Direct Financing Module 2 PDF

Module 2 Direct Financing Introduction - What is Direct Financing Direct financing raises funds for deficit units through the issuing of securities to investors in the financial markets. Deficit units provides means for bringing deficit and surplus units together Deficit units engage firms tha...

Module 2 Direct Financing Introduction - What is Direct Financing Direct financing raises funds for deficit units through the issuing of securities to investors in the financial markets. Deficit units provides means for bringing deficit and surplus units together Deficit units engage firms that assist them to issue securities. These are the investment banks (securities firms) who charge fees for their services Surplus units mostly supply funds to fund managers who invest the pooled funds and who also charge fees. (A) What are the roles of the main financial institutions that arrange the flow of funds (B) What are the preference mismatches they reconcile? Deficit Units; - Role; Engage investment banks or securities firms that assist them in the issue of securities - Preference; Deficit units typically prefer large amounts, for long and inflexible periods, are prepared to take risk and would like to pay as little as possible for funds. Surplus Units; - Role; Mostly supply funds to fund managers who invest in pooled funds - Preference; Surplus units typically prefer to supply small amounts, for short and/or flexible periods, are risk averse and would like high returns. The Role of Financial Institutions in Direct Financing · with indirect & definit ↳ surplus Unite don't know who each other are E goes Direct e y. to bank other ,. financing Institution buying shares In Dantes but stillWould,per or fund when Qantas I manager listed time Shares for first they would work with aninvestmentbanh ens bank to would go throug still but ItI buy shares direct- Mismatches Encountered in the Flow of Funds Whether the flow of funds is direct or indirect differences exist in preference of surplus and deficit units Why have primary and secondary market, why not always go direct? - Due to mismatch in surplus and deficit units (Amount of money, duration of borrow, risk tolerance, return on investment, deficit has certain preference and so does surplus. These preferences do not align with one another. Financial markets are to resolve this. What are the Main Costs Involved for Surplus and Deficit Units with Direct Financing? Deficit units; required to pay returns (interest) to surplus, who own their securities for the use of their funds. They will also pay fees on the investment bank they choose to assist them when they issue securities. The banks will take a commission for brokering the Initial Public Offerings. Surplus units; Typically supply funds through managers who charge fees for their investment management services. Means returns earned by investors are return achieved less fund manager fees and/or commissions. Therefore, returns paid by deficit units are greater than the returns earned by surplus to overcome surplus investment bank and fund manager fees, this difference represents the cost or spread of direct financing. Cash Flow Summary - Surplus Units; Provide money to deficit in exchange for interest or dividend and pay money to fund managers - Fund Managers; Take commission on what investment the surplus have - Investment Banks; Take commission for brokering IPO - Deficit Units; Take on money from surplus and pay Investment banks for IPO. What is Crowdfunding? New e.g. of direct financing - equity crowdfunding Companies pitch ideas to large numbers of potential investors Raise equity directly through online platform (online usually) New alternative to traditional sources e.g. banks Cut out IPO, fund manager, investment bank Good way to invest small amounts of money in exchange for equity Less expensive and time consuming than traditional fundraising methods Primary Markets What is the Primary Market? Usually where we issue shares 1st time. Still same market as secondary 1st - Dircet financing involves; 1. arrangements of the issuing of securities - this is their primary market 2 The subsequent trading of issues securities in the secondary market - The issuing of securities is subject to ASIC regulations, particularly when they are issued to retail investors - Most markets are wholesale only and are self-regulated by the Australian Financial Markets Association (AFMA) - If Qantas were to sell shares for the first time, they issue shares on the ASX but you cannot buy during that time, you cant buy directly form ASX, you buy from investment banker and money goes directly to Qantas. Once the shares are listed on the stock exchange, you would then purchase the shares through a broker through the ASX. Arrange the Issue of Securities - Aus Government securities are issued through a competitive tender - Biggest participator in primary market is Aus gov. Can’t buy shares in government but can by gov bonds and gov