Executive Economic Analysis BUS 571 MODULE 3 LECTURE

Executive Economic Analysis BUS 571 MODULE 3, LECTURE 3

Today’s Topics • Part I – – – Classifying Financial Markets Nature of Major Financial Market Instruments Money Markets • Part II – Capital Markets • Part III – – Primary & Secondary Markets Who “makes” the market? Financial Market Efficiency Market Regulation

Financial Markets The role of language, in any walk of life, is to communicate something—by means of a symbol—to those who recognize the symbols. Words and terms employed by financial market professionals and market participants describe the ideas and instruments with which they deal.

Part I Classifying Financial Markets Nature of Major Financial Market Instruments Money Markets

Financial Markets Recall: To define something is in effect to say what something “is” and “is not. ” We need to know and understand the language of financial markets in order to understand the financial markets themselves.

Financial Markets Can be classified in many ways: Type of financial claim: e. g. , stocks, corporate bonds, T-bills, etc. Length of term of the instruments traded When a security is sold Money market Capital market Primary Secondary When the transaction occurs Spot Market Futures Market/Forward Market

Financial Markets Money Market for short-term credit – – – A. K. A. short-term debt financing One year term or less; 3 mos. on average Low risk Highly liquid Traded over-the-counter (two-parties agree on the settlement terms of a trade) Do not occupy one geographic location

Money Market Instruments Rapid growth & change in MMIs over the last 35 years Many more choices for money market participants Major instruments include: – US Treasury Bills • • – Issued by US Treasury Short-term borrowing needs of The FED Certificates of Deposit (CD) • • • Term-debt instruments Issued by large commercial banks $1 mm CDs are typical; $100, 000 minimum denominations

Money Market Instruments Commercial Paper Issued by large corporations & foreign governments Short-term promissory note Usually offered below prime $5 K to $5, 000 Maturity of 270 days max (to avoid SEC regs)

Money Market Instruments Bankers’ Acceptances Limited secondary market; declining but still in play Bank-backed payment of one firm to another Key for international trade Some risk; rates typically higher than T-bills Repurchase Agreements Short-term Seller agrees to sell and buy back a gov’t security at a higher price at a later date

Money Market Instruments Federal (Fed) Funds loaned/borrowed by one depository institution to another Typical denominations of $5 mm > Generally unsecured; most agreements are verbal in nature Exempt from Fed Reserve requirements

Money Market Instruments US Treasury Bills (T-Bills) Used to finance government debt & revenue shortfalls Bought at discount; redeemed at face value Sold at low denominations Short maturities: 4, 13, and 26 weeks Minimum denominations: $1, 000; most trades in lots of $5 mm

Money Market Instruments Government Sponsored Enterprise (GSE) Securities Raise funds for: Low-income families and veterans Students loans

Money Market Instruments Eurodollars Dollar-denominated deposit liabilities exempt from U. S. banking regulations Pursued to reduce risk Lower transaction costs; no reserve requirements Great example of the nature of markets: they develop in the direction of lower prices and higher profits, quality, etc.

Money Market Instruments Money Market Mutual Funds 1978 is a threshold year Very few individual participants beforehand Merrill Lynch introduced MMMFs Short-term investment pools Use funds to invest in Commercial Paper, T-bills, repurchase agreements, etc. Opened entirely new opportunities Example of “ground-up” nature of market economies

Money Market Participants Commercial Banks & Savings Associations Key roles: Borrow: meet reserve needs and loan needs of commercial & household customers Maintain considerable Treasury securities (to manage cash flow needs) Commercial paper broker Commercial paper market agent & underwriter

Money Market Participants Governments and Government Sponsored Enterprises (GSE’s) U. S. Treasury is the “best” example World’s single largest borrower in the market Government issues T-Bills to: Finance government expenditures (while government waits for tax revenues to flow in) Pay off previously issued T-Bills as they mature

