Financial markets and interest rate

1. Chapter 2
The Financial Markets and Interest
Rates
Foundations of Finance
Arthur J. Keown John D. Martin
J. William Petty David F. Scott, Jr.

2. Chapter 2 The Financial Markets and Interest Rates
Pearson Prentice HallFoundations of Finance2 - 2
Chapter Objectives
• Understanding the historical relationship
between internally generated and
externally generated sources of funds.
• Understand the financing mix that tends to
be used by the firms raising long-term
capital.
• Explain why the financial markets exist in a
developed country.
• Explain the financing process by which
savings are supplied and raised by major
sectors in the economy.

3. Chapter 2 The Financial Markets and Interest Rates
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Chapter Objectives
• Describe key components of the U.S.
financial market system.
• Understand the role of the investment-
banking business in the context of raising
corporate capital.
• Distinguish between privately placed
securities and publicly offered securities.
• Be acquainted with securities floatation
costs and securities markets regulations.

4. Chapter 2 The Financial Markets and Interest Rates
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Chapter Objectives
• Understand the rate-of-return relationships
among various classes of financing
vehicles that persist in the financial
markets.
• Be acquainted with recent interest rate
levels and the fundamentals of interest rate
determination.
• Explain the popular theories of the term
structure of interest rates.
• Understand the relationships among the
multinational firm, efficient financial
markets, and the inter-country risk.

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Principles Used in this Chapter
Principle 1: The Risk-Return Tradeoff - We
Won’t Take on Additional Risk Unless We
Expect to Be Compensated with Additional
Return.
Principle 6: Efficient Capital Markets - The
Markets are Quick and the Prices Are
Right.
Principle 10: Ethical Behavior Is Doing the
Right Thing, and Ethical Dilemmas Are
Everywhere in Finance.

6. Chapter 2 The Financial Markets and Interest Rates
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Federal Funds Rate
• Short-term market rate of interest
• Serves as a sensitivity indicator of
the direction of future changes in
interest rates

7. Chapter 2 The Financial Markets and Interest Rates
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Objectives of the Fed
• Maximum sustainable
employment
• Price stability

8. Chapter 2 The Financial Markets and Interest Rates
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Recent Interest Rate Cycles
Early 1994 &
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 Contracting manufacturing output, slower
business capital spending, equity market
sell-off, recession
Lower
interest rates
Summer
2004
Firming Labor market, stronger retail sales,
improving industrial production, hot housing
market, increases in energy prices, all
suggesting unacceptable future rates of
inflation.
Raise interest
rates

9. Chapter 2 The Financial Markets and Interest Rates
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Nonfinancial Corporate Business
Sources of Funds, 1981-2000
• Changes in market
conditions
influence the way
corporate funds
are raised
• Example: High
interest costs
discourage the use
of debt.
Internal
Funds
72.30%
External
Funds
27.70%

10. Chapter 2 The Financial Markets and Interest Rates
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Corporate Securities Offered for
Cash
• Nonfinancial
Corporations- 3yr.
Cash Weighted
Average, 2001-
2003
• Total Volume($M)
– $1,288,515
Bonds
and
Notes
85.70%
Equities
14.30%
Source:Statistical Supplement to the
Federal Reserve Bulletin, Table 1.46,
October 2004, A29.

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Debt/Equity Mix
• U.S. tax system favors debt as
means of raising capital
• Interest expense is deductible
• Dividends paid are not
deductible

12. Chapter 2 The Financial Markets and Interest Rates
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Financial Markets
• Financial markets are institutions
and procedures that facilitate
transactions in all types of financial
claims
• Financial markets exist in order to
allocate the supply of savings in the
economy to the demanders of those
savings.

13. Chapter 2 The Financial Markets and Interest Rates
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Financial Markets
• Real assets are tangible assets
such as houses, equipment, and
inventories.
• Financial assets represent
claims for future payments in
other economic units.

14. Chapter 2 The Financial Markets and Interest Rates
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• Underwriting — the purchase of financial
claims of borrowing units and reselling
them 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 Markets

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• Indirect Securities – financial claims
offered by financial intermediaries to
economic units with excess savings
• Direct Securities – financial claims
purchased by financial
intermediaries with proceeds from
the sale of indirect securities
Financial Markets

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The Financing Process
Sector Funds
Raised
($)
Funds
Supplied
($)
Net Funds
Supplied ($)
Households 447.4 397.1 (50.3)
Nonfinancial
Corporate
Business
447.5 383.8 (63.7)
U.S. Gov’t 73.9 62.9 (11.0)
State and Local
Gov’ts
56.4 48.4 ( 8.0)
Foreign 320.2 561.7 241.5
Source: Flow of Funds Accounts, First Quarter 2000, Flow if Funds Section, Statistical Release Z.1
(Washington, D.C.; Board of Governors of the Federal Reserve System, June 9,2000).

