Fundamentals of Financial Instruments. Sunil K. Parameswaran
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a public issue of shares and an investor were to purchase them, then it would be termed as a direct market transaction. Similarly, if the government were to issue bonds to individual as well as institutional investors, it too would constitute a direct market transaction. In practice, an issuer of equity shares or debt securities can do so either through a public issue or through a private placement. A public issue entails the sale of the issue to a large and diverse body of investors, both retail and institutional. Such issues are usually underwritten by an investment banker. In the case of private placements, which are more common for debt issues, the issuer will sell the entire issue directly to a single institution or a group of institutions.
In the case of indirect financing the ultimate lender does not interact with the ultimate borrower. There is a financial intermediary who in such markets comes in between the eventual borrower and the ultimate lender. The role of such an intermediary is, however, very different from that of a broker-dealer or an investment banker, who too are financial intermediaries albeit in a different sense.
A classic example of a financial intermediary in an indirect market is a commercial bank. Take the case of a bank like BNP Paribas. It raises deposits from individual and institutional investors. From the standpoint of the depositor, who is the surplus unit in this case, the bank is the corresponding deficit unit. The bank will issue its financial claims to the depositors for whom these claims will constitute an asset. A bank passbook, or computerized statement, or a certificate issued in lieu of a longer-term deposit, is a manifestation of such a claim. The rate of interest on such claims is the rate of return for the depositors. The risk for such depositors is that the bank could fail. If so, they may lose all or a part of their deposits. In the United States bank deposits up to $100,000 are insured by the Federal Deposit Insurance Corporation (FDIC).
After accumulating funds by way of deposits, the bank will then lend to corporate and noncorporate entities in need of funds. For such borrowers, the bank is the surplus budget unit, and for the bank they constitute the deficit units. The bank will hold claims issued by such borrowers in return for the funds lent to them and will be entitled to all cash flows emanating from them. Obviously, the bank is exposed to the risk that the borrowing entities could go bankrupt.
As can be seen, the link between the ultimate lenders and the ultimate borrowers is broken by a financial intermediary such as a bank in the case of indirect markets. The ultimate lenders, that is, the deposit holders at the bank, have no claim on the assets of the eventual borrowers, nor do they have a claim on the cash flows generated by such assets. It is the bank that has a claim on such assets and the corresponding cash flows. The depositors have a claim solely against the bank and are dependent on its performance in order to get the promised return on their savings. Besides commercial banks, other financial intermediaries in indirect markets include insurance companies, mutual funds, and pension funds.
MUTUAL FUNDS
A mutual fund is a financial intermediary in the indirect financial market. It is a collection of stocks, bonds, and other assets that are purchased by pooling the investments made by a large group of investors. The assets of the fund are managed by a professional investment company.
When investors make an investment in a mutual fund, their money is pooled with that of other investors who have chosen to invest in the fund. The pooled sum is used to build an investment portfolio if the fund is just commencing its operations, or to expand its portfolio if it is already in business. The investors receive shares of the fund in proportion to the amount of money they have invested. When a fund is offering shares for the first time, known as an Initial Public Offering or IPO, the shares will be issued at par. Subsequent issues of shares will be made at a price that is based on what is known as the Net Asset Value (NAV) of the fund. The Net Asset Value of a fund at any point in time is equal to the total value of all securities in its portfolio less any outstanding liabilities, divided by the total number of shares issued by the fund.
There are two broad categories of mutual funds, open-ended and closed-ended. Open-ended funds permit investors to acquire and redeem shares at any point in time, at the prevailing NAV. Thus, the capital of these funds is variable. Closed-ended funds make a one-time issue of shares to investors; however, such funds are usually listed on a stock exchange, which ensures that investors have the freedom to trade. Shares of such funds may be priced above or below the prevailing NAV.
The NAV will fluctuate from day to day as the value of the securities held by the fund changes. On a given day, from the perspective of shareholders, the NAV may be higher or lower than the price they paid per share at the time of acquisition. Thus, just like the shareholders of a corporation, mutual fund owners partake in the profits and losses as well as in the income and expenses of the fund.
One of the advantages of a direct market transaction is that the borrower and lender can save on the margin that would otherwise go to the intermediary to the transaction. After all, how does a depository institution like a bank make profits? Obviously, the rate of interest it pays to its depositors will be lower than the interest rate it charges borrowers who avail of loans. This profit margin is called the Net Interest Margin. So, if the borrowing firms could directly interact with parties who would otherwise deposit their funds with a bank, then they could profitably share the spread, which would otherwise constitute income for the bank. We will illustrate this with the help of an example.
EXAMPLE 1.3
First National Bank is accepting deposits at the rate of 3.50% per annum and is lending to companies at 4.50% per annum. Thus, the bank has a margin of 1% of the transaction amount. Now assume that the borrowing companies opt to directly issue debt securities to the public, with an interest rate of 4.00% per annum. If so, the investors would be getting 0.50% more than what they would were they to deposit their funds with a bank. The issuing companies too stand to incur an interest cost that is 0.50% less. Thus, both the parties to the transaction stand to benefit. What we have essentially done is that the profit margin of 1% which was going to the bank has been split 50/50 between the lending public and the borrowing firm. In practice the split need not be 50/50. All that is required is that the total benefit to the two counterparties should be 1%. Hence, a borrower with a high credit rating can directly tap the capital market without going through an intermediary.
Of course, if direct markets were to be all about advantages, then obviously indirect markets will fail to exist. There are certain shortcomings of such markets. One of the major problems in the case of direct markets is that the claims the borrower wants to issue are often not exactly of the type that individual investors want. Such problems could arise with respect to the denomination of the issue, or the maturity of the issue, or both.
For instance, take the case of a firm that is issuing securities with a principal value of $5,000. It will automatically lose access to investors who seek to invest less than that amount. This is known as the denomination problem. Second, in practice, borrowers like to borrow long-term. This is because most projects tend to be long-term in nature, and entrepreneurs would like to avoid approaching the market at frequent intervals in order to raise funds. But lenders usually prefer to commit their funds for relatively shorter periods. Thus, a company issuing debt securities with twenty years to maturity may find that it has few takers if it were to approach the public directly. This is referred to as the maturity problem.
Yet another problem with direct markets is that they are highly dependent on active secondary markets for their success. If the secondary market were to be relatively inactive, borrowers would find it difficult to tap the primary market. This is because most individuals who invest in debt and equity issues place a premium on liquidity and ready marketability, as manifested by an active secondary market. In times of recession, the secondary markets will be less active than normal, and such periods are therefore usually characterized by small and less frequent issues of fresh securities.
Besides, for an issuer of claims, the cost of a public issue can be high. Such issues require a prospectus and application forms to be printed and also require aggressive marketing. This is obviously not cheap. The investment banker has to be paid his fees, which can be substantial in practice. Finally, the issuing firm needs to hire other professionals