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
seat1366 seats since 1953.
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
1 Providing 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 122.3 17.9%
2 Lehman Brothers 70.3 9.9
3 Golden Sachs 68.5 9.7
3 Morgan Stanley 68.5 9.7
5 Salomon Brother 68.1 9.6
6 CS First Boston 64.6 9.1
7 J.R. Morgan 40.2 5.7
8 Bear, Sterns 25.4 3.6
Donaldson Lufkin & Jenrette 22.2 3.1
10 Smith Barney 20.7 2.9

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 $441287 828 172
1993 361860 793 207
1992 443911 852 148
1991 603119 807 193
1990 276259 685 315
1989 298813 607 393
1988 329919 613 387
1987 301447 695 305
1986 313502 742 258
1985 165754 721 279
1984 109903 669 331

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

1929--1932, 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
3.2
3.7
5.4
5.9
12.3
17.6
4.7
3.3
8.7
8.4
20.5
34.8
0
5
10
15
20
25
30
35
40

Average annual returns

Standard deviations
inflation Treasury
bills
long-term
government
bonds
long-term
corporat
bonds
common
stock
common
stocks of
small firms
Figure 2-4 Average Annual Returns and Standard
Deviations of Returns, 1926-1995
0
5
10
15
20
25
30
35
40
0 5 10 15 20
p
e
r
c
e
n
t
a
g
e
Treasury
bills
Inflation
long-term
corporate bonds
common
stocks
long-term
government bonds
common stocks
of small companys
Standard deviation of returns
Figure 2-5 Rates of Return and Standard Deviations, 1926-1995
Table 2-7 Interest Rate Level and Inflation Rates 1981-1995
3-Month 30-Year A
AA
Rated Inflation
Treasury Bills Treasury Bonds Corporate Bonds rate
1981 14.08 13.44 14.17 8.9
1982 10.69 12.76 13.79 3.9
1983 8.63 11.18 12.04 3.8
1984 9.52 12.39 12.71 4.0
1985 7.49 10.79 11.37 3.8
1986 5.98 7.80 9.02 1.1
1987 5.82 8.58 9.38 4.4
1988 6.68 8.96 9.71 4.4
1989 8.12 8.45 9.26 4.6
1990 7.51 8.61 9.32 6.1
1991 5.42 8.14 8.77 3.1
1992 3.45 7.67 8.14 2.9
1993 3.02 6.59 7.22 2.7
1994 4.29 7.37 7.97 2.7
1995 5.51 6.88 7.59 2.5
Mean 7.08 9.31 10.03 3.93

0
2
4
6
8
10
12
14
16
1980 1982 1984 1986 1988 1990 1992 1994
%
Aaa Bonds
30-Years Bonds
3-Month Bills
Inflation rate
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% +
0.02%+ 0.05% = 4.72%

In reality
2.75% - 4.72%
= - 1.97% ???
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)
0.113 = k* + .05 + '05k*
K* = .06 = 6%



MEAN MEAN INFERRED
NOMINAL YIELD INFLATION RATE REAL RATE
SECURITY % % %

Treasury bills 7.08 3.93 3.15
Treasury bonds 9.31 3.93 5.38
Corporate bonds 10.03 3.93 6.10



THE TERM STRUCTURE OF
INTEREST RATES


9
11.5
13
6
8
10
12
14
0 5 10 15 20 25
Year to maturity
P
e
r
c
e
n
t
a
g
e
Historical Interest Rates
2 10 30
9
13
1
Years to maturity
Int
er
est
rat
e
Oct 31, 19 79
Mar 31, 19 90
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 placementsinstitutional 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