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R E T P 19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 141 5 FINANCIAL MARKETS AND INSTITUTIONS A Strong Financial System Is Necessary for a Growing and Prosperous Economy Financial managers and investors don’t operate in a vacuum—they make deci- sions within a large and complex financial environment. This environment includes financial markets and institutions, tax and regulatory policies, and the state of the economy. The environment both determines the available financial alternatives and affects the outcomes of various decisions. Thus, it is crucial that investors and financial managers have a good understanding of the environ- ment in which they operate. History shows that a strong financial system is a necessary ingredient for a growing and prosperous economy. Companies raising capital to finance capital expenditures as well as investors saving to accumulate funds for future use require well-functioning financial markets and institutions. Over the past few decades, changing technology and improving communi- cations have increased cross-border transactions and expanded the scope and efficiency of the global financial system. Companies routinely raise funds throughout the world to finance projects all around the globe. Likewise, with the click of a mouse an individual investor in Nebraska can deposit funds in a European bank or purchase a mutual fund that invests in Chinese securities. It is important to recognize that at the most fundamental level well-functioning markets and institutions are based heavily on trust. An investor who deposits money in a bank, buys stock through an online brokerage account, or contacts her broker to buy a mutual fund places her money and trust in the hands of the financial institutions that provide her with advice and transaction services. Simi- larly, when businesses approach commercial or investment banks to raise capi- tal, they are relying on these institutions to provide them with funds under the best possible terms, and with sound, objective advice. While changing technology and globalization have made it possible for more and more types of financial transactions to take place, a series of scan- dals in recent years have rocked the financial industry and have led many to A H C © JOHN GRESS/REUTERS/CORBIS19843_05_c05_p141-172.qxd 1/4/06 11:07 AM Page 142 142 Part 2 Fundamental Concepts in Financial Management question whether some of our institutions are serving their own or their clients’ interests. Many of these questionable practices have come to light because of the efforts of a single man: the Attorney General of New York, Eliot Spitzer. In 2001, Spitzer exposed conflicts of interest within investment banking firms regarding dealings between their underwriters, who help companies issue new securities, and their analysts, who make recommendations to individual investors to pur- chase these securities. Allegations were made that to attract the business of firms planning to issue new securities, investment banks leaned on their analysts to write glowing, overly optimistic research reports on these firms. While such prac- tices helped produce large underwriting fees for the investment banks, they com- promised their ability to provide the objective, independent research on which their clients depended. A few years later, Spitzer turned his attention to the mutual fund industry, where he exposed unethical fee structures and trading prac- tices of some of the leading funds. More recently, Spitzer has questioned whether some insurance brokers have compromised their clients’ interests in order to steer 1 business toward insurers, who provide the broker with rebates of different types. While some have criticized Spitzer for being overly zealous and politically ambitious, his efforts have appropriately brought to light many questionable practices. Hopefully, this spotlight will put pressure on the institutions to estab- lish practices that will restore the public’s trust and lead to a better financial system in the long run. Putting Things In Perspective Putting Things In Perspective In earlier chapters, we discussed financial statements and showed how financial managers and others analyze them to evaluate a firm’s operations and financial position—past, current, and future. To make good decisions, financial managers must understand the environment and markets within which businesses operate. Therefore, in this chapter we describe the mar- kets where capital is raised, securities are traded, and stock prices are established, as well as the institutions that operate in these markets. Because the overall objective of financial managers is to maximize share- holder value, we also take a closer look at how the stock market operates, and we discuss the concept of market efficiency. 1 For example, some insurance companies allowed brokers to keep premiums for as much as a year before remitting them to the insurance companies. The brokers invested these premiums and earned interest on them, and this gave them an incentive to steer business to these companies rather than to insurance companies whose policies might be better for the brokers’ clients. 19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 143 Chapter 5 Financial Markets and Institutions 143 5.1 AN OVERVIEW OF THE CAPITAL ALLOCATION PROCESS Businesses, individuals, and governments often need to raise capital. For exam- ple, suppose Carolina Power & Light (CP&L) forecasts an increase in the demand for electricity in North Carolina, and the company decides to build a new power plant. Because CP&L almost certainly will not have the 1 billion or so necessary to pay for the plant, the company will have to raise this capital in the financial markets. Or suppose Mr. Fong, the proprietor of a San Francisco hardware store, decides to expand into appliances. Where will he get the money to buy the initial inventory of TV sets, washers, and freezers? Similarly, if the Johnson family wants to buy a home that costs 200,000, but they have only 40,000 in savings, how can they raise the additional 160,000? And if the city of New York wants to borrow 200 million to finance a new sewer plant, or the federal government needs money to meet its needs, they too need access to the capital markets. On the other hand, some individuals and firms have incomes that are greater than their current expenditures, so they have funds available to invest. For exam- ple, Carol Hawk has an income of 36,000, but her expenses are only 30,000, and as of December 31, 2004, Ford Motor Company had accumulated roughly 23.5 billion of cash and equivalents, which it has available for future investments. People and organizations with surplus funds are saving today in order to accumulate funds for future use. A household might save to pay for future expenses such as their children’s education or their retirement, while a business might save to fund future investments. Those with surplus funds expect to earn a positive return on their investments. People and organizations who need money today borrow to fund their current expenditures. They understand that there is a cost to this capital, and this cost is essentially the return that the investors with surplus funds expect to earn on those funds. In a well-functioning economy, capital will flow efficiently from those who supply capital to those who demand it. This transfer of capital can take place in the three different ways described in Figure 5-1: 1. Direct transfers of money and securities, as shown in the top section, occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution. The business delivers its securities to savers, who in turn give the firm the money it needs. 2. As shown in the middle section, transfers may also go through an investment banking house such as Merrill Lynch, which underwrites the issue. An under- writer serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. The businesses’ securities and the savers’ money merely “pass through” the investment banking house. However, the investment bank does buy and hold the securities for a period of time, so it is taking a risk—it may not be able to resell them to savers for as much as it paid. Because new securities are involved and the corporation receives the proceeds of the sale, this is called a primary market transaction. 