Chapter 2

The Financial
Markets
and Interest Rates
 Learning Objectives

• Describe key components of the U.S. financial

market system and the financing of business.
• Understand how funds are raised in the capital
markets.
• Be acquainted with recent rates of return.
• Explain the fundamentals of interest rate
determination and the popular theories of the term
structure of interest rates.

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 Financial Markets:
Transfer of Capital
• Financial markets play a critical role in capitalist
economy. Financial markets help facilitate the
transfer of funds from “saving surplus” units to
“saving deficit” units, i.e., transfer money from
those who have the money to those who need it.
• See Figure 2-1 for three ways to transfer capital in
the economy:
– Direct transfer
– Indirect transfer using the investment banker
– Indirect transfer using the financial intermediary

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 Direct Transfer

Direct Transfer

Firm seeking funds directly approaches a

wealthy investor.

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 Indirect Transfer

Indirect Transfer (using investment banks)

Here the investment bank acts as a link

between the firm (needing funds) and the
investors (with surplus funds)

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 Example of Transfer Using
Investment Banks (IB)

Corporation XYZ sells 5 million shares to

Morgan Stanley (IB) at $10 per share

Morgan Stanley pays $50m to XYZ

IPO –
Morgan Stanley tries to sell those shares
in the stock market (savers) for more than $50m
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 Indirect Transfer

Indirect transfer (using financial

intermediary):

Here the financial intermediary (such as

mutual funds) collects funds from savers in
exchange of its own securities (indirect). The
collected funds are then used to acquire
securities (such as stocks and bonds) from
firm.

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 Indirect Transfer using Financial
Intermediary (FI)

Investors (Savers)
transfer savings to mutual fund companies

Mutual fund (FI) companies issue securities to investors.

Mutual funds use the funds to buy securities from corporations.

Corporations (Users) issue stocks and bonds for

funds received from mutual funds

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 Public Offerings Versus
Private Placements
Public Offering
Both individuals and institutional investors have
the opportunity to purchase securities. The
securities are initially sold by the managing
investment bank firm. The issuing firm never
actually meets the ultimate purchaser of
securities.

Private or Direct Placement

The securities are offered and sold directly to a
limited number of investors.

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 Primary Markets Versus
Secondary Markets
Primary Market (initial issue)
This is the market in which new issues of a securities
are sold to initial buyers. This is the only time the
issuing firm ever gets any money for the securities.
For example, Google raised $1.76 billion through
sale of shares to public in August 2004.

Seasoned Equity Offering (SEO)

It refers to sale of additional shares by a company
whose shares are already publicly traded. For
example, Google raised $4.18 billion in September
2005.

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 Primary Versus
Secondary Markets (cont.)
Secondary Market (subsequent trading)
This is the market in which previously issued
securities are traded. The issuing corporation does not
get any money for stocks traded on the secondary
market. For example, trading among investors today
of Google stocks.

– Primary and secondary markets are regulated by SEC.

Firms have to get approval from SEC before the sale of
securities in primary market. Firms must report financial
information to SEC on a regular basis (ex. financial
statements) to protect investors.

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 The Money Market Versus the
Capital Market
Money Market
This is the market for short-term debt instruments (maturity
periods of one year or less). Money market is typically a
telephone and computer market (rather than a physical
building).
Examples: Treasury bills (issued by federal government),
commercial paper, negotiable CDs, bankers’ acceptances.

Capital Market
This is the market for long-term financial securities
(maturity greater than one year).
Examples: Corporate bonds, common stocks, Treasury
bonds, term loans, and financial leases.

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 Spot Markets Versus Futures
Markets
Cash Markets
This is the market in which something sells immediately.

Futures Markets
This is the market for buying and selling at some future date.

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 Organized
Securities Exchanges

Organized Securities Exchanges are

tangible entities and financial instruments are
traded on its premises.

– New York Stock Exchange (NYSE, also known as “big

board”) is the oldest of all the organized exchanges.
In 2015, the value of the shares of stock listed in the
NYSE was over $22 trillion. The NYSE is a hybrid
market allowing face-to-face and electronic trading.

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 Over-the-Counter Markets

• If firms do not meet the listing requirements of the exchange,

and/or wish to avoid higher reporting requirements and fees
of exchanges, they may choose to trade on OTC.
• OTC (Over-the-Counter) market refers to all securities market
except organized exchanges. There is no specific geographic
location for OTC market. Most transactions are done through
a network of security dealers who are known as broker-
dealers and brokers. Their profit depends on the price at
which they are willing to buy (bid price) and the price at
which they are willing to sell (ask price).
• The most prominent OTC market for stocks is NASDAQ.
NASDAQ lists over 5,000 securities (including Facebook,
Apple, and Amazon). Most corporate bond transactions are
also conducted on OTC markets.

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 Stock Exchange Benefits

– Provides a continuous market

– Establishes and publicizes fair security prices

– Helps businesses raise new capital

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 Investment
Banking Function
Investment Banker/Underwriter
• They are financial specialists involved as an
intermediary in the sale of securities (stocks and
bonds). They buy the entire issue of securities from the
issuing firm and then resell it to the general public.
• The difference between the price the corporation gets
and the public offering price is called the underwriter’s
spread.
• Prominent investment banks in the U.S. include
Goldman Sachs, JP Morgan, Morgan Stanley.

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 Sarbanes-Oxley Act (SOX)

• In response to corporate scandals, Congress passed

this Act in 2002.
• This Act holds senior corporate advisors (such as
accountants, lawyers, board of directors, officers)
responsible for any instance of misconduct.
• The Act attempts to protect the interest of investors
by improving transparency and accuracy of
corporate disclosures.
• SOX has been criticized for imposing additional
compliance costs on the firms. Some firms have
responded by delisting from major exchanges or
choosing to list on foreign exchanges.

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 RATES OF RETURN IN THE
FINANCIAL MARKETS
• Opportunity Cost — Rate of return on next best investment
alternative to the investor

• Standard Deviation — Dispersion or variability around the

mean rate of return in the financial markets

• Real Return — Return earned above the rate of inflation

• Maturity-risk Premium — Additional return required by

investors in long-term securities to compensate for greater
risk of price fluctuations on those securities caused by interest
rate changes

• Liquidity-risk Premium — Additional return required by

investors in securities that cannot be quickly converted into
cash at a reasonably predictable price

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 Interest Rate Determinants

• Nominal interest rate = Real risk-free rate

+ Inflation premium
+ Default-risk premium
+ Maturity-risk Premium
+ Liquidity-risk Premium
• Thus the nominal rate or quoted rate for securities
is driven by all of the above risk premium factors.
Such knowledge is critical when companies set an
interest rate for their issues. Review the example in
text.

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 Real and Nominal Rates

• Real risk-free interest rate = risk-free rate

– inflation premium

• Nominal interest rate ≈ (approximately equals)

real rate of interest
+ inflation risk premium

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 Key Terms

• Default-risk premium • Maturity-risk premium

• Direct sale • Money market
• Futures market • Nominal (or quoted)
• Initial public offering rate of interest
(IPO) • Opportunity cost of
• Inflation premium funds
• Investment banker • Organized security
• Liquidity-risk premium exchanges
• Over-the-counter
• Market segmentation
theory markets
• Primary market

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 Key Terms

• Private placement
• Public offering
• Real rate of interest
• Real risk-free interest
rate
• Secondary market
• Spot market
• Term structure of
interest rates

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