Financial Market

Description

This week’s overarching topic is the financial market environment. Please share your observations and takeaways of this week’s learning objectives as they relate to your job/role. How does the financial market environment impact you personally and/or what impact does this environment have on your professional role?“Your initial post should comprise a minimum of 250 words supported by at least two (2) scholarly peer-reviewed references

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Principles of Managerial Finance
Sixteenth Edition
Chapter 2
The Financial Market Environment
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Pearson Education, Inc. All Rights
Reserved.
Learning Goals (1 of 2)
LG 1 Understand the role that financial institutions play in
managerial finance.
LG 2 Understand the role that financial markets play in
managerial finance.
LG 3 Describe the differences between the money
market and the capital market.
LG 4 Understand the major regulations and regulatory
bodies that affect financial institutions and markets.
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Learning Goals (2 of 2)
LG 5 Describe the process of issuing common
stock, including venture capital, going public,
and the role of the investment bank.
LG 6 Understand what is meant by financial
markets in crisis, and describe some of the
root causes of the Great Recession.
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2.1 Financial Institutions (1 of 2)
•
•
•
Financial institutions are intermediaries that channel
the savings of individuals, businesses, and
governments into loans or investments.
The key suppliers and demanders of funds are
individuals, businesses, and governments.
In general, individuals are net suppliers of funds,
while businesses and governments are net
demanders of funds.
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2.1 Financial Institutions (2 of 2)
•
Commercial Banks, Investment Banks, and the Shadow Banking
System
• Commercial Banks
• Institutions that provide savers with a secure place to
invest their funds and that offer loans to individual and
business borrowers
• Investment Banks
• Assist companies in raising capital, advise firms on major
transactions such as mergers or financial restructurings,
and engage in trading and market-making activities
• Shadow Banking System
• A group of institutions that engage in lending activities,
much like traditional banks, but that do not accept deposits
and therefore are not subject to the same regulations as
traditional banks
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Matter of Fact (1 of 2)
Consolidation in the U.S. Banking Industry
The U.S. banking industry has been going through a long
period of consolidation. According to the Federal Deposit
Insurance Corporation (F D I C), the number of
commercial banks in the United States declined from
14,400 in early 1984 to 4,492 by October 2019, a decline
of almost 69%. The decline is concentrated among small
community banks, which larger institutions have been
acquiring at a rapid pace.
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2.2 Financial Markets (1 of 14)
• The Relationship Between
Institutions and Markets
• Financial markets are forums in which suppliers of
•
•
•
funds and demanders of funds can transact business
directly
Transactions in short-term marketable securities take
place in the money market while transactions in longterm securities take place in the capital market
A private placement involves the sale of a new security
directly to an investor or group of investors
Most firms, however, raise money through a public
offering of securities, which is the sale of either bonds or
stocks to the general public
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2.2 Financial Markets (2 of 14)
• The Relationship Between Institutions
and Markets
• The primary market is the financial market in which securities
•
are initially issued; the only market in which the issuer is
directly involved in the transaction
Secondary markets are financial markets in which preowned
securities (those that are not new issues) are traded
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Figure 2.1 Flow of Funds
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2.2 Financial Markets (3 of 14)
• The Money Market
• A market where investors trade highly liquid securities
with maturities of one year or less
• Most money market transactions are made in
marketable securities which are short-term debt
instruments, such as:
U.S. Treasury bills issues by the federal government
Commercial paper issued by businesses
Negotiable certificates of deposit issued by financial
institutions
Investors generally consider marketable securities to be
among the least risky investments available.
•
•
•
•
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2.2 Financial Markets (4 of 14)
•
The Money Market
• Eurocurrency Market
• International equivalent of the domestic money market
• It is a market for short-term bank deposits denominated in
U.S. dollars or other major currencies
• Nearly all Eurodollar deposits are time deposits
• The bank promises to repay the deposit, with interest,
at a fixed date in the future (e.g., six months)
• During the interim, the bank is free to lend this dollar
•
deposit to creditworthy corporate or government
borrowers
If the bank cannot find a borrower on its own, it may
lend the deposit to another international bank.
