Research paper-The Financial Markets and Interest Rates
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Learning Objectives
1. Describe key components of the U.S. financial
market system and the financing of business.
2. Understand how funds are raised in the capital
markets.
3. Be acquainted with recent rates of return.
4. Explain the fundamentals of interest rate
determination and the popular theories of the
term structure of interest rates.
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FINANCING OF BUSINESS: THE
MOVEMENT OF FUNDS THROUGH
THE ECONOMY
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Financial Markets:
Transfer of Capital
• Financial markets play a critical role in capitalist
economy. Financial markets help facilitate the
transfer of funds from “saving surplus” units to
“saving deficit” units, i.e., transfer money from
those who have the money to those who need it.
• See Figure 2-1 for three ways to transfer capital in
the economy:
– Direct transfer
– Indirect transfer using the investment banker
– Indirect transfer using the financial intermediary
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Figure 2.1
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Direct Transfer
Direct Transfer
Firm seeking funds directly approaches a
wealthy investor.
• For example, a new business venture seeking funding
from venture capitalist.
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Role of Venture Capitalist
• Venture capitalist are the prime source of
funding for start-up companies and
companies in “turnaround” situations.
Funding for such ventures are very risky,
but carry the potential for high returns.
• The borrowing firm may not have the option
of pursuing public offering due to: small
size, no record of profits, and uncertain
future growth prospects.
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Indirect Transfer
Indirect Transfer (using investment banks)
Here the investment bank acts as a link
between the firm (needing funds) and the
investors (with surplus funds)
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Example of Transfer Using
Investment Banks (IB)
Corporation XYZ sells 5 million shares to
Morgan Stanley (IB) at $10 per share
Morgan Stanley pays $50m to XYZ
IPO –
Morgan Stanley tries to sell those shares
in the stock market (savers) for more than $50m
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Indirect Transfer
Indirect transfer (using financial
intermediary):
Here the financial intermediary (such as
mutual funds) collects funds from savers in
exchange of its own securities (indirect). The
collected funds are then used to acquire
securities (such as stocks and bonds) from
firm.
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Indirect Transfer using Financial
Intermediary (FI)
Investors (Savers)
transfer savings to mutual fund companies
Mutual fund (FI) companies issue securities to investors.
Mutual funds use the funds to buy securities from corporations.
Corporations (Users) issue stocks and bonds for
funds received from mutual funds
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Public Offerings Versus
Private Placements
Public Offering
Both individuals and institutional investors have
the opportunity to purchase securities. The
securities are initially sold by the managing
investment bank firm. The issuing firm never
actually meets the ultimate purchaser of
securities.
Private or Direct Placement
The securities are offered and sold directly to a
limited number of investors.
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Primary Markets Versus
Secondary Markets
Primary Market (initial issue)
This is the market in which new issues of a securities
are sold to initial buyers. This is the only time the
issuing firm ever gets any money for the securities.
For example, Google raised $1.76 billion through
sale of shares to public in August 2004.
Seasoned Equity Offering (SEO)
It refers to sale of additional shares by a company
whose shares are already publicly traded. For
example, Google raised $4.18 billion in September
2005.
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Primary Versus
Secondary Markets (cont.)
Secondary Market (subsequent trading)
This is the market in which previously issued
securities are traded. The issuing corporation does not
get any money for stocks traded on the secondary
market. For example, trading among investors today
of Google stocks.
– Primary and secondary markets are regulated by SEC.
Firms have to get approval from SEC before the sale of
securities in primary market. Firms must report financial
information to SEC on a regular basis (ex. financial
statements) to protect investors.
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The Money Market Versus the
Capital Market
Money Market
This is the market for short-term debt instruments (maturity
periods of one year or less). Money market is typically a
telephone and computer market (rather than a physical
building).
Examples: Treasury bills (issued by federal government),
commercial paper, negotiable CDs, bankersʼ acceptances.
Capital Market
This is the market for long-term financial securities (maturity
greater than one year).
Examples: Corporate bonds, common stocks, Treasury
bonds, term loans, and financial leases.
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Organized
Securities Exchanges
Organized Securities Exchanges are
tangible entities and financial instruments are
traded on its premises.
