FFM14, ch 02, slides, 11-03-14 Presented - Financial Markets (1).pdf

Chapter 3 Financial Markets and the Investment Banking Process 1 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Principles of Finance 5e, Ch. 3 Financial Markets © 2012 Cengage Learning. All Ri...

Chapter 3 Financial Markets and the Investment Banking Process 1 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 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. Principle © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in wholesorof in part. Finance 2 INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF What is a market? A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds. A system comprised of individuals and institutions, instruments, and procedures that brings together borrowers and savers. 2-3 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF How is capital transferred between savers and borrowers? Direct transfers: Business sells its stock directly to investors Indirect through Investment banks: Investment banker acts as middleman and facilitates issuance of securities by reselling the securities to savers Financial intermediaries: Bank or mutual fund obtains funds from savers and uses the money to lend or purchase securities 2-4 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF The Capital Allocation Process In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it. Suppliers of capital: individuals and institutions with “excess funds.” These groups are saving money and looking for a rate of return on their investment. Demanders or users of capital: individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow. 2-5 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Types of Financial Markets Physical assets vs. Financial assets Spot vs. Futures Money vs. Capital Primary vs. Secondary Public vs. Private 2-6 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Types of Financial Markets Money Markets  Instruments traded mature in one year or less Capital Markets  Includes instruments with maturities greater than one year Principle © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in wholesorof in part. Finance 7 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” Principle © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in wholesorof in part. Finance 8 Role of Financial Markets 1. Surplus units: participants who receive more money than they spend such as investors. 2. Deficit units: participants who spend more money than they receive, such as borrowers. 3. Securities: claims on an issuers a. Debt securities b. Equity securities 9 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF The Importance of Financial Markets Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.  Markets provide savers with returns on their money  saved/invested, which provide them money in the future. Markets provide users of capital with the necessary funds to finance their investment projects. Well-functioning markets promote economic growth. Economies with well-developed markets perform better than economies with poorly-functioning markets. 2-10 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Market Efficiency 1. Markets are efficient when security prices reflect all available information. 2. Behavioral finance: application of psychology to make financial decisions. Explains why markets are not always efficient. 3. Economic Efficiency  Funds are allocated to their optimal use at the lowest cost  Transactions costs associated with buying and selling 11 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Market Efficiency Information Efficiency  Prices of investments reflect existing information and adjust quickly when new information enters the market  Three categories Weak-form efficiency Semi-strong from efficiency Principle © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in wholesorof in part. Finance 12 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 Principle © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in wholesorof in part. Finance 13 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 Principle © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in wholesorof in part. Finance 14 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 Principle © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in wholesorof in part. Finance 15 INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Types of Financial Institutions Investment banks Commercial banks Financial services corporations Credit unions Pension funds Life insurance companies Mutual funds Exchange traded funds Hedge funds Private equity companies 2-16 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq Differences are narrowing 2-17 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Stock Market Transactions Apple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction?  Since new shares of stock are being issued, this is a primary market transaction. What if instead an investor buys existing shares of Apple stock in the open market. Is this a primary or secondary market transaction?  Since no new shares are created, this is a secondary market transaction. 2-18 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF What is an IPO? An initial public offering (IPO) occurs when a company issues stock in the public market for the first time. “Going public” enables a company’s owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market. Public companies are subject to additional regulations and reporting requirements. 2-19 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Where can you find a stock quote, and what does one look like? Stock quotes can be found in a variety of print sources (The Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral). Stock Quote for Twitter, Inc., June 3, 2014 Source: Twiter, Inc. (TWTR), finance.yahoo.com. 2-20 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF What is meant by stock market efficiency? Securities are normally in equilibrium and are “fairly priced.” Investors cannot “beat the market” except through good luck or better information. Efficiency continuum Highly Inefficient Highly Efficient Small companies not followed by many analysts. Not much contact with investors. Large companies followed by many analysts. Good communications with investors. 2-21 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Implications of Market Efficiency You hear in the news that a medical research company received FDA approval for one of its products. If the market is highly efficient, can you expect to take advantage of this information by purchasing the stock?  No. If the market is efficient, this information will already have been incorporated into the company’s stock price. So, it’s probably too late for her to “capitalize” on the information. 2-22 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Implications of Market Efficiency A small investor has been reading about a “hot” IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this?  Probably not. The long-run track record of hot IPOs is not that great, unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading. 2-23 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Possible Reasons Markets May Not Be Efficient It is costly and/or risky for traders to take advantage of mispriced assets. Cognitive biases cause investors to make systematic mistakes that lead to inefficiencies. This is an area of research know as “behavioral finance.” Behavioral finance borrows insights from psychology to better understand how irrational behavior can be sustained over time. Some examples include:  Evaluating risks differently in up and down markets.  Overconfidence leads to self-attribution bias and hindsight bias. 2-24 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 2-25 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF What are derivatives? How can they be used to reduce or increase risk? A derivative security’s value is “derived” from the price of another security (e.g., options and futures). Can be used to “hedge” or reduce risk. For example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens. Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk. 2-26 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF S&P 500 Index, Total Returns: Dividend Yield + Capital Gain or Loss, 1968-2013 Source: Data taken from various issues of The Wall Street Journal “Investment Scoreboard” section. 2-27 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. INTRO CAP ALLOCATION FIN MARKETS FIN INSTITUTIONS STKMKTS & RETURNS STK MKT EFF Chapter 2 Financial Markets and Institutions The Capital Allocation Process Financial Markets Financial Institutions Stock Markets and Returns Stock Market Efficiency 2-1 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.