Principles of Finance: Financial Markets 2024-25

• Principles of Finance covers financial markets and the investment banking process for 2024-25.

Financial Markets and the Investment Banking Process

• Financial markets are systems comprised of individuals, institutions, instruments, and procedures.
• They facilitate the interaction of borrowers and savers, functioning as a place for sellers and buyers of securities.
• The objective is to explain financial markets and their role in improving the standard of living in an economy.
• Financial markets' efficiency is a key topic for discussion.
• Differentiations among various types of financial markets are explained.
• The study notes define an investment banking house and its role in helping firms raise funds in the financial markets.
• Financial markets in the U.S. are compared to those in other parts of the world.

Flow of Funds

• Financial markets provide the ability to transfer money through time
• Borrowing involves sacrificing future income to boost current available capital.
• This is beneficial if the anticipated returns on the extra capital exceed its after-tax cost.
• Saving or investing involves foregoing current income for increased income later.
• Saving is worthwhile when the expected return surpasses the Cost of Living Adjustments, especially for long-term needs like retirement.

Methods of Transfer

• Direct Transfer happens when a business directly sells stocks or bonds to investors.
• Indirect Transfer through Investment Bankers involves an investment banker acting as an intermediary to facilitate the issuance of securities by reselling them to savers.
• Indirect Transfer through Financial Intermediary is when organizations like banks and mutual funds acquire funds from savers; they then lend or invest the money in securities.

Direct Transfers

• Businesses issue securities such as stocks or bonds to borrowers in exchange for funds.

Indirect Transfers Through an Investment Banker

• Businesses issue securities (stocks or bonds) and work with an investment banker to help corporations issue securities.
• Savers invest through the investment banker in exchange for businesse's seecurites.
• Investment bankers receive fees from issuers and funnel funds to those issuers.

Indirect Transfers Through a Financial Intermediary

• Businesses borrow funds from a financial intermediary and incur liabilities to the intermediary.
• Savers provide funds to the financial intermediary.
• Financial intermediaries use these funds to buy/create loans/other instruments, paying a return to attract funds from savers.
• Savers get intermediary's securities (accounts) in return, completing the flow.

Market Efficiency

• Information efficiency means all material public information is freely available.
• The law of one price applies, which may involve arbitrage.
• Market prices tend to reflect fair value.
• Funds are allocated toward their optimal use, which means firms/individuals with high NPV projects get funding.
• Economic efficiency is found with economic growth and social satisfaction.
• Functional/Operational efficiency occurs when transaction costs are minimized .
• Fair dealing is present for all participants.

Information Efficiency (Fama, 1965)

• Investment prices quickly adjust to reflect new information.
• Weak-form efficiency means current market prices reflect all past (historical) information.
• Semi-strong-form efficiency means current market prices reflect all publicly available information.
• Strong-form efficiency means current market prices reflect all information, whether it is public or private.

Types of Financial Markets

• Money Markets trade instruments that mature in one year or less (short-term markets).
• Capital Markets trade instruments with maturities greater than one year (long-term markets).
• Debt Markets handle loans, including treasury, corporate, and mortgage-backed securities.
• Equity Markets trade in stock markets.

Primary Market

• Corporations raise funds by issuing new securities in primary markets.
• Secondary markets involve trading of securities among investors after their initial issuance.

Derivatives Markets

• Options, futures, and swaps derive their values directly from other assets.
• Derivatives are used to manage risk or to speculate.

Types of Stock Market Transactions

• Trading existing stocks can happen in the secondary market.
• Established firms issue shares in the primary market.
• Initial Public Offerings (IPOs) involve privately held companies offering stock to the public for the first time, resulting in them being listed on the stock exchange.
• IPOs are also called "going public."
• IPOs can be primary, secondary, or both.

New York Stock Exchange (NYSE)

• The NYSE was bought by ICE (Intercontinental Exchange) in 2011.
• Designated Market Makers (specialists) continuously post bid/ask prices to make a market; examples include Citadel, GTS, and Virtu.
• Trading Floor Brokers provide liquidity for retail orders.
• Supplemental Liquidity Providers (SLPs) handle high-volume trades; examples include HRT Financial, Jump Trading, Latour Trading, and Goldman Sachs.

Listing Requirements

• Listing requirements involve quantitative and qualitative characteristics.
• Listing requirments vary by exchange include:
  • Minimum number of shareholders
  • Number of public shares
  • Market value of public shares
  • Pre-tax income,

Over-the-Counter Markets

• Over-the-counter (OTC) markets are composed of electronically connected brokers and dealers.
• They facilitate trading in securities not listed on physical exchanges.
• Dealers hold inventory to make a market.
• Brokers act as agents to connect dealers with investors.
• An Electronic network provides a communications link.
• Many OTC dealers and brokers are members of the National Association of Securities Dealers (NASD).
• The NASD licenses and regulates the practices of it's members.
• The computerized trading network used by NASD is the NASDAQ Automated Quotation System (NASDAQ).
• NASDAQ stands separate from the OTC due to to its sophistication.

Electronic Communications Network (ECN)

• Electronic systems transfer information about securities transactions to facilitate order execution.
• ECNs automatically match buy and sell orders for a large number of transactions.

