CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates

1. CHAPTER 5The Financial Environment:Markets, Institutions,and Interest Rates • Financial markets • Types of financial institutions • Determinants of interest rates • Yield curves

2. The Role of the Financial System • Two general categories: • Those with excess cash (“savers”) • Normally households, but can be others • Those with needs for cash (“borrowers”) • Normally companies & governments, but can be others • The financial system includes a series of institutions that: • aggregate funds • find counterparties for various transactions • In general, connect savers w/ borrowers

3. Define These Markets • Markets in general • Physical assets • Financial assets • Money vs. Capital • Primary vs. Secondary • Spot vs. Future

4. Money Markets Short term (< 1 yr.) Debt Low Risk, Low Return Instruments Treasury Bills Commercial Paper Capital Markets - everything else Various maturities Debt or Equity Various risks, returns Instruments Stocks Bonds Money Vs. Capital Markets

5. Primary New instruments New Bonds Initial Stocks (IPOs, SEOs) Cash Flow goes from investor to company Secondary “Used” instruments Existing Bonds Existing Stocks Cash flow goes from investor to investor. Primary vs. Secondary Markets

6. Three Primary Ways Capital Is Transferred Between Savers and Borrowers • Direct transfer • Investment banking house • Financial intermediary

7. What’s an Investment Banker and what do they do??? • Not really investors or bankers, per se • They consult and assist with primary market transactions - what they do: • Advise companies on issuances • File with S.E.C. • Establish pricing & distribution • Make lots of money (Great job, but VERY high pressure!)

8. Financial Intermediaries • Play the largest role in the economy • Include: • Commercial banks • Credit unions • Life insurance companies • Pension funds • Mutual funds

9. The Top 5 Banking Companiesin the World, 1999 Bank NameCountryTotal assets Deutsche Bank AG Germany $735 billion UBS Group Switzerland $687 billion Citigroup United States $669 billion Bank of America United States $618 billion Bank of Tokyo Japan $580 billion

10. Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets • Auction market vs. Dealer market (Exchanges vs. OTC) • NYSE vs. Nasdaq system • Differences are narrowing

11. Costs of Financing • Companies need money to operate, but this financing always comes at a cost • For bonds (i.e., debt): • Primary cost = stated interest rate • Add’l cost = loss of flexibility • Must disgorge cash on a regular basis • Many inhibitive bond covenants regarding levels of various financial ratios that must be maintained

12. Costs of Financing (cont.) • For stocks (i.e., equity): • No explicit payments required • So, greater flexibility for company • BUT – investors expect co. to perform and ­ the value of their shares, or they will sell off • And Stocks are riskier than bonds Þ need to earn more for S/H than for B/H to keep them happy • How much more? To be discussed later …

13. What do we call the price, or cost, of debt capital? The interest rate • What do we call the price, or cost, of equity capital? Required Dividend Capital return yield gain = +

14. Cost of Debt • We will have more to say about the cost of equity later (a lot more, in fact) • but first, more about interest rates • Interest rates = one of the most important measures and determinants of financial activity • Interest rate = “rent on borrowed money”

15. What four factors affect the cost of money? • Production opportunities • Time preferences for consumption • Risk • Expected inflation

16. Additional Factors • Federal Reserve policy • At least in short term • Federal government deficits • International factors • E.g., Japanese purchases of U.S. debt • Business activity • Interest rates ­ as economy heats up

17. “Real” Versus “Nominal” Rates = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. k* k kRF

18. k = k* + IP + DRP + LP + MRP. Here: k = required rate of return on a debt security. k* = real risk-free rate. IP = inflation premium. DRP = default risk premium. LP = liquidity premium. MRP = maturity risk premium.

19. Premiums Added to k* for Different Types of Debt • S-T Treasury: only IP for S-T inflation • L-T Treasury: IP for L-T inflation, MRP • S-T corporate: S-T IP, DRP, LP • L-T corporate: IP, DRP, MRP, LP

20. What is the “term structure of interest rates”? What is a “yield curve”? • Term structure: the relationship between interest rates (or yields) and maturities. • A graph of the term structure is called the yield curve.

