AC 509 – Business Finance January 19, 2017

Notes on Introduction J.M.DENILA, CPA

I. Financial Markets – the arenas through which funds flow

a. Regulation – by Securities and Exchange Commission. Why regulate?
i. Full and fair disclosure of information
ii. To avoid trading on the basis of inside information by stockholders and managers
iii. Not to protect against poor investment decisions but to ensure that investors have full and
accurate information available about corporate issuers when making their investment decisions.
iv. To reduce excessive price fluctuations by imposing regulations on financial markets (e.g., circuit
breakers – used in stock exchanges that require the market to shut down for a period of time
when prices drop by large amounts during any trading day

II. Primary Markets vs Secondary Markets

a. Primary Markets – markets in which users of funds (e.g., corporations) raise funds through new issues
of financial instruments (e.g., stocks and bonds)
i. Initial Public Offerings –the first public issue of financial instruments by a firm
1. Spinning – a harmful practice in which certain underwriters allocate “hot” IPO issues to
directors and/or executives of potential investment banking clients in exchange for
investment banking business
ii. Private Placement – the securities issuer/user of fund seeks to find an institutional buyer (e.g.,
pension fund) or group of buyers/suppliers of funds to purchase the whole issue. Privately
placed securities have traditionally been among the most illiquid securities with only the very
largest financial institutions or institutional investors being able or willing to buy and hold them
iii. Examples of primary market transactions:
1. IBM issues $200 million of new common stock
2. The New Company issues $50 million of common stock in an IPO

b. Secondary Markets –markets (e.g. NYSE, NASDAQ) that trade financial instruments once they are
issued. Offers quick trade at market values thereby giving buyers and sellers liquidity(ability to turn an
asset into cash quickly) with the existence of centralized markets that allow trade at low transaction
costs. Gives issuers price information to evaluate usage of previously issued shares and predict
performance of any subsequent issue.
i. Secondary markets exist for:
1. Stocks and bonds
2. Mortgages and other assets
3. Foreign Exchange
4. Futures and Options(e.g.,Derivative Securities)
ii. Examples of secondary market transactions:
1. IBM sells $5 million of GM preferred stock out of its marketable securities portfolio
2. The Magellan Fund buys $100 million of previously issued IBM bonds
3. Prudential Insurance Co. sells $10 million of GM common stock

III. Money Markets vs Capital Markets

a. Money Markets – are markets that trade debt securities or instruments with maturities of one year or
less. Most money markets in the U.S. are Over-the-counter markets (these are markets that do not
operate in a specific fixed location – rather, transactions occur via telephones, wire transfers, and
computer trading)
i. Examples of money market instruments:
1. Treasury bills– government securities which mature in less than a year. There are three
tenors of Treasury Bills: (1) 91 day (2) 182-day (3) 364-day Bills. The number of days are
based on the universal practice around the world of ensuring that the bills mature on a
business day. Treasury Bills are quoted either by their yield rate, which is the discount,
or by their price based on 100 points per unit. Treasury Bills which mature in less than
91-days are called Cash Management Bills (e.g. 35-day, 42-day).
2. Federal funds
3. Repurchase Agreements–sale of a short-term security (usually government securities) in
which the seller agrees to buy back the security at a specified price.
4. Commercial Paper – unsecured short-term promissory notes issued by the most
creditworthy corporations
5. Negotiable Certificates of Deposit–certificates of deposit (CDs) issued in specific
denominations whose terms are individually negotiated between the bank and the
saver and for which there exists a secondary market

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 6. Banker’s Acceptances – short-term promissory note (which usually arises from
international trade) guaranteed by a bank
7. Tax anticipation notes–short-term government security secured by expected tax
revenues
8. Eurodollar CDs – similar to domestic negotiable CDs except they are issued by branches
of domestic banks located abroad or by foreign banks and are still denominated in US
dollars.

b. Capital Markets – are markets that trade equity (stocks) and debt (bonds) instruments with maturities
of more than one year.
i. Corporations and Governments – major supplier of capital market securities
ii. Households – major supplier of funds for capital market securities
iii. Examples of capital market instruments:
1. Corporate stocks or equities
2. Residential mortgages
3. Commercial and Farm mortgages
4. Securitized mortgages (are those mortgages that FIs have packaged together and sold
as bonds backed by mortgage cash flows such as interest and principal repayments)
5. Corporate bonds
6. Treasury Bonds - are government securities which mature beyond one year. At present
there are five maturities of bonds (1) 2- year (2) 5 – year (3) 7 – year 4) 10 – year and (5)
20-year. These are sold at its face value on origination. The yield is represented by the
coupons, expressed as a percentage of the face value on per annum basis, payable semi-
annually.
7. Treasury notes
8. State and Local Government Bonds
9. Bank and Consumer Loans

c. What determines the price of financial instruments?The price of any financial instrument is the present
value of future cash flows discounted at an appropriate rate. The longer the maturity of an instrument
the greater the time period of discounting. A small change in interest rates causes a large change in
present value of distant cash flows.

