Chapter 3 Finance

1.) Money Markets versus Capital Markets (pg.41-42)

*Money Markets*: the markets for short-term financial instruments *Capital Markets*: the markets for long-term financial instruments MONEY MARKETS: The segments of the financial markets the instruments that are traded have maturities equal to one year or less ~Include debt instrument that have maturities equal to one year or less when original issued. -Money markets include only debt instruments, b/c stocks (equities) have no specific maturities. -The primary function of the money markets is to provide liquidity to business, governments, and individuals so that they can meet their short-term needs for cash, because, in most cases, the receipt of cash inflows does not coincide exactly with the payment of cash flows. CAPITAL MARKETS: The segments of the financial markets where the instruments that are traded have maturities greater than one year. ~Include instruments with original maturities greater than one year -Capital markets include BOTH equity instruments and such long-term debt instruments as mortgages, corporate bonds, and government bonds. -The primary function of the capital markets is to provide us with the opportunity to transfer cash surpluses or deficits to future years.

(1) Raising Capital: Stage 1 Decisions (pg.46-47)

A corporation that needs to raise funds makes some preliminary decisions on its own, including the following: 1.) Dollars to be raised--- How much new capital is needed? 2.) Type of securities used--- Should stock, bonds, or a combination of these instruments be used? 3.) Competitive bid versus negotiated deal--- Should the company simply offer a block of its securities for sale to the investment banker that submits the highest bid of all interested investment bankers, or should it sit down and negotiate a deal with a single investment banker? These 2 procedures are *competitive bids* and *negotiated deals (purchases), respectively. ~Only a handful of the largest firms, whose secures are already well known to the investment banking community, are in position to use the competitive big process. 4.) Selection of an investment banker--- If the issues is to be negotiated, which investment banker should the firm use?

-Financial Markets (pg.39)

A system consisting of individuals and institutions, instruments, and procedures that bring together borrowers and savers, no matter the location. ~A conceptual mechanism rather than a physical location or a specific type of organization or structure.

Underwriting Syndicate (pg.48)

B/c investment bankers are exposed to large potential losses, an investment banker typically does not handle the purchase and distribution of an issue alone unless it is fairly small. UNDERWRITING SYNDICATE: A group of investment banking firms formed to spread the risk associated with the purchase and distribution of a new issue of securities. ~Whereby the issue is distributed to a number of investment firms around the country in an effort to minimize the amount of risk that is carried by each firm. -The investment banking house that sets up the deal is called the *lead*, or *managing*, *underwriter.* *Selling Group*: which handles the distribution of securities to individuals investors, includes all member of the underwriting syndicate plus additional dealers who take relatively small *participants* (shares of the total issue) from the syndicate members. ~The # of investment banking houses in a selling group depends partly on the size of the issue.

NASDAQ (pg.45)

Brokers and dealer who participate in the OTC market are members of a self-regulating body known as the *National Association of Securities Dealers* (NASD), which license brokers and oversees trading practices. The computerized trading network used by NASD is known as the NASD Automated Quotation system, or NASDAQ. ~Today, the NASDAQ is considered a sophisticated market of its own, separate from the OTC market. -Unlike the general OTC market, the NASDAQ include *market markers* who continuously monitor trading activities in various stocks to ensure that such stocks are available to traders who want to buy or sell them. -they have a smilier role as the designated market markers o the NYSE ~Another feature of the NASDAQ that is similar to the NYSE is that companies must meet minimum financial requirements to be *listed*, or included, on the NASDAQ; the OTC market has no such requirements.

Commercial Banks (pg.50)

Commonly referred to simply as *banks*, are traditional "department stores of finance"--- that is, they offer a wide range of products and services to a variety of customers. At the same time, banking companies offer a greater range if services than before.

3-2f Competition Among Stock Markets (pg.45-46)

Competition among the major stock markets has become increasingly fierce in recent years. In the United States, the major stock markets, especially the NYSE and NASDAQ, continuously explore ways to improve their competitive positions. 2 Factors have changed the competitive arena of the stock markets: 1.) Whereas many years ago stocks could be listed and traded on only one stock exchange, today many popular stocks are *dual listed.* DUAL LISTED: When stocks are listed for trading more than one stock market. -Dual listing increases liquidity because a stock has more exposure through greater number of outlets than if it were listed on only one market. 2.) IN 2005, the Securities and Exchange Commission adopted Regulation NMS (National Market Structure), which mandates that the *trade-through rule* be used when securities are traded. Trade-Through Rule: States that stock trade should be executed at the best price that is available in all the stock markets. ~In other words, a trade order continues to pass through the markets until the best price is reached.

