Direct Finance

1. Learning Unit #4
Direct Finance

2. Objectives of Learning Unit
• Direct Finance
– How Funds are Transferred?
– How Three Financial Services are Provided?
• Direct Finance in Action
– Financial Instruments in Financial Markets
– Financial Institutions in Financial Markets
– Types of Financial Markets

3. Direct Finance
• Direct Finance: Borrowers borrow funds
directly from lenders in financial markets by
selling them securities.
• Securities (Financial instruments): claims on
the borrower’s future income or assets

4. How Financial Markets Transfer Funds
from Lenders to Borrowers
• Financial markets transfer funds from lender-
savers to borrower-spenders in primary
markets.
• Primary Markets: New issues of a security are
sold to initial buyers by the corporation or
government agency borrowing funds.
– Corporations raise funds for investment.
– Governments use funds to finance budget deficits.

5. Issue New Securities
When a firm issues new securities, the firm
• Gets help from investment banks.
• Files a disclosure report to the Security and
Exchange Commission (SEC).
• Prepares a prospectus (information for prospective
buyers of the securities).
• Makes an announcement (tombstone) on the Wall
Street Journal.
In the case of a new stock issue, this sale is called
“initial public offering” (IPO).

6. Tombstone
Tombstone: an announcement of new security
issue on the Wall Street Journal.
• Tombstones are very plain, and have limited
information about new issues such as name of
issuing firm or organization, type of securities to be
issued, number of securities to be issued, sales price
of securities, and financial institutions which help
issuing the securities (underwrites and syndicates).

7. Tombstone Example
TRI-S Security Corporation
will issue 1.8 million shares
of stocks at $6 each to raise
$10.8 million of funds (1.8
million x $6). Capital
Growth Financial and
Bathgate Capital Partners
are investment banks
helping TRI-S Security to
issue the stocks and selling
them to initial buyers.

8. How Financial Markets Provide Three
Financial Services
• Financial Markets provide three financial
services in secondary markets.
• Secondary Markets: Financial instruments that
have already been issued are re-sold by one
investor to another.

9. Risk Sharing
• Secondary markets provide a variety of securities in
small denomination.
– In primary markets new securities are often sold in a large
lot (quantity), requiring buyers large sum of money.
– In primary markets corporations and organizations issue new
securities once in many years, so buyers have to wait for a
long time to purchase a particular security.
• Secondary markets enable small savers to purchase a
collection of assets and achieve diversification.
• With diversification, small savers can reduce an
overall risk on his saving (portfolio).

10. Liquidity
• Secondary markets allow holders of securities
to sell any time and purchase another.
– Without secondary markets holders of securities
must wait until their maturities to get funds back.
• By allowing holders of securities to sell any
time, secondary markets provide liquidity
services.

11. Information
• Secondary markets determine prices of securities
every day.
– The most important information of financial instrument for
savers (buyers of securities) and borrowers (issuers of
securities) is its price.
– Corporations whose securities are publicly traded (in
secondary markets) are required to disclose financial
information to the government (SEC) and security holders.
• Primary markets also help providing information of
issuers and securities to buyers of securities.

12. Classifications of Financial Markets
Financial markets are classified in terms of
– Maturity
– Types of claim
– Trading place

13. Classification by Maturity
• Money Markets
Trade financial instruments with a maturity of one year or
less
Ex. Three-month negotiable certificate of deposits
• Capital Markets
Trade financial instruments with a maturity greater than one
year
Ex. 30-year-maturity corporate bond

14. Maturity
• Maturity: Length of time before a debt instrument
expires
– Short-term (one year or less), Intermediate-term (between one
year and ten years), and long-term debt (ten years or longer)
• Ex. Three-month negotiable certificate of deposit matures in three
months, so buyers of the CD will receive its principal and interest
payments in three months.
• Ex. Three-month Treasury bills (short-term), five-year Treasury
notes (intermediate-term), 30-year Treasury bonds (long-term).
• Question: How long is a maturity of stocks?

15. Classification by Type of Claim
• Debt Markets
Trade debt instruments (e.g. bonds).
• Equity Markets
Trade equity instruments (e.g. stocks).

16. Debt Instruments
• Debt instruments: a contractual agreement by the
borrower to pay the holder of the instrument fixed
dollar amounts at regular intervals until a specified
date.
– Fixed dollar payments are called interest and principal
payments.
– A specific date is maturity.
– Lenders (savers) receive interest as a payment for the rental
of funds.

17. Equity Instruments
• Equity instruments: claims to share in the net income
and the assets of a business.
– Ex. Common stocks
– Equity represents an ownership of corporation, so
stockholders are owners of the corporation, and all assets
and income of the corporation belong to the stockholders.
– There are many stockholders of a corporation, so they
share ownership of the corporation (they are also called
shareholder).
– Stockholders hire managers (CEO) through election of
Board of Directors (which supervises management team)
on behalf of them to do daily operation of the corporation.
– Stockholders receive periodic payments (dividends) out of
corporate income.