– New York Stock Exchange (NYSE, also known as “big
board”) is the most prominent exchange. In 2012,
NYSE listed more than 4,000 U.S. and non-U.S.
securities with total value of over $14 trillion. Firms
listed on the exchanges must comply with the listing
requirements of the exchange (such as for
profitability, size, market value, and public
ownership).
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Over-the-Counter Markets
• If firms do not meet the listing requirements of the exchange,
and/or wish to avoid higher reporting requirements and fees
of exchanges, they may choose to trade on OTC.
• OTC (Over-the-Counter) market refers to all securities market
except organized exchanges. There is no specific geographic
location for OTC market. Most transactions are done through a
network of security dealers who are known as broker-dealers
and brokers. Their profit depends on the price at which they
are willing to buy (bid price) and the price at which they are
willing to sell (ask price).
• Most prominent OTC market for stocks is NASDAQ. NASDAQ
lists over 5,000 securities (including Google, Microsoft,
Starbucks). Most corporate bond transactions are also
conducted on OTC markets.
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Stock Exchange Benefits
– Provides a continuous market
– Establishes and publicizes fair security prices
– Helps businesses raise new capital
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SELLING SECURITIES TO THE
PUBLIC
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Investment
Banking Function
Investment Banker/Underwriter
• They are financial specialists involved as an
intermediary in the sale of securities (stocks and
bonds). They buy the entire issue of securities from the
issuing firm and then resell it to the general public.
• The difference between the price the corporation gets
and the public offering price is called the underwriterʼs
spread.
• Prominent investment banks in the U.S. include
Goldman Sachs, JP Morgan, Morgan Stanley (see Table
2-1).
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Table 2-1
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Functions of an
Investment Banker
Underwriting:
– Underwriting means assuming risk. Since money
for securities is paid to the issuing firm before
the securities are sold, there is a risk to the
investment bank(s).
Distributing:
– Once the securities are purchased from issuing
firm, they are distributed to ultimate investors.
Advising:
– On timing of sale, type of security, etc.
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Demise of Investment Banks
After the 2008 financial crisis, stand-alone
investment banks were either liquidated (such
as Lehman Brothers) or merged with
commercial banks (such as Merrill Lynch).
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Distribution Methods
Negotiated Purchase
– Issuing firm selects an investment banker to
underwrite the issue. The firm and the
investment banker negotiate the terms of the
offer.
Competitive Bid
– Several investment bankers bid for the right to
underwrite the firmʼs issue. The firm selects the
banker offering the highest price.
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Distribution Methods (cont.)
Best Efforts
– Issue is not underwritten, i.e., no money is paid
upfront for the stocks. Investment bank, acting
as an agent, attempt to sell the stocks in return
for a commission.
Privileged Subscription
– Investment banker helps market the new issue
to a select group of investors such as current
stockholders, employees, or customers.
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Distribution Methods (cont.)
Dutch Auction
– Investors place bids indicating how many shares
they are willing to buy and at what price. The
price the stock is then sold for becomes the
lowest price at which the issuing company can
sell all the available shares.
– See Figure 2-2.
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Figure 2-2
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Distribution Methods (cont.)
Direct Sale
– Issuing firm sells the securities directly to the
investing public.
– No investment banker is involved.
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Private Debt Placements
Private placements of debt refers to raising
money directly from prominent investors such
as life insurance companies, pension funds. It
can be accomplished with or without the
assistance of investment bankers.
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Private Debt Placements
Advantages
– Faster to raise money
– Reduces flotation costs
– Offers financing flexibility
Disadvantages
– Interest costs are higher than public issues
– Restrictive covenants
– Possible future SEC registration
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Flotation Cost
Flotation Cost refers to transaction cost
incurred when a firm raises funds by issuing
securities:
– Underwriterʼs spread
(difference between gross and net proceeds)
– Issuing costs
(printing and engraving of security
certificates, legal fees, accounting fees,
trustee fees, other miscellaneous expenses)
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Sarbanes-Oxley Act (SOX)
• In response to corporate scandals, Congress passed
this Act in 2002.
• This Act holds senior corporate advisors (such as
accountants, lawyers, board of directors, officers)
responsible for any instance of misconduct.
• The Act attempts to protect the interest of investors
by improving transparency and accuracy of
corporate disclosures.