3. Transfers can also be made through a financial intermediary such as a bank or mutual fund. Here the intermediary obtains funds from savers in exchange for its own securities. The intermediary uses this money to buy and hold businesses’ securities. For example, a saver might deposit dollars in a bank, receiving from it a certificate of deposit, and then the bank might lend the money to a small business as a mortgage loan. Thus, intermediaries literally create new forms of capital—in this case, certificates of deposit, which are both safer and more liquid than mortgages and thus are better for most19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 144 144 Part 2 Fundamental Concepts in Financial Management FIGURE 5-1 Diagram of the Capital Formation Process 1. Direct Transfers Securities (Stocks or Bonds) Business Savers Dollars 2. Indirect Transfers through Investment Bankers Securities Securities Investment Banking Business Savers Houses Dollars Dollars 3. Indirect Transfers through a Financial Intermediary Business’s Intermediary’s Securities Securities Financial Business Savers Intermediary Dollars Dollars savers to hold. The existence of intermediaries greatly increases the efficiency of money and capital markets. Often the entity needing capital is a business, and specifically a corporation, but it is easy to visualize the demander of capital being a home purchaser, a small business, a government unit, and so on. For example, if your uncle lends you money to help fund a new business after you graduate, this would be a direct transfer of funds. Alternatively, if your family borrows money to purchase a home, you will probably raise the funds through a financial intermediary such as your local commercial bank or mortgage banker, which in turn may acquire its funds from a national institution, such as Fannie Mae. In a global context, economic development is highly correlated with the 2 level and efficiency of financial markets and institutions. It is difficult, if not impossible, for an economy to reach its full potential if it doesn’t have access to a well-functioning financial system. For this reason, policy makers often promote the globalization of financial markets. In a well-developed economy like that of the United States, an extensive set of markets and institutions has evolved over time to facilitate the efficient alloca- tion of capital. To raise capital efficiently, managers must understand how these markets and institutions work. Identify three different ways capital is transferred between savers and borrowers. Why do policy makers promote the globalization of financial markets? 2 For a detailed review of the evidence linking financial development to economic growth, see Ross Levine, “Finance and Growth: Theory and Evidence,” NBER Working Paper no. w10766, September 2004.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 145 Chapter 5 Financial Markets and Institutions 145 5.2 FINANCIAL MARKETS People and organizations wanting to borrow money are brought together with those having surplus funds in the financial markets. Note that “markets” is plural; there are a great many different financial markets in a developed economy such as ours. We briefly describe the different types of financial markets and some recent trends in these markets. Types of Markets Different financial markets serve different types of customers or different parts of the country. Financial markets also vary depending on the maturity of the securities being traded and the types of assets used to back the securities. For these reasons it is often useful to classify markets along the following dimensions: 1. Physical asset versus financial asset markets. Physical asset markets (also called “tangible” or “real” asset markets) are those for products such as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, and other claims on real assets, as well as with derivative securities whose values are derived from Spot Markets changes in the prices of other assets. A share of Ford stock is a “pure finan- The markets in which cial asset,” while an option to buy Ford shares is a derivative security whose assets are bought or value depends on the price of Ford stock. sold for “on-the-spot” delivery. 2. Spot versus futures markets. Spot markets are markets in which assets are bought or sold for “on-the-spot” delivery (literally, within a few days). Futures Markets Futures markets are markets in which participants agree today to buy or The markets in which sell an asset at some future date. For example, a farmer may enter into a participants agree futures contract in which he agrees today to sell 5,000 bushels of soybeans today to buy or sell an six months from now at a price of 5 a bushel. On the other side, an inter- asset at some future date. national food producer looking to buy soybeans in the future may enter into a futures contract in which it agrees to buy soybeans six months from Money Markets now. The financial markets in 3. Money versus capital markets. Money markets are the markets for short-term, which funds are bor- highly liquid debt securities. The New York, London, and Tokyo money mar- rowed or loaned for kets are among the world’s largest. Capital markets are the markets for short periods (less than one year). intermediate- or long-term debt and corporate stocks. The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a Capital Markets prime example of a capital market. There is no hard and fast rule on this, but The financial markets when describing debt markets, “short term” generally means less than 1 year, for stocks and for “intermediate term” means 1 to 10 years, and “long term” means more than intermediate- or long- 10 years. term debt (one year or longer). 4. Primary versus secondary markets. Primary markets are the markets in which corporations raise new capital. If GE were to sell a new issue of common Primary Markets stock to raise capital, this would be a primary market transaction. The corpo- Markets in which ration selling the newly created stock receives the proceeds from the sale in a corporations raise primary market transaction. Secondary markets are markets in which exist- capital by issuing new ing, already outstanding, securities are traded among investors. Thus, if Jane securities. Doe decided to buy 1,000 shares of GE stock, the purchase would occur in Secondary Markets the secondary market. The New York Stock Exchange is a secondary market Markets in which secu- because it deals in outstanding, as opposed to newly issued, stocks and rities and other finan- bonds. Secondary markets also exist for mortgages, various other types of cial assets are traded loans, and other financial assets. The corporation whose securities are being among investors after traded is not involved in a secondary market transaction and, thus, does not they have been issued receive any funds from such a sale. by corporations.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 146 146 Part 2 Fundamental Concepts in Financial Management Private Markets 5. Private versus public markets. Private markets, where transactions are negoti- Markets in which trans- ated directly between two parties, are differentiated from public markets, actions are worked out where standardized contracts are traded on organized exchanges. Bank loans directly between two and private debt placements with insurance companies are examples of parties. private market transactions. Because these transactions are private, they may Public Markets be structured in any manner that appeals to the two parties. By contrast, Markets in which stan- securities that are issued in public markets (for example, common stock and dardized contracts are corporate bonds) are ultimately held by a large number of individuals. Pub- traded on organized lic securities must have fairly standardized contractual features, both to exchanges. appeal to a broad range of investors and also because public investors do not generally have the time and expertise to study unique, nonstandardized con- tracts. Their wide ownership also ensures that public securities are relatively liquid. Private market securities are, therefore, more tailor-made but less liquid, whereas publicly traded securities