d. Which are riskier, capital market instruments or money market instruments? The prices of long-term
capital market instruments are more sensitive to changes in interest rates. In addition, distant cash
flows for stocks are not known with certainty. Changing economic prospects can cause very large
changes in current stock values. Money market instruments have predictable cash flows and mature in
one year or less, so they are much less risky.

e. How does the location of the money market differ from that of the capital market?
i. The capital markets are more likely to be characterized by actual physical locations such as the
New York Stock Exchange or the American Stock Exchange. Money market transactions are
more likely to occur via telephone, wire transfers, and computer trading.

IV. Other types of financial markets

a. Foreign Exchange (FX) Markets–these are markets that deal in trading one currency for another (e.g.
dollar for yen)
i. “Spot” FX transaction - involves the immediate exchange of currencies at the current exchange
rate
ii. “Forward” FX transaction - involves the exchange of currencies at a specified date in the future
and at a specified exchange rate

b. Derivative Securities Market – are markets in which derivative securities trade.

i. Derivative Securities - a financial security whose payoffs are linked to other, previously issued
securities; an agreement between two parties to exchange a standard quantity of an asset at a
predetermined price on a specified date in the future
1. Example of Derivative Security – Foreign exchange futures, options, swaps (to manage
or hedge foreign exchange risk)

V. Direct transfer vs Indirect transfer

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 a. Direct Transfer – e.g., a corporation sells its stock or debt directly to investors without going through a
financial institution

Financial Claims
(Equity and debt instruments)

Users of Funds Suppliers of Funds

(Corporations) (Households)

Cash

i. High Cost of Direct Transfer – If there were no FIs then the users of funds, such as corporations
in the economy, would have to approach the savers of funds, such as households, directly in
order to fund their investment projects and fill their borrowing needs. This would be extremely
costly because of the up-front information costs faced by potential lenders. These include costs
associated with identifying potential borrowers, pooling small savings into loans of sufficient size
to finance corporate activities, and assessing risk and investment opportunities. Moreover,
lenders would have to monitor the activities of borrowers over each loan's life span, which is
compounded by the free rider problem. The net result is an imperfect allocation of resources in
an economy.

ii. Low levels of fund flows in a world limited to Direct Transfers. There are at least two reasons
for this:
1. Once they have lent money in exchange for financial claims, suppliers of funds need to
monitor or check the use of their funds. They must be sure that the user of funds
neither absconds with nor wastes the funds on projects that have low or negative
returns, since this would lower the chances of being repaid and/or earning a positive
income on their investment (such as dividends or interest). Such monitoring actions are
often extremely costly for any given fund supplier because they require considerable
time, expense, and effort to collect this information relative to the size of the average
fund supplier’s investment.
2. The relatively long term nature of some financial claims (e.g., mortgages, corporate
stock, and bonds) creates a second disincentive for suppliers of funds to hold the direct
financial claims issued by users of funds. Specifically, given the choice between holding
cash and long term securities, fund suppliers may well choose to hold cash for liquidity
reasons, especially if they plan to use savings to finance consumption expenditures in
the near future and financial markets are not very deep in terms of active buyers and
sellers.
a. Price Risk – The risk that an asset’s sale price will be lower than its purchase
price

b. Indirect Transfer – a transfer of funds between suppliers and users of funds through a financial
intermediary

FI
Users of (Brokers) Suppliers of
Funds Funds

Cash FI Cash
(Asset
transforme
rs)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and insurance
policies)

VI. Brokers vs Dealers

a. Difference
i. Asset Broker – assists buyers and sellers of securities by providing a mechanism for a buyer or
seller to process their order. If the broker simply assists one party in finding another party, the
broker charges a small fee called a commission.

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 ii. Asset Dealer – buys (sells) the security for their own account at the bid price and then sells
(buys) the security at a higher ask price. The dealer profits by earning the bid-ask spread or the
difference between the buy and sell price.
b. Which is riskier?
i. The dealer function is riskier because the dealer must maintain an inventory of the asset and
honor quotes posted to buy and sell. If the security is risky the value of the inventory can
fluctuate with market prices. The broker takes less risk because they do not own the security.

