Investment Banks
Firms that underwrite new security issues.
Specialize in helping companies sell new debt or equity
Their services include:
-origination
-underwriting
-distribution
Money Center Banks
Large commercial banks that provide both traditional and investment banking services throughout the world.
Financial Assets
Assets that are claims on the cash flows from other assets; business loans, stocks, and bonds are financial assets.
Real Assets
Non-financial assets such as plant and equipment; productive assets are real assets; many financial assets are claims on cash flows from real assets.
Direct Financing
Funds flow directly through the financial systems. Lender-saver and the borrower-spenders deal directly with one another.
Borrower-spenders sell securities (stocks & bonds) in exchange for money.
Origination
Process of preparing a security issue for sale
Underwriting
Process by which the investment banker helps the company sell its new security issue.
Firm-Commitment Underwriting
Investment banker buys the new securities from the issuing company and resells them to investors.
Underwriting Spread
Investment banker's compensation.
Distribution
Process of marketing and reselling the securities to investors
Primary Market
Financial market in which new security issues are sold by companies directly to investors
Secondary Market
Financial market in which the owners of outstanding securities can sell them to other investors.
Enable investors to convert securities easily into cash.
Marketability
Ease with which a security can be sold and converted into cash
The level of marketability depends on the cost of trading the security and the cost of searching for information. The lower these costs are, the greater the security's marketability.
Liquidity
Ability to convert an asset into cash quickly without loss of value
Brokers
Market specialists who bring buyers and sellers together, usually for a commission
Execute the transaction for their client and are compensated for their services with a commission fee.
Dealers
Market specialists who "make markets" for securities by buying and selling from their own inventories
Make a market for a security by buying and selling from an inventory of securities they own.
Money Markets
Markets were short-term financial instruments are traded
Public Markets
Financial Markets where securities registered with the SEC are sold; where the general public buys and sells securities through their stockbrokers.
Private Markets
Company contracts investors directly and negotiates a deal to sell them all or part of a security issue.
Derivative Market
Derive their value from underlying asset.
Futures contracts: contracts for the future delivery of such assets as securities, foreign currencies, interest cash flows, or commodities.
Options contracts: contracts used to hedge risk in situations where the f
Efficient Market Hypothesis
Market where security prices reflect the knowledge and expectations of all investors; reflect future cash flows of the firm.
The more efficient the market, the more likely to offer expected return.
Securities of similar risk will offer the same expected r
Strong-Form Efficiency
Stock prices reflect all information about the securities future cash flows, even private information
Semistrong-Form Efficiency
Theory that security prices reflect all public information but not all private information.
Weak-Form Efficiency
Theory that security prices reflect all information in past prices but do not reflect all private or all public information.
Indirect Market
Involves intermediaries (banks, venture capitalists)
Financial Intermediation
Conversion of securities with one set of characteristics into securities with another set of characteristics.
An intermediary stands between the lender-saver and borrower-spender.
Securitization
pool of loans combined and people pay a certain security that guarantees they will be paid back depending on what security they pay.
Largest financial intermediaries
Commercial Banks - most prominent and offer widest range of financial services to businesses.
Pension Funds
Obtain money from employee and employer contributions during the employee's working years, and they provide monthly cash payments upon retirement.
Investment Funds
Mutual Funds" - Sell shares to investors and use the funds to purchase securities
Important source of business funding.
Business Finance Companies
Obtain majority of their funds by selling short-term debt called Commercial Paper, to investors in direct credit markets.
More willing to make loans and leases to firms with higher levels of default risk.
Initial Public Offering (IPO)
First offering of a corporation's stock to the public.
Real Rate of Interest
The interest rate that would exist in the absence of inflation
**Real rate of interest is (1) the inflation-adjusted return earned by lender-savers
(2) inflation-adjusted cost incurred by borrower-spenders when they borrow.
Nominal Rate of Interest
The rate of interest that is unadjusted for inflation
Determinants of Real Rate of Interest
1. Returns on Investments - The return on investment must exceed the cost of the funds (debt and equity) used to finance it. (cost of funding - aka cost of capital)
2. Time Preference of Consumption - "Positive time preference": most people prefer to cons
Real Interest Rate Reflects:
A complex set of forces that control the desired level of lending and borrowing in the economy.
Fisher Equation
I = r+ (change)Pe + r(change)Pe
I = nominal rate of interest
r = real rate of interest
(change)Pe = expected annualized price-level change
r(change)Pe= adjustment of interest rate for expected price level change
Two General Conclusions about the Level of Interest Rates:
1. The level of interest rates tends to rise and fall with changes in the actual rate of inflation.
2. The level of interest rates tends to rise during periods of economic expansion and decline during periods of economic contraction.