are more liquid but subject to greater standardization. Other classifications could be made, but this breakdown is sufficient to show that there are many types of financial markets. Also, note that the distinctions among markets are often blurred and unimportant except as a general point of reference. For example, it makes little difference if a firm borrows for 11, 12, or 13 months, hence, whether we have a “money” or “capital” market transaction. You should be aware of the important differences among types of markets, but don’t get hung up trying to distinguish them at the boundaries. A healthy economy is dependent on efficient funds transfers from people who are net savers to firms and individuals who need capital. Without efficient transfers, the economy simply could not function: Carolina Power & Light could not raise capital, so Raleigh’s citizens would have no electricity; the Johnson family would not have adequate housing; Carol Hawk would have no place to invest her savings; and so on. Obviously, the level of employment and produc- tivity, hence our standard of living, would be much lower. Therefore, it is absolutely essential that our financial markets function efficiently—not only 3 quickly, but also at a low cost. Table 5-1 (on pages 148–149) gives a listing of the most important instru- ments traded in the various financial markets. The instruments are arranged from top to bottom in ascending order of typical length of maturity. As we go through the book, we will look in more detail at many of the instruments listed in Table 5-1. For example, we will see that there are many varieties of corporate bonds, ranging from “plain vanilla” bonds to bonds that are convertible into common stocks to bonds whose interest payments vary depending on the infla- tion rate. Still, the table gives an idea of the characteristics and costs of the instruments traded in the major financial markets. Recent Trends Financial markets have experienced many changes during the last two decades. Technological advances in computers and telecommunications, along with the globalization of banking and commerce, have led to deregulation, and this has increased competition throughout the world. The result is a much more effi- 3 As the countries of the former Soviet Union and other Eastern European nations move toward capitalism, just as much attention must be paid to the establishment of cost-efficient financial markets as to electrical power, transportation, communications, and other infrastructure systems. Economic efficiency is simply impossible without a good system for allocating capital within the economy.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 147 Chapter 5 Financial Markets and Institutions 147 cient, internationally linked market, but one that is far more complex than existed a few years ago. While these developments have been largely positive, they have also created problems for policy makers. At one conference, Federal Reserve Board Chairman Alan Greenspan stated that modern financial markets “expose national economies to shocks from new and unexpected sources and with little if any lag.” He went on to say that central banks must develop new ways to evaluate and limit risks to the financial system. Large amounts of capital move quickly around the world in response to changes in interest and exchange rates, and these movements can disrupt local institutions and economies. Globalization has exposed the need for greater cooperation among regula- tors at the international level. Various committees are currently working to improve coordination, but the task is not easy. Factors that complicate coordina- tion include (1) the differing structures among nations’ banking and securities industries, (2) the trend in Europe toward financial services conglomerates, and (3) reluctance on the part of individual countries to give up control over their national monetary policies. Still, regulators are unanimous about the need to close the gaps in the supervision of worldwide markets. Another important trend in recent years has been the increased use of Derivative derivatives. A derivative is any security whose value is derived from the price Any financial asset of some other “underlying” asset. An option to buy IBM stock is a derivative, whose value is derived as is a contract to buy Japanese yen six months from now. The value of the from the value of some IBM option depends on the price of IBM’s stock, and the value of the Japanese other “underlying” yen “future” depends on the exchange rate between yen and dollars. The mar- asset. ket for derivatives has grown faster than any other market in recent years, pro- viding corporations with new opportunities but also exposing them to new risks. Derivatives can be used either to reduce risks or to speculate. Suppose an importer’s costs rise and its net income falls when the dollar falls relative to the yen. That company could reduce its risk by purchasing derivatives whose values increase when the dollar declines. This is a hedging operation, and its purpose is to reduce risk exposure. Speculation, on the other hand, is done in the hope of high returns, but it raises risk exposure. For example, several years ago Procter & Gamble disclosed that it lost 150 million on derivative investments, and Orange County (California) went bankrupt as a result of its treasurer’s speculation in derivatives. The size and complexity of derivatives transactions concern regulators, aca- demics, and members of Congress. Fed Chairman Greenspan noted that, in the- ory, derivatives should allow companies to manage risk better, but that it is not clear whether recent innovations have “increased or decreased the inherent sta- bility of the financial system.” Distinguish between physical asset and financial asset markets. What’s the difference between spot and futures markets? Distinguish between money and capital markets. What’s the difference between primary and secondary markets? Differentiate between private and public markets. Why are financial markets essential for a healthy economy and eco- nomic growth? What is a derivative, and how is its value related to that of an “underlying asset”?19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 148 148 Part 2 Fundamental Concepts in Financial Management TABLE 5-1 Summary of Major Market Instruments, Market Participants, and Security Characteristics SECURITY CHARACTERISTICS Major Original Interest Rate a Instrument Market Participants Riskiness Maturity on 2/1/05 (1) (2) (3) (4) (5) (6) U.S. Treasury bills Money Sold by U.S. Treasury to Default-free 91 days 2.48% finance federal expenditures to 1 year Bankers’ acceptances Money A firm’s promise to Low degree of risk Up to 2.68 pay, guaranteed if guaranteed by a 180 days by a bank strong bank Dealer commercial Money Issued by financially secure Low default risk Up to 2.67 paper firms to large investors 270 days Negotiable certificates Money Issued by major money- Default risk depends Up to 2.70 of deposit (CDs) center commercial banks on the strength of 1 year to large investors the issuing bank Money market Money Invest in Treasury bills, CDs, Low degree of risk No specific 1.69 mutual funds and commercial paper; maturity held by individuals (instant and businesses liquidity) Eurodollar market Money Issued by banks Default risk depends Up to 2.70 time deposits outside U.S. on the strength of 1 year the issuing bank Consumer credit, Money Issued by banks/ Risk is variable Variable Variable, including credit credit unions/finance but goes up to card debt companies to individuals 20% or more U.S. Treasury Capital Issued by U.S. No default risk, 2 to 4.65 notes and bonds government but price will decline 30 years if interest rates rise a The yields reported (except for corporate and municipal bonds) are from The Wall Street Journal. Money market rates assume a 3-month maturity. Corporate and municipal bond rates are for 30-year AAA-rated bonds; quotes are from Federal Reserve Statistical Release. 