2.) Debt Market versus Equity Markets (pg.42)

DEBT MARKET: Financial markets where loans are traded. ~A debt instrument is a contract that specifies how and when a borrower must repay a lender. EQUITY MARKETS: Financial markets where corporate stocks are traded. ~Equity represents "ownership" in a corporation that entitles the stockholder to share in future cash distributions generate by the firm.

4.) Derivatives Markets (pg.42)

DERIVATIVES MARKETS: Financial markets where options and futures are traded. ~Options, futures, and swaps are some of the securities traded. -These securities are called *derivatives* because their values are determined, or derived, directly from other assets. Although many investors use derivatives to speculate about the movements of prices in the finical markets, these instruments are typically employed to help manage risk. ~Individuals, corporations, and governments use derivatives to *hedge* risk by contracting to set (fix) future prices, which offsets exposures to uncertain price changes in the future.

Exchange Membership (Licenses) (pg.44)

Exchange members are chargers with different trading responsibilities, depending on which type of license (trading permit) they own. For example, trading licenses on the NYSE are classified into one of the 3 general categories: 1.) Floor Brokers: Act as agents for investors who want to buy or sell securities. Floor brokers generally are employed by brokerage firms, such as Bank of America/ Merrill Lynch. 2.) Designated Market Makers: Which previously were called specialists, are considered the most important participants in NYSE transactions because their role is to ensure that the auction trading process is completed in a fair and efficient manner. ~To accomplish this task, the designated market marker raises or lowers prices of the stocks that he or she is assigned to oversee in an effort to keep supply and demand in balance. -The designated market marker must stand ready to make market when either buyers or sellers are needed; that is, he or she might have to buy (sell) stock when not enough buyers (sellers) exist. 3.) Supplemental Liquidity Providers (SLPs): Deal with high volume trades to ensure that the best price quotes are received. SLP enhance liquidity in large block trades by maintaining continuous up-to-date prices for securities they are assigned.

3-4 Financial Intermediaries and Their Roles in Financial Markets (pg.49-51)

FINANCIAL INTERMEDIARIES: Organizations that create various loans and investments from funds provided by depositors. ~Facilitate the transfer of funds from those who have funds (savers) to those who need funds (borrowers) by *manufacturing* a variety of financial products. -When intermediaries accept funds (generally called *deposits*) from savers, they issue *securities* with such names as savings account, money market funds, and pension plans, that represent claims, or liabilities, against the institutions. -The funds received by intermediaries are, in turn, lent to businesses and individuals via debt instruments created by these institutions, which include automobile loans, mortgages, commercial loans, and similar types of debt. *Financial Intermediation*: The process by which financial intermediaries transform funds provided by savers into funds used by the borrowers. -The presence of intermediaries improves economic wellbeing. ~In fact, financial intermediaries were created to reduce the inefficiencies that would otherwise exist if users of funds could get loans only by borrowing directly from savers. Improving economic well-being is only one of the benefits associated with intermediaries. Following are other benefits: 1.) Reduced Costs: Without intermediaries, the net cost of borrowing would be greater, and the net return earned by savers would be less, b/c individuals with funds to lend would have to seek out appropriate borrowers themselves, and vice versa. ~Are most cost -efficient than individuals b/c they.. (a) create combinations of financial products that better match the fund provided by savers with the needs of borrowers. (b) spread the costs associated with these activities over large numbers of transactions, thus achieving economies of scale. 2.) Diversification (risk): The loan portfolios of intermediaries generally are well diversified, b/c they provide funds to a large number and variety of borrowers by offering many different types of loans. ~Intermediaries spread their risk by "not putting all their financial eggs in one basket." 3.) Funds Divisibility/ Pooling: Intermediaries can pool funds provided by individuals to offer loans or other financial products with different denominations and different maturities. Ex. An intermediary can offer a large loan to a single borrower by combining the funds provided by many small savers, and vice versa. 4.) Financial Flexibility: Because intermediaries offer a variety of financial products--- that is, different types of loans and saints instruments---savers and borrowers have greater choices, or financial flexibility, than can be achieved with direct placements with respect to denominations, maturities, and other characteristics. 5.) Related Services: Many intermediaries provide other financial services, such as check clearing services, insurance, retirement funds, and trust services.

Listing Requirements (pg.44)

For a stock to be traded on an exchange, it must be *listed.* ~Each exchange has establish **listed requirements**,which indicate the quantitative and qualitative characteristics that a firm must possess to be listed. LISTING REQUIREMENTS: Characteristics a firm must posses to be listed on a stock exchange. ~The quantitative and qualitative characteristics that firm must posses to be listed. ~The primary purpose of these requirements is to ensure that investors have some interest in the company so that the firm's stock will be actively traded on the exchange. A listed firm pays a relatively small annual fee to the exchange to receive such benefits as the marketability offered by continuous trading activity and the publicity and prestige associated with being an exchange-listed firm.