VII. Financial Institutions (FIs) – institutions that perform the essential function of channeling funds from those
with surplus funds to those with shortages of funds
a. Types of Financial Institutions
i. Commercial banks – depository institutions whose major assets are loans and major liabilities
are deposits. Commercial banks’ loans are broader in range, including consumer,
commercial,and real estate loans, than other depository institutions. Commercial banks’
liabilities, include more non-deposit sources of funds, such as subordinate notes and
debentures, than other depository institutions.

ii. Thrifts - depository institutions in the form of savings and loans, savings banks, and credit
unions. Thrifts generally perform services similar to commercial banks, but they tend
toconcentrate their loans in one segment, such as real estate loans or consumer loans.

iii. Insurance companies - financial institutions that protect individuals and corporations
(policyholders) from adverse events. Life insurance companies provide protection in the event
of untimely death, illness, and retirement. Property casualty insurance protects against personal
injury and liability due to accidents, theft, fire, etc.

iv. Securities firms and investment banks - financial institutions that underwrite securities and
engage in related activities such as securities brokerage, securities trading, and making a market
in which securities can trade.

v. Finance companies - financial intermediaries that make loans to both individual and businesses.
Unlike depository institutions, finance companies do not accept deposits but instead rely on
short- and long-term debt for funding.

vi. Mutual funds - financial institutions that pool financial resources of individuals and companies
and invest those resources in diversified portfolios of asset.

vii. Pension funds - financial institutions that offer savings plans through which fund participants
accumulated savings during their working years before withdrawing them during
theirretirement years. Funds originally invested in and accumulated in a pension fund are
exempt from current taxation.

b. Services Performed by Financial Intermediaries

i. Services that benefit Suppliers of Funds
1. Monitoring Costs – aggregation of funds in an FI provides greater incentive to collect a
firm’s information and monitor actions. The relatively large size of the FI allows this
collection of information to be accomplished at a lower average cost (economies of
scale).
a. Delegated Monitor – an economic agent (e.g., FIs) appointed to act on behalf of
smaller investors in collecting information and/or investing funds on their behalf

2. Liquidity and Price Risk – FIs provide financial claims to household savers with superior
liquidity attributes and with lower price risk thru:
a. Asset Transformation – The process of turning risky assets into safer assets for
investors by creating and selling assets with risk characteristics that people are
comfortable with and then using the funds acquired by selling these assets to
purchase other assets that may have far more risk.
i. Example: FIs act as Asset Transformers (financial claims issued by an FI
that are more attractive to investors than are the claims directly issued
by corporations) by purchasing the financial claims issued by users of
funds – primary securities such as mortgages, bonds, and stocks – and
finance these purchases by selling financial claims to household
investors and other fund suppliers in the form of deposits, insurance
policies, or other secondary securities
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 b. Diversification – the ability of an economic agent to reduce risk by holding a
number of securities in a portfolio. (E.g., As the number of securities in an FI’s
asset portfolio increases, portfolio risk falls, albeit at a diminishing rate)A
mutual fund invested in a diverse group of stocks and fixed income securities
will best provide diversification for an investor.

3. Transaction Cost Services – similar to economies of scale in information production

costs, and FI’s size can result in economies of scale in transaction costs
a. Economies of Scales – This concept that cost reduction in trading and other
transaction services results from increased efficiency when FIs perform these
services
b. Etrade –an example to reduce transaction costs; refers to the buying and selling
of shares on the internet

4. Maturity Intermediation – FIs can better bear the risk of mismatching the maturities of
their assets and liabilities
a. If net borrowers and net lenders have different optimal time horizons, FIs can
service both sectors by matching their asset and liability maturities. That is, the
FI can offer the relatively short-term liabilities desired by households (say, in the
form of bank deposits) and also satisfy the demand for long-term loans (say, in
the form of home mortgages). By investing in a portfolio of long-and short-term
assets and liabilities, the FI can both reduce risk exposure through
diversification and manage risk exposure by centralizing its hedging activities.

5. Denomination Intermediation – FIs such as mutual funds allow small investors to

overcome constraints to buying assets imposed by large minimum denomination size
a. Because they are sold in very large denominations, many assets are either out of
reach of individual savers or would result in savers holding highly undiversified
asset portfolios. For example, the minimum size of a negotiable CD is $100,000;
commercial paper (short term corporate debt) is often sold in minimum
packages of $250,000 or more. Individual savers may be unable to purchase
such instruments directly. However, by buying shares in a mutual fund with
other small investors, household savers overcome the constraints to buying
assets imposed by large minimum denomination sizes. Such indirect access to
these markets may allow small savers to generate higher returns on their
portfolios as well.

ii. Services that benefit the Overall Economy/Financial System

1. Money Supply Transmissionor Transmission of Monetary Policy – Depository
institutions are the conduit through which monetary policy actions from the central
bank to impact the rest of the financial system and the economy in general because
these deposits are a significant component of the money supply, which in turn directly
impacts the rate of inflation.

2. Credit Allocation–FIs are often viewed as the major, and sometimes only, source of
financing for a particular sector of the economy.
a. Major Sectors Deserving Credit Allocation:
i. Farming
ii. Residential real estate.

