Chapter 14 & 15 Capital Markets and Investment Underwriting.
Post on 21-Dec-2015
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Agenda for today
By issuing financial instruments such as corporate bonds, common stock and preferred shares, a company may raise capital from the public.
Today’s agenda focus on
where and how to issue those financial instruments
Basic Knowledge
To issue financial instruments, we need to know about the followings:
1. Financial System
2. Market Efficiency
3. Underwriting
1. Financial System
Conceptually, a financial system consists of Providers of Capital - mainly householdsUsers of Capital - governments & businessesThe providers and users of capital are linked together by financial intermediaries such as commercial banks, trust companies, mutual funds, pension funds, insurance companies, etc
Role of Financial Intermediaries
Match supply and demand of Capital
Provide related services
Bank services - deposits, loans, currency exchange, international transfer of fund, etc
Trust company services - common stock transfer agent, handling dividend payments, managing clients’ assets, acting for bondholders, etc
Financial Market
A financial market is where the exchange between capital users and providers takes place. It may be classified into
Money market - short-term capital with maturity less than a year, e.g. T-bills, commercial papers, bankers’ acceptances
Capital market - long-term capital with maturity greater than a year, e.g. bonds, common stocks, preferred shares
Where is the Financial Market?
Wall Street in the States or Bay Street in Canada where the financial intermediaries gatherOrganized Exchanges - NYSE or TSX which facilitate the trading of various securities through a competitive auction mechanismOver The Counter Markets - OTC which is a network of brokers and dealers (big players)linked electronically for the trading of mainly bonds and money market securities (10 times the vol of OEs)
Organized Exchanges
TSX - about 100 registered brokers transact orders on behalf of buyers and sellers, 147 years old with 1600 listed equities, 3% of world capital
NYSE - largest stock exchange in the world, 208 years old with more than 3114 equity issuers
OTC Markets
Canadian Dealing Network
NASDAQ -the National Association of Securities Dealers Automated Quotation System
Is the market efficient enough?
With so many participants in the financial system, we will ask if the market is efficient enough to deal with them
By that, we mean the supply is able to meet the demand or vice versa and the price is a fair market price (i.e. no undue cost for capital users and no consistent abnormal returns for capital providers)
2. Market EfficiencyMarkets are efficient when
1. Many buyers and sellers
2. Numerous, frequent and low-cost trades
3. Security analysis is widespread
4. Prices adjust rapidly to new information
5. There is a continuous market in prices
6. Market can absorb large trade of securities
quickly and without price destabilization
Market Efficiency Hypothesis
Weak form - current market prices reflect all the information contained in past transactions (historic information), no abnormal return derived from “chartists”
Semi-strong form - security prices adjust rapidly and fully to reflect all publicly available information including historic, current and future information, no abnormal return derived from outsiders (the general public)
Market Efficiency Hypothesis cont’
Strong form - share prices reflect any relevant information including both public and private information, no abnormal return can be derived from insiders
Empirical Support
Weak form: little evidence to reject his hypothesis, i.e. little evidence that there are gains to trading using decision rules based on historic trading informationSemi-strong form: there is evidence that prices adjust fully and rapidly to new public informationStrong form: difficult to construct a test
What is the conclusion?
No definite conclusion has been made
A good topic for your Ph.D. thesis
Anyway, it seems that the markets are efficient in the semi-strong form
Underwriting
Now you know where to go to raise capital for your company and believe that the market is efficient enough
The second question is: how to raise capital
To answer this question, we need to know the underwriting mechanism
Investment Bankers
The financial intermediary between corporations and investors in general is the Investment BankersExamples: JP Morgan, Goldman SachsInvestment Bankers bring the two parties (capital users and providers) together by channeling money from one to the other
Functions of Investment Bankers
Underwriter function:- buying the security from the large corporate
issuers and reselling it to the public (Firm Commitment or Bought Deal)
- Selling security on commission basis (Best Effort - act as the agent of the issuers – small or new firms)
- Function being carried out by syndicate of investment bankers
Functions of Inv. Bankers cont’
Market maker function:- To create an available market by buying
and selling the security- To initiate trading of a new security- To inform the investors the issuance of
a new security through market trading
Functions of Inv. Bankers cont’
Advisor function:- advice on securities issues, mergers
and acquisitions, leveraged buyouts, corporate restructuring, etcBroker function:
- transact orders on behalf of buyers and sellers,
The Underwriting Process
Let’s focus on one specific area of raising capital – through IPO
Initial public offering refers to the sale of common shares to the public by the issuing firm for the first time
We say the issuing firm is ‘going public’
Advantages of going public
Greater availability of fundsPrestigeHigher liquidity for shareholders (buy and sell in the secondary market)Established price of public issues aids a shareholder’s estate planningEnables a firm to engage in merger activities more readily
Disadvantages of going public
Company information must be made public
Accumulating and disclosing information is expensive
Short-term pressure from security analysts
Embarrassment from public failure
High cost of going public (e.g. underwriting spread and flotation costs)
Underwriting Spread
Spread represents the compensation for those participating in the distribution of IPO
Spread = Public price – Issue offer price
It is shared among the participants
Spread on common stocks is greater than spread on bonds
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