The Financial System, Corporate Governance,

and Interest

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The Financial System

The economy is divided into sectors Consumption Production (includes government) Most people are in both sectors

as workers in production and as consumers at home Services, products, and money flow between the

sectors every day Producers pay wages to workers for labor services Workers spend incomes as consumers on production sector’s

output Producers spend revenues on materials and more labor to make

more product Creates a cyclical flow of money

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BUT, Diagram Omits Two Things

Consumption sector Most people do not consume all of

their income—they save a portion They deposit those savings and earn a

return

Production sector Companies need to raise money from time to time to

finance large, infrequent projects New factories, additional equipment, new enterprises

Economy has a need for and a source of $

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Savings and Investment

Financial markets channel consumer savings to companies through the sale of financial assets Companies issue securities to raise money

usually to spend on big assets or projects Consumers purchase securities to earn a return

on their savings

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The Term Invest

Using a resource to better one’s position in the future rather than for current consumption Individuals invest by putting savings into financial

assets: stocks, bonds, etc. Companies invest by buying assets used in production

Funds available for business investment come from savings put into financial assets by individuals

Hence: SAVINGS EQUALS INVESTMENT More precisely: (Consumer) Savings Equals (Business) Investment

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Raising and Spending Money in Business

Firms spend two kinds of money Day-to-day funds – come from normal profits,

support routine activities Large sums needed for major projects and to

get businesses started - comes from selling financial assets

Borrowing money: Debt Financing Selling stock: Equity Financing

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Term

The length of time between now and the end (or termination) of something Long-term projects (lasting over 5-10 years) are

financed with long-term funds Debt (bonds) Equity

Short-term projects (lasting less than 1 year) are financed with short-term funds Bank loans

Process is known as maturity matching

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Financial Markets

Capital Markets Trade in stocks and long-term debt

Money Markets Trade in short term debt securities

Federal government issues a great deal of short-term debt

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Financial Markets: Primary and Secondary Markets

Primary Market: Initial sale of a security Proceeds go to the issuer

Secondary Market: Subsequent sales of the security Between investors Company not involved

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Primary and Secondary Markets

Corporations care about a stock’s price in the secondary market Influences how much money can be

raised in future stock issues Senior management’s compensation is

usually tied to stock price

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Direct and Indirect Transfers, Financial Intermediaries

Directly Issuer sells directly to

buyers or through an investment bank

Investment bank lines up investors and functions as a broker

Indirectly Financial intermediary sells shares in itself and invests the funds collectively on behalf of investorsMutual fund is an examplePortfolio is collectively owned

Primary market transactions can occur

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Transfer of Funds From Investors to Businesses Figure 5.3

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Direct and Indirect Transfers, Financial Intermediaries

Institutional investors play a major role in today’s financial markets Own ¼ of all stocks, make over ¾ of all trades Examples include:

Mutual funds Pension funds Insurance companies Banks

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The Stock Market and Stock Exchanges

Stock market—a network of exchanges and brokers Exchange—a physical marketplace

such as NYSE, AMEX, regional exchanges

Brokerage houses employ licensed brokers to assist individuals with securities transactions

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Trading—The Role of Brokers

What brokers do… An investor opens an account with a broker and place

trades via phone or online Local broker forwards order to floor broker on the

exchange trading floor Each stock trades in a particular spot on the exchange floor in

an auction-like process Trading supervised by a specialist who makes markets in

designated securities Trade confirmation is forwarded to local broker and

investor

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Exchanges

New York Stock Exchange (NYSE) Trades securities for 2800 US

issuers and 480 foreign companies

American Stock Exchange (AMEX) Handles slightly smaller, younger firms than NYSE

Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc.)

Exchanges are linked electronically

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Stock Market and Exchanges

Stock Market refers to the entire interconnected set of places, organizations and processes involved in trading stocks

Stock Exchanges are the administrative and trading centers of the stock market

Regulation Securities Act of 1933

Required companies to disclose certain information Securities Exchange Act of 1934

Set up Securities and Exchange Commission Securities law is primarily aimed at disclosure

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Private, Public, and Listed Companies, and the NASDAQ Market

Privately Held Companies Can’t sell securities to

the general public Sale of securities is

severely restricted by regulation

Publicly Traded Companies

Received approval from SEC to offer securities to the general public

Process of obtaining approval and registration is known as ‘going public’

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Private, Public, and Listed Companies, and the OTC Market

The IPO Once prospectus is approved by SEC securities can be

sold to public Initial public offering (IPO) is the initial sale

Market for IPOs is very volatile and risky Investment banks usually line up institutional buyers

prior to the actual securities sale IPO occurs in primary market, then trading begins in

the secondary market

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The NASDAQ Market

After a company goes public, its shares can trade in the over-the-counter (OTC) market

Eventually a firm may list on an exchange Smaller, public companies can trade on the

NASDAQ market National Association of Securities

Dealers Automated Quotation System

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The Governance Problem

So top executives are personally motivated to hold financial performance up - often at any cost

Which in turn holds stock price up and makes them rich

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Compensation: Harry Johnson, CEO

Salary $2,500,000 Bonus 1,500,000

$4,000,000

Plus: Stock option: 200,000 shares @ $20, Market Price now $48.65

Option Value: 200,000 x ($48.65 - $20.00) = $5,730,000

Total comp = $9,730,000; 59% from options

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Moral Hazard of Stock Based Compensation

BUT what if Harry can’t exercise his option for another six months AND some disturbing financial information has come

up that will cause the stock’s price to drop by $10. If released that info will cost Harry $2,000,000

Harry is motivated to hold stock price up at any cost until he can exercise his option.

