Intro to Financial Management Financial Markets and Interest Rates.
Chapter 2. The Financial Markets and Interest Rates.
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Transcript of Chapter 2. The Financial Markets and Interest Rates.
Chapter 2Chapter 2
The Financial Markets and The Financial Markets and Interest RatesInterest Rates
Chapter ObjectivesChapter Objectives
Internal and external source of funds
Mix of corporate securities sold
Why financial markets exist
Financing of business U.S. financial market
system Investment banker Private Placements
Flotation costs Regulation Rates of Return and
interest rate determination Term structure of interest
rates Multinational firms,
efficient markets and inter-country risk
Federal Reserve ActionsFederal Reserve Actions
--From Feb 4, 1994 and Dec 11, 2001, the Federal Reserve System (Fed) voted to change the target funds rate on 31 occasions
--Rates were moved upward 14 times--Rates were moved downward 17 times--Rates moved downward 11 consecutive
times in 2001
Federal Funds RateFederal Funds Rate
Short-term market rate of interestServes as a sensitivity indicator of the
direction of future changes in interest rates
Objectives of the FedObjectives of the Fed
Maximum sustainable employmentPrice stability
Recent Interest Rate CyclesRecent Interest Rate CyclesEarly 1994 and 1997
Inflation Raise interest Rates
Fall 1998 International Pressures
Lower interest rates
Summer 1999 Tight labor markets, aggregate real growth, inflation
Raise interest rates
Early 2001 Slower business capital spending, equity market sell-off, recession
Lower interest rates
Market Conditions and Market Conditions and External FundsExternal Funds
Changes in market conditions influence the way corporate funds are raised.
Example:High interest costs discourage the use of
debt.
The Mix of Corporate The Mix of Corporate Securities in The Capital Securities in The Capital
MarketMarket Corporate Stock is
NOT the financing method most relied upon.
Corporate Debt is the dominant financing method
Bonds and
Notes73.60%
Equities26.40%
Debt/Equity MixDebt/Equity Mix
U.S. tax system favors debt as means of raising capital—
--Interest Expense is deductible
--Dividends paid are not deductible
Financial MarketsFinancial Markets
Financial markets are institutions and procedures that facilitate transactions in all types of financial claims—facilitate the transfer of savings from economic units with a surplus to economic units with a deficit.
Real and Financial AssetsReal and Financial Assets
Real Assets—Tangible assets such as houses, equipment and inventories
Financial Assets—Claims for future payment on other economic units—common and preferred stocks
Underwriting — the purchase of financial claims of borrowing units and re-sell at a higher price to other investors.
Secondary Markets—trading in already existing financial claims
Financial Intermediaries—Major financial institutions i.e. Commercial banks, savings and loans, credit unions, life insurance companies, mutual funds etc.
Financial MarketsFinancial Markets
Exist to facilitate the efficient flow of savings from the surplus sectors to deficit sectors
Movement of Funds Through Movement of Funds Through the Economythe Economy
Direct Transfer of Funds
Indirect Transfer of Funds using an Investment Banker
Indirect Transfer of Funds Using the Financial Intermediary
Structure of U.S. Financial Structure of U.S. Financial MarketsMarkets
When a corporation needs to raise external capital, funds can be obtained by a:
– Public Offering -where individuals and institutional investors have the opportunity to purchase securities
or– Private Placement - where securities are sold
to a limited number of investors
Primary and Secondary Primary and Secondary MarketsMarkets
Primary Markets Securities are offered for the first time to investors – a new issue of stock. Increases the total stock of financial assets outstanding in the economy.
Secondary Markets Transactions in currently outstanding securities. All transactions after the initial purchase. Sales do not affect the total stock of financial assets that exist in the economy.
Money Market and Capital Money Market and Capital MarketMarket
Money Market – Short-term debt instruments with maturities of one year or less– Treasury Bills, Federal Agency Securities, Bankers
Acceptances, Negotiable Certificates of Deposit, Commercial Paper.
Capital Market—Long Term financial instruments with maturities than extend beyond one year.
– Term Loans, Financial Leases, Corporate Equities and Bonds
Organized Security Organized Security Exchanges and Over-The –Exchanges and Over-The –
Counter MarketsCounter Markets
Organized Security Exchanges—Tangible entities where financial instruments are traded on the premises– National and regional exchanges
New York Stock Exchange American Stock Exchange Chicago Stock Exchange
Over-The-Counter Markets—All security markets except the organized exchanges– Money Market
Benefits of Organized Benefits of Organized ExchangesExchanges
Provides a continuous market
Establishes and publicizes fair security prices
Helps businesses raise new capital
Listing RequirementsListing Requirements
Listing criteria varies from exchange to exchange. General requirements include:
ProfitabilitySizeMarket ValuePublic Ownership
Investment BankerInvestment Banker
A financial specialist involved as an intermediary in the merchandising of securities—facilitates flow of savings from economic units that want to invest to those units that want to raise funds.
Functions of an Investment Functions of an Investment BankerBanker
UnderwritingDistributingAdvising
Distribution MethodsDistribution Methods
Negotiated PurchaseCompetitive BidCommission or Best Efforts BasisPrivileged SubscriptionDirect Sales
Private PlacementsPrivate Placements
Advantages– Speed– Reduced Flotation Costs– Financing Flexibility
Disadvantages– Interest Costs– Restrictive Covenants– Possible Future SEC Registration
Market RegulationMarket Regulation
Securities Act of 1933—Aims to provide potential investors with accurate, truthful disclosure about the firm and new securities being offered.
Securities Exchange Act of 1934—Created SEC to enforce federal securities laws
Securities Acts Amendments of 1975—Created a national market system
Securities Exchange Act of Securities Exchange Act of 19341934
Major security exchanges must register with the SEC– Insider trading is regulated – Prohibits manipulative trading– SEC control over proxy procedures– Gives Board of Governors of Federal Reserve System
responsibility for setting margin requirements
Rates of Return in Financial Rates of Return in Financial MarketsMarkets
Opportunity Cost—rate of return on next best investment alternative to the investor
Standard Deviation—Dispersion or variability around the mean or average rate of return
Maturity Premium—Additional return required by investors in long-term securities to compensate them for the increased risk of price fluctuations on those securities caused by interest rate changes
Liquidity Premium—Additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price.
Real Return—Return earned above the rate of increase in the general price level for goods and services in the economy (the inflation rate)
Real Rate of Interest—Rate of increase in actual purchasing power—after adjusting for inflation
Term Structure of Interest Term Structure of Interest RatesRates
The relationship between a debt security’s rate of return and the length of time until the debt matures.
Also called: Yield to Maturity
Term Structure of Interest Term Structure of Interest RatesRates
Explained by:
Unbiased Expectations TheoryLiquidity Preference TheoryMarket Segmentation Theory
Unbiased Expectations Unbiased Expectations TheoryTheory
The term structure is determined by an investor’s expectations about future interest rates
Liquidity Preference TheoryLiquidity Preference Theory
Investors require maturity premiums to compensate them for buying securities that expose them to the risks of fluctuating interest rates
Market Segmentation TheoryMarket Segmentation Theory
Legal restrictions and personal preferences limit choices for investors to certain ranges of maturities
Intercountry RiskIntercountry Risk
Financial System Risk
Political System Risk
Exchange Rate Risk