Financial Markets & Securities Offerings

Question 1

What are the functions of financial markets?

Answer 1

Financial markets facilitate the creation and transfer of financial assets and obligations. They bring together entities that have funds to invest with entities that have financing needs. The resulting transactions create assets and obligations

Transfers of funds may be direct or may be through intermediate entities such as banks. The use of intermediate entities and financial markets improves allocative efficiency because of their special expertise. The result is the availability of relatively rapid and low-cost transfers of capital (an essential feature of a modern economy)

Question 2

What type of securities are traded in the money markets?

Answer 2

Money markets trade debt securities with maturities of less than 1 year. These are dealer-driven markets because most transactions involve dealers who buy and sell instruments at their own risk

The dealer is a principal in most transactions, unlike a stockbroker who acts as an agent. Money market exists in New York, London and Tokyo. Money market securities are generally short-term and marketable. They usually have low default risk. Money market securities include the following:

a. Government Treasury bills
b. Government Treasury notes and bonds
c. Federal agency securities
d. Short-term tax-exempt securities
e. Commercial paper
f. Certificates of deposit
g. Repurchase agreements
h. Eurodollar CDs
i. Bankers’ acceptances

Question 3

What type of securities are traded in the capital markets?

Answer 3

Capital markets trade long-term debt and equity securities. The New York Stock Exchange is an example of a capital market

Question 4

What are Primary Markets?

Answer 4

Primary markets are the markets in which corporations and governmental units raise new capital by making initial offerings of their securities. The issuer receives the proceeds of sale in a primary market

Question 5

What are Secondary Markets?

Answer 5

Secondary markets provide for trading of previously issued securities amount investors (i.e. auction and dealer markets)

Question 6

What is the Over-the-counter (OTC) market?

Answer 6

The over-the-counter (OTC) market is a dealer market. It consists of numerous brokers and dealers who are linked by telecommunications equipment that enables them to trade throughout the country. The OTC market conducts transactions in securities not traded on the stock exchanges

Question 7

What type of transactions does the over-the-counter (OTC) market involve?

Answer 7

The OTC market handles transactions involving:

a. Bonds of U.S. companies
b. Bonds of federal, state and local governments
c. Open-end investment company shares of mutual funds
d. New securities issues
e. Most secondary stock distributions, whether or not they are listed on an exchange

Question 8

What organization is the governing authority for the over-the-counter (OTC) markets?

Answer 8

The governing authority for the OTC market is the National Association of Securities Dealers (NASD). Its computerized trading system is the NASD Automated Quotation (NASDAQ) system, which supplies price quotes and volume amounts during the trading day

Question 9

In which market is the trading of corporate bonds primary done in?

Answer 9

Trading in the bonds of corporations is primarily done in the OTC market by large institutional investors (i.e. pension funds, mutual funds and life insurance companies)

Since very large amounts are exchanged among a few investors, dealers in the bond markets can feasibly arrange these transactions. A similar arrangement for trading of stocks would be difficult because they are owned by millions of shareholders

Question 10

What are financial intermediaries?

Answer 10

Financial intermediaries are specialized firms that help create and exchange the instruments of financial markets. Financial intermediaries increase the efficiency of financial markets through better allocation of financial resources

The financial intermediary obtains funds from savers, issues its own securities and uses the money to purchase an enterprise’s securities. Thus, financial intermediaries create new form s of capital. For example, a savings and loan association purchases a mortgage with its funds from savers and issues a savings account or a certificate of deposit

Question 11

What institutions are financial intermediaries?

Answer 11

Financial intermediaries include:

1. Commercial banks
2. Life insurance companies
3. Private pension funds
4. Nonbank thrift institutions (i.e. savings banks & credit unions)
5. State and local pension funds
6. Mutual funds
7. Finance companies
8. Casualty insurance companies
9. Money market funds
10. Mutual savings banks
11. Credit unions
12. Investment bankers

Question 12

What is the efficient markets hypothesis?

