IFMI 2017/2018

The Capital Market

Public Issue
Privileged Subscription
Regulation of Security Offerings
Private Placement
Initial Financing
Signaling Effects
The Secondary Market
 Deja Vu All Over Again
Capital Market -- The market for relatively
long-term (greater than one year original
maturity) financial instruments.
Primary Market -- A market where new
securities are bought and sold for the first
time (a new issues market).
Secondary Market -- A market for existing
(used) securities rather than new issues.
 Deja Vu All Over Again
INVESTMENT SECTOR Public issue

Privileged
subscription

INTERMEDIARIES
Private

FINANCIAL
FINANCIAL BROKERS
placement
Indicates the possible
presence of a
SECONDARY MARKET standby arrangement
Indicates the financial
intermediaries own
SAVINGS SECTOR securities flow to the
savings sector
 Public Issue
Public Issue -- Sale of bonds or stock to
the general public.
Securities are sold to hundreds, and often
thousands, of investors under a formal contract
overseen by federal and state regulatory
authorities.
When a company issues securities to the general
public, it is usually uses the services of an
investment banker.
 Investment Banker
Investment Banker -- A financial institution that
underwrites (purchases at a fixed price on a fixed
date) new securities for resale.
Investment banker receives an underwriting spread when
acting as a middleman in bringing together providers and
consumers of investment capital.
Underwriting spread -- the difference between the price
the investment bankers pay for the security and the price
at which the security is resold to the public.
 Investment Banker
Investment bankers have expertise, contacts, and the sales organization to
efficiently market securities to investors.

Thus, the services can be provided at a lower cost to the

firm than the firm can perform the same services
internally.
Three primary means companies use to offer securities to
the general public:
Traditional (firm commitment) underwriting
Best efforts offering
Shelf registration
 Traditional Underwriting
Underwriting -- Bearing the risk of not being able
to sell a security at the established price by virtue
of purchasing the security for resale to the public;
also known as firm commitment underwriting.

If the security issue does not sell well, either

because of an adverse turn in the market or
because it is overpriced, the underwriter, not the
company, takes the loss.
 Traditional Underwriting
Underwriting Syndicate -- A temporary
combination of investment banking firms formed
to sell a new security issue.
A. Competitive-bid
The issuing company specifies the date that sealed
bids will be received.
Competing syndicates submit bids.
The syndicate with the highest bid wins the security
issue.
 Traditional Underwriting
B. Negotiated Offering
The issuing company selects an investment banking firm
and works directly with the firm to determine the
essential features of the issue.
Together they discuss and negotiate a price for the
security and the timing of the issue.
Depending on the size of the issue, the investment
banker may invite other firms to join in sharing the risk
and selling the issue.
Generally used in corporate stock and most corporate
bond issues.
 Traditional Underwriting
Best Efforts Offering -- A security offering in which the investment bankers
agree to use only their best efforts to sell the issuers securities. The
investment bankers do not commit to purchase any unsold securities.

Shelf Registration -- A procedure whereby a company is permitted to register

securities it plans to sell over the next two years; also called SEC Rule 415.
These securities can then be sold piecemeal whenever the company chooses.
 Shelf Registration: Flotation Costs
and Other Advantages
A firm with securities sitting on the shelf can require that investment
banking firms competitively bid for its underwriting business.

This competition reduces underwriting spreads.

The total fixed costs (legal and administrative) of
successive public debt issues are lower with a single shelf
registration than with a series of traditional registrations.
The amount of free advice available from underwriters is
less than before shelf registration was an alternative to
firms.
 Privileged Subscription
Privileged Subscription -- The sale of new securities in which existing
shareholders are given a preference in purchasing these securities up to the
proportion of common shares that they already own; also known as a rights
offering.