3. Intergenerational Wealth Transfersor Time Intermediation–FIs, especially life insurance

companies and pension funds, provide savers the ability to transfer wealth from one
generation to the next, as well as wealth from their youth to old age.

4. Payment Services – The efficiency with which depository institutions provide payment
services directly benefits the economy. Example of payment services:
a. Check clearing
b. Wire transfer services (e.g., Fedwire and CHIPS – Clearing House Interbank
Payments System)

c. Risks Faced by Financial Institutions

i. Credit Risk – risk that promised cash flows from loans and securities held by FIs may not be paid
in full

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 ii. Foreign Exchange Risk – risk that exchange rate changes can affect the value of an FI’s assets
and liabilities located abroad
iii. Country or Sovereign Risk – risk that repayments from foreign borrowers may be interrupted
because of interference from foreign governments
iv. Interest Rate Risk – risk incurred by an FI when the maturities of its assets and liabilities are
mismatched
v. Market Risk –risk incurred in trading assets and liabilities due to changes in interest rates,
exchange rates, and other asset prices
vi. Off-Balance-Sheet Risk – risk incurred by an FI as the result of activities related to contingent
assets and liabilities
vii. Liquidity Risk – risk that a sudden surge in liability withdrawals may require an FI to liquidate
assets in a very short period of time and at low prices
viii. Technology Risk – risk incurred by an FI when its technological investments do not produce anti
ix. Operational Risk – risk that existing technology or support systems may malfunction or break
down
x. Insolvency Risk – risk that an FI may not have enough capital to offset a sudden decline in the
value of its assets

d. Regulation of Financial Institutions

i. Why regulate FIs? FIs provide vital financial services to all sectors of the economy; therefore,
their regulation is in the public interest. Failure to provide these services, or a breakdown in their
efficient provision, can be costly to both the ultimate suppliers (households) and users (firms) of
funds as well as the overall economy. For example, bank failures may destroy household savings
and at the same time restrict a firm’s access to credit. Insurance company failures may leave
households totally exposed in old age to catastrophic illnesses and sudden drops in income on
retirement. In addition, individual FI failures may create doubts in savers’ minds regarding the
stability and solvency of FIs in general and cause panics and even runs on sound institutions. FIs
are regulated in an attempt to prevent these types of market failures.

e. Advantages of raising funds via a financial intermediary (FI) rather than by selling securities to the public
i. Speed: funds can normally be raised more quickly through FIs.
ii. Registration process/cost: The registration process can be quite costly and time consuming in
terms of person hours, audit fees and fees to investment bankers. Raising funds via a FI can be
less expensive, particularly for smaller capital needs or when funds are needed for only a short
time period. (Maturities of 270 days or less do not require registration, nor do private
placements).
iii. Nonstandard terms can be negotiated with FIs but are difficult to sell to the public. E.G. if a
borrower can only begin paying interest after 2 years, they would have a difficult time selling
bonds to the public.
iv. There is a greater ability to renegotiate terms if necessary. Terms of public issue generally
cannot be changed outside of court.
v. Less information made public.

f. Major disadvantage of putting your money in an intermediary: Forego potentially higher returns if you
do not purchase the more risky direct claims.

VIII. Major Forces in the Financial Services Industry

a. Technological change – Reduced cost of providing financial services to a growing number of individuals
(Economies of scale) and reduced cost to provide related financial services to customers (Economies of
scope). These changes are pressuring all firms to grow, at the same time technology is allowing
individuals to invest on their own at very low cost and changing the way institutions must provide
financial services to customers.
b. Globalization – All financial markets are becoming more closely integrated. What happens in Asia
affects U.S. markets and vice versa. All institutional managers will increasingly need to understand
global investing and have an understanding of global markets and institutions.
i. What have been the major factors contributing to growth in the foreign financial markets?
1. Increase in the amount of savings available for investment in foreign countries.
2. International investors have looked to the U.S. for better investment opportunities.
3. The Internet has helped provide additional information on foreign markets and overseas
investment opportunities.
4. Specialized intermediaries such as country specific mutual funds and ADRs have been
developed to facilitate overseas investments.
5. Deregulation of foreign markets has allowed many new investors to participate in
international investing.
AC 509 Notes on Introduction 2017 – JMD (6)
 ii. Eurodollar bond – dollar-denominated bonds issued mainly in London and other European
centers such as Luxembourg
c. Regulations – Regulations are beginning to allow financial service providers to overlap functions to a
greater degree than ever before, generating more competition and more pressures on profit margins.
After the Enron and WorldCom scandals we can expect tighter regulations in all the financial related
industries.

- Nothing Follows -

AC 509 Notes on Introduction 2017 – JMD (7)