Practical financial managment 7e LASHER chapter 5

Financial MarketsCapital Markets – Trade in stocks and long-term debt Money Markets – Trade in short term debt securities Federal government issues a great deal of short-term debt 11...

Chapter 5 – The Financial System, Corporate Governance, and Interest

The Financial System

The economy is divided into sectors

– Production (includes government)

Services, products, and money flow between the sectors every day

– Producers spend revenues

– Creates a cyclical flow of money

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Figure 5-1 Cash Flows Between Sectors

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Diagram Omits Two Things

Consumption sector

– Most people do not consume all of their income—they deposit savings and earn a return

Production sector

– Companies need to raise money to finance large, infrequent projects

Economy has a need for and a source of $

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Savings and Investment

Financial markets channel consumer savings to companies through the sale of financial assets

– Companies issue securities

– Consumers purchase securities

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Figure 5- 2 Flows Between Sectors

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The Term “Invest”

Individuals invest by putting savings into financial assets: stocks, bonds,

etc.

This makes funds available for business investment

Hence: SAVINGS = INVESTMENT

(Consumer) Savings = (Business) Investment

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Raising and Spending Money

Raising and Spending Money

in Business

Firms to raise money by:

Borrowing money: Debt Financing

Selling stock: Equity Financing

The length of time between now and the end (or termination) of something

– Long-term projects

last over 5-10 years

financed with debt (bonds) and equity (earnings/stocks)

– Short-term projects

last less than 1 year

financed with short-term funds (bank loans)

– Process is known as maturity matching

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Financial Markets

Capital Markets

– Trade in stocks and long-term debt

Money Markets

– Trade in short term debt securities

Federal government issues a great deal of short-term debt

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Financial Markets:

Primary and Secondary Markets

Primary Market: Initial sale of a security

– Proceeds go to the issuer

Secondary Market: Subsequent sales of the security

– Between investors

– Company not involved

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Primary and Secondary Markets

Corporations care about a stock’s price in the secondary

market

– Influences how much money can be raised in future stock issues

– Senior management’s compensation is usually tied to stock price

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Direct and Indirect Transfers, Financial Intermediaries

Directly

– Issuer sells directly to buyers

or through an investment

bank

– Investment bank lines up

investors and functions as a

– Mutual fund is an example

– Portfolio is collectively owned

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Primary market transactions can occur

Figure 5-3 Transfer of Funds

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Direct and Indirect Transfers, Financial Intermediaries

Institutional investors play a major role in today’s financial markets

– Own ¼ of all stocks, make over ¾ of all trades

The Stock Market and Stock Exchanges

Stock market—a network of exchanges and brokers

E xchange —a marketplace such as NYSE, AMEX, NASDAQ, & regional exchanges

• Brokerage houses employ licensed brokers to make securities transactions for investors

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Trading—The Role of Brokers

What brokers do…

– An investor opens an account with a broker and place trades via phone

or online

– Local broker forwards order to floor broker on the exchange trading floor

– Trade confirmation is forwarded to local broker and investor

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Figure 5-4 Schematic Representation of a Stock Market

Transaction

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New York Stock Exchange (NYSE)

NYSE MKT (Previously AMEX)

(NASDAQ)

Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc.)

Exchanges are linked electronically

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Stock Market and Exchanges

Stock Market refers to the entire interconnected set of places, organizations and

processes involved in trading stocks

Regulation

– Securities Act of 1933

Required companies to disclose certain information

– Securities Exchange Act of 1934

Set up Securities and Exchange Commission (SEC)

– Securities law is primarily aimed at disclosure

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Private, Public, and Listed Companies, and the OTCBB Market

Privately Held Companies Can’t sell securities to the general

– Process of obtaining approval and registration is known as ‘going public’

Private, Public, and Listed Companies, and the NASDAQ Market

– Public Companies

Use an investment banking firm to “ go public ” Prospectus—provides detailed information about company SEC reviews prospectus

– Red Herring - an unapproved, or preliminary, prospectus

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Private, Public, and Listed Companies, and the OTC Market

The IPO

– Initial public offering (IPO) is the initial sale

– Investment banks usually line up institutional buyers prior to the actual securities sale

– IPO occurs in primary market, then trading begins in the secondary market

– IPOs are discussed in detail in Chapter 8

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The OTCBB Market

After a company goes public, its shares can trade in the over-the-counter (OTC) market

Firms not listed on an exchange trade through the OTCBB overseen by the NASD

Eventually a firm may list on an exchange

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Figure 5-7 Stock Market Quotation

for Microsoft Corp.

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Corporate Governance

Corporate governance refers to the relationships, rules and procedures under

which businesses are organized and run.

– Focused on ethics and legality of financial relationships between top managers and the corporations they serve.