18. Classification by Trading Place
• Exchange (Auction Markets): Buyers and sellers of securities
or their agents meet in one central location (Exchange) to
conduct trades
– Ex. New York Stock Exchange (NYSE)
• Over-the-Counter (OTC) Markets: Security dealers at different
locations who have an inventory of securities stand ready to
buy and sell securities to anyone who comes to them and is
willing to accept their prices
– Securities are traded through computer networks with no
centralized trading place.
– Ex. NASDAQ (National Association of Security Dealers
Automated Quotation system).

19. Exchange and OTC
In New York Stock Exchange stocks are traded on floor between agents of
buyers and sellers with help of specialists (deal makers). In NASDAQ stocks
are traded between agents (security dealers) of buyers and sellers via online.

20. Stock Market Index
• Stock market index is a weighted average price of a basket of
stocks. It is used to gauge an overall performance of stock
markets.
• There are many stock market indices.
– Dow Jones Industrial Average (DJIA): a weighted average of prices of
stocks of largest and widely-held public companies in the U.S., selected
by Dow Jones.
• It includes Microsoft, Exxon-Mobile, Bank of America, Wal-Mart,
and other well-know corporations.
– Standard & Poor’s 500: a weighted average of prices of stocks of 500
large public companies representing each industry in the U.S.
– NASDAQ composite: a weighted average of prices of all stocks traded
in NASDAQ, where stocks of many medium-size and small-size
corporations are traded.

21. Example of Stock Market Indexes
on Wall Street Journal
• Wall Street Journal reports stock market indexes
prices everyday on Market Data page of Money &
Investing section (Section C).
– See “How to Interpret Market Data of Wall Street
Journal” on Blackboard
– On Market Data, Wall Street Journal shows charts of
three stock market indexes: DJIA, NASDAQ composite,
and S&P 500, and list various stock market indexes on the
previous trading day.

22. Financial Institutions in Direct Finance
• Primary markets
– Investment bank (investment banker)
• Secondary markets
– Security broker: Undertake purchases and sales of
securities for their customers in exchange for a commission
– Security dealer: Hold an inventory of securities and
undertake purchases and sales of securities for their
customers in exchange for a commission
– Ex. Edward Jones, e-Trade

23. Investment Bank
• Investment bank: Assist businesses and governments in raising
new funds by selling newly issued securities to initial buyers.
– Investment banks are not banks (as you know) at all!
– Ex. Lehman Brothers, Goldman Sacks, Salomon Smith
Barney (they are now parts of larger financial institutions).
• Underwriter: investment bank that guarantees the corporation
(which issues securities) a price on the securities and then sells
them to the public.
• Syndicate: a group of investment banks that share
underwriting.
– When a corporation issues a large amount of securities, one investment
bank cannot handle all sales, so it forms underwriting syndicate to
spread tasks and risk.

24. Brokerage Firm
• Brokerage firms: engage in all three securities
market activities: brokers, dealers, and
investment bankers.
– Ex. Meryl Lynch, Morgan Stanley Dean Witter
– Today, all large investment bankers are actually
brokerage firms, and many of them are parts of
even larger financial institutions.
ex. J.P. Morgan Chase

25. Financial Instruments in Direct Finance
• Money market instruments: Financial instruments
with maturity of one year or less
– Ex. U.S. Treasury bills, Negotiable bank certificates of
deposits, commercial paper, Banker’s acceptances,
Repurchase agreements, Federal funds
• Capital market instruments: Financial instruments
with maturity of more than one year
– Ex. Stocks, Mortgages, Corporate bonds, U.S. Government
securities, U.S. Government agency securities, State and
local government bonds, Consumer and bank commercial
loans

26. U.S. Treasury Bills
• U.S. Treasury Bills: short-term debt instruments of
the U.S. government
– One-, three-, and six-month maturity
– Used to finance daily government spending (until tax
revenues come in)
– Have no interest payment, but sold at a discount.
– Most liquid due to large volume actively traded daily.
– No possibility of default (the issuer cannot pay interest or
principal) due to the government’s taxing power and its
ability to issue currencies if necessary for payment.

27. Negotiable Bank Certificates of Deposits
• Certificate of deposits: a debt instrument issued by a
bank to depositors that pays annual interest of a given
amount and pays back at maturity the original
purchase price.
• Negotiable CDs are CDs that can be sold in
secondary markets.
– Usually the minimum denomination is $100,000.

28. Commercial Paper
• Commercial paper: a unsecured short-term debt
instrument issued by large banks and well-known
corporation.
– Up to 270 days of maturity
– Used for daily cash management, not for financing long-
term investment projects.