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2.2 Financial Markets (5 of 14)
• The Capital Market
• A market that enables suppliers and demanders of longterm funds to make transactions
• Key Securities Traded: Bonds and Stocks
• Securities traded in the capital market fall into two
broad categories: debt and equity
• Bonds
• Long-term debt instruments used by business and
government to raise large sums of money,
generally from a diverse group of lenders
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2.2 Financial Markets (6 of 14)
• The Capital Market
• Key Securities Traded: Bonds and Stocks
• Common Stock
• Units of ownership interest, or equity, in a
corporation
• Preferred Stock
• A special form of ownership that has features of
both a bond and common stock
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2.2 Financial Markets (7 of 14)
•
The Capital Market
• Broker Markets and Dealer
Markets
• Securities Exchanges
• Organizations that provide the marketplace in which
•
firms can raise funds through the sale of new securities
and in which purchasers can resell securities
Broker Markets
Securities exchanges in which the two sides of a
transaction, the buyer and the seller, are brought
together to trade securities
Trading takes place on centralized trading floors of
national exchanges, such as NYSE Euronext, as well
as regional exchanges
•
•
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2.2 Financial Markets (8 of 14)
• The Capital Market
• Broker Markets and Dealer Markets
• Dealer Markets
• Markets, like the NASDAQ, in which the
•
buyer and seller are not brought together
directly but instead have their orders
executed by securities dealers who “make
markets” in the given security
The dealer market has no centralized trading
floors
It is made up of a large number of market
makers who are linked together via a
mass-telecommunications network
•
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2.2 Financial Markets (9 of 14)
• The Capital Market
• Broker Markets and Dealer Markets
• Dealer Markets
• As compensation for executing orders,
market makers make money on the bid/ask
spread (ask price – bid price)
Ask Price: The lowest price a seller is
willing to accept for a security
Bid Price: The highest price a buyer is
willing to pay for a security
•
•
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Example 2.1
Mark instructs his broker to submit a market order to buy
100 shares of Facebook common stock. At the time, the
ask price for Facebook is $168.79, and the bid price is
$168.71. Remember, the ask price is the lowest price
offered in the market to sell Facebook to a potential
buyer. Since Mark is trying to buy Facebook stock, and
he wants to buy at the lowest possible price, he will pay
$168.79, plus whatever commissions his broker charges.
If, however, Mark already owned Facebook stock and
wanted to sell it, he would be looking for the market’s
best offer to buy, the bid price. In that case, Mark would
sell his shares for $168.71, less commissions charged by
the broker.
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Personal Finance Example 2.2 (1 of 3)
Assume that the current bid price for Merck & Co. stock
is $83.55 and the ask price is $83.99. Suppose you have
an E*TRADE brokerage account that charges a $25
commission for equity trades placed through a broker.
What is the current bid/ask spread for Merck?
Bid/Ask Spread = Ask Price – Bid Price ( 2.1)
Bid/Ask Spread = $83.99 – $83.55 = $0.44
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Personal Finance Example 2.2 (2 of 3)
Inserting the current bid and ask prices into Equation 2.1,
you find that the bid/ask spread for Merck is $0.44. What
would your total transaction costs be if you purchased
100 shares of Merck by submitting a market order via
your E*TRADE broker? Assume the trade is sent to a
broker market for execution, and the market maker
matches your order with a 100-share sell order for Merck
from another investor. In this case your order will be
executed at the midpoint of the bid/ask spread ($83.77),
so you will pay only the brokerage commission.
Total Transaction Costs = Brokerage Commission = $25
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Personal Finance Example 2.2 (3 of 3)
Now what would your total transaction costs be if you
purchased 100 shares of Merck by submitting a market
order via your E*TRADE account, and it is routed to a
dealer market for execution?
Total Transaction Costs = ( Number of shares  ½  Bid / Ask Spread )
+ Brokerage Commission
= (100  ½  $0.44 ) + $25
= $22 + $25 = $47
Depending on where your brokerage routes your order, you find
that your total transaction costs are either $25 in a broker market
or $47 in a dealer market.
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Matter of Fact (2 of 2)
NYSE Is the World’s Largest Stock Exchange
According to The World Federation of Exchanges, in
2020 the world boasted 77 major stock exchanges with a
combined total market value of $88 trillion. The largest
stock market in the world, as measured by the total
market value of securities listed on that market, is the N Y
S E, with listed securities worth more than $24 trillion, or
about 27% of the total market value for all major
exchanges globally. The
N Y S E’s total market
capitalization is larger than the total market
capitalizations of the world’s 50 smallest major
exchanges combined. The next largest is the Nasdaq at
$11 trillion, with exchanges in Tokyo and Shanghai not
far behind at $6 trillion and $4 trillion, respectively.