– The idea is connected to the agency problem, which refers to a conflict of interest between executives and stockholders

Two major financial crises thus far in the 21st century

– Stock market crash of 2000 caused by financial reporting fraud

– Financial crisis of 2008 caused by the subprime mortgage market

Concept Connection Example 5-1 Executive Stock Options

Harry Johnson, CEO

$4,000,000

Plus: Stock option:

200,000 shares @ $20, Market Price now $48.65

– Option Value:

– 200,000 x ($48.65 - $20.00) = $5,730,000

Total comp = $9,730,000; 59% from options

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Moral Hazard

A situation that tempts people to act in immoral or unethical ways

Concept Connection Example 5-1 Moral Hazard of Stock Based Compensation

What if Harry can’t exercise his option for another six months?

– AND some disturbing financial information comes up that will cause the stock’s price to

drop by $10.

– If released, that info will cost Harry $2,000,000

Harry is motivated to hold stock price up at any cost until he can exercise his option

Usually means suppressing the damaging information while ordinary investors

buy in at inflated price

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Holding Performance Up

Company financial statements - Income Statement and Balance Sheet are actually easy to manipulate by “bending” accounting rules

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Responsibility for Financial Statements

Responsibility for the contents of financial statements primarily falls to top management

Top execs have the power to enhance their own wealth by cheating

on financial reporting

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Events of the 1990s

Stock prices skyrocketed

Top management was willing to bend rules

– Some accountants partnered with unethical executives in deceiving the public

Enron

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Public Accounting Reform

Regulation

SOX (§§101-109) creates the Public Accounting Oversight Board (PCAOB) to oversee and regulate the accounting industry

– Accounting will never be self-regulated again

– Requires firms to register

– Sets standards of performance & compliance

– Inspections and disciplinary procedures

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Events of the 1990s

Resulted in the Sarbanes-Oxley (SOX)Act:

– Title I: Oversight of the Public Accounting Industry

– Title II: Auditor Independence

– Title III: Corporate Responsibility

– Title IV: Enhanced Financial Disclosure

– Title V: Wall Street Reforms—Securities Analyst Conflicts of Interest

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Executives Profit While Others Go Broke

Executives often received huge incentive compensation while the stock tanked and investors/employees lost everything

SOX (§304) requires CEOs & CFOs to repay such gains to corporation

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Stock Analyst Conflicts

SOX (§501) directs the SEC to issue rules insulating analysts from investment banking pressure

– SEC adopted Regulation Analyst Certification (Reg AC): Analysts must certify:

They actually believe in their recommendations

Their compensation is not linked to specific recommendations

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The Financial Crisis of 2008

Home Ownership, Mortgages, and Risk Securitization

Subprime markets

Credit Default Swap (CDS)

Home Ownership, Mortgages, and Risk

Loans are secured by a House

Failure to make payment leads to Foreclosure

Bundle of Loans and Securitization Collateralized debt obligations (CDO) CDO tranche

Flaw in Risk Allocation Method

Subprime Mortgage Market

Institutions borrowed at short-term rates to invest in CDOs Needed money to invest

Banks ran out of qualified borrowers

Subprime Loans

Loans made to unqualified borrowers

Types of loans

– Zero down

– Adjustable Rate Mortgages (ARM)

– Negative Amortization (NegAm)

– Alt-A loans

Credit Default Swaps (CDS)

Contract between buyer and seller in which the seller agrees to repay losses the buyer suffers

The Trigger- Interest Rates Rise

In 2004 - 2006

Concern about inflation

Federal reserve raised rates

Resulting in mortgage rates going up and an end to rising real estate prices

Effect on CDO Market and

CDO Owners

CDO market froze

2008 staggering losses and equity reductions by financial institutions Bailouts arrived

Federal Government Actions in 2008

Intervention

– Government takeover

– Officials brokered merger of at risk institutions

– Bail outs by the federal government

Federal Government Actions

in 2008

Two actions were particularly important to the financial crisis

– Bear- Stearns

– Lehman Brothers

The Crisis is a Governance Issue

The financial system created an incentive for dishonesty

– Make loans regardless of ability to pay

The “too big to fail” concept creates a Moral Hazard in banking

– Executives are rewarded if high risk projects go well

– But government (taxpayers) pay for failures

The Dodd-Frank Act

Signed in 2010

Designed to fix the problem through legislation Governs conduct on more than 240 issues

Interest is the return on debt

– Primary vehicle is the bond

Investor lends money to the bond’s issuer

There are MANY interest rates in debt markets

– Depend on term and risk

– Rates tend to move

together

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The Relationship Between Interest and the Stock Market

Stock returns and interest on debt instruments are related

– Stocks and bonds compete for investor’s dollars

Stocks offer higher returns but have more risk Investors prefer debt if the expected return is equal