29. Repurchase Agreements
• Repurchase agreement (repo): an agreement that one
party sell securities to the other party with a promise
that the former will buy it back the securities from the
later at the set price.
– It is effectively short-term loan for which often U.S.
Treasury bills serve as collateral (an asset that the lender
receives if the borrower does not pay back the loan).
– Usually maturity of less than two weeks
– Analogy: Pawnshop [This is not repo, but the mechanism
behind is same.]

30. Federal Funds
• Federal funds: overnight inter-bank loans (loans between banks)
of deposits at the Federal Reserves.
– One bank has too much deposits at the Federal Reserves, while other
bank does not have enough. Then, the former loans excess deposits at
the Fed to the later.
• Note: the Federal Reserve acts like a bank for banks and each bank
must maintain certain amount of deposits at the Federal Reserve.
This will be discussed in detail on Learning Unit #20)
• Federal funds rate: the interest rate on federal funds
– The Federal Reserve sets its target rate on the federal funds as its
monetary policy tool. This will be discussed in detail on Learning Unit
#23.

31. Banker’s Acceptance
• Banker’s acceptance: a bank draft (like check) issued
by a firm, payable at some future date, and
guaranteed by the bank that stamps it “accepted.”
– An accepting bank requires the issuing firm to deposit the
required funds into a special account.
– Used for foreign trades where exporters and importers do
not each other, but they know some large banks in two
countries
– Analogy: you sell a good at e-bay to someone. You may
not accept any personal check from him, but PayPal
payment since you know PayPal). [This is NOT a banker’s
acceptance, but the mechanism behind is same.]

32. Sizes of Money Market Instruments

33. Example of Money Rates on Barron’s
Dow Jones’ publishes money market rates every day on
“Money Rates” section of the Wall Street Journal and
weekly on “Money Rates” section of Barron’s.
– See “How to Interpret Money Rates of Barron’s” on
Blackboard
– WSJ provides money rates on the previous trading day, one
week ago, and highest and lowest in last one year.
– Barron’s provides money rates on last Friday (Barron’s is
issued on every Monday), on Friday one week ago, and on
Friday one year ago.

34. U.S. Government Securities
• U.S. Treasury Notes and Bonds: intermediate-term
and long-term debt instruments of the U.S.
government
– three- and five-year maturity for Notes and ten-and 30-year
maturity for Bonds
– Used to finance the deficits of the federal government (to
make payments later years with future tax revenues)
– The most liquid capital market instrument

35. U.S. Government Agency Securities
• Long-term bonds issued by various government
agencies and GSE (Government Sponsored
Enterprises) to finance specific government programs.
– Ginnie Mae (Government National Mortgage Association)
within Department of HUD guarantees bonds backed by
home mortgages that have been guaranteed by a government
agency (FHA).
– Federal Farm Credit Bank issues bonds and offer loans,
leases and financial services to U.S. farmers.
– TVA (Tennessee Valley Authority)

36. State and Local Government Bonds
• States and local government bonds: intermediate-term and long-
term debt instruments of the state and local governments (e.g.
State of North Carolina, Guilford county, city of Greensboro)
– They are called “municipal bonds” (muni).
– Used to finance expenditures on schools, roads, and other
programs (e.g. water system).
– Revenue bonds: payments on bonds are made out of revenues
raised from the program for which the proceeds of bonds are
used to finance.
– General obligation bonds: payments on bonds are made out
of tax revenue of the state or local government.

37. Corporate Stocks and Bonds
• Stocks: equity claims on the net income and assets of
a corporation.
– Common stocks and preferred stocks
– Stocks are by far the largest capital market instruments, but
the amount of new stock issues is very little each year.
• Corporate bonds: long-term bonds issued by
corporations with very strong credit rating (low risk).
– The size of corporate bond market is much smaller than the
stock market, but the amount of new corporate bond issued
each year is much greater than the new stock issues.

38. Mortgages
• Mortgage: loans to households or firms to purchase
housing, land, or other real structure.
– The structure or land serve as collateral for the loans.
• Mortgage-backed securities: A bond-like debt
instrument backed by a bundle of individual
mortgages, whose interest and principal payments are
collectively paid to the holders of the security.
– Fannie Mae (Federal National Mortgage Association),
Freddie Mac (Federal Home Loan Mortgage Corporation)

39. Consumer and Bank Commercial Loans
• Consumer loans are made to households by banks and
finance companies.
– Credit card loan: $679 billion in the first quarter of 2012
– Auto loan: $737 billion in the first quarter of 2012
– Student loan: $904 billion as of March 31, 2012
• Commercial loans are made to businesses primarily
by banks.

40. Sizes of Capital Market Instruments

41. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University