5.3 FINANCIAL INSTITUTIONS Direct funds transfers are more common among individuals and small busi- nesses, and in economies where financial markets and institutions are less devel- oped. While businesses in more developed economies do occasionally rely on direct transfers, they generally find it more efficient to enlist the services of one or more financial institutions when it comes time to raise capital. In the United States and other developed nations, a set of highly efficient financial intermediaries has evolved. Their original roles were generally quite specific, but many of them have diversified to the point where they serve19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 149 Chapter 5 Financial Markets and Institutions 149 TABLE 5-1 (Continued) SECURITY CHARACTERISTICS Major Original Interest Rate a Instrument Market Participants Riskiness Maturity on 2/1/05 (1) (2) (3) (4) (5) (6) Mortgages Capital Borrowings from commercial Risk is variable Up to 5.20 banks and S&Ls by 30 years individuals and businesses State and local Capital Issued by state and Riskier than U.S. Up to 4.40 government bonds local governments to government securities, 30 years individuals and but exempt from institutional investors most taxes Corporate bonds Capital Issued by corporations Riskier than U.S. Up to 5.22 b to individuals and government securities, 40 years institutional but less risky than preferred investors and common stocks; varying degree of risk within bonds depending on strength of issuer Leases Capital Similar to debt Risk similar Generally Similar to in that firms can to corporate bonds 3 to bond yields lease assets rather than 20 years borrow and then buy the assets Preferred stocks Capital Issued by corporations Riskier than corporate Unlimited 6 to 8% to individuals and bonds, but less risky institutional investors than common stock c Common stocks Capital Issued by corporations Risky Unlimited NA to individuals and institutional investors b Just recently, a few corporations have issued 100-year bonds; however, the majority have issued bonds with maturities less than 40 years. c While common stocks do not pay interest, they are expected to provide a “return” in the form of dividends and capital gains. As you will see in Chapter 8, historical stock returns have averaged between 10 and 15 percent a year. Of course, if you buy a stock, your actual return may be considerably higher or lower than these historical averages. many different markets. As a result, the differences between institutions have Investment Banking tended to become blurred. Still, there remains a degree of institutional identity, House and therefore it is useful to describe the major categories of financial institu- An organization that tions here: underwrites and dis- tributes new invest- 1. Investment banking houses such as Merrill Lynch, Morgan Stanley, Gold- ment securities and man Sachs, or Credit Suisse Group provide a number of services to both helps businesses obtain financing. investors and companies planning to raise capital. Such organizations (a) help19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 150 150 Part 2 Fundamental Concepts in Financial Management corporations design securities with features that are currently attractive to investors, (b) then buy these securities from the corporation, and (c) resell them to savers. Although the securities are sold twice, this process is really one primary market transaction, with the investment banker acting as a facil- itator to help transfer capital from savers to businesses. Commercial Bank 2. Commercial banks, such as Bank of America, Wells Fargo, Wachovia, and Traditional department J. P. Morgan Chase, are the traditional “department stores of finance” because store of finance serving they serve a variety of savers and borrowers. Historically, commercial banks a variety of savers and were the major institutions that handled checking accounts and through borrowers. which the Federal Reserve System expanded or contracted the money sup- ply. Today, however, several other institutions also provide checking services and significantly influence the money supply. Conversely, commercial banks are providing an ever-widening range of services, including stock brokerage services and insurance. Financial Services 3. Financial services corporations are large conglomerates that combine many Corporation different financial institutions within a single corporation. Examples of finan- A firm that offers a cial services corporations, most of which started in one area but have wide range of financial now diversified to cover most of the financial spectrum, include Citigroup, services, including American Express, Fidelity, and Prudential. investment banking, 4. Savings and loan associations (S&Ls) traditionally served individual savers and brokerage operations, residential and commercial mortgage borrowers, taking the funds of many insurance, and com- small savers and then lending this money to home buyers and other types of mercial banking. borrowers. In the 1980s, the S&L industry experienced severe problems when (a) short-term interest rates paid on savings accounts rose well above the returns earned on the existing mortgages held by S&Ls and (b) commercial real estate suffered a severe slump, resulting in high mortgage default rates. Together, these events forced many S&Ls to merge with stronger institutions or close their doors. 5. Mutual savings banks, which are similar to S&Ls, operate primarily in the northeastern states, accepting savings primarily from individuals, and lend- ing mainly on a long-term basis to home buyers and consumers. 6. Credit unions are cooperative associations whose members are supposed to have a common bond, such as being employees of the same firm. Members’ savings are loaned only to other members, generally for auto purchases, home improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to individual borrowers. 7. Pension funds are retirement plans funded by corporations or government agencies for their workers and administered primarily by the trust depart- ments of commercial banks or by life insurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and real estate. 8. Life insurance companies take savings in the form of annual premiums; invest these funds in stocks, bonds, real estate, and mortgages; and finally make payments to the beneficiaries of the insured parties. In recent years, life insurance companies have also offered a variety of tax-deferred savings plans designed to provide benefits to the participants when they retire. Mutual Funds 9. Mutual funds are corporations that accept money from savers and then use Organizations that pool these funds to buy stocks, long-term bonds, or short-term debt instruments investor funds to pur- issued by businesses or government units. These organizations pool funds chase financial instru- and thus reduce risks by diversification. They also achieve economies of ments and thus reduce scale in analyzing securities, managing portfolios, and buying and selling risks through securities. Different funds are designed to meet the objectives of different diversification. types of savers. Hence, there are bond funds for those who desire safety, stock funds for savers who are willing to accept significant risks in the hope of higher returns, and still other funds that are used as interest-bearing19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 151 Chapter 5 Financial Markets and Institutions 151 Money Market Funds checking accounts (money market funds). There are literally thousands of Mutual funds that different mutual funds with dozens of different goals and purposes. invest in short-term, Mutual funds have grown more rapidly than most other institutions in low-risk securities and recent years, in large part because of a change in the way corporations pro- allow investors to write vide for employees’ retirement. Before the 1980s, most corporations said, in checks against their effect, “Come work for us, and when you retire, we will give you a retirement accounts. income based on the salary you were earning during the last five years before you retired.” The company was then responsible for setting aside funds each year to make sure it had the money available to pay the agreed-upon retire- ment benefits. That situation is changing rapidly. Today, new employees are likely to be told, “Come work for us, and we will give you some money each payday that you can invest for your future retirement. You can’t get the money until you retire (without paying a huge tax penalty), but if you invest wisely, you can retire in comfort.” Most workers recognize that they don’t know enough to invest wisely, so they turn their retirement funds over to a mutual fund. Hence, mutual funds are growing rapidly. Excellent information on the objectives and past performances of the various funds are provided in publications such as Value Line Investment Survey and Morningstar Mutual Funds, which are available in most libraries and on the Internet. 