices.

22. The segmentation of the ______ markets is based on the maturity of the instrument, the issuer, and the investor.

23. Individuals, corporations, and governments use derivatives to _______ risk by offsetting exposures to uncertain price changes in the future.


24. The _______ market is important to financial managers because it is here that the price of each stock, and hence the value of all publicly owned firms, is established.

25. Additional shares sold by established, publicly owned companies occur in the _________ market.

26. Whenever stock in a privately held corporation is offered to the public for the first time, the company is said to be _______ ________.

27. Exchange members are charged with different trading responsibilities, depending on the type of ______ that is owned.

28. _____________ are considered the most important participants in NYSE transactions because their role is to bring buyers and sellers together.

29. The stocks of smaller publicly owned firms are traded in the OTC market and are said to be __________.

30. One of the Stage I investment banking decisions is the basis on which to deal with the investment banker. It can be done either by a(n) _____________ _____ or as a(n) ____________ ______.

Conceptual

31. Flotation costs are generally higher for bond issues than for stock issues.

a. True b. False

32. The primary role of financial markets is to help bring together borrowers and savers by facilitating the flow of funds.

a. True b. False

33. The results of most of the market efficiency studies suggest that the financial markets are highly efficient in the semistrong form and reasonably efficient in the strong form.

a. True b. False

FINANCIAL MARKETS AND THE INVESTMENT BANKING PROCESS3 - 11

34. Financial markets that are informationally efficient also tend to be economically efficient because investors can expect prices to reflect appropriate information and thus make intelligent choices about which investments are expected to provide the highest returns.

a. True b. False

35. Which of the following statements is correct?

a. When the SEC approves the registration statement and prospectus, it provides judgment concerning the quality or value of the issue.

b. An investment banker will normally maintain a market in the shares after a public offering to provide liquidity for the shares and to maintain a good relationship with both the issuer and the investors who purchased the shares.

c. The registration statement summarizes the information in a prospectus and is provided to investors for use in selling securities.

d. Both statements a and c are correct.e. Both statements b and c are correct.

36. Which of the following statements is correct?

a. Large companies such as IBM and Exxon are exempt from SEC listing requirements, but small companies (assets below $10 million) are not. Hence, small companies have listed stock, while large companies have unlisted stock.

b. If a company’s stock is publicly owned, and if its price has been established in the market and is quoted in a source such as The Wall Street Journal, then the price of any new issue of stock will be based on the current market price. However, if the stock is not traded, and if the company is issuing shares in an “initial public offering,” or IPO, then the Securities and Exchange Commission (SEC) must approve the price at which the stock is to be offered to the public.

c. In the United States, most new issues of stock are sold through the investment banking departments of large commercial banks.

d. The SEC must normally approve the prospectuses relating to new stock offerings by companies whose securities are listed on the New York Stock Exchange before the new stock can be sold to the public.

e. Statements b and d are correct.


SELF-TEST PROBLEMS

1. GJC Inc., whose stock price now is $67.50, needs to raise $35 million in common stock. Underwriters have informed the firm’s management that it must price the new issue to the public at $62.00 per share to ensure the shares will be sold. The underwriters’ compensation will be 7 percent of the issue price, so GJC will net $57.66 per share. GJC will also incur expenses in the amount of $810,000. How many shares must GJC sell to net $35 million after underwriting and flotation expenses?

a. 549,825 b. 600,250 c. 621,055 d. 654,975 e. 700,000

2. Mansell Industries needs to raise $125 million in debt. To issue the debt, Mansell must pay its underwriter a fee equal to 2.5 percent of the issue. Mansell estimates that other expenses associated with the issue will total $750,625. If the face value of each bond is $1,000, how many bonds must be issued to net the firm the $125 million it needs? Assume that the firm cannot issue a fraction of a bond (i.e., 1/2 a bond)—only “whole bonds” can be issued.

a. 125,000 b. 126,225 c. 127,775 d. 128,975 e. 130,000

3. Better Brokers Inc. specializes in underwriting new issues by small firms. On a recent offering of Reynolds & Zaun Inc. (RZI), the terms were as follows:

Number of shares 5 millionProceeds to RZI $27 million

The out-of-pocket expenses incurred by Better Brokers in the design and distribution of the issue were $625,000. What profit or loss would Better Brokers incur if the issue were sold to the public at an average price of $6.50 per share?

a. -$3,775,000 b. +$4,875,000 c. +$5,500,000 d. +$32,500,000 e. -$5,000,000

ANSWERS TO SELF-TEST QUESTIONS

1. money; capital 2. primary; secondary 3. intermediary 4. investment banking 5. organized exchanges; over-the-

counter (OTC) 6. listed

7. registered; SEC 8. offering; investment banker 9. underwriting syndicate10. best efforts11. underwritten12. shelf registration13. economic efficiency


14. informational efficiency15. Semistrong-form16. derivatives17. initial public offering18. listing requirements19. Financial asset20. direct transfer21. Weak-form22. debt

23. hedge24. stock25. primary26. going public27. seat28. Specialists29. unlisted30. competitive bid; negotiated deal

31. b. The investment banker normally expends greater effort in selling stocks, thus must charge a higher fee.

32. a. This statement is correct.

33. b. Most studies suggest that the financial markets are highly efficient in the weak form and reasonably efficient in the semistrong form, but strong-form efficiency doesn’t hold.

34. a. This statement is correct.

35. b. When the SEC approves the registration statement and prospectus, it only validates that the required information has been furnished. So, statement a is false. Statement b is correct. Statement c is false; the registration statement provides financial, legal, and technical information about the company.

36. d. All companies are subject to the SEC’s listing requirements, which makes statement a false. The SEC does not have to approve offering prices for IPOs. Therefore, statement b is false. Finally, statement c is false because commercial banks traditionally have not been able to participate in investment banking activities. But at the present time, laws barring commercial banks from investment banking activities are being changed.

1. c. ($62.00X)0.93 – $810,000 = $35,000,000 $57.66X = $35,810,000 X = 621,055 shares.

SOLUTIONS TO SELF-TEST PROBLEMS


2. d. 0.975($1,000X) = $125,000,000 + $750,625 $975X = $125,750,625 X = 128,975 bonds.

3. b. Profit to Better Brokers = Market value of shares – Expenses – Company’s net proceeds= ($6.50)5,000,000 – $625,000 – $27,000,000= $32,500,000 – $27,625,000= $4,875,000.