Financial Markets and the Investment Banking Process Requests for permission to make copies of any part of the work should be mailed to: Thomson/South-Western 5191 Natorp Blvd.

Mason, OH 45040

Chapter 3

Financial Markets  A system comprised of individuals and institutions, instruments, and procedures that bring together borrowers and savers.

Flow of Funds  Provides the ability to transfer income through time  Borrowing sacrifices future income to increase current income.

 Saving , or investing, sacrifices current income in exchange for greater expected income in the future.

Flow of Funds  1. Direct Transfer  business sells its stock directly to investors

Flow of Funds  2. Indirect Transfer through Investment Bankers  investment banker acts as middleman and facilitates issuance of securities by reselling the securities to savers

Flow of Funds  3. Indirect Transfer through financial intermediary  bank or mutual fund obtains funds from savers and uses the money to lend or purchase securities

Market Efficiency  Economic Efficiency  Funds are allocated to their optimal use at the lowest cost  Transactions costs associated with buying and selling

Market Efficiency  Information Efficiency  Prices of investments reflect existing information and adjust quickly when new information enters the market  Three categories

Informational Efficiency 1.

 Weak-form efficiency all information contained in past price movements is fully reflected in current market prices  information about recent or past price trends is of no use when searching for abnormal returns

Informational Efficiency 2.

 Semistrong-form efficiency current market prices reflect all publicly available information   financial analysis is of no use for finding mispriced securities insiders can profit on their own company’s stock

Informational Efficiency 3.

 Strong-form efficiency current market prices reflect all pertinent information, whether publicly available or privately held  even insiders cannot earn abnormal returns

Types of Financial Markets  Money Markets  instruments traded mature in one year or less  Capital Markets  includes instruments with maturities greater than one year

Types of Financial Markets  Debt Markets  treasury, corporate, mortgage-backed, money market, municipal, etc...

 Equity Markets  stock markets

Equity Markets  Primary  corporations raise funds by issuing new securities  Secondary  securities are traded among investors after they have been issued

Derivatives Markets  Options, futures and swaps are securities whose value is determined, or derived directly from other assets  These can be used to manage risk or to speculate

Types of Stock Market Transactions 1.

 Secondary market trading existing stocks 2.

 Primary market existing firm issues additional shares 3.

  Initial Public Offering (IPO) privately held company offers stock to the public for the first time called “going public”

The Physical Stock Exchanges  Physical exchanges  New York Stock Exchange (NYSE)  American Stock Exchange (AMEX)  Chicago Stock Exchange (CHX)  Philadelphia Stock Exchange (PHLX)

NYSE Members 1.

2.

3.

4.

Commission brokers Independent brokers Competitive traders Specialists

Listing Requirements  Quantitative and qualitative characteristics a firm must possess to be listed on an exchange  Vary by exchange  Number of shareholders, number of public shares, market value of public shares, pre-tax income, etc...

Organized Investment Networks — The Over-the-Counter Market (OTC)  Collection of brokers and dealers connected electronically  Provides for trading in securities not listed on the organized exchanges

Over-the-Counter Market (OTC) 1.

2.

3.

Dealers hold inventory and make a market Brokers act as agents in bringing together dealers with investors Electronic network provides communications link

NASD  Many of the dealers and brokers of the OTC are members of the National Association of Securities Dealers (NASD), which licenses and oversees trading practices.

NASDAQ  The computerized trading network used by NASD is the NASD Automated Quotation System (NASDAQ) and is a sophisticated market of its own, separate from the OTC.

Electronic Communications Networks (ECN)  Electronic systems that transfer information about securities transactions to facilitate the execution of orders  Automatically matches buy and sell orders for a large number of transactions

Investment Banker  Organization that underwrites and distributes new issues of securities  Helps businesses and other entities obtain needed financing

Investment Banking Process 1.

2.

3.

Help corporations design securities with the features that are most attractive to investors given existing market conditions.

Buy these securities from the corporations.

Then resell the securities to investors (savers).

Raising Capital: Stage I Decisions 1.

2.

3.

4.

Dollars to be raised Type of securities used Competitive bid or negotiated deal Selection of an investment banker

Raising Capital: Stage II Decisions 1.

2.

3.

4.

Reevaluating the initial decisions Best efforts or underwritten issues Issuance (flotation) costs Setting the offering price

Selling Procedures  Registration statement  filed with the SEC  Prospectus  summarizes a new security issue and the issuing company  Underwriting syndicate  group of investment banking firms to distribute the new issue

Shelf Registration  Securities registered with the SEC for sale at a later date

Maintenance of the Secondary Market  To facilitate orderly market for the new security, the investment banker maintains a market for the security following its issue.

Regulation of Securities Markets  Securities and Exchange Commission (SEC)  U.S. government agency regulates the issuance and trading of stocks and bonds  to ensure investors receive fair financial disclosures  to discourage fraud and misleading stock manipulation

SEC Regulation 1.

2.

Jurisdiction over interstate offerings of new securities to the general public in amounts of $1.5 million or more Regulates national securities exchanges, and listed companies must file annual reports

SEC Regulation 3.

4.

Control stock trades by corporate insiders Prohibit manipulation of securities prices by pools or wash sales

International Financial Markets  Increasingly global markets  Greatest growth in emerging markets of the Pacific Rim  U. S. exchanges still dominate worldwide trading activity

End of Chapter 3 Financial Markets and the Investment Banking Process