Foundations of Finance

Arthur J. Keown John D. Martin

J. William Petty David F. Scott, Jr.

Chapter 2
The Financial Markets and Interest
Rates
Chapter 2 The Financial Markets and Interest Rates

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.

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Chapter 2 The Financial Markets and Interest Rates

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.

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Chapter 2 The Financial Markets and Interest Rates

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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Chapter 2 The Financial Markets and Interest Rates

Principles Used in this Chapter

Principle 1: The Risk-Return Tradeoff - We

Wont 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.

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Chapter 2 The Financial Markets and Interest Rates

Federal Funds Rate

Short-term market rate of interest

Serves as a sensitivity indicator of

the direction of future changes in
interest rates

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Chapter 2 The Financial Markets and Interest Rates

Objectives of the Fed

Maximum sustainable
employment

Price stability

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Chapter 2 The Financial Markets and Interest Rates

Recent Interest Rate Cycles

Early 1994 & Inflation Raise interest

1997 Rates
Fall 1998 International Pressures Lower
interest rates
Summer Tight labor markets, aggregate real growth, Raise interest
1999 inflation rates
Early 2001 Contracting manufacturing output, slower Lower
business capital spending, equity market interest rates
sell-off, recession
Summer Firming Labor market, stronger retail sales, Raise interest
2004 improving industrial production, hot housing rates
market, increases in energy prices, all
suggesting unacceptable future rates of
inflation.
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Chapter 2 The Financial Markets and Interest Rates

Nonfinancial Corporate Business

Sources of Funds, 1981-2000

Changes in market
conditions
External
Funds
influence the way 27.70%
corporate funds
are raised
Example: High
interest costs Internal
discourage the use Funds
of debt. 72.30%

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Chapter 2 The Financial Markets and Interest Rates

Corporate Securities Offered for

Cash

Nonfinancial Equities
14.30%
Corporations- 3yr.
Cash Weighted
Average, 2001-
2003

Total Volume($M) Bonds

$1,288,515 and
Notes
Source:Statistical Supplement to the 85.70%
Federal Reserve Bulletin, Table 1.46,
October 2004, A29.
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Chapter 2 The Financial Markets and Interest Rates

Debt/Equity Mix

U.S. tax system favors debt as

means of raising capital

Interest expense is deductible

Dividends paid are not

deductible

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Chapter 2 The Financial Markets and Interest Rates

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.

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Chapter 2 The Financial Markets and Interest Rates

Financial Markets

Real assets are tangible assets

such as houses, equipment, and
inventories.

Financial assets represent

claims for future payments in
other economic units.

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Chapter 2 The Financial Markets and Interest Rates

Financial Markets

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.
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Chapter 2 The Financial Markets and Interest Rates

Financial Markets

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

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Chapter 2 The Financial Markets and Interest Rates

The Financing Process

Sector Funds Funds Net Funds

Raised Supplied Supplied ($)
($) ($)
Households 447.4 397.1 (50.3)
Nonfinancial 447.5 383.8 (63.7)
Corporate
Business
U.S. Govt 73.9 62.9 (11.0)
State and Local 56.4 48.4 ( 8.0)
Govts
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).
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Chapter 2 The Financial Markets and Interest Rates

Movement of Savings

Direct Transfer of Funds

Indirect Transfer of Funds Using

an Investment Banker

Indirect Transfer of Funds Using

the Financial Intermediary
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Chapter 2 The Financial Markets and Interest Rates

Three Ways to Transfer Financial

Capital in the Economy

Three Ways to Transfer Financial Capital in the Economy

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Chapter 2 The Financial Markets and Interest Rates

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

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Chapter 2 The Financial Markets and Interest Rates

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.
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Chapter 2 The Financial Markets and Interest Rates

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
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Chapter 2 The Financial Markets and Interest Rates

Organized Security Exchanges and

Over-the-Counter Markets

Organized Security ExchangesTangible

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 MarketsAll security
markets except the organized exchanges
Money Market

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Chapter 2 The Financial Markets and Interest Rates

Stock Exchange Benefits

Provides a continuous market

Establishes and publicizes fair

security prices

Helps businesses raise new capital

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Chapter 2 The Financial Markets and Interest Rates

Listing Requirements

Listing criteria varies from

exchange to exchange. General
requirements include:

*Profitability
*Market Value
*Public Ownership

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Chapter 2 The Financial Markets and Interest Rates

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.

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Chapter 2 The Financial Markets and Interest Rates

Functions of an Investment
Banker

Underwriting

Distributing

Advising

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Chapter 2 The Financial Markets and Interest Rates

Distribution Methods

Negotiated Purchase
Competitive Bid Purchase
Commission or Best Efforts Basis
Privileged Subscription
Direct Sales

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Chapter 2 The Financial Markets and Interest Rates

Private Placements

Advantages
Speed
Reduced Flotation Costs
Financing Flexibility

Disadvantages
Interest Costs
Restrictive Covenants
Possible Future SEC Registration
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Chapter 2 The Financial Markets and Interest Rates

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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Chapter 2 The Financial Markets and Interest Rates

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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Chapter 2 The Financial Markets and Interest Rates

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.

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 Chapter 2 The Financial Markets and Interest Rates

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

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Chapter 2 The Financial Markets and Interest Rates

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
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Chapter 2 The Financial Markets and Interest Rates

Rates of Return in Financial

Markets

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 powerafter adjusting for
inflation
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Chapter 2 The Financial Markets and Interest Rates

Term Structure of Interest

Rates

The relationship between a debt

securitys rate of return and the
length of time until the debt
matures.

Also called Yield to Maturity

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Chapter 2 The Financial Markets and Interest Rates

Term Structure of Interest

Rates

Explained by:

Unbiased Expectations Theory

Liquidity Preference Theory
Market Segmentation Theory

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Chapter 2 The Financial Markets and Interest Rates

Unbiased Expectations
Theory

Term Structure is determined

by an Investors expectations
about future interest rates.

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Chapter 2 The Financial Markets and Interest Rates

Liquidity Preference Theory

Investors require maturity

premiums to compensate them
for buying securities that
expose them to the risks of
fluctuating interest rates

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Chapter 2 The Financial Markets and Interest Rates

Market Segmentation Theory

Legal restrictions and

personal preferences limit
choices for investors to
certain ranges of maturities

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Chapter 2 The Financial Markets and Interest Rates

Financial Markets and

Intercountry Risk

Financial System Risk

Political System Risk

Exchange Rate Risk

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