Answer 12

The efficient markets hypothesis states that current stock prices immediately and fully reflect all relevant information. Hence, the market is continuously adjusting to new information and acting to correct pricing errors

In other words, securities prices are always in equilibrium. The reason is that securities are subject to intense analysis by many thousands of highly trained individuals

These analysts work for well-capitalized institutions with the resources to take very rapid action when new information is available

The efficient markets hypothesis states that it is impossible to obtain abnormal returns consistently with either fundamental or technical analysis

Question 13

What is Fundamental analysis?

Answer 13

Fundamental analysis is the evaluation of a security’s future price movement based upon sales, internal developments, industry trends, the general economy and expected changes in each factor

Question 14

What is Technical analysis?

Answer 14

Technical analysis is the evaluation of a security’s future price based on the sales price and number of shares traded in a series of recent transactions

Question 15

How many versions does the Efficient market hypothesis have?

Answer 15

Under the efficient markets hypothesis, the expected return of each security is equal to the return required by the marginal investor given the risk of the security. Also, the price equals its fair value as perceived by investors.

The efficient markets hypothesis has 3 forms (versions):

1. Strong form
2. Semi-strong form
3. Weak form

Note: Empirical data have refuted the Strong form of the efficient markets hypothesis but NOT the Weak and Semi-strong forms

The market efficiency incorporates public information into securities prices. However, when making investment decisions, investors should be aware of economic information about the firm’s markets and the strength of the products of the firm. Since the possibility exists that all information is NOT reflected in security prices, there is an opportunity for arbitrage

Question 16

What is the Strong form of the efficient market hypothesis?

Answer 16

The Strong form of the efficient market hypothesis states that all public and private information is instantaneously reflected in securities’ prices. Thus, insider trading is assumed NOT to result in abnormal returns

Question 17

What is the Semi-strong form of the efficient market hypothesis?

Answer 17

The Semi-strong form of the efficient market hypothesis states that all publicly available data are reflected in security prices, but private or insider data are not immediately reflected. Accordingly, insider trading can result in abnormal returns

Question 18

What is the Weak form of the efficient market hypothesis?

Answer 18

The Weak form of the efficient market hypothesis states that current securities prices reflect all recent past price movement data, so technical analysis will NOT provide a basis for abnormal returns in securities trading

Question 19

What are factors that important to a firm’s rating of their debt?

Answer 19

A firm must pay to have its debt rated. Standard & Poor’s and Moody’s are the most frequently used agencies

The ratings are determined from corporate information (such as financial statements)

Important factors involved in the analysis include the ability of the issuer to service its debt with its cash flows, the amount of debt it has already issued, the type of debt issued and the firm’s cash flow stability

Question 20

What are reasons why a bond rating may change?

Answer 20

A rating may change because the rating agencies periodically review outstanding. A decrease in the rating may increase the firm’s cost of capital or reduce its ability to borrow long-term. One reason is that many institutional investors are NOT allowed to purchase lower-grade securities

A rating agency review of existing securities may be triggered by a variety of factors (i.e. a new issue of debt, an intended merger involving an exchange of bonds for stock, or material changes in the economic circumstances of the firm)

Question 21

What are bond ratings significant to a firm?

Answer 21

The ratings are significant because higher ratings lower interest cost to issuing firms

Lower ratings incur higher required rates of return

The lower the risk of default, the lower the interest rate the market will demand

Question 22

How does the bond rating agency Standard & Poor’s rates their bonds?

Answer 22

Standard & Poor rates bonds as follows:

1. AAA and AA are the highest, signifying little change of default and high quality
2. A and BBB rated bonds are of investment grade. They have strong interest and principal paying capabilities. Bonds with these ratings are the lowest-rated securities that many institutional investors are permitted to hold
3. Debt rated BB and below is speculative (i.e. junk bonds)
4. CCC to D are very poor debt ratings. The likelihood of default is significant or the debt is already in default (D rating)

Note: Standard & Poor’s adjusts its ratings with the use of a plus-minus system. A plus indicates a stronger rating in a category and a minus a weaker rating

Question 23

What are characteristics of junk bonds?

