Chapter 2

1
Chapter 2 Role of FinancialMarkets and
Interest Rates

• Key sections
• Sources of funds used by corporations
• Role and types of financial markets
• Investment banking
• Private placements
• Long-term rates of return

2
Federal Reserve System (Fed)

• The US central bank oversees financial system
  and controls monetary policy. Objectives
• Full employment of resources
• Reasonable price stability
• Sustainable economic growth
• Stable balance of payments

3
Fed Funds Rate - A Benchmark Rate

• Rate on overnight loans between banks
• Influences other rates
• Increase in rates tend to slow growth and
  inflation

4
Where Companies Get Money

• Externally generated (stocks, bonds, bank loans)
• External 28 internal 72 (from profits and
  depreciation)
• Mix of new corporate securities about 75 from
  debt, 25 from equity
• Debt is more tax efficient

5
Internal/External Mix
6
Debt/Equity Mix
7
Why Financial Markets Exist

• Markets institutions and procedures
  facilitating transactions in financial assets
• Some sectors are net suppliers of funds others
  are net users
• Markets allocate the supply of savings
• These institutions bridge gap between
  savers/borrowers

8
Corporate Financial System

• Public offerings versus private placements
• Primary markets trade new securities secondary
  markets trade existing ones
• Money and capital markets (MM under one year CM
  one year plus)
• MM treasury bills, commercial paper, CDs
• CM long-term (stocks, bonds, mortgages)

9
Types of Markets

• Organized exchanges such as NYSE
• Has trading facilities. Members, listing
  requirements
• Over-the-counter markets - decentralized
• Electronic trading between dealers
• More OTC stocks more on exchanges
• NASDAQ shows bid and offer prices

10
Investment Banks

• Intermediaries raise funds for users, sell new
  securities to investors. Activities
• Underwriting buy whole issue at a fixed price
  may use syndicate to reduce risk
• Distribution sale of the new securities
• Advising capital structure, MA
• Make secondary markets
• Major players Citi, Merrill, CS/FB, M-S, GS

11
Private Placements

• Purchased by small number of large, sophisticated
  investors
• Life insurance companies and pension funds
• Limited trading
• Advantages speed (no SEC), lower flotation
  costs flexible structures
• Disadvantages higher interest cost, restrictive
  covenants, illiquid

12
Flotation Costs

• Underwriters spread and out-of-pocket costs
• Paid for risk and efforts
• Difference between what investors pay and what
  company receives
• Higher on stocks greater risk
• 7½ on IPOs
• declines with issue size

13
Securities and Exchange Commission (SEC)

• Federal regulatory body governing operation of
  securities markets and securities sold to public
• Areas covered
• Sale of new securities
• Registration statement and prospectus
• Requires reports from securities issuers
• Operation of markets - underwriting, trading
  (including insiders) and broker activities

14
Market RegulationSecurities Act of 1933

• Requires investors receive accurate and truthful
  info about issuer and security
• SEC does not evaluate quality nor prevent sale of
  risky securities
• Registration can be a time-consuming process
• Exemptions short-term issues and PPs

15
Other Legislation

• Securities Act of 1934 regulates secondary
  markets
• Investment Company Act of 1940
• Covers mutual funds and advisors
• Securities Act Amendments 1975
• National Market System consolidated tape
• Rule 415 (shelf registration) and 144A

16
SIPC

• Securities Investor Protection Corp.
• Federal agency but not like FDIC
• Does not protect against loss of value
• Replaces securities stolen by a broker or loss
  through failure of a brokerage holding your
  securities.
• Up to 500,000 99 recovery rate.

17
Returns Over Long Periods

• Understand relative returns and relative risk
• Inflations impact
• Standard deviation measures risk
• Trends in interest rates

18
Risks and Returns
19
Annual Rates of Return1926 to 2000

• Avg Ann Stand
  Risk
• Security Returns Dev
  Prem
• Small Co Stocks 17.3 33.4 13.4
• Common Stock 13.0 20.2
  9.1
• L-T Corp Bonds 6.0 8.7
  2.1
• L-T Govt Bonds 5.7 9.4
  1.8
• Med-term Govt 5.5 5.8
  1.6
• US T-Bills 3.9 3.2
  0
• Inflation 3.2 4.4

20
2004

• Dow 30 Industrials 3.15
• SP 500 8.99
• SP small cap 21.59
• Treasury bonds flat
• Dollar down

21
2005

• My guess stocks up modestly (5 to 10) bonds
  down
• Wild cards
• Inflation
• Corporate earnings
• Interest rates
• Exchange rates

22
Returns Affected By

• Starts with risk free rate (no inflation) adds
  premiums for
• Inflation risk
• Default risk
• Maturity premium
• Liquidity premium
• s Nominal or quoted rate

23
Term Structure

• Relation between bonds interest rate and its
  maturity
• Securities that are exactly the same (Treasuries)
• Yield curve graphic representation of YTM
• Most often has positive slope long-term rates
  higher than short-term

24
Yield Curves
25
Financial Markets MNCs

• Markets increasingly globalized
• More sources of funds and liquidity
• US companies can borrow in Japan to invest in
  Europe
• Under developed economies lack financial markets
  cost of capital is high