Chapter 2 Role of Financial Markets and Interest Rates - PowerPoint PPT Presentation

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Chapter 2 Role of Financial Markets and Interest Rates

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Long-term rates of return. 2. Federal Reserve System (Fed) ... MM treasury bills, commercial paper, CD's. CM long-term (stocks, bonds, mortgages) ... – PowerPoint PPT presentation

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Title: Chapter 2 Role of Financial Markets and Interest Rates


1
Chapter 2 Role of Financial Markets and
Interest Rates
  • Key sections
  • Sources of funds used by corporations
  • Role and types of financial markets
  • Investment banking
  • Private placements
  • Long-term rates of return

2
Federal Reserve System (Fed)
  • The US central bank oversees financial system
    and controls monetary policy. Objectives
  • Full employment of resources
  • Reasonable price stability
  • Sustainable economic growth
  • Stable balance of payments

3
Fed Funds Rate - A Benchmark Rate
  • Rate on overnight loans between banks
  • Influences other rates
  • Increase in rates tend to slow growth and
    inflation

4
Where Companies Get Money
  • Externally generated (stocks, bonds, bank loans)
  • External 28 internal 72 (from profits and
    depreciation)
  • Mix of new corporate securities about 75 from
    debt, 25 from equity
  • Debt is more tax efficient

5
Internal/External Mix
6
Debt/Equity Mix
7
Why Financial Markets Exist
  • Markets institutions and procedures
    facilitating transactions in financial assets
  • Some sectors are net suppliers of funds others
    are net users
  • Markets allocate the supply of savings
  • These institutions bridge gap between
    savers/borrowers

8
Corporate Financial System
  • Public offerings versus private placements
  • Primary markets trade new securities secondary
    markets trade existing ones
  • Money and capital markets (MM under one year CM
    one year plus)
  • MM treasury bills, commercial paper, CDs
  • CM long-term (stocks, bonds, mortgages)

9
Types of Markets
  • Organized exchanges such as NYSE
  • Has trading facilities. Members, listing
    requirements
  • Over-the-counter markets - decentralized
  • Electronic trading between dealers
  • More OTC stocks more on exchanges
  • NASDAQ shows bid and offer prices

10
Investment Banks
  • Intermediaries raise funds for users, sell new
    securities to investors. Activities
  • Underwriting buy whole issue at a fixed price
    may use syndicate to reduce risk
  • Distribution sale of the new securities
  • Advising capital structure, MA
  • Make secondary markets
  • Major players Citi, Merrill, CS/FB, M-S, GS

11
Private Placements
  • Purchased by small number of large, sophisticated
    investors
  • Life insurance companies and pension funds
  • Limited trading
  • Advantages speed (no SEC), lower flotation
    costs flexible structures
  • Disadvantages higher interest cost, restrictive
    covenants, illiquid

12
Flotation Costs
  • Underwriters spread and out-of-pocket costs
  • Paid for risk and efforts
  • Difference between what investors pay and what
    company receives
  • Higher on stocks greater risk
  • 7½ on IPOs
  • declines with issue size

13
Securities and Exchange Commission (SEC)
  • Federal regulatory body governing operation of
    securities markets and securities sold to public
  • Areas covered
  • Sale of new securities
  • Registration statement and prospectus
  • Requires reports from securities issuers
  • Operation of markets - underwriting, trading
    (including insiders) and broker activities

14
Market Regulation Securities Act of 1933
  • Requires investors receive accurate and truthful
    info about issuer and security
  • SEC does not evaluate quality nor prevent sale of
    risky securities
  • Registration can be a time-consuming process
  • Exemptions short-term issues and PPs

15
Other Legislation
  • Securities Act of 1934 regulates secondary
    markets
  • Investment Company Act of 1940
  • Covers mutual funds and advisors
  • Securities Act Amendments 1975
  • National Market System consolidated tape
  • Rule 415 (shelf registration) and 144A

16
SIPC
  • Securities Investor Protection Corp.
  • Federal agency but not like FDIC
  • Does not protect against loss of value
  • Replaces securities stolen by a broker or loss
    through failure of a brokerage holding your
    securities.
  • Up to 500,000 99 recovery rate.

17
Returns Over Long Periods
  • Understand relative returns and relative risk
  • Inflations impact
  • Standard deviation measures risk
  • Trends in interest rates

18
Risks and Returns
19
Annual Rates of Return 1926 to 2000
  • Avg Ann Stand
    Risk
  • Security Returns Dev
    Prem
  • Small Co Stocks 17.3 33.4 13.4
  • Common Stock 13.0 20.2
    9.1
  • L-T Corp Bonds 6.0 8.7
    2.1
  • L-T Govt Bonds 5.7 9.4
    1.8
  • Med-term Govt 5.5 5.8
    1.6
  • US T-Bills 3.9 3.2
    0
  • Inflation 3.2 4.4

20
2004
  • Dow 30 Industrials 3.15
  • SP 500 8.99
  • SP small cap 21.59
  • Treasury bonds flat
  • Dollar down

21
2005
  • My guess stocks up modestly (5 to 10) bonds
    down
  • Wild cards
  • Inflation
  • Corporate earnings
  • Interest rates
  • Exchange rates

22
Returns Affected By
  • Starts with risk free rate (no inflation) adds
    premiums for
  • Inflation risk
  • Default risk
  • Maturity premium
  • Liquidity premium
  • s Nominal or quoted rate

23
Term Structure
  • Relation between bonds interest rate and its
    maturity
  • Securities that are exactly the same (Treasuries)
  • Yield curve graphic representation of YTM
  • Most often has positive slope long-term rates
    higher than short-term

24
Yield Curves
25
Financial Markets MNCs
  • Markets increasingly globalized
  • More sources of funds and liquidity
  • US companies can borrow in Japan to invest in
    Europe
  • Under developed economies lack financial markets
    cost of capital is high
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