Financial Markets and the Investment Banking Process
Chapter 3

Financial Markets
 A system comprised of individuals and institutions, instruments, and procedures that bring together borrowers and savers.

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.

Flow of Funds
 1. Direct Transfer
 business sells its stock directly to investors

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

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

Market Efficiency
 Economic Efficiency
 Funds are allocated to their optimal use at the lowest cost
 Transactions costs associated with buying and selling

Market Efficiency
 Information Efficiency
 Prices of investments reflect existing information and adjust quickly when new information enters the market
 Three categories

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

Informational Efficiency
 2. Semistrong-form efficiency
 current market prices reflect all publicly available information
 financial analysis is of no use for finding mispriced securities
 insiders can profit on their own company’s stock

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

Types of Financial Markets
 Money Markets
 instruments traded mature in one year or less
 Capital Markets
 includes instruments with maturities greater than one year

Types of Financial Markets
 Debt Markets
 treasury, corporate, mortgage-backed, money market, municipal, etc...
 Equity Markets
 stock markets

Equity Markets
 Primary
 corporations raise funds by issuing new securities
 Secondary
 securities are traded among investors after they have been issued

Derivatives Markets
 Options, futures and swaps are securities whose value is determined, or derived directly from other assets
 These can be used to manage risk or to speculate

Types of Stock Market
Transactions
 1. Secondary market
 trading existing stocks
 2. Primary market
 existing firm issues additional shares
 3. Initial Public Offering (IPO)
 privately held company offers stock to the public for the first time
 called “going public”

The Stock Exchanges
 Organized security exchanges
 tangible physical entities
 New York Stock Exchange (NYSE)
 American Stock Exchange (AMEX)
 Chicago Stock Exchange (CHX)
 Philadelphia Stock Exchange (PHLX)

NYSE Members
 1. Commission brokers
 2. Independent brokers
 3. Competitive traders
 4. Specialists

Listing Requirements
 Quantitative and qualitative characteristics a firm must possess to be listed on an exchange
 Vary by exchange
 Number of shareholders, number of public shares, market value of public shares, pre-tax income, etc...

Over-the-Counter Market
(OTC)
 Collection of brokers and dealers connected electronically
 Provides for trading in securities not listed on the organized exchanges

Over-the-Counter Market
(OTC)
 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

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.

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.

Investment Banker
 Organization that underwrites and distributes new issues of securities
 Helps businesses and other entities obtain needed financing

Investment Banking
Process
 1. Help corporations design securities with the features that are most attractive to investors given existing market conditions.
 2. Buy these securities from the corporations.
 3. Then resell the securities to investors
(savers).

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

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

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

Shelf Registration
 Securities registered with the SEC for sale at a later date

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.

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

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 listed companies must file annual reports

SEC Regulation
 3. Control stock trades by corporate insiders
 4. Prohibit manipulation of securities prices by pools or wash sales

International Financial
Markets
 Increasingly global markets
 Greatest growth in emerging markets of the Pacific Rim
 U. S. exchanges still dominate worldwide trading activity

End of Chapter 3
Financial Markets and the Investment
Banking Process