PRINCIPLES OF FINANCE
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FIN100
Chapter 2:
The Financial Markets and
Interest Rates
Keown, Petty, Martin, and Scott
Foundations of Finance: The Logic and
Practice or Financial Management
(with EVA Tutor Package) (4th ed.)
© 2003 Prentice Hall
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Learning Objectives
To understand:
Internal and external sources
of funds
Mix of corporate securities
sold
Why financial markets exist
U.S. financial market system
Investment banking
Private Placements
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Flotation costs
SEC Regulation
Rates of return and interest
rate determination
Term structure of interest
rates
Multinational firms, efficient
markets and inter-country risk
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Federal Reserve Actions
The Federal Reserve is the central bank of the U.S.
It is active in trying to control inflation and the rate of growth
of the economy.
From Feb 4, 1994 to Dec 11, 2001, the Federal Reserve
System (The 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
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Federal Funds Rate
The Federal Funds rate establishes the short-term market
rate of interest
It serves as a sensitivity indicator of the direction of future
changes in interest rates
The Fed manipulates rates as one of its tools for:
Maintaining the maximum sustainable rate of employment
Maintaining prices (with a general bias toward some inflation
preferred to no inflation)
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Internal and External Funds
Firms oten find themselves with an opportunity that internally
generated funds will not be sufficient to finance.
In these circumstances, managers look to external sources
of cash (capital) to pay the bills.
Businesses rely heavily on external funding, which in turn
means there is an active market system that enables the
exchanges.
This market system must be organized and resilient.
Economic contractions will continue to occur.
Businesses will invest in risky projects that may fail or more
produce fewer profits than projected
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Market Conditions and External
Funds
Changes in market conditions influence the way corporate
funds are raised.
Example:
High interest costs discourage the use of debt.
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The Mix of Corporate Securities
in The Capital Market
The sale of corporate stock is
NOT the financing method
most relied upon.
Debt is the dominant financing
method.
Equities
26.40%
Bonds and notes payable.
Also, the U.S. tax system
favors debt as means of
raising capital
Interest Expense is tax
deductible
Dividend payaments are
not deductible
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Bonds
and
Notes
73.60%
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Financial Markets
Financial markets are institutions and procedures that
facilitate transactions in all types of financial claims.
The facilitate the transfer of savings from economic units
with a surplus to economic units with a deficit.
That is, they transfer financial assets (e.g., cash) from lenders
to borrowers.
The borrowers use the borrowed financial assets to pay for real
assets (e.g., to buy new equipment) or to cover the costs of
providing products or services to the market.
Remember, customers want to buy goods and services on credit
and then tend to pay late; and sometimes they do not pay at all.
Therefore, businesses must have excess cash to pay debts before
the customers pay for the goods or services received.
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Real and Financial Assets
Real Assets are tangible assets such as houses, equipment
and inventories.
Financial Assets are claims for future payment on other
economic units, e.g., common and preferred stock.
Underwriting is the purchase of financial claims of
borrowing units and resale at a higher price to investors.
Secondary Markets trade in already existing financial
claims.
Financial Intermediaries are the major financial institutions
i.e. commercial banks, savings and loans, credit unions, life
insurance companies, mutual funds etc.
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Movement of Funds Through the
Economy
Financial institutions facilitate the flow
Direct Transfer of Funds
The firm that needs money sells its securities directly to investors.
Indirect Transfer of Funds using an Investment Banker
The firm sells its securities as a block to a syndicate of investors
for a price; the syndicate then sells the stocks to the public at a
higher price.
Indirect Transfer of Funds Using the Financial Intermediary
A financial intermediary (e.g., an insurance company or a
pension fund) collects the savings of individuals, issuing its own
(indirect) securities in exchange for the savings.
The financial intermediary then invests the funds to acquire other
assets, such as stocks and bonds, with the aim of achieving higher
returns than are promised to those who gave their savings.
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Structure of U.S. Financial
Markets
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
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Primary and Secondary Markets
Primary Markets
Securities are offered for the first time to investors – a new
issue of stock.
The effect is to increase the total stock (supply) of financial
assets outstanding in the economy.
Secondary Markets
Transactions take place using currently outstanding securities.
All transactions after the initial purchase are in secondary
markets.
Transactions do not affect the total stock of financial assets that
exist in the economy.