treasury bills through a tender offer while shares are usually issued through investment bank. - If i want to issue shares on market, this is done through a prospectus through an investment bank - Shares are mainly issued in Aus under contracts known as best efforts, with an investment bank arranging the issue. - They prepare a prospectus and market the issue - Earn fees, normally in the form of commission - They do not guarantee all the securities will be sold - this requires an additional standby underwriting contract. Rating Agencies - Ratings agencies are firms paid to provide expert opinion about level of credit risk for a security or financial institution - The 3 rating agencies are Standard & Poor’s (S&P), Moody’s & Fitch Ratings - Lowest risk securities are given the highest rating, ratings are reviewed and changed if required - Their role is overcome info asymmetry - Debt securities usually have to be rated before issue, and the rating influences the demand for the security. - Help judges quality of the investment Settlement and Clearing - When shares are bought for first time, they and the buyer details are recorded on the security registry - They can be maintained by the market’s clearinghouse or by a separate organisation - Securities and security registers, are electronic Secondary Markets - Market where individuals and fund managers can buy shares from other investors. - Trade, sell, buy more shares - ASX Australian Securities Exchange - What are secondary markets? - Where I would buy or sell securities from another investor - Trade requires buyer and seller to agree on; security being traded e.g. Qantas, the quantity e.g. amount of shares being purchased, the price; $ - Trading is easier and faster for standardised securities; meaning security has no optional features, either the company pays dividends or doesn’t. - Primary Market; Investor A > IPO (Investment Bank) > Qantas - Secondary Market; Investor A > ASX (Broker - Intermediary) > Investor B - Components of Secondary Markets 1 Trading Platform; The facility where trading occurs 2 Trading Rules and Protocols; Such as who can trade and how trades are expressed 3 Clearing and Settlement producedures which organise the exchange of the securities for payment. - Went form open outcry to computer based trading - Two types of secondary markets; a) Securities Exchanges > Order Driven > Brokers - Order driven; Buyer orders broker to us something e.g. shares. Broken will then post this on ASX and investor B would see order and decide to trade with Investor A. Can do this on Broker app now. ASX is Oder driven b) OTC (Over the Counter - Market predominantly for bonds and money markets, pretty much all direct financing market. No orders, instead Investor A would go directly to individual dealer and be given a quote) > Quote Driven > Dealers - Dealer has the inventory but broker gives the quote. - Dealers are financing institutions that trade securities on their own behalf as well as the individuals who are employed to do the trading. - Trading Arrangements - Secondary markets are either; 1) Orgainsed by securities exchange; where trades are arranged through brokers on behalf of clients 2) Conducted on an OTC basis with trading between dealers 1. Exchange Organised Markets - Exchanges were developed by share brokers to organise their trading - Brokers do not buy form or sell to their clients, they are agent through whom the clients can access the market. - Brokers may provide online systems to allow their clients to place orders - They earn a commission on completed trades - They must ensure clients can pay for the securities they purchase, and that they own the securities they sell. - Order Driven Markets - Trading is on the bases of orders from traders, so they are referred to as order driven markets - An order specifies; - A buying or sell in intention - The security - The quantity - The price - Th price can either be; - A limit price; specifies the max buying price, or min selling price which specifies minimum selling price OR - An at market price; which is the best available price - When brokers do not cancel limit orders (that have not yet resulted in a trade), they remain stored in the market’s central order book, and are observable and provide other traders with trading opportunities. - An important factor of exchange organised market is their transparency - Electornic trading systems records every trade & can be monitored by investors and market regulators. - Automated Trading Systems - These are dumpster based trading platforms for displaying and matching orders - ATSs have replaced an open-outcry because they are cheaper and keep record of transaction. - Brokers (or their clients through systems provided by brokers) enter orders online - the markets are location-less - The difference between the buyer share price and selling share price is known as the spread. 