1、“FINANCIAL MARKETS & INSTITUTIONS”,CLICK MOUSE OR HIT SPACEBAR TO ADVANCE,1 Introduction: Role of Mkts & Institutions,Firms need capital for investment projects (NPV0 investments),The objective of the firm is to maximize shareholder wealth (maximize the value of the firm). Financial markets and inst
2、itutions assist with this goal in the following ways,Provide liquidity and ease of transactions,Allow for discovery of value (efficiency),Major Roles of Financial Markets & Institutions,Allow for risk management,2 Primary markets,A. Primary Market:,Where securities are sold to the public to raise ca
3、pital for the firm.,IPO and Seasoned Offers:,Seasoned Offer: Securities have been issued to the public previously, and this is an additional offer.,Initial Public Offering (IPO): Securities are being issued to the public for the first time.,3 IPO Performance,Krispy Kreme,4 Issuing securities to the
4、public,Investment Banks:,E.g., Credit Suisse First Boston, Deutsche Bank, Goldman Sachs,Objective is to raise capital for firms,I. Straight Underwriting,Underwriter buys the securities from the issuing firm and resells them to the public. The firm gets its capital right away.,E.g., GS buys the secur
5、ities from the firm for $20 (concession price) and sells them to the public for $20.10.,Bank earns a return from the spread, i.e., $0.10 per share or 50 bps. (If there are 30m shares issued, the bank earns $3m.),Note: The underwriter bears the risk that the securities will not sell.,5 Issuing securi
6、ties to the public continued,II. Best Efforts,The underwriter uses its expertise and “best efforts” to sell the securities.,Unsold securities are returned to the firm (no risk of not selling).,Funds are remitted to the firm as the securities are sold. Return is based on a spread, which is generally
7、less than that of straight underwriting (less risky to the underwriter).,6 Issuing securities to the public continued,III. Private Placement,Securities are sold to a small group of “sophisticated” investors.,Investors have the ability to:,a. Evaluate the risks;,b. Withstand economic risks.,Tim Geith
8、ner: US Treasury Secretary,7 Issuing securities to the public continued,Underwriting Variations,I. Bought Deal,Underwriters arrange buyers and approach issuing firm.,II. Google,Held a public auction of their securities (online), bypassing the investment banks.,8 Issuing securities to the public cont
9、inued,Reasons for using Investment Banks,Help with registering the issue.,Help with pricing the issue.,Sell the securities quickly and efficiently (low cost).,Provide market liquidity (act as market makers).,May create derivative securities for risk management.,9 Pre-emptive rights offering,Say a fi
10、rm has 1m shares outstanding at $25/share.,Market Value of equity =,1m x $25 = $25m,Now suppose that the firm issues 250k shares at $20/share.,Market Value of equity =,$25m + (250k)(20) = $30m,The new price per share =,$30m/1.25m = $24/share,Value for old shareholders = 1m x $24 = $24m ($1m loss),Va
11、lue for new shareholders = 250k x $24 = $6m ($1m gain),Wealth Effects,10 Pre-emptive rights offering continued,Rights Offering,Existing shareholders have the right to purchase new shares in proportion to their current ownership. That is,N = number of rights needed to buy “1” new share,N=1m/250k=4,Sa
12、y an investor has 1000 shares:,Wealth before issue:,1000 x $25 = $25,000,11 Pre-emptive rights offering continued,Option I: Buy new shares,Equity Value before = $25,000,Buy new shares = 1000/4 x $20 = $5000,Equity Total = $30,000,Equity Value after = 1,250 x 24 = $30,000,Option II: Sell the Rights,G
13、ain/loss = $0,Equity Value before = $25,000,Equity Value after = $24,000,Loss = -$1000,Proceeds from sale of rights = 1000 x $1 = $1000,Gain/loss = $0,Rights valuation:,12 Secondary Markets,B. Secondary Markets,Where outstanding securities trade.,Does not involve cash flows to and from the firm unle
14、ss there is a share repurchase or repo.,Three critical roles of secondary markets:,(i) Price discovery,(ii) Liquidity,(iii) Low transactions costs,13 Secondary markets continued,Examples of secondary markets:,NYSE (specialist system),NASDAQ (competitive dealer system),AMEX (specialist system),OTC (O
15、ver-the-counter system computer system),Equity,Equity,Fixed income, e.g. bonds, money market,Equity and derivatives,14 Secondary markets continued,Bid-Ask spread:,Bid price: The highest price at which a market maker will buy.,Ask price: The lowest price at which a market maker will sell.,Spread = As
16、k - Bid,15 Money Market,C. Money Market:,The market for short-term securities (one year or less to maturity).,Examples: Treasury Bills, CDs, Commercial Paper,16 Derivatives Market,D. Derivatives Market:,Securities whose values are “derived” from the value of an underlying asset.,E.g., Options, futur
17、es, forwards, SWAPs, Futures Options, and Swaptions.,Derivatives are used for two purposes:,(i) Risk management,(ii) Speculation,Warren Buffet: Berkshire Hathaway,17 Miscellanea,Recent Important Innovations:,ETFs: Portfolios of securities that trade like equities.,Hedge Funds: Portfolios that invest
18、 funds for “qualified” investors.,Securitization (ongoing).,James Simons: Renaissance Technologies,18 Risk/Return,Recall from GBA 522,The higher the the higher the expected,risk,return.,This assumes that investors are risk-averse and will only accept an investment with higher risk if rewarded with h
19、igher expected return.,If investors are risk-averse, consider TWO statistics: average and variance (or standard deviation).,19 Measures of Risk/Return,Return:,The return on an asset is:,Capital Gains Yield,Income Yield,Returns are generally measured over a period of time, say 60 months.,20 Expected
20、Return and Variance (Risk),The expected return on an asset is;,The variance of returns is;,The standard deviation of returns is;,21 Portfolio Theory,Portfolio:,A combination of two or more assets.,The idea is to spread risk across various assets, i.e., diversification.,Portfolio Return: (Say we form
21、 a portfolio using two assets),Note:,22 Risk/Return continued,Using this relationship, the expected return on a portfolio is;,Thus, a portfolios expected return is a weighted average of the expected returns of the component securities.,23 Risk/Return continued,The variance of returns for a portfolio
22、 is;,24 Risk/Return continued,Covariance and correlation of returns:,where,25 Risk/Return continued,If the correlation is equal to +1, then,Thus,Weighted-average risk: No diversification effect.,Result:,If correlation is +1, you obtain weighted-average return, and LESS than weighted-average risk!,26
23、 Risk/Return continued,Suppose that variance has TWO components:,Variance = Systematic Risk + Unsystematic Risk,Un-diversifiable,Diversifiable,Assume that ALL investors form portfolios to eliminate unsystematic risk (costless).,Then the only relevant risk is systematic (beta):,27 Risk/Return continu
24、ed,A Model of Risk/Return:,First recognize that beta for a portfolio is,Noting that wA + wF = 1, we know that wF = 1 wA so that,Next, lets create a portfolio with risk identical to the overall market.,28 Risk/Return continued,Let “F” be riskless so that its beta is zero. We also know that beta for the market “M” is 1.0. Therefore,and,The expected return on this portfolio is:,29 Risk/Return continued,We now have two assets with the same risk. These assets must have the same expected return!,This simplifies easily to,This is a no-arbitrage proof of the CAPM.,