10. Hedge funds are similar to mutual funds because they accept money from savers and use the funds to buy various securities, but there are some important differences. While mutual funds are registered and regulated by the Securities and Exchange Commission (SEC), hedge funds are largely unregulated. This difference in regulation stems from the fact that mutual funds typically target small investors, whereas hedge funds typically have large minimum investments (often exceeding 1 million) that are effectively marketed to institutions and individuals with high net worths. Different hedge fund managers follow different strategies. For example, a hedge fund manager who believes that the spreads between corporate and Treasury bond yields are too large might simultaneously buy a portfolio of corporate bonds and sell a portfolio of Treasury bonds. In this case, the portfolio is “hedged” against overall movements in interest rates, but it will do well if the spread between these securities narrows. Likewise, hedge fund managers may take advantage of perceived incorrect valuations in the stock market, that is, where a stock’s market and intrinsic values differ. Hedge funds generally charge large fees, often a fixed amount plus 15 to 20 percent of the fund’s capital gains. The average hedge fund has done quite well in recent years. In a recent report, Citigroup estimates that the average hedge fund has produced an annual return of 11.9 percent since 1990. Over the same time period, the average annual returns of the overall stock market were 10.5 percent, and the returns on mutual funds were even lower, 9.2 per- cent. Given the stock market’s relatively lackluster performance in recent years, an increasing number of investors have flocked to hedge funds. Between 1999 and 2004, the money managed by them more than quadru- pled to roughly 800 billion. However, the same article in BusinessWeek that highlighted the strong growth and relative performance of these funds also suggested that their returns are showing signs of weakness and empha- 4 sized that they are certainly not without risk. Indeed, some hedge funds take on risks that are considerably higher than that of an average individual stock or mutual fund. Moreover, in recent years, some have also produced spectacular losses. For example, many 4 See Anne Tergesen, “Time to Hedge on Hedge Funds? New Research Shows that Returns Are Slid- ing, and Some Don’t Help You Diversify,” BusinessWeek, September 13, 2004, p. 104.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 152 152 Part 2 Fundamental Concepts in Financial Management hedge fund investors suffered large losses in 1998 when the Russian econ- omy collapsed. That same year, the Federal Reserve had to step in to help rescue Long Term Capital Management, a high-profile hedge fund whose managers included several well-respected practitioners as well as two Nobel 5 Prize–winning professors who were experts in investment theory. As hedge funds have become more popular, many have begun to lower their minimum investment requirements. Perhaps not surprisingly, their rapid growth and shift toward smaller investors have also led to a call for more regulation. With the notable exception of hedge funds, financial institutions have been heavily regulated to ensure the safety of these institutions and thus to protect investors. Historically, many of these regulations—which have included a prohi- bition on nationwide branch banking, restrictions on the types of assets the insti- tutions could buy, ceilings on the interest rates they could pay, and limitations on the types of services they could provide—tended to impede the free flow of capital and thus hurt the efficiency of our capital markets. Recognizing this fact, policy makers took several steps during the 1980s and 1990s to deregulate finan- cial services companies. For example, the barriers that restricted banks from expanding nationwide were eliminated. Likewise, regulations that once forced a strict separation of commercial and investment banking have been relaxed. The result of the ongoing regulatory changes has been a blurring of the dis- tinctions between the different types of institutions. Indeed, the trend in the United States today is toward huge financial services corporations, which own banks, S&Ls, investment banking houses, insurance companies, pension plan operations, and mutual funds, and which have branches across the country and around the world. For example, Citigroup combines one of the world’s largest commercial banks (Citibank), a huge insurance company (Travelers), and a major investment bank (Smith Barney), along with numerous other subsidiaries that operate throughout the world. Citigroup’s structure is similar to that of major institutions in Europe, Japan, and elsewhere around the globe. Panel A of Table 5-2 lists the 10 largest U.S. bank and thrift holding compa- nies, while Panel B shows the leading world banking companies. Among the world’s 10 largest, only one (Citigroup) is based in the United States. While U.S. banks have grown dramatically as a result of recent mergers, they are still small by global standards. Panel C of the table lists the 10 leading underwriters in terms of dollar volume of new debt and equity issues. Six of the top underwriters are also major commercial banks or are part of bank holding companies, which confirms the continued blurring of distinctions among different types of finan- cial institutions. What is the difference between a pure commercial bank and a pure investment bank? List the major types of financial institutions, and briefly describe the primary function of each. What are some important differences between mutual and hedge funds? How are they similar? 5 See Franklin Edwards, “Hedge Funds and the Collapse of Long Term Capital Management,” Jour- nal of Economic Perspectives, Vol. 13, no. 2 (Spring 1999), pp. 189–210, for a thoughtful review of the implications of Long Term Capital Management’s collapse.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 153 Chapter 5 Financial Markets and Institutions 153 TABLE 5-2 10 Largest U.S. Bank and Thrift Holding Companies and World Banking Companies and Top 10 Leading Underwriters Panel A Panel B Panel C U.S. Bank and Thrift World Banking Leading Global a b c Holding Companies Companies Underwriters Citigroup Inc. Mizuho Financial Group (Tokyo) Citigroup Inc. Bank of America Corp. Citigroup Inc. (New York) Morgan Stanley J. P. Morgan Chase & Co. Allianz AG (Munich) J. P. Morgan Wells Fargo & Co. UBS AG (Zurich) Merrill Lynch Wachovia Corp. HSBC Holdings PLC (London) Lehman Brothers MetLife Inc. Deutsche Bank AG (Frankfurt) Credit Suisse First Boston Bank One Credit Agricole (Paris) Deutsche Bank AG Washington Mutual Inc. BNP Paribas (Paris) UBS AG U.S. Bancorp ING Group NV (Amsterdam) Goldman Sachs SunTrust Banks Inc. Sumitomo Mitsui Financial Banc of America Securities Group (Tokyo) Notes: a Ranked by total assets as of June 30, 2004. Source: “Top 150 Bank and Thrift Holding Companies with the Most Assets,”, October 19, 2004. b Ranked by total assets as of December 31, 2003. Source: “World’s Largest Banking Companies by Assets,”, November 12, 2004. c Ranked by dollar amount raised through new issues (stocks and bonds) in 2004. For this ranking, the lead underwriter (manager) is given credit for the entire issue. Source: Adapted from The Wall Street Journal, January 3, 2005, p. R17. 