2. Over-The-Counter Markets - Dealers act as principals meaning they buy and sell on their own behalf. They own their own securities where as brokers only transact the deal. - They trade with each other and wholesale clients - Mostly through automated trading systems - They hold an inventory of securities (this is known as their position) and so are exposed to price risk - Retail Clients; Individual investors like households and individual. That buy and sell securities. Generally deal in ASX markets - Wholesale Clients; Institutional clients like banks and companies including governments, councils. Generally deal in OTC money and bond markets due to inflated price. - Quote Driven Markets - In OTC, investor will buy individual investment directly from dealer. Would go to dealer and ask for quote over the counter - Traditionally, OTC markets have been quote driven because dealers provide the bid and offer quotes (two-way quotes) - Dealers are known as market makers because they quite bids and offers and must be prepared to trade when their quotes are accepted. Making market by quoting a price - This also provides counterparties with transaction immediacy - Dealer Trading - Dealers earn a trading spread when traders sell to and buy from them, on a round-trip transaction - They aim to buy low and sell high - They would like to see a wide spread, but they must compete with other dealers - Dealers also initiate trades with others dealers in order to manage their position - Their desired position will have regard to its risk, the requirements of clients and to expected future price movements. $5 difference > - Takesbest highestbuypie is the trading spread ference market se are - Given above, there is a 2 Point Market Spread and between a 4 and 5 Point individual dealer spread. - Market Rules and Conventions - For OTC markets, rules are set by AFMA and include; - Trading hours - Pricing Practices - Trading Protocols - Transaction Sizes - The ASX also has rules regarding trading hours, the securities it trades - Market Information - Traders have a huge appetite for information relevant to security values - companies such as Bloomberg and Reuters supply information both real time and video data bases. - Listed companies are required by the ASX to provide price sensitive information in a timely fashion. - How Secondary Markets Assist Primary Markets - Two ways secondary assist primary; 1 To provide investors with liquidity and thus transform the maturity of funds in the market 2 To perform the price discovery process through which the market judges the value of the traded securities. - - Liquidity and Maturity Transformation - Investors have a preference for liquidity and are more likely to buy securities that can be subsequently sold in a liquid secondary market. - Liquidity is determined by; 1 Daily turnover/turnover ratio; (higher ratio=higher liquidity) 2 Bid-Ask Spread; Liquidity = narrow spread 3 Price Resilience; Liquidity varies inversely with the impact - Non liquid shares; 5 buyers, 5 sellers, 1000 shares total, $2 spread. - Price Discovery and It’s Uses - Markets generate prices (including market indices), interest rates and exchange rates that may be regarded as fair when they are a result of trading by informed traders. - Fair prices are performed by efficient and liquid markets - This information; - Allows investors to monitor the value of their investments - Informs potential issuers of securities of their expected proceeds. - Short Selling - Go to broker and borrow Qantas shares sell them at current market price - If correct and share price drops, investor goes and buys stock back and give stock back to person they borrow them to. - Lender will charge interest for borrowing shares. TUTORIAL NOTES How do Markets Become Informationally Efficient? - Efficient Market Hypothesis - EMH states that security markets efficiently use information to generate fair prices that move randomly. - Markets are info efficient when all info relevant to a security;s value is reflected in price. - Efficient Market Hypothesis distinguishes 3 different forms of informational efficiency; 1) Weak Form Efficiency; When prices embed previous price. Implies that in this market, studying previous prices and patterns will not identify opportunities for abnormally profitable trades. 2) Semi-Strong Form Efficiency; When prices reflect all publicly available info. Implies studying public info (newspapers, analyst reports, accounting statements) and patterns will not identify abnormally profitable trades. 3) Strong-Form Efficiency; When prices reflect all existing price-sensitive info. When this occurs, abnormally profitable trades cannot be made with insider information. - According to EMH security prices; - They resent fair value (when both sides benefit) - Adjust quickly in response to price sensitive info. - They change randomly since flow of new price sensitive info is random - Are best forecast by today’s market price. - Public company bound to continuous disclosure and thus must disclose new financial information - Share price will eventually flatten out when info is no longer new. 2) Fair Value Prices - Asset’s fair value is price that does not systematically advantage either the buyer or seller of the asset - The value of most financial assets depends on their uncertain future payments and so fair value is difficult to determine - Prices are based on available information. 