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The Financial System, Corporate Governance,
and Interest
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The Financial System
The economy is divided into sectors Consumption Production (includes government) Most people are in both sectors
as workers in production and as consumers at home Services, products, and money flow between the
sectors every day Producers pay wages to workers for labor services Workers spend incomes as consumers on production sector’s
output Producers spend revenues on materials and more labor to make
more product Creates a cyclical flow of money
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BUT, Diagram Omits Two Things
Consumption sector Most people do not consume all of
their income—they save a portion They deposit those savings and earn a
return
Production sector Companies need to raise money from time to time to
finance large, infrequent projects New factories, additional equipment, new enterprises
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 to raise money
usually to spend on big assets or projects Consumers purchase securities to earn a return
on their savings
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The Term Invest
Using a resource to better one’s position in the future rather than for current consumption Individuals invest by putting savings into financial
assets: stocks, bonds, etc. Companies invest by buying assets used in production
Funds available for business investment come from savings put into financial assets by individuals
Hence: SAVINGS EQUALS INVESTMENT More precisely: (Consumer) Savings Equals (Business) Investment
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Raising and Spending Money in Business
Firms spend two kinds of money Day-to-day funds – come from normal profits,
support routine activities Large sums needed for major projects and to
get businesses started - comes from selling financial assets
Borrowing money: Debt Financing Selling stock: Equity Financing
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Term
The length of time between now and the end (or termination) of something Long-term projects (lasting over 5-10 years) are
financed with long-term funds Debt (bonds) Equity
Short-term projects (lasting less than 1 year) are 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 broker
Indirectly Financial intermediary sells shares in itself and invests the funds collectively on behalf of investorsMutual fund is an examplePortfolio is collectively owned
Primary market transactions can occur
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Transfer of Funds From Investors to Businesses Figure 5.3
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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 Examples include:
Mutual funds Pension funds Insurance companies Banks
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The Stock Market and Stock Exchanges
Stock market—a network of exchanges and brokers Exchange—a physical marketplace
such as NYSE, AMEX, regional exchanges
Brokerage houses employ licensed brokers to assist individuals with securities transactions
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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 Each stock trades in a particular spot on the exchange floor in
an auction-like process Trading supervised by a specialist who makes markets in
designated securities Trade confirmation is forwarded to local broker and
investor
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Exchanges
New York Stock Exchange (NYSE) Trades securities for 2800 US
issuers and 480 foreign companies
American Stock Exchange (AMEX) Handles slightly smaller, younger firms than NYSE
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
Stock Exchanges are the administrative and trading centers of the stock market
Regulation Securities Act of 1933
Required companies to disclose certain information Securities Exchange Act of 1934
Set up Securities and Exchange Commission Securities law is primarily aimed at disclosure
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Private, Public, and Listed Companies, and the NASDAQ Market
Privately Held Companies Can’t sell securities to
the general public Sale of securities is
severely restricted by regulation
Publicly Traded Companies
Received approval from SEC to offer securities to the general public
Process of obtaining approval and registration is known as ‘going public’
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Private, Public, and Listed Companies, and the OTC Market
The IPO Once prospectus is approved by SEC securities can be
sold to public Initial public offering (IPO) is the initial sale
Market for IPOs is very volatile and risky 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
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The NASDAQ Market
After a company goes public, its shares can trade in the over-the-counter (OTC) market
Eventually a firm may list on an exchange Smaller, public companies can trade on the
NASDAQ market National Association of Securities
Dealers Automated Quotation System
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The Governance Problem
So top executives are personally motivated to hold financial performance up - often at any cost
Which in turn holds stock price up and makes them rich
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Compensation: Harry Johnson, CEO
Salary $2,500,000 Bonus 1,500,000
$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 of Stock Based Compensation
BUT what if Harry can’t exercise his option for another six months AND some disturbing financial information has come
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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Measures of Performance
The market measures performance on three important financial results Revenue Earnings per share Debt
Revenue and Earnings per share More is better Rapid growth is great
Debt Less is better
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The Crime Against Investors
Company executives with auditors help misstated financial statements Stocks became grossly overvalued
When fraud discovered stock price crashes Small investors who bought at high prices lose their
investments Executives see crash coming and cash out early
Some firms had forced employee retirement savings into their own stock Ordinary employees lost their entire retirements
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Recognition
In 2000 Enron, the seventh largest company in the country got caught. Fraudulent reporting was discovered CPA’s complicity was revealed The firm collapsed along with its pension assets Arthur Anderson, one of the largest accounting
firms failed and disappeared completely Resulting investigations revealed many
companies had misstated financials
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Federal Government Moves to Fix the Problem
Three major culpable groups were identified Top management Auditors Wall Street financial analysts
Federal government creates legislation that in future will Regulate the Public Accounting profession Enhance accounting/reporting controls Punish guilty executives severely Regulate Analyst reporting
Sarbanes-Oxley Act (SOX)
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Stock Analyst Conflicts
Investors buy and sell stocks based on Wall Street analysts’ recommendations
But many analysts worked for brokerage houses that had Investment Banking departments doing business with the firms being analyzed investment banks advise companies on selling securities
Employers pressured analysts for favorable reports pressure = compensation, threat of firing of 33,000 buy/sell/hold recommendations issued in 1999, only
125 were sells (.3%) While market was on the brink of collapse
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Interest
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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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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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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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 If people feel good about the economy they will
spend with borrowed money and businesses will borrow for expansion and new projects
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The Components of an Interest Rate
Interest rates include base rates rates and risk premiums
Interest rate represented by the letter k k = base rate + risk premium
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 Generally between 2% and 4%
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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 Interest rates include estimates of average annual inflation
over loan periods
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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 Some loans are more risky than others
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
Maturity Risk (MR) Bond prices and interest rates move in opposite
directions Long-term bond prices change more with interest rate
swings than short-term bond prices Larger loss possible on long term bond if rates change Gives rise to maturity risk
Investors demand a maturity risk premium on longer term bonds Generally ranges from 0% to 2%
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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 Treasury bills - terms from 90 days to a year Treasury notes - terms from 1 to 10 years
Risk in Federal Government Debt No default risk: Can print money to pay off its debt No liquidity risk: It’s easy to sell federal securities Federal debt does have maturity risk
But not on very short-term debt
Hence very short term federal securities, Treasury Bills, pay the RISK FREE RATE
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The Risk-Free Rate
The risk-free rate is approximately the yield on short-term Treasury bills Includes the pure rate and inflation the inflation
adjustment
Conceptual floor for interest rates Denoted as kRF
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The Real Rate of Interest
Real implies the effects of inflation removed
Tells investors whether or not they are getting ahead Loss in purchasing power - earn a real rate of 8% when inflation
is 10%
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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Yield Curves—The Term Structure of Interest Rates
The graphic relation between interest rates and the term of debt
The normal yield curve Short-term rates are usually lower than long-term rates
– curve slopes up The inverted yield curve
Long-term rates are lower than short-term rates – curve slopes down
A sustained inverted curve usually signals an economic downturn is ahead
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Yield Curves Figure 5.10