Chapter 3 Financial Markets PDF

Chapter 3 Financial Markets and the Investment Banking Process Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 Chapter 3 – Learning Objectives...

Chapter 3 Financial Markets and the Investment Banking Process Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 Chapter 3 – Learning Objectives  Explain what financial markets are and what role they play in improving the standard of living in an economy.  Explain why it is important for financial markets to be somewhat efficient.  Explain why there are so many different types of financial markets as well as how various financial markets are differentiated.  Describe an investment banking house and explain the role an investment banking house plays in helping firms raise funds in the financial markets.  Explain how financial markets in the United States differ from financial markets in other parts of the world. Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 Financial Markets A system comprised of individuals and institutions, instruments, and procedures that brings together borrowers and savers. Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 Flow of Funds  Provides the ability to transfer income through time  Borrowing sacrifices future income to increase current income  Saving, or investing, sacrifices current income in exchange for greater expected income in the future Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 Flow of Funds 1. Direct Transfer  Business sells its stock directly to investors Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 Flow of Funds 2. Indirect Transfer through Investment Bankers  Investment banker acts as middleman and facilitates issuance of securities by reselling the securities to savers Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Flow of Funds 3. Indirect Transfer through financial intermediary  Bank or mutual fund obtains funds from savers and uses the money to lend or purchase securities Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 Diagram of Capital Formation Process 1. Direct Transfers Business’s Securities (Stocks or Bonds) Business (Borrower) Savers (Investors) Funds 2. Indirect Transfers through an Investment Banker Business (Borrower) Business’s Securities (stocks or bonds) Funds less issuing costs Investment Banker Helps corporations issue securities (stocks and bonds) Receives fees from issuers Business’s Securities (stocks or bonds) Savers (Investors) Funds 3. Indirect Transfers through a Financial Intermediary Business (Borrower) Borrower’s Liability (Debt owed to intermediary) Funds Financial Intermediary Uses funds to buy/create loans and other financial instruments Pays a return/interest to attract funds from savers Intermediary’s Securities (Account at intermediary Savers (Investors) Funds Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 Market Efficiency Economic Efficiency  Funds are allocated to their optimal use at the lowest cost  Transactions costs associated with buying and selling Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 Market Efficiency Information Efficiency  Prices of investments reflect existing information and adjust quickly when new information enters the market  Three categories Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Informational Efficiency 1. Weak-form efficiency  All information contained in past price movements is fully reflected in current market prices  Information about recent or past price trends is of no use when searching for abnormal returns Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Informational Efficiency 2. Semistrong-form efficiency  Current market prices reflect all publicly available information  Financial analysis is of no use for consistently finding mispriced securities  Insiders can profit on their own company’s stock Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 Informational Efficiency 3. Strong-form efficiency  Current market prices reflect all pertinent information, whether publicly available or privately held  Even insiders cannot earn abnormal returns Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Types of Financial Markets Money Markets  Instruments traded mature in one year or less Capital Markets  Includes instruments with maturities greater than one year Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 Types of Financial Markets Debt Markets  Loans - treasury, corporate, mortgagebacked, money market, municipal, etc... Equity Markets  Stock markets Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 Debt Markets in the U.S. 2010 Type of debt Mortgages Corporate bonds Federal agency bonds Treasury issues Consumer loans Municipal bonds Money market debt Bank loans Other loans Total Debt Amount ($ billion) $13,947.4 11,427.8 8,993.8 7,593.5 2,856.6 2,408.8 1,855.3 1,050.5 2,146.8 $52,280.5 Percentage of Total 26.7% 21.9 17.2 14.5 5.5 4.6 3.5 2.0 4.1 Source: Statistics: Releases and Historical Data, Flow of Funds Account of the United States, Federal Reserve Board http://federalreserve.gov/releases/ Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 Financial Markets Primary  Corporations raise funds by issuing new securities Secondary  Securities are traded among investors after they have been issued Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Derivatives Markets Options, futures and swaps are securities whose values are determined, or derived directly from other assets Derivatives can be used to manage risk or to speculate Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Types of Stock Market Transactions  Secondary market  Trading existing stocks  Primary market  Existing firm issues additional shares  Initial Public Offering (IPO)  Privately held company offers stock to the public for the first time  Called “going public” Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 The Physical Stock Exchanges Physical exchanges  New York Stock Exchange (NYSE)  American Stock Exchange (AMEX)  Chicago Stock Exchange (CHX)  Philadelphia Stock Exchange (PHLX) Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 NYSE Members Floor brokers  House brokers employed by brokerage firms  Independent brokers Specialists Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 Listing Requirements Quantitative and qualitative characteristics a firm must possess to be listed on an exchange Vary by exchange Minimum number of shareholders, number of public shares, market value of public shares, pre-tax income, etc... Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Organized Investment Networks Over-the-Counter Market (OTC)  Collection of brokers and dealers connected electronically  Provides for trading in securities not listed on the physical and other organized exchanges Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Over-the-Counter Market 1. Dealers hold inventory and make a market 2. Brokers act as agents in bringing together dealers with investors 3. Electronic network provides communications link Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 NASD Many of the dealers and brokers of the OTC are members of the National Association of Securities Dealers (NASD), which licenses and oversees trading practices. Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 NASDAQ The computerized trading network used by NASD is the NASD Automated Quotation System (NASDAQ) and is a sophisticated market of its own, separate from the OTC. Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 Electronic Communications Networks (ECN) Electronic systems that transfer information about securities transactions to facilitate the execution of orders Automatically matches buy and sell orders for a large number of transactions Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 Investment Banker Organization that underwrites and distributes new issues of securities Helps businesses and other entities obtain needed financing Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Investment Banking Process Help corporations design securities with the features that are most attractive to investors given existing market conditions. Buy these securities from the corporations. Then resell the securities to investors (savers). Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Raising Capital: Stage I Decisions 1. Dollars to be raised 2. Type of securities used 3. Competitive bid or negotiated deal 4. Selection of an investment banker Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 Raising Capital: Stage II Decisions 1. Reevaluating the initial decisions 2. Best efforts or underwritten issues 3. Issuance (flotation) costs 4. Setting the offering price Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 Selling Procedures  Registration statement  Filed with the SEC  Prospectus  Summarizes a new security issue and the issuing company  Underwriting syndicate  Group of investment banking firms to distribute the new issue Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 Shelf Registration Securities registered with the SEC for sale at a later date Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 Maintenance of the Secondary Market To facilitate orderly market for the new security, the investment banker maintains a market for the security following its issue. Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 Regulation of Securities Markets  Securities and Exchange Commission (SEC)  U.S. government agency regulates the issuance and trading of stocks and bonds  To ensure investors receive fair financial disclosures  To discourage fraud and misleading stock manipulation Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 SEC Regulation 1. Jurisdiction over interstate offerings of new securities to the general public in amounts of $1.5 million or more 2. Regulates national securities exchanges, and requires listed companies must file annual reports Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 SEC Regulation 3. Controls stock trades by corporate insiders 4. Prohibits manipulation of securities prices by pools or wash sales Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37 International Financial Markets Financial markets have become more global Greatest growth in emerging markets of the Pacific Rim U. S. exchanges still dominate worldwide trading activity Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 Chapter Principles Key Financial Markets Concepts  What are financial markets?  Financial markets are the mechanisms by which borrows and lenders are brought together  Why is it important for financial markets to be economically efficient?  Investors invest in assets that yield the highest returns at the lowest cost  Borrowers borrow money at the lowest costs  Why is it important for financial markets to be informationally efficient?  Prices of financial securities reflect available information Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 Chapter Principles Key Financial Markets Concepts  Why are there so many different types of financial markets?  Different types exist because savers and borrowers have different needs  What is an investment banking house  An organization that acts as a middleman to help firms and governments raise funds by issuing financial instruments Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40 Chapter Principles Key Financial Markets Concepts  How do the financial markets in the United States differ from financial markets in other parts of the world?  United States has the largest and most active financial markets  U.S. markets are generally more efficient than foreign markets Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 End of Chapter 3 Financial Markets and the Investment Banking Process Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42