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1
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Gleim P2 2023 Study Unit Five: Financial Markets and Financing Summary

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2
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5.1 Financial Markets and Securities Offerings

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3
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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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4
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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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5
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markets cause people to adjust their consumption patterns. Financial intermediaries increase the efficiency of financial

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6
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markets through better allocation of financial resources

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not by clearing the market.

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7
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 Money Markets vs. Capital Markets:

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8
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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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9
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acceptances

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commercial paper

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10
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time deposits

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and consumer credit loans.

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11
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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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12
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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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13
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secondary markets involve trading of previously issued securities.

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14
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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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15
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were already issued in this market.

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16
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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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17
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equipment

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18
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 Insider Trading and Efficient Markets Hypothesis:

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19
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 Insider trading

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using nonpublic information for securities trading

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20
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 The efficient markets hypothesis (EMH) posits that security prices reflect all available information

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21
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The efficient markets hypothesis states that it is impossible to obtain abnormal returns consistently with either

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22
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fundamental or technical analysis.

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23
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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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24
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developments

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industry trends

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25
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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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26
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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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27
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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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28
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private company becomes public is called “going public”.

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29
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 When the company goes public

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it offers its shares for the first time in the market

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30
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 After the IPO

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if the company issues more shares

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31
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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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32
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due to the existence of a benchmark price

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33
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 There are two types of secondary offerings:

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34
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 Dilutive secondary offering: In this type

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the company issues new shares and sells them to the public. The company

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35
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receives proceeds from the sale

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and the number of outstanding shares increases.

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36
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 If the company sells shares from its treasury

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this is also considered a subsequent offering.

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37
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 Nondilutive secondary offering: In this type

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existing shareholders (such as founders or executives) sell their shares to

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38
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the public. The company does not receive any proceeds from this sale

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and the number of outstanding shares does

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39
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not change.

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40
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In other words

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in a dilutive offering

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41
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nondilutive offering

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existing shareholders sell their own shares

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42
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11

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43
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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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44
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and the protection for investors in case of default.( The chances of default)

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45
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 The ratings are based on the company’s financial information

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such as financial statements.

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46
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 Important factors in the analysis include:

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47
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  1. The company’s ability to repay its debt using cash flows.
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48
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  1. The amount of debt the company has issued.
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49
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  1. The type of debt issued.
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50
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  1. The stability of the company’s cash flows.
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51
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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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52
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capital or reduce the company’s ability to borrow long-term.

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53
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 Rating agencies may review securities due to various factors

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such as new debt issuance

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54
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the company.

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55
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 Ratings are important because higher ratings lower interest costs for the company

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while lower ratings increase the

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56
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required rate of return.

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57
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 Standard & Poor’s ratings:

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58
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  1. AAA and AA are the highest
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indicating very high quality and low default risk.

59
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  1. A and BBB represent investment-grade bonds with strong capabilities to repay interest and principal.
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60
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  1. BB and below are considered speculative bonds or “Junk Bonds.”
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61
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Investment banks act as intermediaries between companies and capital providers.

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62
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They help with selling new securities

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engage in business combinations

63
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their own accounts.

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64
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 In their traditional role

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investment banks: Determine the method of issuing securities and set the price

65
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the securities

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Provide specialized advice

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 Typically

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investment banks are selected through a negotiated deal

67
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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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68
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a high chance of closing the deal.

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69
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 Securities issuance can occur in two ways:

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70
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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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71
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investment bank receives commissions and must do its best to sell the securities.

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72
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 Underwritten (firm commitment): The investment bank agrees to buy the entire issue and resell it

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meaning the issuer

73
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does not bear the risk of not selling the securities.

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74
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 Setting the offering price for securities is critical.

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75
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For seasoned issues

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the offering price may be tied to the market price of the existing securities.

76
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 Typically

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a single investment bank does not underwrite the entire issue unless the amount is small.

77
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 To distribute the risk of overpricing or market declines during the offering period

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the lead investment bank forms an

78
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underwriting syndicate with other firms.

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79
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 Syndicate members share the underwriting commission

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and their risk is limited to their participation percentage

80
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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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81
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compared to preferred stock

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and higher for stocks than for bonds.

82
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 Flotation costs include:

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83
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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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84
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 Other expenses such as filing fees

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taxes

85
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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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86
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negatively to the market

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as management might avoid issuing new stock if it is undervalued.

87
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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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88
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effects from their initial public offering (IPO).

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89
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 In the Euromarket

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securities must trade for at least 40 days to be considered “seasoned.”

90
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 Initial public offerings (unseasoned securities) are often underpriced compared to their aftermarket price.

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91
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Note: Mutual funds are corporations that use funds from savers to invest in stocks

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long-term bonds

92
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financial intermediary)

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93
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12

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94
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5.2 Risk and Return

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95
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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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96
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 Types of Risk:

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97
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 Systematic Risk (Market Risk): Affects all firms and cannot be diversified away.(such as Market risk

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Interest rate risk

98
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Foreign exchange risk

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Purchasing power risk)

99
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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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100
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as Credit

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or default

101
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102
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103
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104
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105
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 Risk-Return Relationship: Investors

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generally risk-averse

106
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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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107
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of a loss of the same amount. Thus

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a risk-neutral investor has a purely rational attitude toward risk.

108
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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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109
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a loss of the same amount.

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110
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5.3 Portfolio Management

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111
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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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112
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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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113
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 Expected Rate of Return: Weighted average of possible returns based on their probabilities.

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114
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Expected rate of return (R) = ∑ (Possible rate of return × Probability)

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115
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 Standard Deviation: Measures the volatility and dispersion of possible returns.

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116
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● The smaller the standard deviation

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the tighter the probability distribution and the lower the risk.

117
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● The greater the standard deviation

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the riskier the investment.

118
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 Correlation: Measures the degree to which two variables move together

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ranging from -

119
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1 (perfect negative correlation) to +1 (perfect positive correlation).

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120
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 Covariance: Measures the joint variability of two assets.(= Correlation coefficient × Standard deviation1 × Standard

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121
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deviation2)

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122
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 Diversification: Reduces specific risk by investing in a variety of assets.

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123
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13

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124
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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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125
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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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126
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5.4 Short-Term Financing

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127
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Spontaneous Financing:

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128
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Trade Credit: Allows purchasing goods on credit from suppliers.

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129
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Accrued Expenses: Obligations like salaries and wages that provide short-term financing.

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130
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Short-Term Bank Loans:

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131
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Term Loans: Loans with a specified repayment date.

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132
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Lines of Credit: Allow borrowing up to a pre-approved limit.

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133
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Revolving Lines of Credit: Continuous borrowing and repayment within a credit limit.

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134
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Effective Interest Rate: The true cost of borrowing

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considering factors like discounts

135
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Market-Based Instruments:

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136
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Bankers’ Acceptances: Short-term financing instruments guaranteed by a bank.

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137
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Commercial Paper: Unsecured promissory notes issued by corporations.

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138
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Secured Financing: Loans secured by collateral

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such as accounts receivable or inventory.

139
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Maturity Matching: Aligning the maturity of assets and liabilities to minimize financial risk.

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140
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5.5 Long-Term Financing

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141
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Leases: Allow using assets without a large upfront investment.

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142
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Convertible Securities: Debt or preferred stock that can be converted into common stock.

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143
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Stock Purchase Warrants: Options to buy company stock at a specified price within a certain period.

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144
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Retained Earnings: Profits reinvested in the company

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representing the lowest-cost source of capital.

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