3) Random Walk - Movement overtime in security’s price where an increase is equally likely to be followed by a fall as by a further increase. - Movements in share prices, interest rates and exchange rates generally display a random walk. - At any point in time prices have all available info. As we don’t know if next news will be good or bad, we cant tell if prices will go up or down and this is called a random walk - EMH plains random price movements by the random arrival of new information that alerts fair value 4) Forecasting and Excess Returns - According to EMH, all relevant info has been encorporated in security prices including anticipated movements, so price movements should be random in response to new info. - EMH implies traders should not be able to achieve excess returns over a sustained period. > Excess return is where returns are greater than what could be achieved by trading at fair prices. - Higher returns generated through market research. Funds would need to buy newsfeeds, hire financial economists but all for a cost. On average, higher return only compensates you for the costs of being informed. Can Investors Achieve Excess Returns - Prices established by efficient markets should be fair meaning individual traders should not be able to consistently earn excess returns through investment selections and timing decisions. - There evidence of anomalies - abnormal or excess returns not explained by the efficient market hypothesis, suggest markets are not always efficient. - As far as we know, anomalies are not enduring, and so their identification will not consistently deliver excess returns. 5) Some Evidence of Price Behaviour - Some studies identify anomalies e.g. the firm size effect (investing in smaller stocks will earn consistently higher returns and higher will not earn as consistent, higher returns) and the January effect (if you buy stock in January you generally get higher return) - Anomalies offer opportunities to earn excess returns but are eliminated by the trading that seeks to exploit them. A) Price Bubbles - With the benefit of hindsight, it is apparent that financial markets sometimes generate prices that are too high or low - Price bubbles are periods where prices exceed fair values and are followed by a sharp correction - Such as dot-com boom evidenced in the NASDAQ - Bubbles demonstrate that trader’s sentiment such as ‘irrational exuberance’ distorts their expectations - Bubbles are where market prices exceed intrinsic values E.g. Tulip mania (prices went up by 200 pounds, people came to realisation and the price dropped) Cryptocurrencies & NFTs - Bubble occurs when prices no longer reflect fundamental factors - Irrationality of the dollar auction; When the market rallies it is difficult to jump out of the bubble. B) Bull and Bear Markets - A bull market refers to long periods of generally rising prices and a bear market refers to periods where prices are generally falling - These generally reflect conditions in the economy, such as the business cycle. - During bull markets, the increase in share prices is not fully explained by the growth in corporate profits (and vice versa in bear market) - In an efficient market we shouldn’t see this. At start of bull market or end of bear, we should invest 6) Behavioural Finance - Anchoring; Tendency for individuals to rely too heavy on one piece of info when making decisions - Confirmation Bias; Seeking out info that confirms an existing belief and ignoring info that doesn’t - Overconfidence; Individual’s subjective confidence in their judgements in greater than the objective accuracy of those judgements. - Self-Attribution; Taking credit for positive outcomes but blaming external circumstances for negative ones. What is the Contribution of Behavioural Finance to an Understanding of Market Prices? - Behavioural Finance; The area of research that attempts to understand and explain how reasoning errors influenced investor decisions and market prices. - Understands how researchers don’t act rationally - Behavioural finance recognises investor behaviour is not always based on rational expectations and may be resultative of behavioural bias. - Could result in market prices not being traded at fair value - E.g. of behavioural finance Volatility and Market Risk - When you invest youre subject to risk and we measure this through volatility. - Volatility degree of movement in a variable and indicates market risk. - Low volatility - relatively smooth line - High Volatility - Greater spike in graph - Volatility represented through frequency distribution which records size and direction of price movements over long periods.