The Financial Market and Interest Rate

firm, financial market, interest rate

What does a financial market do?

facilitate the transfer of funds from saving surplus units to saving deficit units

Fixed Income (Parts of Financial Market)

investments the provide regular fixed payments (mostly interest)

Equity/Stocks (Parts of Financial Market)

ownership shares in a company

Derivatives (Parts of Financial Market)

financial contracts whose value depends on another asset

Money Market (Fixed Income)

market for short term, low risk debt securities (< 1 year)

Bond Market (Fixed Income)

long term debt securities where issuers borrow money and pay interest

Common Stock (Equity)

shares that represent ownership and voting rights and variable dividends

Preferred Stocks (Equity)

shares with fixed dividends and priority over common stock, usually no voting rights

Options (Derivatives)

contracts giving the right (not obligation) to buy or sell an asset at a set price

Futures (Derivatives)

Contracts obligating the buyer/seller to trade an asset at a future date for a set price

Capital Market (Bond Market, Common & Preferred Stock, Options & Futures)

market for long term financing so → anything but money markets

Direct Transfer of Capital

a firm seeking funds directly approaches a wealthy investor (venture capitalist)

Indirect Transfer of Capital via Investment Banks

the investment bank acts as a link between the firm (needing funds) and the investors (with surplus funds)

Indirect Transfer via Financial Intermediary

(ex mutual fund) collect funds from savers in exchange for its own securities (indirect) the following funds are used to acquire securities from the firm

Public Offering

individuals and institutional investors have the opportunity to purchase securities

initially sold by the managing investment bank firm; issuing firm never meets ultimate buyer of securities

Private/Direct Placement

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

Primary Market (Initial Issue)

the market which new issues are sold to a limited buyer; this is the only time the issuing firm ever gets any money for the securities

SEO

seasoned equity offering; the sale of additional shares after the initial issue

Secondary Market

where previously issued securities are traded; the issuing corp does not get any money from this

Organized Securities Exchanges

tangible entities and financial instruments that are traded on its premises ex. NYSE

OTC markets

over the counter markets; securities are traded directly between parties rather than on a formal exchange

no central exchange floor, dealers/brokers used, lower listing reqs, higher risk

Function of Investment Bankers/Underwriters

financial specialists involved as an intermediary in the sale of securities

they buy entire issues of securities and sell it to the gen pop

Underwriting

assuming risk; money for securities is paid to the issuing firm before the securities are sold

Distributing

when securities from the initial firm are distributed to the ultimate investors

Advising

on timing of sale, type of security, etc.

Negotiated Purchase (Distribution Method)

firm selects banker → firm and investment banker negotiate term

Competitive Bid Purchase (Distribution Method)

several bankers bid to underwrite → firm selects highest bidder

Commission/Best-Effort Basis (Distribution Method)

issue is not underwritten; the investment banker attempts to sell the stocks in return for a commission

Privileged Subscription (Distribution Method)

investment banker markets new issue to select group

Dutch Auction (Distribution Method)

investors place bids → the price the stock is soled for becomes the lowest price at which the company can sell all the available shares

Direct Sale (Distribution Method)

issuing firm sells the securities directly to the investing public

no investment banker is involved

Flotation Costs

transaction costs incurred when a firm raises funds by issuing securites

Underwriters Spread

difference between gross and net proceeds

Future Value General Formula

FV=PV(1+r)^n

r=growth rate

Interest Rate

the amount of interest due per period as a proportion the the principle

Simple Interest

interest earned only on the principle

Compound Interest

Interest earned on the principle and interest accumulated and reinvested

Real Interest Rate

what you actually earn adjusted for inflation

Nominal Rate

stated interest rate before adjusting for inflation

Risk Premium

an additional rate of return that compensates the additional amount of risk