Financial Markets and the Investment

Banking Process
Ø Explain what financial markets are and what role they
play in improving the standard of living in an economy.
Ø Explain why it is important for financial markets to be
somewhat efficient.
Ø Explain why there are so many different types of
financial markets as well as how various financial
markets are differentiated.
Ø Describe an investment banking house and explain the
role an investment banking house plays in helping firms
raise funds in the financial markets.
Ø Explain how financial markets in the United States differ
from financial markets in other parts of the world.

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ØA system comprised of individuals and
institutions, instruments, and procedures that
brings together borrowers and savers
i.e . Sellers and Buyers of securities

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Ø Provides the ability to transfer money
through time
◦ Borrowing sacrifices future income to increase
available capital
◦ If this capital is expected to generate greater
returns than its cost (after taxes)
◦ Saving, or investing, sacrifices current income in
exchange for greater income in the future
◦ If the expected return is higher than the Cost of
Living Adjustments and there is a greater funding
need in the future (e.g. retirement)

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1. Direct Transfer
◦ Business sells its stocks or bonds directly to investors
2. Indirect Transfer through Investment Bankers
◦ Investment banker acts as middleman and facilitates
issuance of securities by reselling the securities to savers
3. Indirect Transfer through financial intermediary
◦ Organizations such as banks or mutual funds obtain funds
from savers and then use the money to lend or to
purchase securities

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1. Direct Transfers
Business’s Securities (Stocks or Bonds)
Business Savers
(Borrower) (Investors)
Funds

2. Indirect Transfers through an Investment Banker

Business’s Business’s
Securities Investment Banker Securities
Business (stocks or bonds) (stocks or bonds) Savers
Helps corporations issue
(Borrower) (Investors)
securities (stocks & bonds)
Funds less
issuing costs Receives fees from issuers Funds

3. Indirect Transfers through a Financial Intermediary

Borrower’s Intermediary’s
Liability Financial Intermediary Securities
Business (Debt owed to (Account at Savers
(Borrower) Uses funds to buy/create (Investors)
intermediary) loans/other instruments intermediary

Funds Pays a return/interest to attract Funds

funds from savers

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Ø Information efficiency
◦ All material public information is freely available
◦ Law of one price (/arbitrage)
◦ Market prices tend to reflect fair value
Ø Economic efficiency
◦ Funds are allocated towards their optimal use
◦ Economic growth, social satisfaction
Ø Functional/Operational efficiency
◦ Transactions costs are minimized
◦ Fair dealing for all participants

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Ø Information Efficiency
◦ Prices of investments reflect existing information
and adjust quickly when new information enters the
market
◦ Three forms (interpretations) of Market Efficiency :
1. Weak-form efficiency—all past (historical)
information is reflected in current market prices
2. Semistrong-form efficiency—current market prices
reflect all publicly available information
3. Strong-form efficiency—current market prices
reflect all information, whether it is public or private

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Ø Money markets
◦ Instruments traded mature in one year or less
(short-term markets)

Ø Capital Markets
◦ Includes instruments with maturities greater than
one year (long-term markets)

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Ø Debt Markets
◦ Loans - treasury, corporate, mortgage-backed,
money market, municipal, etc...

Ø Equity Markets
◦ Stock markets

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Global Bond Markets

Source: ICMA analysis using Bloomberg Data (August 2020)

Government Bond Markets

Source: ICMA analysis using Bloomberg Data (August 2020)

Corporate Bond Markets

Source: ICMA analysis using Bloomberg Data (August 2020)

US Government Bond Markets

Source: ICMA analysis using Bloomberg Data (August 2020)

US Corporate Bond Markets

Source: ICMA analysis using Bloomberg Data (August 2020)

Changing composition of US Bond Markets

Source: Statistics: Releases and Historical Data, Flow of Funds Account of the
United States, Federal Reserve Board, http://federalreserve.gov/releases/

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European Government Bond Markets

Source: ICMA analysis using Bloomberg Data (May 2020)

European Corporate Bond Markets

Source: ICMA analysis using Bloomberg Data (May 2020)

European Corporate Bond Markets

Source: ICMA analysis using Bloomberg Data (May 2020)

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Ø Primary
◦ Corporations raise funds by issuing new
securities

Ø Secondary
◦ Securities are traded among investors after they
have been issued

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Ø Options, futures and swaps are securities
whose values are determined, or derived
directly from other assets
Ø Derivatives can be used to manage risk or to
speculate

