Financial Markets and the Investment Banking Process

1
Financial Markets andthe Investment Banking
Process

• Chapter 3

2
Financial Markets

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

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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.

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Flow of Funds

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

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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

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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

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Market Efficiency

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

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Market Efficiency

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

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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

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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

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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

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Types of Financial Markets

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

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Types of Financial Markets

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

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Equity Markets

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

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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

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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

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The Stock Exchanges

• Organized security exchanges
• tangible physical entities
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• Chicago Stock Exchange (CHX)
• Philadelphia Stock Exchange (PHLX)

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NYSE Members

• 1. Commission brokers
• 2. Independent brokers
• 3. Competitive traders
• 4. Specialists

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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...

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Over-the-Counter Market (OTC)

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

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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

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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.

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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.

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Investment Banker

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

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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).

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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

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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

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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

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Shelf Registration

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

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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.

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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

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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

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SEC Regulation

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

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International Financial Markets

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

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End of Chapter 3

• Financial Markets and the Investment Banking
  Process