Answer 23

Junk bonds are high-yield or low-grade bonds

These high-risk bonds have received much attention in the last decade because of their use in corporate mergers and restructurings and the increase in junk-bond defaults

Question 24

What functions do investment bankers serve?

Answer 24

Investment bankers serve as intermediaries between businesses and the provides of capital. They not only help to sell new securities, but also assist in business combinations, act as brokers in secondary markets and trade from their own accounts

In their traditional role in the sale of new securities, investment bankers help determine the method of issuing the securities and the price to be charged, distribute the services, provide expert advice and perform a certification function

Investment bankers contribute to the efficiency with which securities are sold. An investment banker has a professional staff, a network of dealers and a regular clientele

Question 25

How does an issuer of new securities usually select their investment banker?

Answer 25

An issuer of new securities ordinarily selects an investment banker in a negotiated deal. Only a few large issuers seek competitive bids. The reason for the predominance of negotiated deals is that the costs of learning about the issuer and setting an issue price and fees are usually prohibitive unless the investment banker has a high probability of closing the deal

Question 26

What choice does an investment banker has to make prior issuing new securities for a firm?

Answer 26

A choice must be made as to whether to have the securities underwritten or sold through the best efforts of the investment banker

Best efforts sales of securities provide no guarantee that the securities will be sold or that enough cash will be raised. The investment banker receives commissions and is obligated to use its best efforts to sell the securities

An underwritten deal or a firm commitment provides a guarantee. The investment banker agrees to purchase the entire issue and resell it

Question 27

What does the certification function that an investment banker perform entail?

Answer 27

The certification function of an investment banker derives form its reputation capital

The expertise, integrity and experience of the investment banker help to offset the information asymmetry between the management of the issuing firm and potential buyers of the securities

Thus, buyers rely on the investment banker’s reputation for pricing the issue fairly

Question 28

What does the first phase entail when a firm initially decides that they want to issue securities?

Answer 28

A prospective issuer and an investment banker conduct pre-underwriting conferences to discuss basic questions - type of securities to issue and the nature of the agreement

After the parties agree that a flotation will occur, the investment banker conducts an investigation of the issuer. Thus, a firm of public accountants is engaged to audit the issuer and to assist in preparing the registration statement to be filed with the SEC. Attorneys are hired as advisers concerning the legal issues and other experts are consulted as necessary

The investment banker that serves as the managing underwriter will also analyze the issuer’s financial condition and prospects

The result of this phase is an agreement establishing all of the terms of the arrangement, including the amount of capital to be raised, the type of securities and the basis for determining the offering price

Question 29

Why is determining the offering price of securities is crucial in an issuing?

Answer 29

Determining the offering price of securities is crucial. For a seasoned issue, the offering price may be pegged to the price of the existing securities (i.e. the market price of stock or yield on bonds)

For example, an issue of common stock may be priced at a certain percentage below the closing price on the last day of the registration period

However, if the closing price falls below a certain price (the upset price), the agreement is voided

The issuer and the investment banker obviously have divergent interests regarding price. The investment banker wants to set a price as low as possible to facilitate sale; whereas, the issuer desires as high a price as possible to raise the maximum amount of funds

Note: For seasoned issues, recent market prices may provide clear guidelines, but the problem may be acute for an initial public offering

Question 30

What is the spread?

Answer 30

The spread is the difference between the price paid by the investment banker (underwriter) and the offering price paid by investors. It provides a profit and covers the cost of underwriting

For example, if an investment banker buys a firm’s stock for $50.00 per share and the offering price is $53.50, then the underwriter’s spread is $3.50 per share ($53.50 - $50.00) or 7% of the offer price

Question 31

How does an investment banker share the risk of overpricing an issuance or market decline during the offering period?

Answer 31

A single investment banker ordinarily does not underwrite an entire issue of securities unless the amount is relatively small

To share the risk of overpricing the issue or of a market decline during the offering period, the investment banker (the lead or managing underwriter) forms an underwriting syndicate with other firms

The members of the syndicate share in the underwriting commission, but their risk is limited to the percentage of their participation

Question 32

What does the formation of a syndicate do?

