New Text Document Flashcards
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Gleim P2 2023 Study Unit Five: Financial Markets and Financing Summary
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5.1 Financial Markets and Securities Offerings
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Financial(Securities) Markets: These platforms facilitate the creation and exchange of financial assets
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connecting
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investors with entities seeking funding
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They facilitate the transfer of assets and obligations. Due to this activity
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markets cause people to adjust their consumption patterns. Financial intermediaries increase the efficiency of financial
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markets through better allocation of financial resources
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not by clearing the market.
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Money Markets vs. Capital Markets:
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Money markets deal with short term debt securities (maturities under 1 year)
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such as U.S. Treasury bills
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acceptances
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commercial paper
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time deposits
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and consumer credit loans.
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capital markets handle long-term debt and equity securities. Such as Preferred stocks
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Mortgages
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Primary vs. Secondary Markets: Companies raise new capital through initial offerings in primary markets
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while
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secondary markets involve trading of previously issued securities.
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The sale of the stock in the primary market can be used as a benchmark because the same type of securities
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were already issued in this market.
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The over-the-counter market (OTC) is a dealer market
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in which brokers and dealers are linked by telecommunications
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equipment
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Insider Trading and Efficient Markets Hypothesis:
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Insider trading
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using nonpublic information for securities trading
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The efficient markets hypothesis (EMH) posits that security prices reflect all available information
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The efficient markets hypothesis states that it is impossible to obtain abnormal returns consistently with either
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fundamental or technical analysis.
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● Fundamental analysis is the evaluation of a security’s future price movement based upon sales
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internal
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developments
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industry trends
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● Technical analysis is the evaluation of a security’s future price based on the sales price and number of shares traded in
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a series of recent transactions. financial managers cannot benefit from timing the sales and purchases of securities.
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Initial Public Offering (IPO) is the first time a company issues its securities (shares) to the public. The process by which a
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private company becomes public is called "going public".
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When the company goes public
it offers its shares for the first time in the market
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After the IPO
if the company issues more shares
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A subsequent or secondary offering the best describes a public offering where there is less price uncertainty
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due to the existence of a benchmark price
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There are two types of secondary offerings:
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Dilutive secondary offering: In this type
the company issues new shares and sells them to the public. The company
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receives proceeds from the sale
and the number of outstanding shares increases.
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If the company sells shares from its treasury
this is also considered a subsequent offering.
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Nondilutive secondary offering: In this type
existing shareholders (such as founders or executives) sell their shares to
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the public. The company does not receive any proceeds from this sale
and the number of outstanding shares does
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not change.
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In other words
in a dilutive offering
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nondilutive offering
existing shareholders sell their own shares
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Rating agencies charge companies to evaluate their debt. Ratings are determined based on the probability of default
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and the protection for investors in case of default.( The chances of default)
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The ratings are based on the company's financial information
such as financial statements.
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Important factors in the analysis include:
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1. The company's ability to repay its debt using cash flows.
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2. The amount of debt the company has issued.
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3. The type of debt issued.
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4. The stability of the company's cash flows.
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The rating may change when rating agencies review issued securities. A downgrade in the rating can increase the cost of
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capital or reduce the company's ability to borrow long-term.
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Rating agencies may review securities due to various factors
such as new debt issuance
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the company.
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Ratings are important because higher ratings lower interest costs for the company
while lower ratings increase the
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required rate of return.
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Standard & Poor's ratings:
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1. AAA and AA are the highest
indicating very high quality and low default risk.
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2. A and BBB represent investment-grade bonds with strong capabilities to repay interest and principal.
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3. BB and below are considered speculative bonds or "Junk Bonds."
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Investment banks act as intermediaries between companies and capital providers.
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They help with selling new securities
engage in business combinations
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their own accounts.
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In their traditional role
investment banks: Determine the method of issuing securities and set the price
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the securities
Provide specialized advice
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Typically
investment banks are selected through a negotiated deal
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This is because the cost of learning about the issuer and setting the price and fees is high unless the investment banker has
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a high chance of closing the deal.
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Securities issuance can occur in two ways:
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Best efforts sales: There is no guarantee that the securities will be sold or that enough funds will be raised. The
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investment bank receives commissions and must do its best to sell the securities.
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Underwritten (firm commitment): The investment bank agrees to buy the entire issue and resell it
meaning the issuer
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does not bear the risk of not selling the securities.
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Setting the offering price for securities is critical.
