Foundations of Financial Management

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Foundations of Finance

Tenth Edition

Chapter 2

The Financial Markets and Interest Rates

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Learning Objectives

2.1 Describe key components of the U.S. financial market system and the financing of business.

2.2 Understand how funds are raised in the capital markets.

2.3 Be acquainted with recent rates of return.

2.4 Explain the fundamentals of interest rate determination and the popular theories of the term structure of interest rates.

Financing of Business: The Movement of Funds Through the Economy

Financial Markets: Transfer of Capital

Financial markets play a critical role in capitalist economies. 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

Figure 2.1 Three Ways to Transfer Capital in the Economy

Direct Transfer

Firm seeking funds directly approaches a wealthy investor.

For example, a new business venture seeking funding from venture capitalist.

Role of Venture Capitalist

Venture capitalist are the prime source of funding for start-up companies and companies in “turnaround” situations. Funding such ventures is very risky but carries 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.

Indirect Transfer (1 of 2)

Indirect Transfer (using investment banks)

Here the investment bank acts as a link between the firm (needing funds) and the investors (with surplus funds)

Indirect Transfer (2 of 2)

Indirect Transfer (using financial intermediary)

Here the financial intermediary (such as mutual funds) collects funds from savers in exchange for its own securities (indirect). The collected funds are then used to acquire securities (such as stocks and bonds) from the firm.

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.

Primary Markets versus Secondary Markets (1 of 2)

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 public sale of shares in August 2004.

Seasoned Equity Offering (SEO)

It refers to sale of additional shares by a company with shares that are already publicly traded. For example, Google raised $4.18 billion in September 2005.

Primary Markets versus Secondary Markets (2 of 2)

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 the SEC. Firms have to get SEC approval 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.

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, bankers’ 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

Spot Markets Versus Futures Markets

Cash Markets

This is the market in which something sells immediately.

Futures Markets

This is the market for buying and selling at some future date.

Organized Securities Exchanges

Organized Securities Exchanges are tangible entities and financial instruments are traded on its premises.

New York Stock Exchange (N Y S E, also known as “big board”) is the oldest of all the organized exchanges. In 2018, the value of the shares of stock listed in the NYSE was more than $22 trillion.

The N YS E is a hybrid market allowing face-to-face and electronic trading.

Over-the-Counter Markets

If firms do not meet the listing requirements of the exchange or wish to avoid higher reporting requirements and fees of exchanges, they may choose to trade on over-the-counter (OTC) markets.

OTC 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).

The most prominent OTC market for stocks is NASDAQ. NASDAQ lists more than 5,000 securities (including Facebook, Apple, and Amazon). Most corporate bond transactions are also conducted on OTC markets.

Stock Exchange Benefits

Provides a continuous market

Establishes and publicizes fair security prices

Helps businesses raise new capital

Selling Securities to the Public

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 underwriter’s spread.

Functions of an Investment Banker

Underwriting

Underwriting means assuming risk. Because 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.

Distribution Methods (1 of 4)

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 Purchase

Several investment bankers bid for the right to underwrite the firm’s issue. The firm selects the banker offering the highest price.

Distribution Methods (2 of 4)

Commission or Best-Efforts Basis

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.

Distribution Methods (3 of 4)

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.

Figure 2.2 A Dutch Auction Primer

Distribution Methods (4 of 4)

Direct Sale

Issuing firm sells the securities directly to the investing public.

No investment banker is involved.

Private Debt Placements (1 of 2)

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.

Private Debt Placements (2 of 2)

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

Flotation Costs

Flotation costs are transaction costs incurred when a firm raises funds by issuing securities:

Underwriter’s spread (difference between gross and net proceeds)

Issuing costs (printing and engraving of security certificates, legal fees, accounting fees, trustee fees, other miscellaneous expenses)

Sarbanes-Oxley Act (SOX)

In response to corporate scandals, Congress passed SOX in 2002.

SOX holds senior corporate advisors (such as accountants, lawyers, board of directors, officers) responsible for any instance of misconduct.

SOX 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.

Rates of Return in the Financial Markets

Long-Term Rates of Return

See Figure 2.3.

Higher returns are associated with higher risk.

Investors demand compensation for inflation and other elements of risk (such as default).

Figure 2.3 Rates of Return and Standard Deviations, 1926 to 2017

Important Definitions

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

Interest Rate Levels

Interest rate levels and inflation are displayed in Table 2.2 and Figure 2.4. We observe the following:

Inflation and interest rates have a direct relationship.

The returns are affected by the degree of inflation, default premium, maturity premium, and liquidity premium.

