CHAPTER 3: INVESTMENT BANKING

PURPOSE OF FINANCIAL MARKETS

- Facilitate the transfer of funds from individuals with

funds to invest to those individuals that need funds.

METHODS:

1. INDIRECT
- Through financial intermediary (commercial bank)
2. DIRECT
- Investment in the firm by general public

THE ROLE OF INVESTMENT BANKERS

INVESTMENT BANKER

- Middleman who brings together investors and firms issuing

new securities

INITIAL PUBLIC OFFERING (IPO)

- First sale of common stock

UNDERWRITING

- Purchase of new securities for subsequent sale by

investment banker
- Guaranteeing of sale of a new issue of securities

ORIGINATING HOUSING

- Makes an agreement to sell a new issue and forms a

syndicate to sell the securities

SYNDICATE

- Selling group formed to market a new issue of securities

BEST EFFORTS AGREEMENT

- Contract for the sale of securities

- Does not guarantee, but does agree to make the best efforts
to sell the securities
PRICING A NEW ISSUE
When this occurs, the investment bankers have two choices:

1. To maintain the offer price and to hold the securities in

inventory until they are sold
2. To let the market find a lower price level that will induce
investors to purchase the securities

MARKETING NEW SECURITIES

PRELIMINARY PROSPECTUS (red herring)

- Initial document detailing the financial condition of a

firm that must be files with the SEC to register a new
issue of securities

SECURITIES AND EXCHANGE COMMISSION (SEC)

- Government agency that enforces the federal securities law

REGISTRATION

- Process of filing information with the SEC concerning a

propose sale of securities to the general public

VOLATILITY OF THE MARKET FOR INITIAL PUBLIC OFFERING

The new issue market is volatile not only regarding the
number of securities that are offered but also regarding the
price changes of the new issue. When the new issue market is
“hot”, it is not unusual for the prices to rise dramatically

SELF REGISTRATION
The new securities must be registered with and approved by
the SEC before they may be sold to the public, and the firm
often uses the services of an investment banker to facilitate
the sale

PRIVATE PLACEMENT

- Non-public sale of securities to a financial institution

THE REGULATION OF NEW PUBLIC ISSUES OF CORPORATE
SECURITIES
FULL DISCLOSURE LAWS

- Federal securities laws requiring the timely disclosure of

information that may affect the value of a firm’s
securities

10-K REPORT

- Required annual report filed with the SEC by publicly held

firms

SECURITIES INVESTOR PROTECTION CORPORATION (SIPC)

- Federal agency that insures investors against failure by

brokerage firms

SARBANES-OXLEY ACT OF 2002

- Was intended to restore public confidence in the securities
market

THE MAIN PROVISION ENCOMPASSES THE FOLLOWING:

- The independence of auditors and the creation of the public

company accounting oversight board
- Corporate responsibility and financial disclosure
- Conflicts of interest and corporate fraud and
accountability

PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD

Purpose is to oversee the auditing of the financial

statements of publicly held companies

- Has the power to establish audit reporting rules and

standards and to enforce compliance by public accounting
firms
CHAPTER 4: SECURITIES MARKET
MARKET MAKERS
BID AND ASK PRICES

- Prices quoted by market makers at which they are willing to

buy and sell securities

ROUND LOT

- Normal unit of trading in a security

ODD LOT

- Unit of trading in a security

SPREAD

- Difference between the bid and ask prices

THE MECHANICS OF INVESTING IN SECURITIES

MARKET ORDER

- Order to buy or sell a security at the best current price

DAY ORDER

- Order to buy or sell at a specified price that is cancelled

at the end of the day if is not executed

GOOD TILL CANCELLED ORDER

- Order to buy or sell at a specified price that remains in

effect until it is executed by the broker or cancelled by
the investor

COMMISSION

- Payment to broker for executing an investor’s buy and sell

orders

SETTLEMENT DATE

- Date by which payment for the purchase of securities must

be made
- Date by which delivery of securities sold must be made
MARGIN

- Investor’s equity in a security position

MARGIN REQUIREMENT

- Minimum percentage, set by the federal reserve, of the

total price that must be put up to buy securities

FINANCIAL LEVERAGE

- Use of borrowed funds to magnify the percentage return on

an investment

THE SHORT SALE

LONG POSITION

- Purchase of securities in anticipation of a price increase

SHORT POSITION

- Sale of borrowed securities in anticipation of a price

decrease

FOREIGN SECURITIES
AMERICAN DEPOSITARY RECEIPTS (ADRs)

- Receipts issued for foreign securities held by a trustee

EUROBONDS

- Bonds sold in a foreign country but denominated in the

currency of the issuing firm

COMPETITION IN THE SECURITIES MARKETS

EFFICIENT MARKET HYPOTHESIS (EMH)

- Theory that securities prices correctly measure the current

value of a firm’s future earnings and dividend
CHAPTER 5: THE FEDERAL RESERVE
THE ROLE OF THE FEDERAL RESERVE
MONETARY POLICY

- Management of the money supply for the purpose of

maintaining stable prices, full employment and economic
growth

STRUCTURAL OF THE FEDERAL RESERVE

BOARD OF GOVERNORS

- Controlling body of the federal reserve, whose members are

appointed by the president of the united states

DISTRICT BANK

- One of 12 banks that compose the federal reserve

THE EXPANSION OF MONEY AND CREDIT

One way that the Federal Reserve affects the supply of
money and credit is through its impact on the reserves of banks,
which alters their lending capacity. A small change in bank’s
reserves can produce a much larger change in the money supply
because of the fractional reserve system

