Chapter 2The Financial Markets and Interest RatesChapter ObjectivesFederal Reserve ActionsFederal Funds RateObjectives of the FedRecent Interest Rate CyclesMarket Conditions and External FundsThe Mix of Corporate Securities in The Capital MarketDebt/Equity MixFinancial MarketsReal and Financial AssetsPowerPoint PresentationSlide 14Movement of Funds Through the EconomyStructure of U.S. Financial MarketsPrimary and Secondary MarketsMoney Market and Capital MarketOrganized Security Exchanges and Over-The –Counter MarketsBenefits of Organized ExchangesListing RequirementsInvestment BankerFunctions of an Investment BankerDistribution MethodsPrivate PlacementsMarket RegulationSecurities Exchange Act of 1934Rates of Return in Financial MarketsSlide 29Term Structure of Interest RatesSlide 31Unbiased Expectations TheoryLiquidity Preference TheoryMarket Segmentation TheoryIntercountry RiskChapter 2Chapter 2The Financial Markets and The Financial Markets and Interest RatesInterest RatesChapter ObjectivesChapter ObjectivesInternal and external source of fundsMix of corporate securities soldWhy financial markets existFinancing of businessU.S. financial market systemInvestment bankerPrivate PlacementsFlotation costsRegulationRates of Return and interest rate determinationTerm structure of interest ratesMultinational firms, efficient markets and inter-country riskFederal Reserve ActionsFederal Reserve Actions--From Feb 4, 1994 and Dec 11, 2001, the Federal Reserve System (Fed) voted to change the target funds rate on 31 occasions--Rates were moved upward 14 times--Rates were moved downward 17 times--Rates moved downward 11 consecutive times in 2001Federal Funds RateFederal Funds RateShort-term market rate of interestServes as a sensitivity indicator of the direction of future changes in interest ratesObjectives of the FedObjectives of the FedMaximum sustainable employmentPrice stabilityRecent Interest Rate CyclesRecent Interest Rate CyclesEarly 1994 and 1997Inflation Raise interest RatesFall 1998 International PressuresLower interest ratesSummer 1999 Tight labor markets, aggregate real growth, inflationRaise interest ratesEarly 2001 Slower business capital spending, equity market sell-off, recessionLower interest ratesMarket Conditions and Market Conditions and External FundsExternal FundsChanges in market conditions influence the way corporate funds are raised.Example:High interest costs discourage the use of debt.The Mix of Corporate The Mix of Corporate Securities in The Capital Securities in The Capital MarketMarketCorporate Stock is NOT the financing method most relied upon.Corporate Debt is the dominant financing methodBonds and Notes73.60%Equities26.40%Debt/Equity MixDebt/Equity MixU.S. tax system favors debt as means of raising capital—--Interest Expense is deductible--Dividends paid are not deductibleFinancial MarketsFinancial MarketsFinancial markets are institutions and procedures that facilitate transactions in all types of financial claims—facilitate the transfer of savings from economic units with a surplus to economic units with a deficit.Real and Financial AssetsReal and Financial AssetsReal Assets—Tangible assets such as houses, equipment and inventoriesFinancial Assets—Claims for future payment on other economic units—common and preferred stocksUnderwriting — the purchase of financial claims of borrowing units and re-sell at a higher price to other investors.Secondary Markets—trading in already existing financial claimsFinancial Intermediaries—Major financial institutions i.e. Commercial banks, savings and loans, credit unions, life insurance companies, mutual funds etc.Financial MarketsFinancial MarketsExist to facilitate the efficient flow of savings from the surplus sectors to deficit sectorsMovement of Funds Through Movement of Funds Through the Economythe EconomyDirect Transfer of FundsIndirect Transfer of Funds using an Investment BankerIndirect Transfer of Funds Using the Financial IntermediaryStructure of U.S. Financial Structure of U.S. Financial MarketsMarketsWhen a corporation needs to raise external capital, funds can be obtained by a:–Public Offering -where individuals and institutional investors have the opportunity to purchase securitiesor–Private Placement - where securities are sold to a limited number of investorsPrimary and Secondary Primary and Secondary MarketsMarketsPrimary Markets Securities are offered for the first time to investors – a new issue of stock. Increases the total stock of financial assets outstanding in the economy.Secondary Markets Transactions in currently outstanding securities. All transactions after the initial purchase. Sales do not affect the total stock of financial assets that exist in the economy.Money Market and Capital Money Market and Capital MarketMarketMoney Market – Short-term debt instruments with maturities of one year or less–Treasury Bills, Federal Agency Securities, Bankers Acceptances, Negotiable Certificates of Deposit, Commercial Paper.Capital Market—Long Term financial instruments with maturities than extend beyond one year. –Term Loans, Financial Leases, Corporate Equities and BondsOrganized Security Organized Security Exchanges and Over-The –Exchanges and Over-The –Counter MarketsCounter MarketsOrganized Security Exchanges—Tangible entities where financial instruments are traded on the premises–National and regional exchangesNew York Stock ExchangeAmerican Stock ExchangeChicago Stock ExchangeOver-The-Counter Markets—All security markets except the organized exchanges–Money MarketBenefits of Organized Benefits of Organized ExchangesExchangesProvides a continuous marketEstablishes and publicizes fair security pricesHelps businesses raise new capitalListing RequirementsListing RequirementsListing criteria varies from exchange to exchange. General requirements include:ProfitabilitySizeMarket ValuePublic OwnershipInvestment BankerInvestment BankerA financial specialist involved as an intermediary in the merchandising of securities—facilitates flow of savings from economic units that want to invest to those units that want to raise funds.Functions of an Investment Functions of an Investment BankerBankerUnderwritingDistributingAdvisingDistribution MethodsDistribution