-Economic Efficiency (pg.40)

Funds are allocated to their optimal use at the lowest costs (interest rates) in financial markets. ~In economically efficient markets, businesses and individuals invest their funds in assets that yield the highest returns, and the costs of searching for such opportunities are lower than those observed in less efficient markets.

Shelf Registrations (pg.48)

However, a large, well-known public company (called a *seasoned company*) that frequently issues securities will often file a master registration statement with the SEC and then update it with a short-form statement just prior to each individual offering. SHELF REGISTRATION: Registration of securities with the SEC for sale at a later date. The securities are held "on the shelf" until the scale.

Maintenance of the Secondary Market (pg.49)

If a company is going public for the first time, the investment banker has an obligation to maintain a market for the shares after the issue has been completed. ~Such stocks typically are traded in the OTC market, and the lead underwriter generally agrees to "make a market" in the stock and keep it reasonably liquid.

3-1c Market Efficiency (pg.40)

If the financial markets did not provide efficient funds transfers, the economy simply could not function as it does now. It is essential that our financial markets function efficiently--- not only quickly, but also at a low cost. When we speak of *market efficiency,* we generally mean either economic efficiency or informational efficiency.

Credit Union (pg.50)

Is a depository institution that is owned by its depositors, who often are members of a common organization or association, such as an occupation, a religious group, or a community.

3-2d The Over-the-Counter (OTC) Market and NASDAQ (pg.44-45)

OVER-THE-COUNTER (OTC) MARKET: A collection of brokers and dealers, connected electronically by telephones and computers, that provide for trading in securities not listed in the physical stock exchanges. These facilitates consist of (1) the *dealers* who hold inventories of OTC securities and who are said to "make a market" in these securities ~A person or firm in the business of buying and selling securities for their own account. (2) the *brokers* who act as *agents*in bringing the dealers together with investors (3) the *electronic networks* that provide a communications link between dealers and brokers The dealers who make a market in a particular stock continuously quote a price at which they are willing to buy sot (the *bid price*) and a price at which they will sell shares (the *asked price*). ~Each dealer's price, which are adjusted as supply and demand conditions change, can be read off computer screens across the country. *Dealer's Spread*: the spread between the bid and asked prices represents the dealer's markup, or profit.

Raising Capital: Selling Procedures (pg.48-49)

Once the company and its investment banker have decided how much money to raid, the types of securities to issue, and the basis for pricing the issue, they will prepare and file a registration statement and prospectus with the SEC. REGISTRATION STATEMENT: A statement of facts filed with the SEC about a company that plans to issue securities. ~Provides financial, legal, and technical information about the company PROSPECTUS: A document describing a new security issue and the issuing company. ~Summarizes the information in the registration statement and is provided to prospective investors for use in selling the securities. When the SEC approves the registration statement and the prospectus, it merely validates that the required information has been furnished; it does not judge the quality or value of the issue.

3-2c Physical Stock Exchanges (pg.43-44)

PHYSICAL STOCK EXCHANGES: Formal organizations with physical locations that facilitate trading in designated ("listed") securities. The major U.S. stock exchange is the New York Stock Exchange (NYSE). ~Are tangible physical entities. *Mutual Ownership*: Organizations such as these, which are owned and operated by their members. ~Not-for-profit (until the late 1990s) *Demutualization*: the process of converting an exchange form mutual ownership organization to a stock ownership organization (for-profit). More than 80% of the world's developed stock markets have demutualized.

3.) Primary Markets versus Secondary Markets (pg.42)

PRIMARY MARKETS: Markets in which various organizations raise funds by issuing new securities. ~Are where "new" securities are traded ~Are the markets in which corporations raise new capital. ~The corporation selling a newly created stock receives the proceeds from the ale (less issuing costs) in primary market transaction. SECONDARY MARKETS: Markets where finical assets that have previously been issued by various organizations are traded among investors. ~Are where "used" securities are traded ~Are markets in which existing, previously issued securities are traded among investors. ~The corporation whose securities are traded in the secondary market is not involved in the transaction and therefore, does not receive any funds from the transaction; rather, funds are transferred from one investor to another investor.

3-1 What Are Financial Markets? (pg.39-41)

People who need money are brought together with those who have surplus funds un the *financial markets." -Physical Asset Markets: which deal with products such as wheat, autos, real estate, and machinery -Financial Asset Markets: stocks, bonds, mortgages,and other *claims on real assets* with respect to the distribution of the future cash flows generated by such assets.