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2.2 Financial Markets (10 of 14)
•
The Capital Market
• International Capital Markets
• Eurobond Market
• The market where corporations and governments
•
•
typically issue bonds denominated in dollars and
sell them to investors located outside the United
States.
Foreign Bond Market
A market for bonds issued by a foreign
corporation or government that is denominated in
the investor’s home currency and sold in the
investor’s home market
International Equity Market
Allows corporations to sell blocks of shares to
investors in a number of different countries
simultaneously
•
•
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2.2 Financial Markets (11 of 14)
• The Efficient Markets Hypothesis
• An efficient market establishes prices for securities by
rapidly incorporating all available information.
• A security’s price is an unbiased estimate of its true
or intrinsic value
• “correct on average”
• Information in Efficient Markets
• Prices respond to new information, and by definition,
new information is unpredictable
• New information refers to things that market
participants do not know today and cannot predict
based on other information that they possess.
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Figure 2.2 Walmart’s Quarterly
Revenue from 2000 to 2020
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Figure 2.3 Walmart’s Stock Price at Each
Quarter End, 2000 to 2020
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2.2 Financial Markets (12 of 14)
• The Efficient Markets Hypothesis
• Price Movements in Efficient Markets
• Random Walk Hypothesis is the idea that in an
efficient financial market, prices should be virtually
unpredictable because they move in response to new
information, which is itself unpredictable.
Even if a company’s financial results follow a
highly predictable pattern, its stock price will not
follow the same pattern (or perhaps even any
pattern)
If stock prices do exhibit predictable patterns, the
actions of investors will tend to eliminate those
patterns over time
•
•
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2.2 Financial Markets (13 of 14)
•
•
The Efficient Markets Hypothesis
Price Movements in Efficient Markets
• The price of an individual security is determined by
the interaction of buyers and sellers in the market.
• The stock price is the best available estimate of
the stock’s true value.
• Investors compete with each other for information
about a stock’s true value, so at any given time, a
stock’s price reflects all information known about
the stock.
The more efficient the markets is, the more
rapidly this whole process works.
That relatively few professional managers
outperform the overall market consistently is
exactly what the efficient markets hypothesis
predicts.
•
•
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2.2 Financial Markets (14 of 14)
• The Efficient Markets Hypothesis
• The Behavioral Finance Challenge to Efficient Markets
• Behavioral finance is an emerging field that blends
ideas from finance and psychology, arguing that stock
prices and prices of other securities can deviate from
their true values for extended periods and that these
deviations may lead to predictable patterns in stock
prices.
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2.3 Regulation of Financial Markets
and Institutions (1 of 4)
• Regulations Governing Financial
Institutions
• Glass-Steagall Act
• Prohibited institutions that took deposits from
•
engaging in activities such as securities underwriting
and trading, thereby effectively separating
commercial banks from investment banks
Federal Deposit Insurance Corporation (FDIC)
An agency created by the Glass-Steagall Act that
provides insurance for deposits at banks and
monitors banks to ensure their safety and soundness
•
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•
•
2.3 Regulation of
Financial Markets and
Institutions (2 of 4)
Regulations Governing Financial Institutions
Gramm-Leach-Bliley Act
•
• Allows mergers between commercial banks,
investment banks, and insurance companies and thus
permits these institutions to compete in markets that
prior regulations prohibited them from entering
• Realigns the duties of several existing agencies and
Dodd-Frank Wall Street Reform and Consumer Protection Act
•
requires existing and new agencies to report to
Congress regularly
Nearly a decade after Dodd-Frank became law, the
various agencies affected or created by the new law
were still writing rules specifying how the new law’s
provisions would be implemented
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•
•
2.3 Regulation of
Financial Markets and
Institutions (3 of 4)
Regulations Governing Financial Markets
Securities Act of 1933
•
• Regulates the sale of securities to the public via the
primary market
• Requires sellers of new securities to provide
extensive disclosures to the potential buyers of those
securities
• Regulates the trading of securities in the secondary
market
• Created the Securities and Exchange Commission
• Requires ongoing disclosure by companies whose
Securities Exchange Act of 1934
•
securities trade in secondary markets (e.g., 10-Q, 10K)
Imposes limits on the extent to which “insiders” can
trade in their firm’s securities
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2.3 Regulation of
Financial Markets and
Institutions (4 of 4)
• Regulations Governing Financial
Markets
• Securities and Exchange Commission
• The primary government agency responsible for
enforcing federal securities laws
• Stop Trading on Congressional Knowledge (STOCK) Act
of 2012
• Prohibits members of Congress from trading based
•
on inside information they receive while performing
their official duties.
