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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, CD’s– CM – long-term (stocks, bonds, mortgages)

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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

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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, M&A• Make secondary markets• Major players: Citi, Merrill, CS/FB, M-S, GS

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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

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Flotation Costs

• Underwriter’s 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 IPO’s– % 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

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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 PP’s

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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

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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.

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Returns Over Long Periods

• Understand relative returns and relative risk

• Inflation’s impact

• Standard deviation measures risk

• Trends in interest rates

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Risks and Returns

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Annual Rates of Return1926 to 2000

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

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2004

• Dow – 30 Industrials +3.15%

• S&P 500 +8.99

• S&P small cap +21.59

• Treasury bonds flat

• Dollar down

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2005

• My guess – stocks up modestly (5 to 10%); bonds down

• Wild cards– Inflation– Corporate earnings– Interest rates– Exchange rates

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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

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Term Structure

• Relation between bond’s 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

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Yield Curves

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Financial Markets & MNC’s

• 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