-Abnormal Return (pg.41)

Return that exceeds what is justified by the risk associated with the investment. Ex. If you and all of your friends invest in similar-risk securities, you should all earn about the same return. However, if you earn a 20% return and your friends earn a 12% return on investments with the same risk, the additional 8% is considered an abnormal return.

3-2g Regulation of Securities Markets (pg.46)

Sale of new securities, such as stocks and bonds, as well as operations in the secondary markets, are regulated by the SEC and, to lesser extent, by each of the 50 states. For the most part, the SEC regulations are intended to ensure that investors receive fair disclosure of financial and nonfinancial information from publicly traded companies and to discourage fraudulent and misleading behavior by firms' investors, owners, and employees who might contemplate manipulating stock prices. The primary elements of SEC regulations include: (1) jurisdiction over most interstate offerings of new securities to the general investing public (2) regulation of national securities exchanges (3) power to prohibit manipulation of securities prices (deliberate manipulation of securities prices is illegal) (4) control over stock traders by corporate *insiders*, which include the officers, directors, and major stockholders of a company.

3-3b Raising Capital: Stage II Decisions (pg.47-48)

Stage II decisions, which are made jointly by the firm and its selected investment banker, include the following: 1.) Reevaluating the initial decisions--- The firm and its investment banker will reevaluate the initial deacons about the size of the issue and the type of securities to use to determine whether revisions are needed, given current market conditions. 2.) Best-efforts or underwritten issue--- The firm and its investment banker must decide whether the investment banker will work on a best-efforts basis or underwrite the issue. UNDERWRITE ARRANGEMENT: Agreement for the sale of securities in which the investment bank guarantees the sale by purchasing the securities from the issuer, thus agreeing to bear any risks involved in selling the securities in the financial markets. ~the investment banker bears significant risks BEST-EFFORTS ARRANGEMENTS: Agreement for the sale of securities in which the investment bank handling the transaction gives no guarantee that the securities will be sold. ~the issuing firm takes the chance 3.) Issuance (floatation) costs--- The investment banker's fee must be negotiated, and the firm must estimate the other expenses that will incur in connection with the issue, including lawyers' fees, accountants' costs, printing and engraving costs, and so forth. ~The investment banker will buy the issue form the company at a discount below the price at which the securities are to offered to the public. This *underwriter's spread* covers the investment banker's costs and provides for a profit. FLOTATION COSTS (Issuing Costs): The costs associated with issuing new stocks or bonds. ~Associated with public issues are higher for stocks then for bonds, and they are also higher for small issues than for large issues (because certain fixed costs exist). 3.1 Equation (pg.48): Amount of Issue= (NP)/(1-F) NP= the net proceeds from the issue F= the floatation costs stated in decimal form 4.) Setting the offering price--- If the company is already publicly owned, the *offering price* will be based on the existing market price of the stock or the yield on the firm's existing bonds.

3-1b Flow of Funds (pg.39-40)

The financial markets allow us to consume amounts different from our current incomes by providing *mechanisms* that help us transfer income through time. The ability to transfer income to different time periods allows us to pass through three financial phases during our lives that would be possible without financial markets. 1.) As young adults, we generally consumer more than our incomes to buy such items as houses and cars. To do so, we borrow based on our ability to generate future income that will be used to pay off the debt. 2.) As older working adults in the prime of our careers, we generally earn more than we consume, so we save some of our income. Such savings are often designated for use during retirement. 3.) As retired adults, we use funds accumulated in earlier years to at least partially replace income that is lost when we retire from our careers. In absence of financial markets, consumption would be restricted to income earned each year plus any amounts out aside (perhaps in a coffee can) in previous years. As a result, b/c it would be difficult to transfer income to periods prior to when it is earned, our standard of living would be lowers than exists with financial markets. Funds are transferred (flow) from those with surpluses (savers) to those with needs (borrowers) by the three different processes diagrammed in Figure 3.1 (pg.40) 1.) *Direct Transfer*: A direct transfer of money and securities, as shown in the top section, occurs when a business sells its stocks and bonds directly to savers (investors) without going through any type of intermediary or financial institution. ~The business delivers its securities to savers, who in turn provide the firm with some of the money it needs. 2.) *Investment Banking House*: As shown in the middle section, a transfer can also go through an *investment banking house,*which serves as the middleman that facilitates the issuance of securities by firms that need to raise funds. The firm's securities and the savers' money merely "pass through" the investment banking house. ~Government entities use investment bankers to help them raise needed capital in the financial markets 3.) *Financial Intermediary*: Transfers can also be made through a *financial intermediary,* such as a bank or mutual fund. In this case, the intermediary obtains funds from savers and then uses the money to lend out or to purchase another company's securities. ~Greatly increases the efficiency of the finical markets. ~Individuals use financial intermediaries to help borrow (raise) needed funds. Ex. a bank or mutual fund