Required financial disclosures made by members of
Congress be posted in a searchable online database
(phased out one year later)
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2.4 The Securities Issuing Process
(1 of 12)
• Issuing Common Stock
• Private Equity
• External equity financing that is raised via a
•
private placement, typically by private early-stage
firms with attractive growth prospects
Angel Investors (or Angels)
Wealthy individual investors who make their
own investment decisions and are willing to
invest in promising startups in exchange for a
portion of the firm’s equity
•
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2.4 The Securities Issuing Process
(2 of 12)
• Issuing Common Stock
• Private Equity
• Venture Capitalists (VCs)
• Formal business entities that take in private
•
equity capital from many individual investors,
often institutional investors such as
endowments and pension funds or individuals
of high net worth, and make private equity
investment decisions on their behalf
Organization and Investment Stages
VC Limited Partnership is the most common
structure
•
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Table 2.1 Organization of Venture
Capital Investors
Organization
Small business
investment
companies (SBICs)
Description
Corporations chartered by the federal government that can
borrow at attractive rates from the U.S. Treasury and use the
funds to make venture capital investments in private companies.
Financial VC funds
Subsidiaries of financial institutions, particularly banks, set up to
help young firms grow and, it is hoped, become major customers
of the institution.
Corporate VC funds
Firms, sometimes subsidiaries, established by nonfinancial firms,
typically to gain access to new technologies that the corporation
can access to further its own growth.
VC limited
partnerships
Limited partnerships organized by professional VC firms, which
serve as the general partner and organize, invest, and manage
the partnership using the limited partners’ funds; the professional
VCs ultimately liquidate the partnership and distribute the
proceeds to all partners.
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2.4 The Securities Issuing Process
(3 of 12)
• Issuing Common Stock
• Deal Structure and Pricing
• The deal structure allocates responsibilities and
•
ownership interests between the existing owners
(typically the founders) and the venture capitalist,
and its terms depend on numerous factors
related to the founders; the business structure,
stage of development, and outlook; and other
market and timing issues
Venture capitalists will require more equity
ownership and pay less for it the riskier and less
developed the business
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2.4 The Securities Issuing Process
(4 of 12)
• Issuing Common Stock
• Going Public
• Private Placement
• The firm sells new securities directly to an
investor or group of investors
• Rights Offering
• The firm sells new shares to existing stockholders
• Public Offering
• The firm sells new shares to the general public
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2.4 The Securities Issuing Process
(5 of
12)
•
Issuing Common Stock
• Going Public
• Initial Public Offering (IPO)
• The first public sale of a firm’s stock, typically made by
•
small, rapidly growing companies that either require
additional capital to continue growing or have met a
milestone for going public that was established in an
earlier agreement to obtain VC funding
Prospectus
A portion of a security registration statement that
describes the key aspects of the issue, the issuer, and
its management and financial position
•
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2.4 The Securities Issuing Process
(6 of 12)
• Issuing Common Stock
• Going Public
• Red Herring
• A preliminary prospectus made available to
•
prospective investors during the waiting period
between the registration statement’s filing with
the SEC and its approval
Quiet Period
Period during which the law places restrictions
on what company officials may say about the
company
•
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2.4 The Securities Issuing Process
(7 of
12)
• Issuing Common Stock
• Going Public
• Roadshow
• A series of presentations to potential investors
•
around the country and sometimes overseas,
providing investors with information about the
new issue
Sessions help investment banks gauge
demand for the offering and set a preliminary
offer price range
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2.4 The Securities Issuing Process
(8 of 12)
•
Issuing Common Stock
• The Investment Bank’s Role
• Investment Bank
• Financial intermediary that specializes in selling
new security issues and advising firms with
regard to major financial transactions
Promotes the stock and facilitates the sale of the I
PO shares
Underwriting
The role of the investment bank in bearing the risk
of reselling, at a profit, the securities purchased
from an issuing corporation at an agreed-on price
•
•
•
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2.4 The Securities Issuing Process
(9 of
12)
•
Issuing Common Stock
• The Investment Bank’s Role
• IPO Offer Price
• The price at which the issuing firm sells its securities
• Originating Investment Bank
• The investment bank initially hired by the issuing firm,
•
which brings other investment banks in as partners to
form an underwriting syndicate
Underwriting Syndicate
A group of other banks formed by the originating
investment bank to share the financial risk associated
with underwriting new securities
•
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2.4 The Securities Issuing Process
(10 of 12)
• Issuing Common Stock
• The Investment Bank’s Role
• Tombstone
• The list of underwriting syndicate banks,
•
presented in such a way to indicate a syndicate
member’s level of involvement, located at the
bottom of the IPO prospectus cover page
Selling Group
A large number of brokerage firms that join the
originating investment bank(s); each accepts
responsibility for selling a certain portion of a new
security issue on a commission basis
•
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Figure 2.4 Cover of a Final Prospectus
for a Stock Issue
Source: Pinterest.