Answer 32

The formation of a syndicate improves marketing efficiency by combining the efforts of the firms’ selling organizations

Question 33

When an offering is large, how does the syndicate function?

Answer 33

For a large offering, a selling group is formed. It consists of the members of the syndicate and other dealers who take small shares of the issue (participants) from the original underwriters. Accordingly, the syndicate members are in effect wholesalers of the securities and the additional members of the selling group are retailers

The members of the selling group agree to subscribe to the new issue at the public offering price minus the concession they receive as a commission

They also agree not to sell below the public offering price

Question 34

When would a lead underwriter place orders to buy securities in the market?

What are the effects of doings this?

Answer 34

While the public offering is in force (but not for more than approximately 30 days) the lead underwriter customarily attempts to maintain a stable price for the securities by placing orders to buy in the market

One incidental effect of this operation is that the certificate numbers of repurchased securities are examined to determine whether members of the selling group have violated their agreement not to sell below the public offering price

Question 35

What are Flotation costs?

Answer 35

Flotation costs are the costs of issuing new securities. They are relatively lower for large issues than those for small issues. These costs include the following:

1. The underwriting spread - difference between the price paid by purchasers and the net amount received by the issuer
2. The issuer incurs expenses for filing fees, taxes, accountants’ fees and attorneys’ fees. These costs are essentially fixed
3. The issuer incurs indirect costs because of management time devoted to the issue

Note: Flotation costs tend to be greater for common stock than for preferred stock and for stocks than bonds

Question 36

What does an announcement of a new issue of seasoned securities usually result in?

Answer 36

Announcement of a new issue of seasoned securities usually results in a price decline. One theory is that the announcement is a negative signal to the market

Management may not want to issue new stock when it is undervalued. Also, existing owners do not want to share the company’s growth with additional owners

Question 37

What is the green shoe option?

Answer 37

The green shoe option allows underwriters to buy additional shares of securities to compensate for oversubscriptions. A cost is involved because the option will be exercised only when the offer price is lower than the market price

Question 38

What is usually the relationship between the price of unseasoned securities (IPO) vs. the price in the aftermarket?

Answer 38

An offer of unseasoned securities (an initial public offering) tends to be significantly underpriced compared to the price in the aftermarket

Question 39

How is an initial public offering (IPO) defined?

Answer 39

A firm’s first issuance of securities to the public is an initial public offering

The process by which a closely held corporation issues new securities to the public is called going public. When a firm goes public, it issues its stock on a new issue or initial public offering market

Later issues of stock by the same company are subsequent offerings

Question 40

What are advantages of going public?

Answer 40

Advantages of going public include:

1. The ability to raise additional funds
2. The establishment of the firm’s value in the market
3. An increase in the liquidity of the firm’s stock

Question 41

What are the disadvantages of going public?

Answer 41

Disadvantages of going public include:

1. Costs of the reporting requirements of the SEC and other agencies
2. Access to the company’s operating data by competing firms
3. Access to net worth information of major shareholders
4. Limitations on self-dealing by corporate insiders, such as officers and major shareholders
5. Pressure from outside shareholders for earnings growth
6. Stock prices that do not accurately reflect the true net worth of the company
7. Loss of control by management as ownership is diversified
8. Need for improved management control as operations expand
9. Increased shareholder servicing costs

Question 42

What type of decisions much an issuer make prior to an IPO?

Answer 42

Once the decision to make an IPO has been made, the questions are similar to those for seasoned issues: the amount to be raised, the type of securities to sell and the method of sale

For example, the following matters should be considered in selecting the type of securities to issue:

1. Should fixed charges be avoided? The issuance of debt would create fixed charges
2. Is a maturity date on the security preferable or is permanent capital more attractive?
3. Does the firm want a cushion to protect itself from losses to the firm’s creditors?
4. How quickly and easily does the firm want to raise the capital?
5. Is the firm concerned about losing control of the company?
6. How does the cost of underwriting differ among the types of securities?