Understanding the potential impact of monetary policy

requires understanding how the banking system expands and
contracts the supply of money and credit ─ that is,
understanding how a fractional reserve banking system alters the
supply of money

CASH WITHDRAWALS AND THE REDUCTION IN RESERVES

FEDERAL FUNDS MARKET

- Market in which banks borrow and lend excess reserves

FEDERAL FUNDS RATE

- Interest rate charged by banks on overnight loans of

reserves
DISCOUNT RATE

- Interest rate charged banks for borrowing reserves from the

Federal Reserve

THE IMPACT OF FISCAL POLICY ON CREDIT MARKETS

FISCAL POLICY

- Taxation, expenditures, and debt management by the federal

government

DEFICIT

- Disbursement exceeding receipts

SURPLUS

- Receipts exceeding disbursements

IMPACT OF AN INFLATIONARY ECONOMIC ENVIRONMENT ON

CREDIT MARKETS
INFLATION

- General increase in prices with special emphasis on

increases in consumer prices

DEFLATION

- General decline in prices

RECESSION

- Period of at least six months during which the economy

experiences increased unemployment and negative growth
CHAPTER 7: THE TIME VALUE OF MONEY
THE FUTURE VALUE OF A DOLLAR
COMPOUNDING

- Process by which interest is paid on interest that was

previously earned

FUTURE VALUE OF A DOLLAR

- Amount to which a single payment will grow at some rate of

interest

THE PRESENT VALUE OF A DOLLAR

PRESENT VALUE

- Current value of a dollar to be received in the future

FORMULA: = Pn

DISCOUNTING

- Process of determining present value

FORMULA:

NON ANNUAL COMPOUNDING

- Payment of interest more frequently than once a year

SUMMARY OF THE EQUATIONS FOR THE INTEREST FACTORS

CHAPTER 8: RISK AND ITS MEASUREMENT
THE RETURN ON AN INVESTMENT
RETURN

- What is earned on an investment: the sum of income and

capital gains generated by an investment

REQUIRED RETURN

- Return necessary to induce an individual to make an

investment

THE SOURCE OF RISK

RISK

- Possibility of loss; the uncertainty that the anticipated

return will not be achieved

DIVERSIFIABLE RISK (UNSYSTEMATIC RISK)

- Risk associated with individual events that affect a

particular asset; firm-specific risk that is reduced
through the construction of diversified portfolios

BUSINESS RISK

- Risk associated with the nature of a business

FINANCIAL RISK

- Risk associated with the types of financing used to acquire

assets

NON-DIVERSIFIABLE RISK (SYSTEMATIC RISK)

- Risk associated with fluctuations in securities prices and

other non-firm specific factors: market risk that is not
reduced through the construction of diversified portfolios

MARKET RISK

- Risk associated with fluctuations in securities prices

INTEREST RATE RISK

- Risk associated with changes in interest rates

RE-INVESTMENT RATE RISK

- Risk associated with re-investing earnings on principal at

a lower rate than was initially earned

PURCHASING POWER RISK

- Uncertainty that future inflation will erode the purchasing

power of assets and income

EXCHANGE RATE RISK

- Risk of loss from changes in the value of foreign

currencies

SOVEREIGN RISK

- Risk associated with a government defaulting on its debt

obligations

THE STANDARD DEVIATION AS A MEASURE OF RISK

STANDARD DEVIATION

- Measure of dispersion around an average value; a measure of

risk

BETA COEFFICIENT

- Index of systematic risk; measure of the volatility of a

stock’s return relative to the market return

PORTFOLIO RISK

- Total risk associated with owning a portfolio; sum of

systematic and unsystematic risk

BETA COEFFICIENT

- Measure the risk associated with individual stocks. The

concept is also applied to portfolios, as betas are
computed for mutual funds, in which case they compare the
return Son the fund with the return on the market
CHAPTER 10: THE FEATURES OF STOCK
COMMON STOCK
Security representing ownership in a corporation; common
stock owners have a final claim on the firm’s assets and
earnings after the firm has met its obligations to creditors and
preferred stockholders

BOARD OF DIRECTORS

- Body elected by and responsible to stockholders to set

policy and hire management to run a corporation

CUMULATIVE VOTING

- Voting system that encourages minority representation by

permitting stockholders to cast all their shares (votes)
for one candidate for the firm’s board of directors

PRE-EMPTIVE RIGHTS
Right of current stockholders to maintain their
proportionate ownership in the firm

RIGHTS OFFERING

- Sale of new securities to stockholders by offering them the

option (right) to purchase new shares

DIVIDEND POLICY
CASH DIVIDENDS

- Distribution from earnings paid in the form of cash

- After a corporation has earned profits, management must
decide what to do with these earnings; retain them and
increase each stockholder’s investment in the firm, or
distribute them in cash dividends

• PAYOUT RATIO

- Ratio of cash dividends to earnings

• DATE OF RECORD

- Day on which an investment must own stock in order to

receive the dividend payment

• EX-DIVIDEND

- Stock purchases exclusive of any dividend payment

• PAY DATE OR DISTRIBUTION DATE

- Day on which a dividend is paid to stockholders

STOCK DIVIDENDS
Distribution from earnings paid in additional shares of
stock

DILUTION

- Reduction in earnings per share as the result of issuing

additional shares

STOCK SPLITS

- Recapitalization achieved by changing the number of shares

outstanding

DIVIDEND REINVESTMENT PLANS (DRIPs)

- Plans that permit stockholders to have cash dividends

reinvested in additional shares instead of receiving the
cash