17. Chapter 2 The Financial Markets and Interest Rates
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Movement of Savings
• Direct Transfer of Funds
• Indirect Transfer of Funds Using
an Investment Banker
• Indirect Transfer of Funds Using
the Financial Intermediary

18. Chapter 2 The Financial Markets and Interest Rates
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Three Ways to Transfer Financial
Capital in the Economy
Three Ways to Transfer Financial Capital in the Economy

19. Chapter 2 The Financial Markets and Interest Rates
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Public Offerings and Private
Placements
• Public Offering – both individuals and
institutional investors have the
opportunity to purchase securities
• Private Placement (direct
placement) – the securities are
offered and sold to a limited number
of investors

20. Chapter 2 The Financial Markets and Interest Rates
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Primary and Secondary Markets
• 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.

21. Chapter 2 The Financial Markets and Interest Rates
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Money Market and Capital Market
• Money Market: all institutions and
procedures that provide for
transactions in short-term debt
instruments
• Capital Market: all institutions and
procedures that provide for
transactions in long-term financial
instruments

22. Chapter 2 The Financial Markets and Interest Rates
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Organized Security Exchanges and
Over-the-Counter Markets
• Organized Security Exchanges—Tangible
entities; physically operate space, 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

23. Chapter 2 The Financial Markets and Interest Rates
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Stock Exchange Benefits
• Provides a continuous market
• Establishes and publicizes fair
security prices
• Helps businesses raise new capital

24. Chapter 2 The Financial Markets and Interest Rates
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Listing Requirements
• Listing criteria varies from
exchange to exchange. General
requirements include:
*Profitability
*Market Value
*Public Ownership

25. Chapter 2 The Financial Markets and Interest Rates
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Investment Banker
• A financial specialist involved as an
intermediary in the merchandising of
securities; facilitates flow of savings
from economic units that want to
invest in those units that want to
raise funds.

26. Chapter 2 The Financial Markets and Interest Rates
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Functions of an Investment
Banker
• Underwriting
• Distributing
• Advising

27. Chapter 2 The Financial Markets and Interest Rates
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Distribution Methods
• Negotiated Purchase
• Competitive Bid Purchase
• Commission or Best Efforts Basis
• Privileged Subscription
• Direct Sales

28. Chapter 2 The Financial Markets and Interest Rates
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Private Placements
• Advantages
– Speed
– Reduced Flotation Costs
– Financing Flexibility
• Disadvantages
– Interest Costs
– Restrictive Covenants
– Possible Future SEC Registration

29. Chapter 2 The Financial Markets and Interest Rates
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Market 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

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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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Sarbanes-Oxley Act of 2002
• Congress passed in July 2002 the
Public Accounting and Reform and
Investor Protection Act
• The Act contains 11 titles which
tighten significantly the latitude
given corporate advisors who have
access to or influence company
decisions.

32. Chapter 2 The Financial Markets and Interest Rates
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Sarbanes-Oxley Act of 2002
Key Elements
• Public Company Accounting Oversight Board
• Auditor Independence
• Corporate Responsibility
• Enhanced Financial Decisions
• Analysts Conflicts of Interest
• Commission Resources and Authority
• Studies and Reports
• Corporate and Criminal Fraud Accountability
• White-Collar Crime Penalty Enhancements
• Corporate Tax Returns
• Corporate Fraud and Accountability

33. Chapter 2 The Financial Markets and Interest Rates
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Rates of Return in Financial
Markets
• Opportunity Cost — Rate of return on next
best investment alternative to the investor
• Standard Deviation — Dispersion or
variability around the mean, or average of
the rate of return in the financial markets
• Maturity Premium — Additional return
required by investors in long-term
securities to compensate them for greater
risk of price fluctuations on those
securities caused by interest rate changes

34. Chapter 2 The Financial Markets and Interest Rates
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• 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
Rates of Return in Financial
Markets

35. Chapter 2 The Financial Markets and Interest Rates
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Term Structure of Interest
Rates
• The relationship between a debt
security’s rate of return and the
length of time until the debt
matures.
• Also called “Yield to Maturity”

36. Chapter 2 The Financial Markets and Interest Rates
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Term Structure of Interest
Rates
Explained by:
• Unbiased Expectations Theory
• Liquidity Preference Theory
• Market Segmentation Theory

37. Chapter 2 The Financial Markets and Interest Rates
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Unbiased Expectations
Theory
• Term Structure is determined
by an Investor’s expectations
about future interest rates.

38. Chapter 2 The Financial Markets and Interest Rates
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Liquidity Preference Theory
• Investors require maturity
premiums to compensate them
for buying securities that
expose them to the risks of
fluctuating interest rates

39. Chapter 2 The Financial Markets and Interest Rates
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Market Segmentation Theory
• Legal restrictions and
personal preferences limit
choices for investors to
certain ranges of maturities

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Financial Markets and
Intercountry Risk
• Financial System Risk
• Political System Risk
• Exchange Rate Risk