Financial Markets and the Investment Banking Process

1
Financial Markets andthe Investment Banking
Process
Chapter 3
Requests for permission to make copies of any
part of the work should be mailed to
Thomson/South-Western5191 Natorp Blvd.Mason,
OH 45040
2
Financial Markets

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

3
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.

4
Flow of Funds

• 1. Direct Transfer
• business sells its stock directly to investors

5
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

6
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

7
Market Efficiency

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

8
Market Efficiency

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

9
Informational Efficiency

• 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

10
Informational Efficiency

• 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

11
Informational Efficiency

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

12
Types of Financial Markets

• Money Markets
• instruments traded mature in one year or less
• Capital Markets
• includes instruments with maturities greater than
  one year

13
Types of Financial Markets

• Debt Markets
• treasury, corporate, mortgage-backed, money
  market, municipal, etc...
• Equity Markets
• stock markets

14
Equity Markets

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

15
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

16
Types of Stock Market Transactions

• Secondary market
• trading existing stocks
• Primary market
• existing firm issues additional shares
• Initial Public Offering (IPO)
• privately held company offers stock to the public
  for the first time
• called going public

17
The Physical Stock Exchanges

• Physical exchanges
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• Chicago Stock Exchange (CHX)
• Philadelphia Stock Exchange (PHLX)

18
NYSE Members

• Commission brokers
• Independent brokers
• Competitive traders
• Specialists

19
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...

20
Organized Investment NetworksThe
Over-the-Counter Market (OTC)

• Collection of brokers and dealers connected
  electronically
• Provides for trading in securities not listed on
  the organized exchanges

21
Over-the-Counter Market (OTC)

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

22
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.

23
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.

24
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

25
Investment Banker

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

26
Investment Banking Process

• 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).

27
Raising Capital Stage I Decisions

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

28
Raising Capital Stage II Decisions

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

29
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

30
Shelf Registration

• Securities registered with the SEC for sale at a
  later date

31
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.

32
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

33
SEC Regulation

• 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

34
SEC Regulation

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

35
International Financial Markets

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

36
End of Chapter 3

• Financial Markets and the Investment Banking
  Process