Preemptive Right -- The privilege of shareholders to maintain their

proportional company ownership by purchasing a proportionate share of any
new issue of common stock, or securities convertible into common stock.
 Terms of Offering
Right -- A short-term option to buy a certain number
(or fraction) of securities from the issuing corporation;
also called a subscription right.
Terms specify:
the number of rights required to subscribe for
an additional share of stock
the subscription price per share
the expiration date of the offering
 Subscription Rights
Options available to the holder of rights:
Exercise the rights and subscribe for
additional shares
Sell the rights (they are transferable)
Do nothing and let the rights expire

Generally, the subscription period is

three weeks or less.
 Standby Arrangement

Standby Arrangement -- A measure taken to

ensure the complete success of a rights offering in
which an investment banker or group of
investment bankers agrees to stand by to
underwrite any unsubscribed (unsold) portion of
the issue.
Fee often composed of a flat fee and an additional fee for
each unsold share of stock.
The greater the risk of an unsuccessful rights offering, the
more desirable a standby arrangement.
 Oversubscription Privilege
Oversubscription Privilege -- The right to
purchase, on a pro rata basis, any unsubscribed
shares in a rights offering.

For example, shareholders subscribe for 450,000 shares of

a 500,000-share rights offering. Let us assume that some
shareholders would like more shares and oversubscribe by
80,000 shares.
As a result, each shareholder oversubscribing receives
5/8ths (50,000 / 80,000) of a share for each share
oversubscribed.
 Privileged Subscription versus
Underwritten Issue
Investors are familiar with the firms operations when
using a rights offering.
The principal sales tool is a discounted price (rights
offering) and the investment banking organization
(underwriting).
A disadvantage of a rights offering is that the shares
will be sold at a lower price.
There is greater dilution with a rights offering which
many firms attempt to avoid.
There is a wider distribution of shares with a public
offering.
 Regulation of Security
Offerings -- Federal
Securities Act of 1933 -- Generally requires that
public offerings be registered with the federal
government before they may be sold; also known
as Truth in Securities Act.
Securities Exchange Act of 1934 -- Regulates the
secondary market for long-term securities -- the
securities exchanges and the over-the-counter
market.

Securities and Exchange Commission (SEC)

enforces both of these acts.
 Regulation of Security
Offerings -- Federal
Registration Statement -- The disclosure
document filed with the SEC in order to register a
new securities issue.
Part 1: Prospectus -- Discloses information about
the issuing company and its new offering
and is distributed to investors.
Part 2: Additional information required by the SEC
that is not part of the printed prospectus.
 Red Herring
Red Herring -- The preliminary prospectus. It
includes a legend in red ink on the cover stating
that the registration statement has not yet become
effective.
SEC reviews the registration statement to see that all the
required information is presented and that it is not
misleading.
Deficiencies are communicated in a comment letter.
Once the SEC is satisfied, it approves the registration. If
not, it issues a stop order.
 Regulation of Security
Offerings -- Federal
Registration Statement Effective Date
Registration statements become effective
on the 20th day after filing (or on the 20th
day after filing the last amendment).
The SEC, at its discretion, can advance
the date. Typical time from filing to
approval is 40 days.
 Regulation of Security
Offerings -- Federal
Impact with shelf registration:
A shelf registration allows a company to register
with the SEC in advance of a security offering.
The company can sell off the shelf by filing a
simple amendment and having the SEC accelerate
the normal 20-day waiting period accorded
amendments.
Typically, the waiting period following this simple
amendment is only a day or two.
 Regulation of Security
Offerings -- Federal
Tombstone Advertisement -- An announcement
placed in newspapers and magazines giving just
the most basic details of a security offering.