21. Treasury Yield Curve Interest Rate (%) 1 yr 5.2% 5 yr 5.8% 10 yr 5.9% 30 yr 6.0% 15 Yield Curve (August 1999) 10 5 Years to Maturity 0 10 20 30

22. Normal/Abnormal Yield Curve • Most frequent: • “normal” or upward sloping curve. • Current: • relatively flat • More unique: • downward sloping (1981-1983) • also seen last year

23. Yield Curve Construction Step 1:Find the average expected inflation rate over Years 1 to n: IPn = . n

24. Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP1 = 5%/1.0 = 5.00%. IP10 = [5 + 6 + 8(8)]/10 = 7.50%. IP20 = [5 + 6 + 8(18)]/20 = 7.75%. Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).

25. Step 2: Find MRP Based on This Equation: MRPt = 0.1%(t – 1). MRP1 = 0.1% x 0 = 0.0%. MRP10 = 0.1% x 9 = 0.9%. MRP20 = 0.1% x 19 = 1.9%.

26. Step 3: Add the IPs and MRPs to k*: kRFt = k* + IPt + MRPt . kRF = Quoted market interest rate on treasury securities. Assume k* = 3%: kRF1 = 3.0% + 5.0% + 0.0% = 8.0%. kRF10 = 3.0% + 7.5% + 0.9% = 11.4%. kRF20 = 3.00% + 7.75% + 1.90% = 12.65%.

27. Hypothetical Treasury Yield Curve Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% 15 Maturity risk premium 10 Inflation premium 5 Real risk-free rate Years to Maturity 0 1 20 10

28. What factors can explain the shape of this yield curve? • This constructed yield curve is upward sloping. • This is due to increasing expected inflation and an increasing maturity risk premium.

29. What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues? • Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not neces-sarily parallel to the Treasury curve. • The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.

30. BB-Rated AAA-Rated Hypothetical Treasury and Corporate Yield Curves Interest Rate (%) 15 10 Treasury yield curve 6.0% 5.9% 5 5.2% Years to maturity 0 0 1 5 10 15 20

31. How does the volume of corporate bond issues compare to that of Treasury securities? Gross U.S. Treasury Issuance (in blue) Investment Grade Corporate Bond Issuance (in red) 600 450 300 150 Billions of dollars ‘95 ‘96 ‘97 ‘98 ‘99 Recently, the volume of investment grade corporate bond issues has overtaken Treasury issues.

32. The Pure Expectations Hypothesis (PEH) • Shape of the yield curve depends on the investors’ expectations about future interest rates. • If interest rates are expected to increase, L-T rates will be higher than S-T rates and vice versa. Thus, the yield curve can slope up or down.

33. PEH assumes that MRP = 0. • Long-term rates are an average of current and future short-term rates. • If PEH is correct, you can use the yield curve to “back out” expected future interest rates.

34. Observed Treasury Rates Maturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 6.2% 6.4% 6.5% 6.5% If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?

35. x% 6.0% 0 1 2 3 4 5 6.2% (6.0% + x%) 2 6.2% = 12.4% = 6.0 + x% 6.4% = x%. PEH tells us that one-year securities will yield 6.4%, one year from now (x%).

36. 6.2% x% 0 1 2 3 4 5 6.5% [ 2(6.2%) + 3(x%) ] 5 6.5% = 32.5% = 12.4% + 3(x%) 20.1% = 3(x%) 6.7% = x%. PEH tells us that three-year securities will yield 6.7%, two years from now (x%).

37. Conclusions about PEH • Some argue that the PEH isn’t correct, because securities of different maturities have different risk. • General view (supported by most evidence) is that lenders prefer S-T securities, and view L-T securities as riskier. • Thus, investors demand a MRP to get them to hold L-T securities (i.e., MRP > 0).

38. What various types of risks arise when investing overseas? Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment. Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate.

39. Two Factors Lead to Exchange Rate Fluctuations 1. Changes in relative inflation will lead to changes in exchange rates. 2. An increase in country risk will also cause that country’s currency to fall.