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Money Market and Capital Market
Money Market
Short-term debt instruments with maturities of one year or less
E.g., Treasury Bills, Federal Agency Securities, Bankers
Acceptances, Negotiable Certificates of Deposit, Commercial
Paper.
Capital Market
Long-term financial instruments with maturities that extend
beyond one year.
E.g., Term Loans, Financial Leases, Corporate Equities and
Bonds
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Organized Security Exchanges
and Over-the –Counter Markets
Organized Security Exchanges
These are tangible entities where financial instruments are
traded on their premises.
National and regional exchanges
New York Stock Exchange
American Stock Exchange
Chicago Stock Exchange
Over-the-Counter Markets
Includes all security markets except the organized exchanges
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Benefits of Organized Exchanges
Both corporations and investors enjoy benefits from the
operation of organized security exchanges.
Provides a continuous market: Trades take place on a
continuing basis, with knowledge of prices from prior
transactions affecting current transaction, thus reducing price
volatility (to an extent).
Establishes and publicizes fair security prices: Competitive
forces (buying and selling) reach a price point that balances
sellers and buyers.
Helps businesses raise new capital: With an organized market,
it is easier to “float” a new stock offering.
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Listing Requirements
Exchanges set a number of criteria that a given security
must meet before it can be listed.
Listing criteria varies from exchange to exchange.
NYSE is the most stringent in the world.
General requirements of NYSE include:
Profitability: Earning before tax of at least $2.5 million in the
most recent year and at least $2.0 million for the prior 2 years
Market Value: Revenues for the most recent fiscal year must
be at least $100 million and the global market capitalization
must be at least $1 billion.
Public Ownership: There must be at least 1.1 million publicly
held common shares, distributed among at least 2,000 holders
of at least 100 shares or more each.
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Investment Banker
An investment banker is a financial specialist involved as an
intermediary in the merchandising of securities.
He/she acts as a “middle person” to facilitate the flow of savings
from economic units that want to invest to those units that want to
raise funds.
An investment banker may a firm or a person.
In the wake of the Great Depression, the Banking Act of 1933
(known as the Glass-Steagall Act) required commercial banks to
cease all investment activities.
In 1999 the Financial Modernization Act (Gramm-Leach-Bliley Act)
repealed Glass-Steagall and allows the combination of financial
activities, including commercial and investment banking along with
insurance and securities brokerage.
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Functions of an Investment
Banker
Underwriting
Term is borrowed from insurance industry; it means “assuming
the risk.”
The investment banker forms a syndicate of other investment
bankers who are invited to help buy and resell the stock issue.
On a specific day, the corporation raising funds by the sale of
stock is given a check in exchange for the shares.
The investment bank then owns the shares and can proceed to
sell them to whoever is willing to buy them.
The corporation has its cash and can use it as it wishes. It is
not affected by the stock price offered to the public.
The investment bankers (the syndicate) can sell all or a portion
of the stock to the public in hopes of earning profits.
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Functions of an Investment
Banker (cont’d)
Distributing
Once the syndicate owns the shares, it must get them into the
hands of willing investors.
This is the distribution or selling function of investment bankers.
The investment bankers may have branch offices across the
nation that seek to sell shares.
Or it may have arrangements with securities dealers who
regularly contact their clients to buy and sell new offerings.
Advising
Investment bankers are experts in issuing and marketing
securities, so the expectation is that they maintain a high level
of awareness of market conditions and the value of securities.
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Distribution Methods
Corporations may place a new security offering in the hands
of final investors in several ways:
Negotiated Purchase: investment banker agrees to a price the
syndicate will pay (e.g., $2 less than the closing price on the
first day of issue). This approach is prevalent.
Competitive Bid: several underwriters bid for the right to issue
the security. Most auctions are confined to three situations:
(1) railroad issues, (2) public utility issues, (3) state and
municipal bond issues.
Commission or Best Efforts Basis: investment banker acts
as an agent rather than as a principal. The securities are not
underwritten. Instead, each banker tries to sell the issue in
return for a fixed commission. A successful sale is not
guaranteed.
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Distribution Methods (cont’d)
Privileged Subscription: When a firm believes it has a
distinct market for its new securities, it may offer the new
issue only to a definite and select group of investors. Three
common target markets are: (1) current stockholders, (2)
employees, and (3) customers.
Offering directly to current stockholders are called rights
offerings.