Money Market Participants Privately-owned Government Sponsored Enterprises (GSE’s) Implicit government guarantee on debt Thus, able to borrow at lower interest rates Issue long-term securities Who are they? – – Fannie Mae Freddie Mac Sallie Mae Federal Farm Credit Banks Funding Corporation

Money Market Participants State & Municipal Governments Issue long-term securities Finance own expenditures and those of schools, hospitals, and private firms (GSE’s) Interest is generally exempt from federal taxation > allows state & municipal governments to borrow at a lower cost

Money Market Participants Federal Reserve Fed is a private corporation Monetary policy conducted primarily through FOMC Operations Buy & sell T-bills Serves as US Treasury’s agent in securities market

Money Market Participants Corporations & Finance Companies Use money markets to raise & store funds Finance companies use commercial paper as primary source of funds for commercial and consumer loans Corporations utilize money markets to maintain balanced cash flow

Money Market Participants Pension Funds & Insurance Companies Cash flow Maintain investment portfolio liquidity Brokers & Dealers Key participants in money market Purchase new issues of money market securities Create/facilitate market for secondary securities

Money Market Participants Individuals Prior to 1978 very few individuals participated directly in the money market Merrill Lynch created Money Market Mutual Funds (MMMFs) investment pools MMMFs use revenue to invest in commercial paper, repurchase agreements, certificates of deposit, T-bills, and other US & foreign short-term debt securities NOTE: What was once available only to large institutional investors is now available to the individual person

Capital Market for long-term credit A. K. A. long-term debt financing Terms longer than one year Private placement of debt & equity Organized Trading: Over-the-counter Exchanges (e. g. , NYSE)

Part II Capital Markets

Capital Market Instruments Raises revenue that Deficit Spend Units (DSUs) seek for their own investment plans Major instruments include: Stocks Mortgages Corporate bonds US Government/US Government Agency securities State & local government bonds (MUNIs)

Capital Market Instruments Common Stock Issued by publicly-owned corporations to meet longterm capital needs Represents ownership of net income & assets Pays variable dividend, if paid Paid after preferred stockholders Owners possess voting rights

Capital Market Instruments Preferred Stock “Mixed” instrument: represents both equity and debt Pays a fixed dividend, similar to interest that a bondholder receives Paid before common stockholders Generally no voting rights

Capital Market Instruments Mortgages Long-term debt instruments used to purchase properties Underlying property serves as collateral

Capital Market Instruments Secondary Markets in Mortgages Buying & selling of previously issued securities Took about five decades to develop Congress established Fannie Mae in 1938 but forged secondary market in 1972

Capital Market Instruments Publicly-backed mortgage securities Buyers get guaranteed payment (interest + principal) Firms gather federally guaranteed mortgages in “pools” or “bundles” of $1 mm or more and then sell all or part to third-party investors

Capital Market Instruments Privately-backed mortgage-securities Similar to publicly-backed securities (i. e. , sale of previously issued securities) Difference? Not publicly guaranteed Backed by private corporations issuing them Rated by major credit-rating agencies

Capital Market Participants National Stock Exchanges • New York Stock Exchange (NYSE) – – – – Situated in New York City > Wall Street A. K. A. , “Big Board” Largest market dollar-wise - for trading securities Second largest business listing From Blue-Chips to start-ups; most IPOs Physical exchange Surpassed by NASDAQ in the ‘ 90 s Owned and operated by NYSE Group (Corp. )

Capital Market Participants National Association of Securities Dealers Automated Quotations (NASDAQ) Largest market in terms of company listings Electronic exchange Trades more shares per day than any stock exchange Owned by NASDAQ Stock Market (Corp. )

Capital Market Participants American Stock Exchange (AMEX) Smaller than NYSE & NASDAQ Criteria for stock to be traded is less stringent Small to mid-size stocks & specialized securities Owned by its members (Mutual Organization)

Capital Market Participants OTC Bulletin Board (OTC) = “Over the Counter” Regulated quotation service for stocks NOT on one of the major exchanges Typically avoided due to investment risk (prices can be easily manipulated) Often hard to differentiate between OTC shares and penny stocks