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Ø Secondary market
◦ Trading existing stocks
Ø Primary market
◦ Established firm issues additional shares
Ø Initial Public Offering (IPO)
◦ Privately held company offers stock to the public
for the first time
◦ Called “going public”

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ØExamples of physical exchanges:

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Ø 2011: bought by ICE (Intercontinental Exchange)
Ø Designated market makers (specialists)
◦ Make a market (continuous bid/ask posting)
◦ Citadel, GTS, Virtu
Ø Trading Floor Brokers
◦ Provide liquidity for retail orders
Ø Supplemental liquidity providers (SLPs)
◦ Deal with high-volume trades
◦ HRT Financial, Jump Trading, Latour Trading, Goldman Sachs

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Ø Quantitative and qualitative characteristics
a firm must possess to be listed on an
exchange
Ø Vary by exchange
◦ Minimum number of shareholders,
◦ number of public shares,
◦ market value of public shares,
◦ pre-tax income,
◦ etc.

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ØOver-the-Counter Market (OTC)
◦ Collection of brokers and dealers connected
electronically
◦ Provides for trading in securities not listed on the
physical and other organized exchanges

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1. Dealers hold inventory and make a market
2. Brokers act as agents in bringing together
dealers with investors
3. Electronic network provides
communications link

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Ø Many of the dealers and brokers of the OTC
are members of the National Association of
Securities Dealers (NASD), which licenses and
oversees trading practices.

Ø The computerized trading network used by

NASD is the NASD Automated Quotation
System (NASDAQ) and is a sophisticated
market of its own, separate from the OTC.

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} Electronic systems that transfer information
about securities transactions to facilitate the
execution of orders
} Automatically matches buy and sell orders for
a large number of transactions

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Ø Organization that underwrites and
distributes new issues of securities
Ø Helps businesses and other entities
obtain needed financing

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Ø Help corporations design securities with the
features that are most attractive to investors
given existing market conditions.
Ø Generally buy these securities from the
corporations (underwriting)
Ø Then organizes the placement of the
securities to investors (Book running,
syndication, placement).

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1. Amount to be raised
2. Type of securities used
3. Competitive bid or negotiated deal
4. Selection of an investment banker

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1. Reevaluating the initial decisions
2. Best efforts or underwritten issues
3. Issuance (flotation) costs
Amount = NP + (Other costs)
of issue (1- F)

NP = Net proceeds, or amount needed

F = flotation (issuance) costs in decimal form
4. Setting the offering price

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Source: PWC 2020

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Ø Registration Statement
◦ Filed with the SEC (in the U.S. case)
Ø Prospectus
◦ Summarizes a new security issue and the issuing
company
Ø Underwriting syndicate
◦ Group of investment banking firms to distribute
the new issue

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ØSecurities registered with the SEC for sale at
a later date

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ØTo facilitate orderly market for the new
security, the investment banker maintains a
market for the security following its issue by
actively trading the security, if necessary.

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Ø Securities and Exchange Commission (SEC)
◦ U.S. government agency regulates the issuance
and trading of stocks and bonds
◦ To ensure investors receive fair financial
disclosures
◦ To discourage fraud, insiders’ trading, market
abuse and misleading stock manipulation

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1. Jurisdiction over interstate offerings of
new securities to the general public in
amounts of $1.5 million or more
2. Regulates national securities exchanges,
and requires that listed companies file
annual reports
3. Controls stock trades by corporate
insiders
4. Prohibits manipulation of securities
prices by pools and limits wash sales

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Ø Financial markets have become more global
Ø Greatest growth is in emerging markets in
Asia and South America
Ø U.S. market still dominates worldwide
trading activity

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Relative size of World Markets
1899 2020

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Relative industry weightings
1899 2020

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Cumulative returns on US asset classes

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Annualized returns on Global assets

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Annualized returns on Global assets

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Ø What are financial markets?
◦ Financial markets are the mechanisms by which
borrows and lenders are brought together
Ø Why is it important for financial markets
to be economically efficient?
◦ Investors invest in assets that yield the
highest returns at the lowest cost
◦ Borrowers borrow money at the lowest costs
Ø Why is it important for financial markets
to be informationally efficient?
◦ Prices of financial securities reflect
available information

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Ø Why are there so many different types of
financial markets?
◦ Different types exist because savers and
borrowers have different needs
Ø What is an investment banking house?
◦ An organization that acts as a middleman to help
firms and governments raise funds by issuing
financial instruments

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Ø How do the financial markets in the United
States differ from financial markets in
other parts of the world?
◦ United States has the largest and most active
financial markets
◦ U.S. markets are generally more efficient than
foreign markets

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