The term reflects the stark, black-bordered

look of the ad.
Includes the companys name, a brief
description of the security, the offering price,
and the names of the investment bankers in the
underwriting syndicate.
 Sarbanes-Oxley
Act of 2002
Sarbanes-Oxley Act of 2002 (SOX) Addresses,
among other issues, corporate governance,
auditing and accounting, executive
compensation, and enhanced and timely
disclosure of corporate information.
Most important security law reform since 1930s.
Establishes:
an oversight board to regulate public accounting firms that
audit public companies
New audit and audit committee standards
Executive officers of public companies must certify the
companys SEC reports
Increases liability for violations of federal security laws
 Regulation of Security
Offerings -- State
Blue Sky Laws -- State laws regulating the
offering and sale of securities.
Individual states have security commissions that regulate
securities in their states.
These laws are particularly important when a security issue
is sold entirely to people within the state and may not be
subject to SEC regulation.
Important if the SEC provides only limited review.
States vary on the strictness of their regulation.
 Private Placement
Private (or Direct) Placement -- The sale of an entire
issue of unregistered securities (usually bonds)
directly to one purchaser or a group of purchasers
(usually financial intermediaries).
Eliminates the underwriting function of the
investment banker.
The dominant private placement lender in this group
is the life-insurance category (pension funds and
bank trust departments are very active as well).
 Private
Placement Features
Allows the firm to raise funds more quickly.
Eliminates risks with respect to timing.
Eliminates SEC regulation of the security.
Terms can be tailored to meet the needs of the
borrower.
Flexibility in borrowing smaller amounts more
frequently rather than a single large amount.
 Private Placement and
Other Developments
Event Risk -- The risk that existing debt will
suffer a decline in creditworthiness because of
the issuance of additional debt securities,
usually in connection with corporate
restructuring.
Qualified Institutional Buyers (QIBs) --
Eligible purchasers, by SEC Rule 144a, of
previous securities from a private placement
without having to go through a public market
registration.
 Private Placement and
Other Developments
Private Placement with Registration Rights It
combines a standard private placement with a
contract requiring the issuer to register the
securities with the SEC for possible resale in the
public market.
Underwritten Rule 144a Private Placement The
issuer sells its securities initially to an investment
bank that resells them to the same institutional
buyers that are candidates for a regular private
placement. Often includes registration rights.
 Initial Financing -- Venture
Capital
Wealthy investors and financial institutions are the
primary providers of funds for a new enterprise (usually
common stock).
Rule 144 and the 1933 Act require privately placed securities
to be held for at least two years or be registered before they
can be resold.
Letter stock * -- Privately placed common stock that
cannot be immediately resold.
* Note: Under SEC Rule 144a, however, letter stock could be sold
to qualified institutional buyers (QIBs) without a waiting period.
Initial Financing -- Initial
Public Offerings
Initial Public Offering (IPO) -- A companys first
offering of common stock to the general public.
Often prompted by venture capitalists who wish to
realize a cash return on their investment.
Founders of the firm may wish to go through an
IPO to establish a value for their company.
There exists greater price uncertainty with an IPO
than with other new public stock issues.
 Signaling Effects
Negative stock
price reaction to 3 Relative Abnormal
common stock or Stock Returns for a
2 New Equity Issue

Abnormal Return (%)

convertible issues. Cumulative Average
1
Straight debt and
0
preferred stock do
not tend to show -1

statistically -2
significant effects. -3
-4

-10 -8 -6 -4 -2 0 2 4 6 8
Time Around Announcement (in days)
 Possible Explanations for Price
Reactions
Expectations of Future Cash Flows
The unexpected sale of securities may be associated with lower than expected
operating cash flows and interpreted as bad news. Hence, the stock price might
suffer accordingly.