Capital Market Participants Pink Sheets Electronic system Published by Pink Sheets LLC Used by brokers trading OTC securities Pink Sheet stocks do NOT qualify for OTC Very risky; SEC advises lots of research on prospective companies

Capital Market Participants Mortgage companies Mortgage brokers Home buyers Bonds Private firms including the Fed, banks, dealers Government: Federal, state, & local GSEs

Part III Primary & Secondary Markets Who “makes” the market? Financial Market Efficiency Market Regulation

Financial Markets Primary Market for new issues of securities Issuer of securities receives the proceed of the sales Issuer obtains funds Investors secure debt & equity (i. e. , ROI) claims

Financial Markets Secondary Market for re-issue of previously issued securities; they are re-sold Over-the-counter and organized exchanges are bought and sold after the first (i. e. , original) issuance Selling dealers and investors obtain funds, NOT original issuer

Market Makers Who are they? – – – Make buyer and seller activities, in the securities market, possible Link and execute trades May specialize in one kind of security or several different kinds Brokers: Arrange trades between buyers and sellers Dealer: – – Arranges trades Stands ready to purchase and inventory securities that are resold to other investors

Market Makers Help sustain an orderly, functioning market – For example: Dealers offset buyer and seller shortages by becoming a principal in a transaction when needed Facilitate the exchange of needed information Provide investment advice to traders Conduct trades in the secondary market Offer advice and marketing services in the primary market Market makers are the “middle man” of the financial market

Price Expectations Determined by looking at: – – – Current and past prices Anticipated changes in national income Anticipated changes in costs of production Theory of Rational Expectations – – Prices will equal, on average, the optimal forecast Optimal forecast = Best guess determined by utilizing all available information

Price Expectations Challenges with “optimal” forecast? It is a best GUESS NO guarantee that it is accurate Random nature of markets precludes perfect accuracy Lack of information at a given point in time “Rational” equals “average” based on all available information at a given point in time

Price Expectations Rational Expectations It is in the best interest for participants to utilize all available information New information should lead to adjusted expectations

Financial Market Efficiency Efficient Markets Hypothesis “When financial markets are in equilibrium, the prices of financial instruments will reflect all readily available information. ” – Burton, Nesiba, & Lombra Equilibrium? Qty. of securities demanded = Qty. of securities supplied Information? What is known about a company; everything from earnings reports to “unofficial” but credible word-of-mouth reports

Financial Market Efficiency General version of FME: Prices reflect rational expectations of participants Prices are determined by available information Stricter version of FME: Prices reflect true value of securities at every point in time Prices are derived from complete and accurate information available to all participants at the same time and in the same manner

Financial Market Efficiency Markets tend toward equilibrium Beating the market consistently (higher than average returns) is not the norm Information… – – Does not always travel at the same rate Is often understood/interpreted differently Thus, potential for extraordinary gains and losses exists and… Stricter version of FME is not as realistic

Regulation of Securities Markets SEC (Securities and Exchange Commission) is the “big dog” Created by Congress in 1934 to prevent investor fraud Regulates all security exchanges in US markets More recent scandals such as Enron & World. Com brought about greater scrutiny & more legislation

Regulation of Securities Markets Securities Act of 1933 Covers primary market New securities must be registered and fully disclosed (public) Originally administered by the Federal Trade Commission (FTC) Securities Exchange Act of 1934 Covers secondary market Formed SEC, which supplanted FTC Securities Amendments Act of 1975 Amendment to the Securities Act of 1933 Established a National Market System Goal: Incentivize honest, fair, and efficient securities transactions

Regulation of Securities Markets SEC Rule 415 of 1982 – – Companies that want to issue and sell more new securities after an IPO would have to go through the same basic procedure as the IPO SEC adopted Rule 415 in 1982 • – Allows public companies to register new securities but then shelve the public offering for up to 2 years Benefit? • • Greater flexibility > Firm can make a public offering (sale) when it needs the money or when such a move would be profitable Requires very little expense and effort

Wrap-Up/Close Questions? Comments?