5.4 THE STOCK MARKET As noted earlier, secondary markets are those in which outstanding, previously issued securities are traded. By far the most active secondary market, and the most important one to financial managers, is the stock market, where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock market is impor- tant to anyone involved in managing a business. While the two leading stock markets today are the New York Stock Exchange and the Nasdaq stock market, stocks are actually traded using a vari- ety of market procedures. However, there are just two basic types of stock markets: (1) physical location exchanges, which include the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and several regional stock exchanges, and (2) electronic dealer-based markets that include the Nas- daq stock market, the less formal over-the-counter market, and the recently developed electronic communications networks (ECNs). (See the box entitled, “The NYSE and Nasdaq Combine Forces with the Leading Online Trading Sys- tems.”) Because the physical location exchanges are easier to describe and understand, we consider them first.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 154 154 Part 2 Fundamental Concepts in Financial Management Citigroup Built to Compete in a Changing Environment The financial environment has been undergoing 2. Increased globalization made it desirable for tremendous changes, including breakthroughs in financial institutions to follow their clients and technology, increased globalization, and shifts in the operate in many countries. regulatory environment. All of these factors have pre- 3. Changing technology led to increased economies sented financial managers and investors with oppor- of scale and scope, both of which increase the tunities, but those opportunities are accompanied by relative efficiency of huge, diversified companies substantial risks. such as Citigroup. Consider the case of Citigroup Inc., which was The same forces that are transforming the financial created in 1998 when Citicorp and Travelers Group services industry have affected other industries. In (which included the investment firm Salomon Smith particular, the growth of the Internet has provided Barney) merged. Citigroup today operates in more many companies with increased opportunities, but it than 100 countries, has roughly 200 million cus- has also created additional competition and risk. For tomers and 275,000 employees, and holds more example, it has altered the way millions of consumers than 1.4 trillion (that’s over a thousand billion) purchase airline tickets, hotel rooms, books, and worth of assets. automobiles. Consequently, financial managers must Citigroup resulted from three important trends: understand today’s technological environment and 1. A regulatory change made it possible for U.S. be ready to change operations as the environment corporations to engage in commercial banking, evolves. investment banking, and insurance. The Physical Location Stock Exchanges Physical Location The physical location exchanges are tangible physical entities. Each of the larger Exchanges ones occupies its own building, has a limited number of members, and has an Formal organizations elected governing body—its board of governors. Members are said to have having tangible “seats” on the exchange, although everybody stands up. These seats, which are physical locations that bought and sold, give the holder the right to trade on the exchange. There are conduct auction currently 1,366 seats on the New York Stock Exchange (this number has remained markets in designated constant since 1953). In early 2005, a seat on the NYSE sold for 1.0 million, (“listed”) securities. which was considerably lower than the record high of 2.65 million. Seat prices are at multiyear lows due to low trading volume, declines in commissions earned, and recent scandals that have rocked the NYSE. Most of the larger investment banking houses operate brokerage departments, and they own seats on the exchanges and designate one or more of their officers as members. The exchanges are open on all normal working days, with the members meeting in a large room equipped with telephones and other electronic equipment that enable each member to communicate with his or her firm’s offices throughout the country. Like other markets, security exchanges facilitate communication between buyers and sellers. For example, Merrill Lynch (the fourth largest brokerage firm) might receive an order in its Atlanta office from a customer who wants to buy shares of GE stock. Simultaneously, the Denver office of Morgan Stanley (the second largest brokerage firm) might receive an order from a customer wishing to sell shares of GE. Each broker communicates electronically with the firm’s representative on the NYSE. Other brokers throughout the country are19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 155 Chapter 5 Financial Markets and Institutions 155 The NYSE and Nasdaq Combine Forces with the Leading Online Trading Systems The forces that spurred consolidation in the financial shareholders will own the remaining 30 percent. Two services industry have also promoted online trading days after this stunning announcement, Nasdaq systems that bypass the traditional exchanges. These announced its own plans to purchase Instinet. systems, which are known as electronic communica- These announced mergers confirm the growing tions networks (ECNs), use electronic technology to importance of electronic trading and have led many bring buyers and sellers together. As of early 2005, to conclude that the floor traders who buy and sell the majority of these transactions were conducted by stock on the NYSE may soon become a thing of the two firms: Instinet Group and Archipelago. past as an increasing number of transactions take The rise of ECNs has accelerated the move place electronically. Others contend that there will toward 24-hour trading. Large clients who want to remain a role for these floor traders for at least the trade after other markets have closed may utilize an foreseeable future. In any event, what is clear is that ECN, thus bypassing the NYSE and Nasdaq. The the financial landscape of stock trading will continue move toward faster, cheaper, and continuous trading to undergo dramatic changes in the upcoming years. obviously benefits investors, but it does present regu- lators, who try to ensure that all investors have access to a “level playing field,” with a number of headaches. Recognizing the new threat, the two leading Sources: Katrina Brooker, “Online Investing: It’s Not Just for exchanges have not been content to stand idly by. In Geeks Anymore,” Fortune, December 21, 1998, pp. 89–98; April 2005, the NYSE announced plans to acquire “Fidelity, Schwab Part of Deal to Create Nasdaq Challenger,” The Milwaukee Journal Sentinel, July 22, Archipelago and to turn itself into a public company. 1999, p. 1; Aaron Lucchetti, Susanne Craig, and Dennis K. If the deal goes through, the new company will be Berman, “NYSE to Acquire Electronic Trader and Go called NYSE Group Inc., and 70 percent of the Public,” The Wall Street Journal, April 21, 2005, p. A1; and combined company will be owned by those who “Nasdaq Agrees to Buy Instinet for 1.88 Billion,”, Wall Street Online, April 22, 2005. currently hold seats on the NYSE. Archipelago also communicating with their own exchange members. The exchange members with sell orders offer the shares for sale, and they are bid for by the members 6 with buy orders. Thus, the exchanges operate as auction markets. 6 The NYSE is actually a modified auction market, wherein people (through their brokers) bid for stocks. Originally—about 200 years ago—brokers would literally shout, “I have 100 shares of Erie for sale; how much am I offered?” and then sell to the highest bidder. If a broker had a buy order, he or she would shout, “I want to buy 100 shares of Erie; who’ll sell at the best price?” The same general situation still exists, although the exchanges now have members known as specialists who facilitate the trading process by keeping an inventory of shares of the stocks in which they specialize. If a buy order comes in at a time when no sell order arrives, the specialist will sell off some inventory. Similarly, if a sell order comes in, the specialist will buy and add to inventory. The specialist sets a bid price (the price the specialist will pay for the stock) and an asked price (the price at which shares will be sold out of inventory). The bid and asked prices are set at levels designed to keep the inventory in balance. If many buy orders start coming in because of favorable develop- ments or sell orders come in because of unfavorable events, the specialist will raise or lower prices to keep supply and demand in balance. Bid prices are somewhat lower than asked prices, with the difference, or spread, representing the specialist’s profit margin. Special facilities are available to help institutional investors such as mutual or pension funds sell large blocks of stock without depressing their prices. In essence, brokerage houses that cater to institutional clients will purchase blocks (defined as 10,000 or more shares) and then resell the stock to other institutions or individuals. Also, when a firm has a major announcement that is likely to cause its stock price to change sharply, it will ask the exchanges to halt trading in its stock until the announcement has been made and digested by investors.