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For seasoned issues
the offering price may be tied to the market price of the existing securities.
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Typically
a single investment bank does not underwrite the entire issue unless the amount is small.
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To distribute the risk of overpricing or market declines during the offering period
the lead investment bank forms an
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underwriting syndicate with other firms.
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Syndicate members share the underwriting commission
and their risk is limited to their participation percentage
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Flotation costs are relatively lower for large issues compared to small issues. These costs are higher for common stock
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compared to preferred stock
and higher for stocks than for bonds.
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Flotation costs include:
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Underwriting spread: the difference between the price paid by purchasers and the net amount received by the issuer.
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Other expenses such as filing fees
taxes
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Announcing a new issue of seasoned securities usually leads to a price decline. This is because the announcement may signal
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negatively to the market
as management might avoid issuing new stock if it is undervalued.
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Seasoned securities are financial instruments that have been publicly traded long enough to eliminate any short-term
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effects from their initial public offering (IPO).
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In the Euromarket
securities must trade for at least 40 days to be considered "seasoned."
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Initial public offerings (unseasoned securities) are often underpriced compared to their aftermarket price.
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Note: Mutual funds are corporations that use funds from savers to invest in stocks
long-term bonds
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financial intermediary)
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5.2 Risk and Return
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Rate of Return: is the amount received by an investor as compensation for taking on the risk of the investment.
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Types of Risk:
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Systematic Risk (Market Risk): Affects all firms and cannot be diversified away.(such as Market risk
Interest rate risk
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Foreign exchange risk
Purchasing power risk)
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Unsystematic Risk (Company Risk): Specific to a company or industry and can be mitigated through diversification.( such
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as Credit
or default
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Risk-Return Relationship: Investors
generally risk-averse
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● A risk neutral investor adopts an expected value approach because (s)he regards the utility of a gain as equal to the disutility
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of a loss of the same amount. Thus
a risk-neutral investor has a purely rational attitude toward risk.
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● A risk-seeking investor has an optimistic attitude toward risk. (S)he regards the utility of a gain as exceeding the disutility of
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a loss of the same amount.
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5.3 Portfolio Management
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Efficient Portfolios: Offer the highest expected return for a given level of risk or the lowest risk for a given expected return.
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Measures of Risk:( Risk is the chance that the actual return on an investment will differ from the expected return)
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Expected Rate of Return: Weighted average of possible returns based on their probabilities.
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Expected rate of return (R) = ∑ (Possible rate of return × Probability)
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Standard Deviation: Measures the volatility and dispersion of possible returns.
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● The smaller the standard deviation
the tighter the probability distribution and the lower the risk.
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● The greater the standard deviation
the riskier the investment.
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Correlation: Measures the degree to which two variables move together
ranging from -
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1 (perfect negative correlation) to +1 (perfect positive correlation).
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Covariance: Measures the joint variability of two assets.(= Correlation coefficient × Standard deviation1 × Standard
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deviation2)
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Diversification: Reduces specific risk by investing in a variety of assets.
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Quantitative Risk Assessment Tools: Value at risk (VaR) is a technique that employs a normal distribution (bell curve) to
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determine the maximum potential gain or loss within a certain period at a given level of confidence.
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5.4 Short-Term Financing
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Spontaneous Financing:
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Trade Credit: Allows purchasing goods on credit from suppliers.
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Accrued Expenses: Obligations like salaries and wages that provide short-term financing.
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Short-Term Bank Loans:
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Term Loans: Loans with a specified repayment date.
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Lines of Credit: Allow borrowing up to a pre-approved limit.
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Revolving Lines of Credit: Continuous borrowing and repayment within a credit limit.
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Effective Interest Rate: The true cost of borrowing
considering factors like discounts
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Market-Based Instruments:
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Bankers’ Acceptances: Short-term financing instruments guaranteed by a bank.
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Commercial Paper: Unsecured promissory notes issued by corporations.
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Secured Financing: Loans secured by collateral
such as accounts receivable or inventory.
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Maturity Matching: Aligning the maturity of assets and liabilities to minimize financial risk.
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5.5 Long-Term Financing
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Leases: Allow using assets without a large upfront investment.
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Convertible Securities: Debt or preferred stock that can be converted into common stock.
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Stock Purchase Warrants: Options to buy company stock at a specified price within a certain period.
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Retained Earnings: Profits reinvested in the company
representing the lowest-cost source of capital.