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Figure 2.5 The Selling Process for a
Large Security Issue
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2.4 The Securities Issuing
Process
(11 of 12)
•
•
Issuing Common Stock
The Investment Bank’s Role
• Total Proceeds
• The total amount of proceeds for all shares sold in
the I P O
• Total Proceeds = (IPO Offer Price  # of IPO Shares Issued)
• Market Price
• The
price of the firm’s shares as determined by the
interaction of buyers and sellers in the secondary market
• Market Capitalization
• The
total market value of a publicly traded firm’s
outstanding stock
• Market Capitalization = ( Market Price  # of Shares Outstanding )
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2.4 The Securities Issuing Process
(12 of 12)
•
• • IPO Market Price
• The final trading price on the first day in the
secondary market
• IPO Underpricing
• The percentage change from the final I P O offer
Issuing Common Stock
The Investment Bank’s Role
•
•
price to the I P O market price, which is the final
trading price on the first day in the secondary
market; this is also called the
I P O initial return
I P O Underpricing = (Market Price − Offer Price) ÷
Offer Price
The term underpricing applies because the offer
price is usually set below what secondary market
investors are willing to pay.
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Example 2.3 (1 of 2)
Investors looking for a good night’s sleep might have
been interested in the February 2020 I P O of Casper
Sleep, Inc. Known for its inexpensive mattresses shipped
in a box easy enough for one person to handle, Casper
offered its shares to primary market investors at $12.
After one day of trading the stock closed at $13.50,
which means that Casper underpriced its shares by
12.5% as Equation 2.6 indicates.
I P O Underpricing = ($13.50 − $12) ÷ $12 = 0.125 =
12.5%
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Example 2.3 (2 of 2)
Casper Sleep’s I P O underpricing of 12.5% is
considerably less than the 28% underpricing for
Pinterest. This demonstrates another interesting fact
about I P O s, specifically, that the degree to which I P O s
are underpriced varies tremendously from one deal to
another and one time to another. Usually, smaller I P O s
are underpriced more than larger ones, but that was not
the case here. Casper raised about $100 million in its
offering, which is a small fraction of the $1.4 billion raised
by Pinterest.