Investment Bank

• Organizations underwrite and distribute new securities.
• Investment banks help businesses obtain funding.
• Investment banks differentiate from traditional banks that use balance sheets to finance corporations

Investment Banking Process

• Investment banks assist corporations in designing securities that appeal to investors under existing market conditions.
• Investment Banks buy securities from corporations through underwriting.
• The organizations handles the placement of the securities to investors.

Raising Capital Stage 1

• Determine amount to be to be raised
• Determine the type of securities used
• Decide on a competitive bid or negotiated deal, where the lowest fee wins.
• Selection of an investment banker.

Raising Capital Stage 2

• Reevaluate the initial decisions.
• Consider best-efforts or underwritten issues.
• Best efforts: Underwriter (investment bank) does not purchase the securities (firm takes the risk of the offering).
• Underwritten issues: Investment bank purchases the shares from the firm.
• Issuance (flotation) costs arise.
• Setting the offering price sets precedence.

Issue Size

• The amount of the issue can be obtained: Issue amount = (Net proceeds + other costs) / (1 - flotation costs).
• Net proceeds represents the funds needed in the issue.
  • $2,000,000 may be needed to build a new factory for example.
• Issue amount is the gross proceeds from the offering's issued amount.
• Flotation costs represents the investment banking fees in decimal form.

Flotation Costs for IPOs

• Flotation costs are investment banking fees (gross spread) in decimal form.
• Lower average UW fee percentages correspond with higher deal value ranges.
• The average investment banks on deals increase in number with the deal value range.
• Most IPOs include accounting fees, exchange listing, legal fees, and FINRA fees.

Selling Procedure

• A registration statement must be filed with the SEC (in the U.S. case).
• A prospectus summarizes a new security issue and the issuing company.
• An underwriting syndicate serves as a group of investment banking firms distribute the new issue

Shelf Registration

• Securities registered with the SEC can be sold at a later date.

Maintenance of the Secondary Market

• Investment bankers maintain a market for the new security by actively trading the security.
• This facilitates an orderly market for the new security is promoted after launch.

Regulation of Securities Markets

• The Securities and Exchange Commission (SEC) regulates the issuance and trading of stocks and bonds in the U.S.
• The goal is to ensure disclosure, prevent fraud, and oversee trading practices.
• The SEC has jurisdiction over interstate offerings to the public over $1.5 million or more.
• The org regulates national securities exchanges, requiring companies to file annual reports.
• Prohibits manipulation and controls stock trades by corporate insiders.
• The SEC also limits wash sales.

International Financial Markets

• Financial markets have become more global
• Emerging markets in Asia and South America are where greatest is growth.
• U.S. markets are still leading in worldwide trading activity

Global Bond Markets

• The total outstanding in Global bond markets is $128.3tn.
• SSA represents 68% of global bond markets.
• Corporates represents 32% of global bond markets.

Government Bond Markets

• In Global SSA Bond Markets, the total outstanding in $87,452bn.

Corporate Bond Markets

• In global corporate bond markets, the total outstanding is approximately $40,891bn.

US and European Government Bonds

• Government and corporate bonds data are presented for the US, Europe, and globally, showing composition and issuers.

Largest Stock Exchanges

• Listed from largest to smallest:
  • NYSE, United States - 25.24
  • NASDAQ, United States - 20.58
  • Shanghai Stock Exchange, China - 6.6
  • Euronext, Europe - 6.26
  • Japan Exchange Group - 5.75
  • Shenzhen Stock Exchange, China - 4.38
  • Hong Kong Exchanges - 4.1
  • National Stock Exchange of India - 3.59
  • LSE Group, UK - 3.42
  • Saudi Stock Exchange (Tadawul) - 3.06
  • TMX Group, Canada - 2.81
  • Deutsche Boerse AG - 1.98
  • SIX Swiss Exchange - 1.85
  • Nasdaq Nordic and Baltics - 1.82

Relative Size of World Markets in 1899

• United Kingdom: 25%
• United States: 15%
• Germany: 13%
• France: 11.5%
• Russia: 6.1%
• Austria: 5.2%
• Belgium: 3.5%
• Australia: 3.5%
• South Africa: 3.3%
• Netherlands: 2.5%
• Italy: 2.1%
• Smaller Yearbook: 7.7%
• Omitted: 1.7%

Relative Size of World Markets in 2020

• United States: 54.5%
• Japan: 7.7%
• Not in Yearbook: 8.9%
• United Kingdom: 5.1%
• China: 4.0%
• France: 3.2%
• Switzerland: 2.7%
• Canada: 2.7%
• Germany: 2.6%
• Australia: 2.2%
• Smaller Yearbook: 6.3%

Cumulative Returns on US Asset Classes.

• In nominal terms, equities(9.6%) outperform bonds(4.9%) and bills(3.7%) year over year.
• There is a 2.9% inflation rate.
• In real terms, there is a 6.5% increase in equites, 2.0% increase in bonds year over year.

Annualised Returns on Global Assets

• Real equity returns are positive and provide a high return, but can carry a min return of -37.8%(Switzerland in 1974).
• Real bond returns are low.

Chapter Principles

• Financial markets serve as platforms for borrowers and lenders.
• Financial market efficiency is found through:
  • Investors investing in high-return, low-cost assets.
  • Borrowers obtaining money at minimal rates.
• Informational efficiency is important for markets.
• Prices will reflective available financial information in markets.
• Financial market types are due to different needs of savers and borrowers.
• Investment banking houses act a a middleman.
• US financial markets are the largest and most efficient globally.