Finance Concepts and Financial Markets Overview

Developing Skills for Your Career

Overview of Finance Skills

  • Finance skills are essential across all career paths.
  • This course will cover:
    • Critical thinking skills
    • Excel skills
    • Data analysis skills
    • Collaboration and communication skills

Basics of Finance

Chapter 2: The Financial Markets and Interest Rates

Learning Objectives
  1. Describe the key components of the financial market system and business financing.
  2. Understand how funds are raised in the capital markets.
  3. Be acquainted with recent rates of return.
  4. Explain the fundamentals of interest rate determination and theories of the term structure of interest rates.

Financing of Business

The Movement of Funds Through the Economy

  • Financial markets facilitate the transfer of capital in capitalist economies.
    • They transfer funds from surplus units (those with extra money) to deficit units (those in need of funds).

Three Ways to Transfer Capital

  1. Direct Transfer: Firm seeking funds approaches an investor directly (e.g., a venture capitalist funding a startup).
  2. Indirect Transfer via Investment Banker: Investment banks act as intermediaries between firms and investors.
  3. Indirect Transfer via Financial Intermediary: Financial intermediaries collect funds from savers and invest them in securities.

Types of Offerings

Public Offerings vs. Private Placements

  • Public Offering: Securities are available for both individual and institutional investors. The issuing firm does not meet the ultimate purchasers.
  • Private Placement: Securities are sold directly to a limited number of investors, typically avoiding public offering protocols.

Primary vs. Secondary Markets

  1. Primary Market: New securities are sold to initial buyers (e.g., Google's public sale raised $1.76 billion in 2004).
  2. Secondary Market: Previously issued securities are traded (e.g., existing Google stock being traded among investors). The issuing corporation does not receive funds from secondary trades. Both markets are regulated by the SEC.

Money Market vs. Capital Market

  • Money Market: Short-term debt instruments with maturities of one year or less (e.g., Treasury bills, commercial paper).
  • Capital Market: Long-term financial securities with maturities greater than one year (e.g., corporate bonds, common stocks).

Market Types

  • Spot Markets: Transactions take place immediately.
  • Futures Markets: Transactions occur at a future date.

Over-the-Counter (OTC) Markets

  • OTC markets are for securities not meeting organized exchange requirements and are facilitated by broker-dealers. The most prominent OTC market for stocks is NASDAQ.

Benefits of Stock Exchanges

  • Continuous market presence.
  • Fair pricing of securities.
  • Assist businesses in raising new capital.

Investment Banking Functions

Role of Investment Bankers

  • Underwrite: Investment banks buy securities from issuers and sell them to the public, assuming the risk.
  • Distribute: Securities are distributed to the final investors.
  • Advise: Provide advice on timing and types of security offerings.

Distribution Methods

  1. Negotiated Purchase: Firm chooses an investment banker to negotiate terms of the offer.
  2. Competitive Bid: Investment bankers bid for the right to underwrite the offering.
  3. Best Efforts Basis: The investment bank sells stocks without assuming risk.
  4. Direct Sale: Issuers sell directly to the public, bypassing investment bankers.

Private Debt Placements

  • Raising money directly from sophisticated investors (e.g., insurance companies).
  • Advantages: Faster capital raising, lower flotation costs, flexible financing.
  • Disadvantages: Higher interest rates than public issues, restrictive covenants, potential future SEC registration.

Flotation Costs

  • Transaction costs associated with issuing securities, including underwriting spreads and issuing costs (legal fees, printing).

Rates of Return in Financial Markets

Long-Term Rates of Return
  • Higher returns are linked with higher risk; investors seek compensation for risks such as inflation and default risk.
Important Definitions
  • Opportunity Cost: Rate of return of the next best investment alternative.
  • Standard Deviation: Measure of the variability around the mean return.
  • Real Return: Return earned above inflation.
  • Risk Premiums: Compensations required for bearing various types of risks in securities.
Interest Rate Levels
  • There is a direct relationship between interest rates and inflation.
  • Factors affecting returns: inflation rate, premium for default risk, maturity premium, liquidity premium.
Key Observations
  • Average inflation premium, default risk premium, and maturity risk premium were calculated for the period 1990-2017.

Interest Rate Determinants

Formula for Nominal Rate
  • extNominalInterestRate=extRealRisk−FreeRate+extInflationPremium+extDefault−RiskPremium+extMaturity−RiskPremium+extLiquidity−RiskPremiumext{Nominal Interest Rate} = ext{Real Risk-Free Rate} + ext{Inflation Premium} + ext{Default-Risk Premium} + ext{Maturity-Risk Premium} + ext{Liquidity-Risk Premium}

Real vs. Nominal Rates

  • The real rate is adjusted for inflation, representing the actual purchasing power of investment returns.

Term Structure of Interest Rates

  • Reflects the relationship between rate of return on securities and maturity duration with a constant default risk.
  • Three possible shapes:
    1. Upward Sloping: Longer-term securities yield higher returns.
    2. Flat: Equal returns for varying securities.
    3. Inverted: Longer-term yields lower than short-term.

Theories Explaining Term Structure

  1. Unbiased Expectations Theory: Rates are based on future interest expectations.
  2. Liquidity Preference Theory: Investors demand maturity-risk premiums for long-term securities.
  3. Market Segmentation Theory: Rate determined by supply and demand for particular maturities.
Key Terms
  1. Angel investor
  2. Basis point
  3. Capital markets
  4. Default-risk premium
  5. Direct sale
  6. Flotation costs
  7. Initial public offering (IPO)
  8. Investment banker
  9. Liquidity preference theory
  10. Maturity-risk premium
  • Additional Terms in Economics: Nominal Rate, Real Rate, Underwriting, Venture Capitalist…