The company may arrange a standby agreement with an
investment banker, who will underwrite the offering if the
privileged subscription is does not raise all that is needed.
Direct Sales: The firm sells stock directly to investing public
itself. This approach is relatively rare today.
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Private Placements
Private placement is an alternative to a public offering or to
a privileged subscription.
The goal still is raise funds, but the most likely security
instrument is a bond or note payable.
Private placement is not limited to fixed-income securities.
There is an extensive, organized venture capital market.
Private placement is attractive to small- and medium-sized
businesses.
The major investors in private placements are large financial
institutions such as insurance companies and pension funds.
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Private Placements (cont’d)
Advantages
Speed: There is no SEC filing and no bureaucracy to manage.
Reduced Flotation Costs: The lengthy registration process
with the SEC is avoided and underwriting costs do not have to
be absorbed.
Financing Flexibility: The firm deals on a face-to-face basis
and may tailor the arrangements in detail. E.g., a “line of credit”
may be arranged so that the entire debt need not be accepted
at once. Or there is the chance to renegotiate later.
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Private Placements (cont’d)
Disadvantages
Interest Costs: Interest costs are greater than on public
issues.
Restrictive Covenants: Divident policy, working-capital levels,
and the raising of additional debt capital may be affected by the
terms of the agreement.
Possible Future SEC Registration: In some cases, the lender
may want to sell the issue to the public before maturity, in which
case, the lender may require the borrower to agree in advance
to the possible future SEC registration – which may be costly.
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Flotation Costs
There are two types of flotation costs, which are the costs
that accrue to the firm that is trying to raise capital:
Underwriter’s Spread: the difference between the gross
proceeds from the issue and the net receipts by the company.
Issuing Costs: include (1) printing and engraving, (2) legal
fees, (3) accounting charges, (4) trustee fees, and (5)
miscellany.
According to the SEC, flotation cost
Are significantly higher for common stock than preferred stock
Are significantly higher for preferred stock than for bonds.
Thus, the costs reflect the difference in risk.
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Market Regulation
Primary Markets
Securities Act of 1933: Aims to provide potential investors with
accurate, truthful disclosure about the firm and new securities
being offered.
Secondary Markets
Securities Exchange Act of 1934: Created SEC to enforce
federal securities laws
Securities Acts Amendments of 1975: Created a national
market system
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Securities Exchange Act of 1934
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
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Shelf Registration
Formally called a SEC Rule 415 registration, a shelf
registration is a master registration statement that covers
the financial plans of the firm over the coming two years.
With the approval of the SEC, the firm can sell some or all of
the securities over the two-year period covered by the shelfregistration.
Before each piecemeal sale of securities, a brief registration
statement is filed with the SEC giving notice.
A shelf registration allows a firm to use the market as a
virtual “line of credit” based on the sale of securities in the
open market
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Rates of Return in Financial
Markets
Users of funds (borrowers) compete with one another to
obtain the capital needed from savers (lenders).
Offering higher rates of return is an obvious tactic.
Opportunity Cost of Funds
The rate of return on the next best investment alternative to
the investor.
Critical to financial management.
History teaches us the rates of return vary over time.
Inflation may be used as an “average” of sorts.
If your investments do not keep up with inflation, then you are
losing money daily.
The variability or returns compared to average inflation can be
used to compute a standard deviation that can be useful.
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Rates of Return in Financial
Markets (cont’d)
Data from 1926 to 2000 indicate that the average annual
rate of inflation has been 3.2 percent.
The investor who earns only 3.2 percent has zero “real return”
on investment.
The inflation-risk premium, therefore, is 3.2 percent.
Default-risk premium is an additional charge to cover the
potential the borrower will not repay.
The U.S. government is assumed to be a zero-risk borrower.
For the period 1926-2000, the government paid 5.7 percent.
In contrast, corporations paid 6 percent.
So we surmise there is a 0.3 percent (30 basis points)
default-risk premium on corporate debt.
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Rates of Return in Financial
Markets (cont’d)
We also would expect a higher default-risk premium for
common stock.
The data from 1926 to 2000 support this thinking.
The average annual rate of return on stocks was 13 percent.
Subtracting the 6 percent return on corporate bonds, we arrive
at a risk premium of 7 percent for common stock.
Nominal interest rates are those shown by fixed income
securities.
Subtracting the rate of inflation, we obtain an estimate of the
“real” interest rate.
