Chapter 2 COMPONENTS OF FINANCIAL MARKET SYSTEM

Financial Markets Primary Market Second Market Money Market Capital Market Organized Securities Exchanges Over-the-Counter Markets Public Offerings and Private Placement

Organized Securities Exchanges (1) New York Stock Exchange, (NYSE) (2) American Stock Exchange, (AMEX) (3) Mid-west Stock Exchange, (4) Pacific Stock Exchange, (5) Philadelphia Stock Exchange, (6) Boston Stock Exchange, and

New York Stock Exchange (NYSE) Membership seat 1366 seats since Seat fee: $760,000 to a high of $830,000.' 1995 auction :make a market matching pricing (asked and offered) Price Quotes 82%

Function of the NYSE 1Providing a continuous market. 2. Establishing and publicizing fair security prices. 3. Helping business raise new capital.

Listing Requirements (1) profitability (2) size (3) market value (4) public ownership.

Profitability EBT: at 1east $2.5 million. For the two years preceding EBT:at least $2.0 million. Size Net tangible assets: at least $18.0 million.

Market Value The market value: at least $18.0 million. Public Ownership common shares :1.1 million publicly held holders of 100 shares :at least 2,000.

THE INVESTMENT BANKER a financial specialist involved as an intermediary in the merchandising of securities. Banking Act of 1933(also known as the Glass-Steagall Act of 1933).

Functions of Institutes (1) underwriting, (2) distributing, (3) advising.

Distribution Methods Most competitive bid purchases (1) rail-road issues, (2) public utility issues, (3) state and municipal bond issues. (4) Commission or Lest-Efforts Basis (5) Privileged Subscription (6) Direct Sale

(1) current stockholders, (2) employees, or (3) customers.

PRIVATE PLACEMENTS (1) life insurance companies, (2) state and local retirement funds, (3) private pension funds.

Advantages of private placement 1. Speed. 2. Reduced flotation costs. 3. Financing flexibility.

disadvantages 1. Interest costs. 2. Restrictive covenants. 3. The possibility of future SEC registration.

Leading U.S. Investment Bankers, 1995 (Domestic debt and Equity issue) (BILLION OF DOLLARS FIRM UNDERWRITING VOLUME Percent 1 Merrill Lynch % 2 Lehman Brothers Golden Sachs Morgan Stanley Salomon Brother CS First Boston J.R. Morgan Bear, Sterns Donaldson Lufkin & Jenrette Smith Barney

Table 2-6 Public and Privately Placed Corporate Debt Placed Domestically (Gross proceeds of All New U.S. Corporate Debt Issue) Total Volume Percent Publicly Percent Privately Year (S Millions) Placed (%) Placed (%) 1994 $

FLOTATION COSTS (1) the underwriters spread (2) issuing costs. (a) printing and engraving, (b) legal fees, (3) accounting fees, (4) trustee fees, several other miscellaneous components.

REGULATION , State statutes (blue sky laws) Securities Acts Amendments of 1975 Primary Market Regulations 1982

25 investors not be registered 1. less than $1.5 billion of new securities per year. 2. Issues that are sold entirely intrastate. 3. short-term instruments: maturity periods of 270 days or less. 4. Issues that are already regulated or controlled by some other federal agency

Mr. Ivan F. Boesky, a loophole in the 1940 Ponzis Scheme Enron and WorldCom

Primary market regulation Full public disclosure Firm file a registration statement with the SEC a minimum 20-day waiting period, registration process a preliminary prospectus (the red herring )

Secondary Market Regulations Shelf Registration 1. Major security exchanges must register with the SEC. 2. Insider trading is regulated. 3. Manipulative trading 4. The SEC is given control over proxy procedures. 5. The Board of Governors of the Federal Reserve System

Figure 2-4 Average Annual Returns and Standard Deviations of Returns,

Figure 2-5 Rates of Return and Standard Deviations,

Table 2-7 Interest Rate Level and Inflation Rates Month 30-Year A AA Rated Inflation Treasury Bills Treasury Bonds Corporate Bonds rate Mean

INTEREST RATE and DETERMINANTS k = k* + IRP + DRP + MP + LP k = the nominal or observed rate k* = the real risk--free rate of interest, IRP = inflation-risk premium. DRP = default-risk premium MP = maturity LP = liquidity premium

Nominal Interest rate k = k* + IRP + DRP + MP + LP k = ? k* = 3.1%, IRP = 1.5% DRP = 0.05% MP = 0.02% LP = 0.05% K = 3.1% + 1.5% +0.05% %+ 0.05% = 4.72%

In reality 2.75% % = % ??? Housing ?? Medical care?? Education?? Electricity?? Special interest group.

K rf = k* + IRP (2-2)

The Effects of Inflation on Rates of Return and the Fisher Effect K rf =k *+ IRP + (k*. IRP) = k* '05k* –K* =.06 = 6%

MEAN MEAN INFERRED NOMINAL YIELD INFLATION RATE REAL RATE SECURITY % % % Treasury bills Treasury bonds Corporate bonds

THE TERM STRUCTURE OF INTEREST RATES

Historical Interest Rates Years to maturity Int er est rat e Oct 31, Mar 31, Nov 13, 19 91

Explaining Term Structure (1) the unbiased expectations theory, (2) the liquidity preference theory, (3) the market segmentation theory.

SUMMARY market environment structure of financial markets the institution of investment banking various methods for distributing securities role of interest rates

Components of financial market public offerings private placements institutional investors. financial instruments The secondary market money and capital markets primary and secondary organized security exchanges over-the-counter market

Investment banker functions of (l) underwriting, (2) distributing, and (3) advising. the negotiated purchase, (2) the competitive bid purchase, (3) the commission or best- efforts basis, (4) privileged subscriptions, and (5) direct sales.

Private placements (l) life insurance firms, (2) state and local retirement funds, and (3) private pension funds. advantages and disadvantages

Flotation costs securities Act Of l933. Rates of return