Table 2.1 Interest Rate Levels and Inflation Rates, 1990 through 2017 (1 of 4)

Year	3-month Treasury Bills %	30-yr Treasury Bonds %	30-yr Aaa Corporate Bonds %	Inflation Rate %
1990	7.50	8.61	9.32	5.4
1991	5.38	8.14	8.77	4.2
1992	3.43	7.67	8.14	3.0
1993	3.00	6.59	7.22	3.0
1994	4.25	7.37	7.97	2.6
1995	5.49	6.88	7.59	2.8
1996	5.01	6.71	7.37	2.9

Table 2.1 Interest Rate Levels and Inflation Rates, 1990 through 2017 (2 of 4)

Year	3-month Treasury Bills %	30-yr Treasury Bonds %	30-yr Aaa Corporate Bonds %	Inflation Rate %
1997	5.06	6.61	7.27	2.3
1998	4.78	5.58	6.53	1.6
1999	4.64	5.87	7.05	2.2
2000	5.82	5.94	7.62	3.4
2001	3.40	5.49	7.08	2.8
2002	1.61	5.43	6.49	1.6
2003	1.01	4.93	5.66	2.3
2004	1.37	4.86	5.63	2.7

Table 2.1 Interest Rate Levels and Inflation Rates, 1990 through 2017 (3 of 4)

Year	3-month Treasury Bills %	30-yr Treasury Bonds %	30-yr Aaa Corporate Bonds %	Inflation Rate %
2005	3.15	4.51	5.23	3.4
2006	4.73	4.91	5.59	3.2
2007	4.36	4.84	5.56	2.9
2008	1.37	4.28	5.63	3.8
2009	0.15	4.08	5.31	−0.4
2010	0.14	4.25	4.94	1.6
2011	0.05	3.91	4.64	3.2
2012	0.09	2.92	3.67	2.1

Table 2.1 Interest Rate Levels and Inflation Rates, 1990 through 2017 (4 of 4)

Year	3-month Treasury Bills %	30-yr Treasury Bonds %	30-yr Aaa Corporate Bonds %	Inflation Rate %
2013	0.06	3.45	4.23	1.5
2014	0.03	3.34	4.16	1.6
2015	0.23	2.97	4.06	0.1
2016	0.51	3.11	4.04	1.3
2017	1.32	2.77	3.52	2.0
Mean	2.78	5.22	6.08	2.48

Source: Federal Reserve System, Release H-15, Selected Interest Rates. Office of Inspector General c/o Board of Governors of the Federal Reserve System.

Figure 2.4 Interest Rate Levels and Inflation Rates, 1990 through 2017

Source: Federal Reserve System, Release H-15, Selected Interest Rates. Office of Inspector General c/o Board of Governors of the Federal Reserve System.

Observations from Table 2.1 and Figure 2.4

Between 1990 and 2017:

Average inflation premium = 2.48%

Average default risk premium = 0.86%

Average maturity risk premium = 2.44%

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 these risk premium factors. Such knowledge is critical when companies set an interest rate for their issues.

Real and Nominal Rates

Real risk-free interest rate = risk-free rate − inflation premium

Nominal interest rate ≈ 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.

The Term Structure of Interest Rates

Figure 2.5 shows the relationship between a debt security’s 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. An upward-sloping curve is most commonly observed.

Figure 2.5 The Term Structure of Interest Rates

Figure 2.6 Changes in the Term Structure of Interest Rates around September 11, 2001

Source: Federal Reserve System, Release H-15, Office of Inspector General c/o Board of Governors of the Federal Reserve System.

Figure 2.7 Historical Term Structures of Interest Rates for Government Securities

Source: Federal Reserve System, Release H-15, Office of Inspector General c/o Board of Governors of the Federal Reserve System.

What Explains the Shape of the Term Structure? (1 of 3)

The Unbiased Expectations Theory

Term structure is determined by an investor’s expectations about future interest rates.

What Explains the Shape of the Term Structure? (2 of 3)

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.

What Explains the Shape of the Term Structure? (3 of 3)

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.

Key Terms (1 of 5)

Angel investor

Basis point

Capital markets

Default-risk premium

Direct sale

Dutch auction

Flotation costs

Futures market

Key Terms (2 of 5)

Initial public offering (I P O)

Inflation premium

Investment banker

Liquidity preference theory

Liquidity-risk premium

Market segmentation theory

Maturity-risk premium

Money market

Key Terms (3 of 5)

Nominal (or quoted) rate of interest

Opportunity cost of funds

Organized security exchanges

Over-the-counter markets

Primary market

Private placement

Privileged subscription

Public offering

Key Terms (4 of 5)

Real rate of interest

Real risk-free interest rate

Seasoned equity offering (S E O)

Secondary market

Spot market

Syndicate

Term structure of interest rates

Unbiased expectations theory

Key Terms (5 of 5)

Underwriting

Underwriter’s spread

Venture capitalist

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