Investors will not accept a rate of return that is less than the
rate of inflation…at least, smart investors will not anyway.
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Rates of Return in Financial
Markets (cont’d)
Investors also demand additional premiums:
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.
For example, shares of a bank holding company traded on the
NYSE (e.g., SunTrust) will be more liquid – that is, more easily
converted to cash when needed – than common stock in the
Citizens Bank of Fairfax.
Therefore, the Citizens Bank of Fairfax must offer greater total
returns (which may include dividends) than SunTrust.
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Interest Rates in a Nutshell
The nominal interest rate, or the quoted rate, is the
interest paid on debt securities without an adjustment for any
loss in purchasing power. It is the rate you would find in the
Wall Street Journal for a specific fixed-income security.
k = k* + IRP + DRP + MP + LP
Where,
k = nominal interest rate (i.e., the rate that is quoted)
k* = the real risk-free rate of interest (cf, Treasury bond rate)
IRP = inflation-risk premium
DRP = default-risk premium
MP = maturity premium
LP = liquidity premium
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Nominal Risk-Free Rate
Sometimes we wish to focus on the nominal risk-free rate of
interest.
This is the risk-free rate plus the inflation-risk premium.
krf = k* + IRP
This rate is much debated and is a source of constant
discussion among financial economists.
We can be pragmatic and use the U.S. Treasuries lowest
interest rate (likely the 3-month) as a proxy for k* and then add
3.2 percent as a reasonable guess for IRP.
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Estimating Specific Interest
Rates Using Published Data
A reasonable estimate for a nominal interest rate for a new
issue can be calculated using historical data.
Instead of looking at 50 years, you probably would look at the
most recent few years and several projections for future rates.
k* = the difference between the average return of the 3-month
T-bill and inflation over the same period.
IRP = the average inflation over the period.
DRP = the difference between the 30-yr Treasury bond and
Aaa-rated corporate bonds
MRP = the difference between the average yield on 30-yr
Treasury bonds and 3-month Treasury bills.
LRP = whatever you think is best, depending on the market you
will have.
Then compute k = k* + IRP + DRP + MRP + LRP.
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Effects of Inflation
Nominal Rate of Interest
When a rate of interest is quoted, it is the nominal rate unless
otherwise indicated.
Real Rate of Interest
The real rate of interest represents the rate of increase in actual
purchasing power, after adjusting for inflation.
Fisher Effect
The nominal rate of interest (using the risk-free rate) is the sum
of the real rate of inflation (k*) plus the inflation risk premium
(IRP) plus the real rate times the IRP (as an additional
adjustment):
krf = k* + IRP + (k* • IRP)
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Inflation and Real Rates
Financial analysts often use an approximation method to
estimate the real rate of interest over a selected past time
frame.
Using published data on inflation rates, the following formula
may be applied
k* = Nominal Interest – Inflation Rate
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Term Structure of Interest Rates
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Term Structure of Interest
14
12
10
Interest Rate
The relationship between a
debt security’s rate of
return and the length of
time until the debt matures
is known as the term
structure of interest rates
or yield to maturity.
The term structure reflects
observed rates or yields on
similar securities, except for
the time to maturity.
As a general rule, the
longer the time to maturity,
the higher the interest rate.
8
6
4
2
0
1
5
10
15
20
25
Years to Maturity
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Term Structure of Interest Rates
A number of theories have been offered to explain the term
structure of interest rates:
Unbiased Expectations Theory
The term structure is determined by expectations about future
interest rates.
Liquidity Preference Theory
Investors require maturity premiums to compensate them for
buying securities that have a longer time to maturity and hence
expose them to greater risks of interest rate fluctuations
Market Segmentation Theory
The rate of interest for a particular maturity is determined solely by
demand and supply for securities with that maturity and is
independent of the demand and supply of maturities with different
maturities.
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Efficient Financial Markets and
Intercountry Risk
One of the reasons underdeveloped countries are indeed
underdeveloped is that they lack a financial market system
that has earned the confidence of those who must use it.
The development of industry and the creation of real capital
assets requires financial market mechanisms to operate.
Operating in a foreign country creates various risks:
Financial System Risk: The financial systems may not be stable
and may lack integrity.
Political System Risk: Governments change and may align with
anti-Western factions, placing foreign assets at risk of
conversion or destruction
Exchange Rate Risk: Currency fluctuations in world markets
can quickly devalue a currency, destroying its value
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