Financial Markets and the Investment Banking Process Chapter 3 Requests for permission to make copies of any part of the work should be mailed to: Thomson/South-Western.

Financial Markets andthe Investment Banking Process

Chapter 3Requests for permission to make

copies of any part of the work should be mailed to:

Thomson/South-Western5191 Natorp Blvd.Mason, OH 45040

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 timeBorrowing 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 intermediarybank or mutual fund obtains funds

from savers and uses the money to lend or purchase securities

Market Efficiency

Economic EfficiencyFunds are allocated to their optimal use at

the lowest costTransactions costs associated with buying

and selling

Market Efficiency

Information EfficiencyPrices 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 company’s

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 exchangesNew 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 syndicategroup 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