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 156 156 Part 2 Fundamental Concepts in Financial Management The Over-the-Counter and the Nasdaq Stock Markets While the stocks of most large companies trade on the NYSE, a larger number of stocks trade off the exchange in what has traditionally been referred to as the over-the-counter (OTC) market. An explanation of the term “over-the-counter” Over-the-Counter (OTC) Market will help clarify how this term arose. As noted earlier, the exchanges operate as A large collection auction markets—buy and sell orders come in more or less simultaneously, and of brokers and exchange members match these orders. If a stock is traded infrequently, perhaps dealers, connected because the firm is new or small, few buy and sell orders come in, and matching electronically by them within a reasonable amount of time would be difficult. To avoid this prob- telephones and lem, some brokerage firms maintain an inventory of such stocks and stand pre- computers, that pared to make a market for these stocks. These “dealers” buy when individual provides for trading in investors want to sell, and then sell part of their inventory when investors want unlisted securities. to buy. At one time, the inventory of securities was kept in a safe, and the stocks, when bought and sold, were literally passed over the counter. Today, these markets are often referred to as dealer markets. A dealer market Dealer Market Includes all facilities includes all facilities that are needed to conduct security transactions, but they are that are needed to not made on the physical location exchanges. These facilities include (1) the rela- conduct security tively few dealers who hold inventories of these securities and who are said to transactions not “make a market” in these securities; (2) the thousands of brokers who act as conducted on the agents in bringing the dealers together with investors; and (3) the computers, ter- physical location minals, and electronic networks that provide a communication link between deal- exchanges. ers and brokers. The dealers who make a market in a particular stock quote the price at which they will pay for the stock (the bid price) and the price at which they will sell shares (the ask price). Each dealer’s prices, which are adjusted as supply and demand conditions change, can be read off computer screens all across the world. The bid-ask spread, which is the difference between bid and asked prices, represents the dealer’s markup, or profit. The dealer’s risk increases if the stock is more volatile, or if the stock trades infrequently. Generally, we would expect volatile, infrequently traded stocks to have wider spreads in order to compensate the dealers for assuming the risk of holding them in inventory. Brokers and dealers who participate in the over-the-counter market are members of a self-regulatory body known as the National Association of Securities Dealers (NASD), which licenses brokers and oversees trading practices. The com- puterized network used by the NASD is known as the NASD Automated Quota- tion System (Nasdaq). Nasdaq started as just a quotation system, but it has grown to become an organized securities market with its own listing requirements. Over the past decade the competition between the NYSE and Nasdaq has become increasingly fierce. In an effort to become more competitive with the NYSE and with interna- tional markets, the Nasdaq and the AMEX merged in 1998 to form the Nasdaq- Amex Market Group. The merger turned out to be less than successful, and in early 2005 the AMEX members agreed to buy the exchange back from the NASD. Since most of the larger companies trade on the NYSE, the market capi- talization of NYSE-traded stocks is much higher than for stocks traded on Nasdaq (12.6 trillion compared with 3.7 trillion at year-end 2004). However, reported volume (number of shares traded) is often larger on Nasdaq, and more 7 companies are listed on Nasdaq. Interestingly, many high-tech companies such as Microsoft and Intel have remained on Nasdaq even though they easily meet the listing requirements of the NYSE. At the same time, however, other high-tech companies such as Gateway, America Online, and Iomega have left Nasdaq for the NYSE. Despite these defec- 7 One transaction on Nasdaq generally shows up as two separate trades (the buy and the sell). This “double counting” makes it difficult to compare the volume between stock markets.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 157 Chapter 5 Financial Markets and Institutions 157 tions, Nasdaq’s growth over the past decade has been impressive. In the years ahead, competition between Nasdaq and the NYSE will no doubt remain fierce. What are the differences between the physical location exchanges and the Nasdaq stock market? What is the bid-ask spread? 5.5 THE MARKET FOR COMMON STOCK Some companies are so small that their common stocks are not actively traded; they are owned by only a few people, usually the companies’ managers. These Closely Held firms are said to be privately owned, or closely held, corporations, and their stock Corporation is called closely held stock. In contrast, the stocks of most larger companies are A corporation that is owned by thousands of investors, most of whom are not active in management. owned by a few These companies are called publicly owned corporations, and their stock is individuals who are called publicly held stock. typically associated A recent study found that institutional investors owned about 46 percent of with the firm’s all publicly held common stocks. Included are pension plans (26 percent), management. mutual funds (10 percent), foreign investors (6 percent), insurance companies Publicly Owned (3 percent), and brokerage firms (1 percent). These institutions buy and sell rela- Corporation tively actively, however, so they account for about 75 percent of all transactions. A corporation that is Thus, institutional investors have a significant influence on the prices of individ- owned by a relatively ual stocks. large number of individuals who are not actively involved in its Types of Stock Market Transactions management. We can classify stock market transactions into three distinct categories: 1. Trading in the outstanding shares of established, publicly owned companies: the secondary market. Allied Food Products, the company we analyzed in Chapters 3 and 4, has 50 million shares of stock outstanding. If the owner of 100 shares sells his or her stock, the trade is said to have occurred in the secondary market. Thus, the market for outstanding shares, or used shares, is the second- ary market. The company receives no new money when sales occur in this market. 2. Additional shares sold by established, publicly owned companies: the primary market. If Allied decides to sell (or issue) an additional 1 million shares to raise 8 new equity capital, this transaction is said to occur in the primary market. 3. Initial public offerings by privately held firms: the IPO market. In the summer of 2004 Google sold shares to the public for the first time at 85 per share. By September 2005, the stock was selling for 303, so it had more than tripled. Several years ago, the Coors Brewing Company, which was owned by the Coors family at the time, decided to sell some stock to raise capital 9 needed for a major expansion program. These types of transactions are called 8 Allied has 60 million shares authorized but only 50 million outstanding; thus, it has 10 million authorized but unissued shares. If it had no authorized but unissued shares, management could increase the authorized shares by obtaining stockholders’ approval, which would generally be granted without any arguments. 