Introduction to Capital Markets September 30, 2014

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Table of Contents Current Events Siemens to acquire Dresser-Rand Subprime Auto Loan Bubble Introduction to Financial Markets Equity Markets Debt Markets Why Invest?

Current Events

Siemens to acquire Dresser-Rand • Siemens is a conglomerate that makes products for the energy sector • Plans to acquire Dresser-Rand Group, an oil services & equipment manufacturer company in Texas – $7.6 billion deal, at an implied 16x EV/EBITDA multiple the deal was considered pricey • Hoping this acquisition will allow them to benefit from the explosive growth in equipment capex (~100% real growth from 2000-2013)

Subprime Auto Loan Bubble • Number of auto loans made to subprime borrowers has doubled since 2009 – Greater increase than in any other loan type

• Allegations of dealer misbehavior and the involvement in the stock market – Auto loans are also being bundled into risky securities, much like the subprime mortgage loans

Financial Markets

Why Study Financial Markets? • Markets channel funds from savers to investors  leading to economic efficiency • Market activity affects personal wealth, the behavior of business firms and the economy as a whole

Function of Financial Markets • Improves economic efficiency by channeling funds between people and businesses • Lenders-Savers – – – –

Households Business firms Governments Foreigners

• Borrowers-Spenders – – – –

Business firms Government Households Foreigners

Structure of Financial Markets • Primary Market – New security issues sold to initial buyers

• Secondary Market – Securities previously issued are bought and sold – Allows for liquidity and sets a selling price – Exchanges and Over-the-Counter Markets

What is the difference between direct and indirect finance?

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Segments of Financial Markets • Direct Finance – Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets

• Indirect Finance – Borrowers borrow indirectly from lenders via financial intermediaries by issuing financial instruments which are claims on the borrower’s future income or assets

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Function of Financial Markets

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Financial Intermediaries • the intermediary obtains funds from savers • the intermediary then makes loans/investments with borrowers – primary means of moving funds from lenders to borrowers.

• Reduces the impact of asymmetrical information *More important source of finance than securities markets (such as stocks) 13

Equity Markets

Financial Intermediaries • Transaction Costs – Financial intermediaries make profits by reducing transactions costs – Reduce transactions costs by developing expertise and taking advantage of economies of scale – Allows more liquidity for customers

• Allow customers to diversify their asset holdings

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Stocks • A stock represents ownership in a company – every stock represents a small portion of the assets of a company, after subtracting the portion that was financed with debt • Shareholders get special privileges depending on the type of stock – Right to vote – Right to purchase new shares

Stock Markets • The stock market is where common stock is traded • Companies initially sell stock in the primary market to raise money – The stock is then traded among investors in the secondary market

Debt Markets

Debt Markets • Debt markets allow governments, corporations and individuals to borrow to finance activities • In this market, borrowers issue a security – called a bond – Promises timely payment of interest and principal over a specific amount of time

• Interest rate is the cost of borrowing

Why Invest?

Inflation

Average inflation rate, measured by change in CPI, between 1915 and now is 3.3%

How Do Stocks Make You Money? • Two ways to get a return in a company’s stock – Capital Appreciation – Dividends

• Capital appreciation – increase in the price of a stock • Dividends – payments made by a corporation to its shareholders – When a company earns a profit, they can reinvest it in the business or paid to shareholders – Can be cash dividends or stock dividends

• A stock is only worth the investment if you can receive a fair return on it

What to Invest in? • Several types of investment vehicles: – – – – – –

Savings accounts Treasury Bills Bonds Preferred Stock Common Stock Derivatives

• Each investment vehicle comes with a certain level of risk – this determines the expected return • Hedge – an investment that is made in order to offset the volatility in another investment  theoretically reduces exposure to unwanted risk