-Informational Efficiency (pg.41)

The price of investments reflect existing information and adjust quickly when new information entered the markets. Informational efficiency typically is classified into one of the following 3 categories: 1.) Weak-Form Efficiency: States that all information contained in *past price movements* is fully reflected in current market prices. ~Therefore, information about pat trends (including recent ones) in investment prices is of no use in selecting "winning" investments; the fact that an investment has risen for the past 3 days, for example, gives us no clues as to what it will do today or tomorrow. 2.) Semistrong-Form Efficiency: States that current market prices reflect all *publicly available information,* whether it is historical or newly released. ~In this case, it does no good to scrutinize such published data as a corporation's financial statements to seek *abnormal returns,*b/c market prices will adjust to any good news or bed news contained in such reports as soon as they are made public. 3.) Strong-Form Efficiency: States that current market prices reflect *all pertinent

3-1a Importance of Financial Markets (pg.39)

The primary role of financial markets is to facilitate the flows of funds *from* individuals and businesses that have surplus funds *to* individuals, businesses, and governments that have needs for funds in excess of their income.

3-2 Types of Financial Markets (pg.41-46)

There are many types of financial markets, with a variety of investments and participants. ~We generally differentiate among financial markets based on the type of investments, maturities of investments, types of borrowers and lenders, locations of the markets, and type of transactions. There are too many different financial markets to discuss here. Instead, we only describe the more common classifications. 1.) Money Markets versus Capital Markets 2.) Debt Markets versus Equity Markets 3.) Primary Markets versus Secondary Markets 4.) Derivatives Markets

3-4a Types of Financial Intermediaries (pg.50-51)

This trend has caused the lines among the various types of intermediaries to become blurred. Still, some degree of institutional identity persists, and these distinctions are discussed in this section. ~Commercial Banks ~Credit Unions ~Thrift Institutions ~Mutual Funds ~Whole-Life Insurance Companies ~Pension Funds

3-2e Electronic Communications Networks (ECN)

Today many trades are executed electronically using trading systems known as electronic communications networks (ECN). ~ECNs, which are registered with the **Securities and Exchange Commission (SEC)**, are electron systems that quickly transfer information about securities transaction to facilitate the execution of ores at the best available prices. SECURITIES AND EXCHANGE COMMISSION: The U.S. government agency that regulates the issuance and trading of stocks and bonds. Investors use ECNs through accounts they have at brokerage firms that offer online trading services and subscribe to ECNs. ~When an order (buy or sell) is placed electrically, the process is seamless in the sense that nesters have no indication that an ECN is used to execute their transactions

3-2b Types of General Stock Market Activities (pg.42-43)

We generally classify basic stock market activities into three distinct categories: 1.) Trading in the outstanding, previously issued shares of established, publicly owned companies: secondary market--- 2.) Additional shares sold by established, publican owned companies: the primary market--- 3.) New public offerings by privately held firms: the initial public offering (IPO) market; the primary market---

3-3 The Investment Banking Process (pg.46-49)

When a business needs to raise funds in the financial markets, it generally enlists the service of an **investment banker**. INVESTMENT BANKER: An organization that underwrites and distributes new issues of securities; it helps businesses another entities obtain needed financing. Such Organizations Perform 3 Tasks: (1) They help corporations design securities with the features that are most attractive to investors, given existing market conditions (2) They generally buy these securities from the corporations (3) They resell the securities to investors (savers) Although the securities are sold twice, this process is actually one primary market transaction, with the investment banker acting as a middleman (agent) as funds are transferred from investors (savers) to businesses. The general procedures that are followed when stocks and bonds are issued in the finical markets with the aid of investment bankers.: (1) Raising Capital: Stage 1 Decisions (2) Raising Capital: Stage II Decisions (3) Raising Capital: Selling Procedures

3.) New public offerings by privately held firms: the initial public offering (IPO) market; the primary market--- (pg.43)

When a privately held corporation raises funds by issuing stock to the public for the first time, the company is said to be *going public,* and the market for stocks in companies that have recently gone public is called the INITIAL PUBLIC OFFERING (IPO) MARKET. INITIAL PUBLIC OFFERING (IPO) MARKET: Market consisting of stocks of privately held companies that have recently gone public for the first time.