• SOX has been criticized for imposing additional
compliance costs on the firms. Some firms have
responded by delisting from major exchanges or
choosing to list on foreign exchanges.
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RATES OF RETURN IN THE
FINANCIAL MARKETS
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Long-term Rates of Return
• See Figure 2-3.
• Higher returns are associated with higher
risk.
• Figure also shows that investors demand
compensation for inflation and other
elements of risk (such as default).
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Figure 2-3
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Some Terms
• Opportunity Cost — Rate of return on next best investment
alternative to the investor
• Standard Deviation — Dispersion or variability around the mean rate of return in the financial markets
• Real Return — Return earned above the rate of inflation
• Maturity-risk Premium — Additional return required by investors in long-term securities to compensate for greater
risk of price fluctuations on those securities caused by interest
rate changes
• Liquidity-risk Premium — Additional return required by
investors in securities that cannot be quickly converted into
cash at a reasonably predictable price
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Interest Rate Levels
• Interest rate levels and inflation are
displayed in Table 2-2 and Figure 2-4. We
observe:
– A direct relationship between inflation and
interest rates.
– The returns are affected by the degree of
inflation, default premium, maturity premium,
and liquidity premium.
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Table 2-2
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Figure 2-4
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Observations
From Table 2-2 and Figure 2-4
• Between 1987 and 2011:
– Average inflation premium = 2.92%
– Average default risk premium = 0.86%
– Average maturity risk premium = 2.29%
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INTEREST RATE
DETERMINANTS
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Interest Rate Determinants
• Nominal interest rate = Real risk-free rate
+ Inflation premium
+ Default-risk premium
+ Maturity-risk Premium
+ Liquidity-risk Premium
• Thus the nominal rate or quoted rate for securities
is driven by all of the above risk premium factors.
Such knowledge is critical when companies set an
interest rate for their issues. Review the example in
text.
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Real and Nominal Rates
• Real risk-free interest rate = risk-free rate
– inflation premium
• Nominal interest rate ≈ (approximately equals)
real rate of interest
+ inflation risk premium
• The real rate of interest is the nominal (quoted)
rate of interest less any loss in purchasing power of
the dollar during the time of the investment.
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The Term Structure of Interest
Rates
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The Term Structure of
Interest Rates
• Figure 2-5 shows the relationship between a debt
securityʼs rate of return and the length of time until
the debt matures, where the risk of default is held
constant.
• The graph could be upward-sloping (indicating
longer-term securities command higher returns),
flat (equal returns for long- and short-term
securities), or inverted (longer-term securities
command lower returns compared to short-term
securities).
• The graph changes over time. Upward-sloping
curve is most commonly observed.
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Figure 2-6
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Figure 2-7
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What Explains the Shape of the Term
Structure? The Unbiased Expectations Theory
• Term structure is determined by an
investorʼs expectations about future interest
rates.
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What Explains the Shape of the Term
Structure? The Liquidity Preference Theory
• Investors require maturity-risk premiums to
compensate them for buying securities that
expose them to the risks of fluctuating
interest rates.
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What Explains the Shape of the Term
Structure? The Market Segmentation Theory
• Legal restrictions and personal
preferences limit choices for investors to
certain ranges of maturities.
• This theory implies that the rate of
interest for a particular maturity is
determined by demand and supply for a
given maturity.
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Key Terms
• Angel investor
• Capital markets
• Default-risk premium
• Direct sale
• Dutch auction
• Flotation costs
• Futures market
• Initial public offering
(IPO)
• Inflation premium
• Investment banker
• Liquidity preference
theory
• Liquidity-risk premium
• Market segmentation
theory
• Maturity-risk premium
• Money market
• Nominal (or quoted)
rate of interest
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Key Terms
• Opportunity cost of funds
• Organized security
exchanges
• Over-the-counter markets
• Primary market
• Private placement
• Privileged subscription
• Public offering
• Real rate of interest
• Real risk-free interest rate
• Seasoned equity offering
(SEO)
• Secondary market
• Spot market
• Syndicate
• Term structure of interest
rates
• Unbiased expectations
theory
• Underwriting
• Underwriterʼs spread
• Venture capitalist
• Yield to maturity