9 The stock Coors offered to the public was designated Class B, and it was nonvoting. The Coors family retained the founders’ shares, called Class A stock, which carried full voting privileges. The company was large enough to obtain an NYSE listing, but at that time the Exchange had a requirement that listed common stocks must have full voting rights, which precluded Coors from obtaining an NYSE listing.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 158 158 Part 2 Fundamental Concepts in Financial Management Going Public going public—whenever stock in a closely held corporation is offered to the The act of selling stock public for the first time, the company is said to be going public. The market to the public at large for stock that is just being offered to the public is called the initial public by a closely held offering (IPO) market. corporation or its principal stockholders. IPOs have received a lot of attention in recent years, primarily because a number of “hot” issues have realized spectacular gains—often in the first few minutes of trading. Consider the 1999 IPO of Red Hat Inc., the open-source Initial Public Offering provider of software products and services. The company’s underwriters set an (IPO) Market offering price of 14 per share. However, because of intense demand for the The market for stocks of companies that are issue, the stock’s price rose more than 270 percent the first day of trading. in the process of going With the recent stock market decline, we have also seen a decline in the public. number of new IPOs. Table 5-3 lists the largest, the best performing, and the worst performing IPOs of 2004, and it shows how they performed from their offering dates through year-end 2004. As the table shows, not all IPOs are as well received as Red Hat’s. Moreover, even if you are able to identify a “hot” issue, it is often difficult to purchase shares in the initial offering. These deals are generally oversubscribed, which means that the demand for shares at the offering price exceeds the number of shares issued. In such instances, investment bankers favor large institutional investors (who are their best customers), and small investors find it hard, if not impossible, to get in on the ground floor. They can buy the stock in the after-market, but evidence suggests that if you do not get in on the ground floor the average IPO underperforms the overall market over the 10 long run. Indeed, the subsequent performance of Red Hat illustrates the risks that arise when investing in new issues. Figure 5-2 plots Red Hat’s stock price from the time of its IPO in 1999 to early February 2005. After its dramatic first day run-up, Red Hat’s stock closed just above 54 per share. Demand for the stock continued to surge, and the price reached a high of just over 300 in December 1999. Soon afterward, the company announced a two-for-one stock split. (Note that Figure 5-2 considers the stock split.) The split effectively cut the stock’s price in half, but it doubled the number of shares held by each shareholder. After adjusting for the split, the stock’s price stood at 132 per share in early January 2000. Soon thereafter, Red Hat’s price tumbled—indeed, by mid-year 2001 its price was 3.50 per share, which was equivalent to 7.00 per share before the split. As Figure 5-2 shows, Red Hat’s stock has slowly rebounded over the past few years, but its price still remains below its initial offering price of 14. Amidst concerns about the allocation of IPO shares, Google Inc.’s highly publicized 2004 IPO attracted attention because of its size (Google raised 1.67 billion in stock) and the way it was conducted. Rather than having the offer price set by its investment bankers, Google conducted a Dutch auction in which individual investors directly placed bids for shares. In a Dutch auction, the actual transaction price is set at the highest price (“the clearing price”) that causes all of the offered shares to be sold. Investors who set their bids at or above the clear- ing price receive all the shares they subscribed to at the offer price. While Google’s IPO was in many ways precedent setting, it remains unclear whether other firms going public in the future will be able, or willing, to use the Dutch auction method to allocate shares in their IPOs. It is important to recognize that firms can go public without raising any additional capital. For example, the Ford Motor Company was once owned 10 See Jay R. Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance, Vol. 46, no. 1 (March 1991), pp. 3–27.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 159 Chapter 5 Financial Markets and Institutions 159 TABLE 5-3 Initial Public Offerings in 2004 PERCENT CHANGE FROM OFFER U.S. Issue Proceeds First Day Through Issuer Date (Billions) Trading 12/31/04 The Biggest IPOs Genworth Financial 05/24/04 2.86 unch. 38.5% Assurant 02/04/04 2.02 12.3% 38.9 Google 08/18/04 1.92 18.0 126.8 Semiconductor Manufacturing Intl. 03/11/04 1.80 11.3 38.5 Freescale Semiconductor 07/16/04 1.69 7.9 37.1 China Netcom 11/10/04 1.31 14.1 22.6 LG Philips 07/15/04 1.06 6.3 19.9 Navteq 08/06/04 1.01 15.0 110.7 Dex Media 07/21/04 1.01 2.6 31.4 Dreamworks Animation 10/27/04 0.93 38.4 34.0 PERCENT CHANGE FROM OFFER U.S. Issue Offer Proceeds First Day Through Issuer Date Price (Millions) Trading 12/31/04 The Best Performers Shanda Interactive Ent 05/12/04 11.00 169.0 8.8% 286.4% 51Job 09/28/04 14.00 84.5 51.1 271.2 Marchex 03/30/04 6.50 26.0 35.4 223.1 Volterra Semiconductor 07/28/04 8.00 36.5 3.1 177.0 08/27/04 5.80 20.1 3.5 175.0 Cogent 09/23/04 12.00 248.4 49.8 175.0 Jed Oil 04/05/04 5.50 10.5 103.6 165.5 Syneron Medical 08/05/04 12.00 60.0 10.4 155.0 Kinetic Concepts 02/23/04 30.00 621.0 34.7 154.3 Kanbay International 07/22/04 13.00 106.9 16.9 140.8 PERCENT CHANGE FROM OFFER U.S. Issue Offer Proceeds First Day Through Issuer Date Price (Millions) Trading 12/31/04 The Worst Performers Xcyte Therapies 03/16/04 8.00 33.6 8.6% 65.5% Staktek Holdings 02/05/04 13.00 145.5 14.5 64.3 AlphaSmart 02/06/04 6.00 26.4 2.0 50.8 Corgentech 02/12/04 16.00 110.4 20.3 48.3 Corcept Therapeutics 04/14/04 12.00 54.0 1.9 47.9 Daystar Technologies 02/05/04 5.00 10.6 1.0 43.0 Infosonics 06/16/04 6.00 12.0 2.5 40.3 Linktone 03/03/04 14.00 86.0 24.4 40.0 Semiconductor Manufacturing International 03/11/04 17.50 1,803.0 11.3 38.5 Cherokee International 02/19/04 14.50 110.1 13.8 33.7 Source: “Initial Public Offerings of Stock Bounce Back in 2004,” The Wall Street Journal, January 3, 2005, p. R10.19843_05_c05_p141-172.qxd 12/7/05 9:43 AM Page 160 160 Part 2 Fundamental Concepts in Financial Management FIGURE 5-2 Red Hat Inc.’s Stock Price Performance from Its IPO to February 2005 Source: exclusively by the Ford family. When Henry Ford died, he left a substantial part of his stock to the Ford Foundation. When the Foundation later sold some of it to the general public, the Ford Motor Company went public, even though the company itself raised no capital in the transaction. Differentiate between closely held and publicly owned corporations. Differentiate between primary and secondary markets. What is an IPO? What is a Dutch auction? Why is it used? 5.6 STOCK MARKETS AND RETURNS Anyone who has ever invested in the stock market knows that there can be, and generally are, large differences between expected and realized prices and returns. Figure 5-3 shows how total realized portfolio returns have varied from year to year. As logic would suggest (and as we demonstrate in Chapter 8), a stock’s expected return as estimated by investors at the margin is always positive, for otherwise investors would not buy the stock. However, as Figure 5-3 shows, in some years actual returns are negative. Stock Market Reporting Up until a couple of years ago, the best source of stock quotations was the busi- ness section of a daily newspaper, such as The Wall Street Journal. One problem with newspapers, however, is that they report yesterday’s prices. Now it is pos- sible to obtain quotes all during the day from a wide variety of Internet

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