Asymmetric (Unequal) Information

Potential investors have less information than management
(particularly for common stock).
Exchanges of different types of securities show that
increases (decreases) in financial leverage are associated
with positive (negative) abnormal returns.
 The Secondary Market
Purchases and sales of existing stocks and bonds occur in
the secondary market.
Transactions in the secondary market do not provide
additional funds to the firm.
The secondary market increases the liquidity of securities
outstanding and lowers the required returns of investors.
Composed of organized exchanges like the New York Stock
Exchange and American Stock Exchange plus the over-the-
counter (OTC) market.
Indonesia Stock Exchange (IDX)
Indonesia Capital Market
Structure
Trading Hour
Remote Trading Process
Price Step
 Autorejection System
1. The selling or buying order is smaller than Rp 50 (fifty rupiah);
2. The selling or buying orders input into the JATS are more than
35% (thirty five percent) above or 10% (ten percent) below the
Reference Price for stock price that ranges from Rp 50 (fifty
rupiah) to Rp 200 (two hundred rupiah);
3. The selling or buying order input into the JATS are more than
25% (twenty five percent) above or 10% (ten percent) below the
Reference Price for stock price that ranges from above Rp 200
(two hundred rupiah) to Rp 5,000 (five thousand rupiah);
4. The selling or buying order input into the JATS are more than
20% (twenty percent) above or 10% (ten percent) below the
Reference Price for stock price that is more than Rp 5,000 (five
thousand rupiah).
Settlement Period
Transaction Fee
Stock Trading Snapshot
(April 7, 2017)
Stock Trading Snapshot
(April 7, 2017)
Stock Trading Snapshot
(April 7, 2017)
What are Mutual Funds?
Mutual funds are a type of investment that takes
money from many investors and uses it to make
investments based on a stated investment objective.
Each shareholder in the mutual fund participates
proportionally (based upon the number of shares
owned) in the gain or loss of the fund.
Why do People Invest in Mutual
Funds?
Mutual funds offer investors an affordable way to diversify
their investment portfolios.
Mutual funds allow investors the opportunity to have a
financial stake in many different types of investments.
These investments include: stocks, bonds, money markets,
real estate, commodities, etc
Individually, an investor may be able to own stock in a few
companies, a few bonds, and have money in a money
market account. Participation in a mutual fund, however,
allows the investor to have much greater exposure to each
of these asset classes.
Continued
Most mutual funds are professionally managed by
an investment expert known as a portfolio
manager.
This individual makes all of the buying and selling
decisions for the fund.
There are thousands of different mutual funds in
the United States.
This provides investors with many options to help
them achieve their investment objectives.
Basic Mutual Fund Categories
Mutual Funds can be divided into four basic
categories based upon the funds investment
objective.
These categories are:
1. Money Market Mutual Funds
2. Stock Mutual Funds
3. Index Funds
4. Bond Mutual Funds
5. Balanced Mutual Funds
Money Market Mutual Funds
This is the most conservative type of mutual fund.
The goal is to maintain the $1 value of its shares while
providing income.
Invests in high-quality, short-term securities such as
certificates of deposit, U.S. Treasury Bills, and U.S. Treasury
Notes.
MMMFs are an appropriate place for savings.
These funds have typically offered higher interest rates
than bank savings accounts.
Money market mutual funds are not insured by the FDIC.
Stock Mutual Funds
Type of fund that invests in stocks.
These funds are also known as equity funds.
There are many different types of stock mutual
funds.
Some of the most common include:
Large-cap funds, mid-cap funds, small-cap funds,
income funds, growth funds, value funds, blend
funds, international funds, and sector funds.
Index Funds
These are mutual funds whose holdings aim to track the
performance of a specific stock market index.
The most common index fund tracks the S&P 500. These
index funds invest in the exact stocks (and in the same
percentages) as those found in the S&P 500.
Index funds also track bonds, real estate, and other types of
assets.
These funds are lower cost than other types of funds.
Bond Mutual Funds
Type of mutual fund that invests in bonds.
There are different types of bond mutual funds.
Typically, bond mutual funds have the objective of
providing stable income with minimal risk.
Types of Bond Mutual Funds
Short, Intermediate, and Long-Term U.S. Bond
Funds
Short, Intermediate, and Long-Term Corporate
Bond Funds
Municipal Bond Funds
High-Yield (junk) Bond Funds
We will talk more about bonds and bond funds
later in this unit of study.
Balanced Mutual Funds
These are also known as hybrid funds.
These mutual funds invest in stocks, bonds, and
money markets.
These are very diversified mutual funds. The stock
portion of the fund provides the potential for capital
appreciation, while the bond and money market
portion provide income.
The Mutual Fund Prospectus
This is a legal document which describes the
investment objective of the fund, the manner in which
the fund is administered and operated, the fees and
other pertinent information.
The prospectus should be read thoroughly before
making an investment decision.
Load v. No Load Mutual Funds
A mutual fund that charges a commission to cover its
administrative costs is called a load fund.
A front-end load charges the load when the shares are
purchased, while a back-end load charges the load
when the shares are sold.
A no-load mutual fund doesnt charge a purchase or
sales commission.