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2.5 Financial Markets in Crisis (1 of 6)
• Financial Institutions and Real
Estate Finance
• Securitization
• The process of pooling mortgages or other types of
•
loans and then selling claims or securities against
that pool in the secondary market
Mortgage-Backed Securities
Securities that represent claims on the cash flows
generated by a pool of mortgages
A primary risk associated with mortgage-backed
securities is that homeowners may not be able to, or
may choose not to, repay their loans
•
•
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2.5 Financial Markets in Crisis (2 of 6)
•
Financial Institutions and Real Estate Finance
• Falling Home Prices and
Delinquent Mortgages
• Rising home prices between 1987 and 2006 kept mortgage
default rates low
• Lenders relaxed standards for borrowers and created
subprime mortgages
• As housing prices fell from 2006 to 2009, many borrowers
had trouble making payments, but were unable to refinance
• As a result, there was a sharp increase in the number of
delinquencies and foreclosures
• Subprime Mortgages
• Mortgage loans made to borrowers with lower incomes
and poorer credit histories as compared with “prime”
borrowers
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2.5 Financial Markets in Crisis (3 of 6)
• Financial Institutions and Real
Estate Finance
• Crisis of Confidence in Banks
• With delinquency rates rising, the value of mortgage•
•
backed securities began to fall and so did the
fortunes of financial institutions that had invested
heavily in real estate assets
Only 3 banks failed in 2007, but 25 failed in 2008, 140
failed in 2009, peaking at 157 bank failures in 2010
It was not until 2015 that bank failures fell back into
the single digits
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2.5 Financial Markets in Crisis (4 of 6)
• Spillover Effects and Recovery from
the Great Recession
• As banks came under intense financial pressure in 2008,
•
•
they began to tighten their lending standards,
dramatically reduce the quantity of loans they made, and
increase the rates that they charged borrowers.
Corporations found that they could no longer raise money
in the money market, or could only do so at
extraordinarily high rates
As a consequence, businesses began to hoard cash and
cut back on expenditures, and economic activity
contracted
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2.5 Financial Markets in Crisis (5 of 6)
• Pandemic Effects on Financial
Markets
• On January 11, 2020, Chinese state media reported the
•
•
death of a 61-year-old man who had died from an
unknown virus that had infected many others in Wuhan.
Just 10 days later, came the first confirmed case in the
United States and soon dozens of countries reported
outbreaks.
By March 13, President Trump declared a national
emergency, and within days many states issued “shelterin-place” orders to residents and shuttered nonessential
businesses.
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2.5 Financial Markets in Crisis (6 of 6)
• Pandemic Effects on Financial
Markets
• The effects on financial markets were immediate and
dramatic.
• S&P 500 Stock Index, which had peaked in February,
•
•
fell in 17 out of the next 23 trading sessions, dropping
by more than 30%, perhaps the most rapid decline in
stocks in U.S. history.
Yields on investment-grade corporate bonds, a
measure of what it costs financially sound companies
to borrow money, rose from 2.36% to 4.12% in two
weeks
For companies with less than stellar finances,
borrowing costs soared from 6% to more than 11%.
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Review of Learning Goals (1 of 10)
•
LG 1
• Understand the role that financial
institutions play in managerial
finance.
• Financial
institutions bring net suppliers of funds and net
demanders together to help translate the savings of
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•
individuals, businesses, and governments into loans and
other types of investments
The net suppliers of funds are generally individuals or
households who save more money than they borrow
Businesses and governments are generally net demanders
of funds, meaning they borrow more money than they save
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Review of Learning Goals (2 of 10)
• LG 2
• Understand the role that financial markets play in
managerial finance.
• Like financial institutions, financial markets help
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•
•
businesses raise the external financing they need to
fund new investments for growth
Financial markets provide a forum in which savers
and borrowers can transact business directly
Businesses and governments issue debt and equity
securities directly to the public in the primary market
Subsequent trading of these securities between
investors occurs in the secondary market
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Review of Learning Goals (3 of 10)
•
LG 3
• Describe the differences between
the money market and the capital
market.
• In the money market, savers who want a temporary place
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•
•
to deposit funds where they can earn interest interact with
borrowers who have a short-term need for funds
Marketable securities, including Treasury bills, commercial
paper, and other instruments, are the main securities
traded in the money market
The Eurocurrency market is the international equivalent of
the domestic money market.
In contrast, the capital market is the forum in which savers
and borrowers interact on a long-term basis
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Review of Learning Goals (4 of 10)
•
LG 3 (Cont.)
• Describe the differences between
the money market and the capital
market.
• Firms
issue either debt (bonds) or equity (stock) securities
in the capital market
• Once
issued, these securities trade on secondary markets
that are either broker markets or dealer markets
• An
important function of the capital market is to determine
the underlying value of the securities issued by businesses
• Inestimate
an efficient market, the price of a security is an unbiased
of its true value
Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved.
Review of Learning Goals (5 of 10)
•
LG 4
• Understand the major regulations
and regulatory bodies that affect
financial institutions and markets.
• The
Glass-Steagall Act created the FDIC and imposed a
separation between commercial and investment banks
• The
act was designed to limit the risks that banks could
take and to protect deposit