Usually means suppressing the damaging information while ordinary investors buy in at inflated price

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Measures of Performance

The market measures performance on three important financial results Revenue Earnings per share Debt

Revenue and Earnings per share More is better Rapid growth is great

Debt Less is better

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The Crime Against Investors

Company executives with auditors help misstated financial statements Stocks became grossly overvalued

When fraud discovered stock price crashes Small investors who bought at high prices lose their

investments Executives see crash coming and cash out early

Some firms had forced employee retirement savings into their own stock Ordinary employees lost their entire retirements

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Recognition

In 2000 Enron, the seventh largest company in the country got caught. Fraudulent reporting was discovered CPA’s complicity was revealed The firm collapsed along with its pension assets Arthur Anderson, one of the largest accounting

firms failed and disappeared completely Resulting investigations revealed many

companies had misstated financials

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Federal Government Moves to Fix the Problem

Three major culpable groups were identified Top management Auditors Wall Street financial analysts

Federal government creates legislation that in future will Regulate the Public Accounting profession Enhance accounting/reporting controls Punish guilty executives severely Regulate Analyst reporting

Sarbanes-Oxley Act (SOX)

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Stock Analyst Conflicts

Investors buy and sell stocks based on Wall Street analysts’ recommendations

But many analysts worked for brokerage houses that had Investment Banking departments doing business with the firms being analyzed investment banks advise companies on selling securities

Employers pressured analysts for favorable reports pressure = compensation, threat of firing of 33,000 buy/sell/hold recommendations issued in 1999, only

125 were sells (.3%) While market was on the brink of collapse

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Interest

Interest is the return on debt Primary vehicle is the bond

Investor lends money to the bond’s issuer There are MANY interest

rates in debt markets Depend on term and risk Rates tend to move

together

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Interest and the Economy

Interest rates have a significant effect on the economy Lower interest rates stimulate business and

economic activity Debt financed projects cost less if rates are low

More projects are undertaken

Consumers purchase more houses, cars, etc. when rates are low

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Supply and Demand – A Brief Review

Interest rates are set by supply and demand

Demand curve relates price and quantity of a product that consumers will buy Reflects desires and abilities of buyers at a particular

time Usually slopes downward to the right since people buy

more when the price of a product is low

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The Determinants of Supply and Demand

Demand for borrowed funds depends on: Opportunities available to use the funds Attitudes of people and businesses about using

credit If people feel good about the economy they will

spend with borrowed money and businesses will borrow for expansion and new projects

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The Components of an Interest Rate

Interest rates include base rates rates and risk premiums

Interest rate represented by the letter k k = base rate + risk premium

Components of the Base Rate Base rate = kPR + INFL The pure interest rate plus expected inflation

Rate people lend money when no risk is involved

Pure interest rate (kPR) = earning power of money Would exist in the real world if no inflation Generally between 2% and 4%

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The Components of an Interest Rate

The Inflation Adjustment (INFL) Inflation refers to a general increase in prices If prices rise, $100 at the beginning of the year will

not buy as much at the end of the year If you loaned someone $100 at the beginning of the

year, you need to be compensated for what you expect inflation to be during the year Interest rates include estimates of average annual inflation

over loan periods

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Risk Premiums

Risk in loans is the chance that the lender will not receive the full amount of principal and interest payments Some loans are more risky than others

Lenders demand risk premiums of extra interest for risky loans

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Different Kinds of Lending Risk

Bond lending losses can be associated with price fluctuations and the failure of borrowers to repay loans

Three sources of risk, each with its own risk premium: Default risk Liquidity risk Maturity risk

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Different Kinds of Lending Risk

Maturity Risk (MR) Bond prices and interest rates move in opposite

directions Long-term bond prices change more with interest rate

swings than short-term bond prices Larger loss possible on long term bond if rates change Gives rise to maturity risk

Investors demand a maturity risk premium on longer term bonds Generally ranges from 0% to 2%

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Federal Government Securities, the Risk Free Rate

Federal Government Securities The Federal government issues long-term bonds as well

as shorter-term securities Treasury bills - terms from 90 days to a year Treasury notes - terms from 1 to 10 years

Risk in Federal Government Debt No default risk: Can print money to pay off its debt No liquidity risk: It’s easy to sell federal securities Federal debt does have maturity risk

But not on very short-term debt

Hence very short term federal securities, Treasury Bills, pay the RISK FREE RATE

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The Risk-Free Rate

The risk-free rate is approximately the yield on short-term Treasury bills Includes the pure rate and inflation the inflation

adjustment

Conceptual floor for interest rates Denoted as kRF

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The Real Rate of Interest

Real implies the effects of inflation removed

Tells investors whether or not they are getting ahead Loss in purchasing power - earn a real rate of 8% when inflation

is 10%

There are periods during which the real rate has been negative

The Real Risk-Free Rate implies that both the inflation adjustment and the risk premium is zero

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Yield Curves—The Term Structure of Interest Rates

The graphic relation between interest rates and the term of debt

The normal yield curve Short-term rates are usually lower than long-term rates

– curve slopes up The inverted yield curve

Long-term rates are lower than short-term rates – curve slopes down

A sustained inverted curve usually signals an economic downturn is ahead

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Yield Curves Figure 5.10