Interest rates and security prices move in opposite directions

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Interest and the Economy

Interest rates have a significant effect on the economy

– Lower interest rates stimulate business and economic activity

Debt financed projects cost less if rates are low

– More projects are undertaken

Consumers purchase more houses, cars, etc when rates are low

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Debt Markets: Supply and Demand

A Brief Review

Interest rates are set by supply and demand

Demand curve relates price and quantity of a product that consumers will buy

– Reflects desires and abilities of buyers at a particular time

– Usually slopes downward to the right since people buy more when the price of a product is low

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Debt Markets: Supply and Demand

A Brief Review

A supply curve relates prices with quantities supplied by producers

– Generally upward sloping to the right since firms will to produce more

at higher prices

– Equilibrium – intersection of supply and demand curves

Sets market price and quantity

– Changing conditions shift supply and demand curves for a new

equilibrium

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Figure 5-8 Supply & Demand Curves

for a Product or Service

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Supply and Demand for Money

In the debt market

– Lenders represent supply

– Borrowers represent demand

The price represents the interest rate

Debt securities are bills, notes and bonds

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Figure 5-9 Supply and Demand Curves for Money (Debt)

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The Determinants of Supply

and Demand

Demand for borrowed funds depends on:

– Opportunities available to use the funds

– Attitudes of people and businesses about using credit

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The Determinants of Supply

The Components of an

Interest Rate

Interest rates include base rates and risk premiums

Interest rate represented by the letter k

– k = base rate + risk premium

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The Components of an Interest Rate

Components of the Base Rate

– Base rate = kPR + INFL

– The pure interest rate plus expected inflation

Rate people lend money when no risk is involved

– Pure interest rate (kPR) = earning power of money

Would exist in the real world if no inflation

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The Components of an

Interest Rate

The Inflation Adjustment (INFL)

– Inflation refers to a general increase in prices

– If prices rise, $100 at the beginning of the year will not buy as much at the end of the year

– If you loaned someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year

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Risk Premiums

Risk in loans is the chance that the lender will not receive the full amount

of principal and interest payments

Lenders demand risk premiums of extra interest for risky loans

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Different Kinds of Lending Risk

Bond lending losses can be associated with price fluctuations and the failure of borrowers to repay loans

Three sources of risk, each with its own risk premium:

– Default risk

– Liquidity risk

– Maturity risk

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Different Kinds of Lending Risk

Default Risk (DR)

– The chance the lender won't pay principal or interest

Losses can be as much as the entire amount

– Investors demand a default risk premium based on the their perception of the borrower’s creditworthiness

Considers firm's financial condition and credit record

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Different Kinds of Lending Risk

Liquidity Risk (LR)

– Associated with being unable to sell the bond of an little known issuer

– Debt of small, hard to market firms is “illiquid”

– Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk

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Different Kinds of Lending Risk

Maturity Risk (MR)

– Bond prices and interest rates move in opposite directions

– Long-term bond prices change more with interest rate swings than term bond prices

short-68

Putting the Pieces Together:

The Interest Rate Model

k = kPR + INFL + DR + LR + MR

k is the nominal or quoted interest rate

Model tells what theoretically should be in an interest rate Setting Interest Rates

– set by supply and demand

– No one uses the model to set rates

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Federal Government Securities,

the Risk Free Rate

Federal Government Securities

– The Federal government issues long-term bonds as well as shorter-term securities

Risk in Federal Government Debt

– No liquidity risk: It’s easy to sell federal securities

– Federal debt does have maturity risk

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The Risk-Free Rate

Very short term federal securities, Treasury Bills, pay the risk free rate

The risk-free rate is approximately the yield on short-term Treasury bills

Denoted as kRF

Conceptual floor for interest rates

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The Real Rate of Interest

The Real Rate of Interest implies the effects of inflation removed

– Tells investors whether or not they are getting ahead

– There are periods during which the real rate has been negative

The Real Risk-Free Rate implies that both the inflation adjustment and

the risk premium is zero

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Concept Connection Example 5-3 Using the Interest Rate Model

Using the Interest Rate Model, Sunshine Inc is planning to borrow by issuing three year bonds (notes)

The following information is available.

1 The pure interest rate is 2.0%.

2 Inflation will be 3% next year and 4% thereafter.

3 Sunshine’s debt carries a default risk premium of 1.5%.

4 The firm carries a liquidity risk premium of 5%.

5 Maturity risk premiums on three-year debt are 1.0%.

a Estimate the interest rate Sunshine will have to offer.

b Moonlight Ltd recently issued three-year debt paying 11% What does the interest rate model imply about Moonlight’s risk relative to Sunshine’s?