Financial Markets and the Investment Banking Process

Chapter 3
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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 companys 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. Commission brokers
2. Independent brokers 3. Competitive traders 4. 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. Dealers hold inventory and make a market
2. Brokers act as agents in bringing together dealers with investors 3. 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. Help corporations design securities with the features that are most attractive to investors given existing market conditions. 2. Buy these securities from the corporations. 3. Then resell the securities to investors (savers).

Raising Capital: Stage I Decisions

1. Dollars to be raised
2. Type of securities used 3. Competitive bid or negotiated deal 4. Selection of an investment banker

Raising Capital: Stage II Decisions

1. Reevaluating the initial decisions
2. Best efforts or underwritten issues 3. Issuance (flotation) costs 4. 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. Jurisdiction over interstate offerings of new securities to the general public in amounts of $1.5 million or more
2. Regulates national securities exchanges, and listed companies must file annual reports

SEC Regulation
3. Control stock trades by corporate insiders
4. 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