Finance Chapter 2 The Financial Markets and Interest Rates Terms

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the process of marketing a new security issue to a select group of investors.

Underwriting

the purchase of a new security issue. The risk of selling the new issue at a satisfactory (profitable) price is assumed (underwritten) by the investment banker.

Term structure of interest rates (yield curve)

the relationship between interest rates and the term to maturity, where the risk of default is held constant.

Seasoned equity offering (SEO)

the sale of additional stock by a company whose shares are already publicly traded.

Direct sale

the sale of securities by a corporation to the investing public without the services of an investment-banking firm. (very rare)

Market segmentation theory

the theory that the shape of the term structure of interest rates implies that the rate of interest for a particular maturity is determined solely by demand and supply for a given maturity. This rate is independent of the demand and supply for securities having different maturities. INVESTORS ARE LIMITED TO CERTAIN MATURITY RANGES DUE TO LEGAL RESTRICTIONS AND PERSONAL PREFERENCES.

Liquidity preference theory

the theory that the shape of the term structure of interest rates is determined by an investor's additional required interest rate in compensation for additional risks.

unbiased expectations theory

the theory that the shape of the term structure of interest rates is determined by an investor's expectations about future interest rates.

Flotation costs

the transaction costs incurred when a firm raises funds by issuing a particular type of security.

Underwriter's spread

the difference between the price the corporation raising money gets and the public offering price of a security.

The least liquid current asset is...

...inventory

Initial Public Offering (IPO)

the first time a company issues its stock to the public.

Best-effort basis

Here the securities are not underwritten. The investment banker attempts to sell the issue in return for a fixed commission on each security actually sold. Unsold securities are then returned to the corporation. Used for more speculative issues.

Sarbanes-Oxely Act (SOX)

Holds corporate advisors who have access to or influence on company decisions (such as a firm's accountants, lawyers, company officers, and boards of directors) legally accountable for any instances of misconduct.

What are the basic functions of an investment banker?

1. underwriting 2. distributing 3. advising.

Nominal (or quoted) rate of interest

the interest rate paid on debt securities without an adjustment for any loss in purchasing power.

Opportunity cost of funds

the next best rate of return available to the investor for a given level of risk.

What are SECURITIES?

Financial Assets that companies sell to raise capital. Investors purchase them hoping to earn a high rate of return.

Suppose your firm selects an investment banking firm to assist with your firm's 50 million dollar bond issue. The investment bank will buy the entire issue and sell each new and to investors. This distribution method is referred to as:

A negotiated price.

Over-the-counter market

All security markets except organized security exchanges. A network of brokers and dealers linked by computer. (NASDAQ)

Since there is a virtual certainty that the U.S. government will pay interest on Treasury securities and will redeem them at face value when they mature, Treasury securities are free of any

Default risk.

Secondary market

Investors buy and sell existing securities.

Liquidity Preference Theory

Investors require maturity premiums to invest in longer term securities.

Capital market

Market for long-term financial instruments. (loans, stocks, bonds.)

Money market

Market for short term (less than 1 year) debt instruments. (treasury bills, negotiable CDs, commercial paper.) LOW RATE OF RETURN

Fisher Effect

Mathematically: (1+Krf)=(1+k*)(1+IRP) Conceptually: Nominal risk-free Interest Rate (Krf) = Real risk-free Interest Rate (k*) + Inflation risk premium (IRP)

Competitive bid purchase

Several underwriters bid for the right to purchase the new issue from the corporation that is raising funds.

Who are the true owners of a corporation?

Stockholders

which of the following is true regarding the over-the-counter market?

The otc brokers and dealers are linked by NASDAQ

Unbiased Expectations Theory

The term structure is determined by expectations of future rates.

Term Structures of Interest Rates

The yield curve may be downward sloping or "inverted" if rates are expected to fall.

Market Segmentation Theory

There are separate markets for long and short term investments.

Negotiated purchase

This is the most prevalent method of securities distribution in the private sector.

Types of securities

Treasury Bills and Treasury Bonds, Municipal Bonds, Corporate Bonds, Preferred Stocks, Common Stocks.

Investment banker

a financial specialist who underwrites and distributes new securities and advises corporate client about raising new funds.

Syndicate

a group of investment bankers who contractually assist in the buying and selling of a new security issue.

Dutch auction

a method of issuing securities (common stock) by which investors place bids indicating how many shares they are willing to buy and at what price. The price the stock is then sold for becomes the lowest price at which the issuing company can sell all the available shares.

Inflation premium

a premium to compensate for anticipated inflation that is equal to the price change expected to occur over the life of the bond or investment instrument.

Angel Investor

an affluent individual that provides capital for a start-up, usually in exchange for convertible debt or owner equity.

Venture Capitalist

an investment firm (or individual investor) that provides money to business start-ups.

Primary market

corporation receives money by selling new securities, often to an investment bank.

Organized security exchange

formal organization for buying and selling securities. (NYSE, AMEX, regional exchanges)

Spot market

market where something sells today. (also called the cash market)

Futures market

market where you can buy or sell something at some future date. DERIVATIVE

Basis point

one basis point is equal to 1/100th of 1 percent or 0.01

Profit maximization does no adequately describe the goal of the firm because:

profit maximization does not consider the riskiness of returns, profit maximization ignores the timing of returns.

Real rate of interest

the nominal (quoted) rate of interest less any loss in purchasing power of the dollar during the time of the investment.

Real risk-free interest rate

required rate of return on a fixed-income security that has no risk in an economic environment of zero inflation.

Public Offering

securities are offered and made available to all individuals and institutions

Private placement

securities are offered and sold directly to a limited number of investors

liquidity-risk premium

the additional return required by investors for securities that cannot be quickly converted into cash at a reasonably predictable price.

Maturity-risk premium

the additional return required by investors in longer-term securities to compensate them for the greater risk of price fluctuations on those securities caused by interest rate changes.

default-risk premium

the additional return required by investors to compensate the for the risk of default. It is calculated as the difference in rates between a U.S. Treasury bond and a corporate bond of the same maturity and marketability.