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Financial Markets

- A market is a place where goods and services are exchanged.
- A financial market is a place where individuals and organizations who want to borrow funds are brought together with those having a surplus of funds.

We can classify markets

Based on: Underlying asset

Delivery date

Maturity

Players

Physical/Financial/Derivatives

Spot/Futures

Money/Capital

Primary/Secondary

Private/Public

Examples

- London Gold Market physical, spot
- New York Stock Exchange

financial, spot, secondary, capital

- Sale of commercial paper by HP

financial, money, primary

How is capital transferred between savers and borrowers?

- Direct transfers
- Investment banking house
- Financial intermediaries

A firm’s selling its stock directly to

another firm/individual is an example of

direct transfer

Through Investment bankers

Investment banking firm helps a company in the

design and sale of securities. The investment

banker is also called the underwriter.

The agreement between the firm and

underwriter can be of two types:

- firm-commitment basis: underwriter bears all the risk
- best-efforts basis: underwriter does not buy the issue but acts as a selling agent

Through Investment bankers

- In general, the lead investment banker puts together a purchase group and a selling group
- purchase group underwrites the offering (purchases securities from the issuing corporation)
- selling group contacts potential buyers and do the selling on a commission basis

Examples of Investment Banking Firms:

Merrill Lynch, Salomon Smith Barney

Examples of financial intermediaries

- Commercial banks
- Pension funds
- Life insurance companies
- Mutual funds

Financial intermediaries get savings from individuals by

creating new financial products

For example, commercial banks open checking and

saving accounts, life insurance companies sell policies

and mutual funds sell new shares and are ready to buy

back outstanding shares.

financial intermediaries

Strengths offinancial intermediaries

- Economies of scale in analyzing creditworthiness of potential borrowers
- Pooling risk

Mutual funds

Mutual funds differ in their investment objectives, e.g.

- Pursue Aggressive growth
- Invest in Precious metals
- Invest in Global equity
- Turkish: type A minimum 25% investment in stocks, it may also include fixed income securities. Type B investment only in fixed income securities. Type B liquid funds limit maturity up to 90 days.

Ranking of Mutual Funds (US):

- Lipper Ranking
- Morningstar Ranking
- Each fund is ranked within the universe of funds similar in investment objectives

Physical location stock exchanges vs. Electronic dealer-based markets

Auction market vs. Dealer market (Exchanges vs. OTC)

Exchanges can have continuous trading, call auctions

or both

Mostly: Continuous-auction also contain opening call

How do they provide continuity: Limit Order Book

Liquidity: conversion to cash

quickly, with low cost, and

for reasonable transaction sizes

Physical location stock exchanges vs. Electronic dealer-based markets

Members have seats (e.g. NYSE ≈1400 members)

Only members can execute transactions

Over-the-counter (OTC) market

e.g. Nasdaq

Several dealers assigned to each stock

They quote bid/ask prices

Computerized system

Dealers hold inventory

Cost of Money

except social, strategic policies capital is allocated

through a price system

debt capital: interest rate

equity capital: dividend yield

capital gains

Four fundamental factors

Four fundamental factors

- Production opportunities
- Time preferences for consumption
- Risk
- Inflation

Different markets

- Interest rates differ due to differences in risk, but the rates are interrelated

Determinants of Market Interest Rates

rate = k* + IP + DRP + LP + MRP

k*: real risk-free rate

IP: Inflation Premium

DRP: Default risk premium

LP: Liquidity premium

MRP: Maturity risk premium

Determinants of Market Interest Rates

- Inflation is expected future inflation, not the past rate
- Default: The borrower will not pay the interest or principal, probably because of financial distress
- Liquidity: being able to sell the security quickly at fair market value

Determinants of Market Interest Rates

Government securities e.g. T-bonds have basically no DRP and

little LP. They are only subject to IP and MRP

- Maturity risk premium: Extra return offered by securities with longer time to maturity.

Bond prices are negatively related to interest rates. In other words,

as interest rate rises, bond price will fall.

Simple example

A security that has a single payoff of $110 in one year.

If the market price of this security is $100, what is the

promised return?

If the market price of this security is $90, what is the

promised return?

So a decrease in price increases return.

For example

Interest rate (promised return)=10% and bond price=$920 now

I own this bond but I have just decided to sell it (I need cash).

If interest rate rises to 12% (market prices similar securities so

that their promised return rises to 12%), price of the bond will fall.

So I and other bondholders will have a loss due to a fall in price

when interest rates rise. This is called as the interest risk.

When I sell the bond at the new (lower) price, the buyer will have

a promised return of 12%.

The amount and the timing of payments made by the issuer of the

bond to bondholders are fixed. The market price is the only bond

feature that can change. So to raise the promised return from 10%

to 12%, the price of the bond has to fall.

interest rate risk

For a given holding period, the interest rate risk as measured by the price change at the end of your holding period increases with the time to maturity of the bond.

So other things being equal, a bond with 20 year time-to-maturity will have larger MRP than that of a 10 year bond.

reinvestment rate risk

- We did ignore another type of risk, the reinvestment rate risk from the discussion above. Actually, MRP is the net effect of interest rate and reinvestment rate risks.

We will return to this discussion after we

cover the Time Value of Money concept.

Ratings

Bond Rating Agencies:

Moody’s and S&P

Attributes associated with better ratings

- Lower financial leverage
- Larger firm size
- Larger and steadier profits
- Larger cash flows
- Lack of subordination to other debt issues

Term Structure of Interest Rates

- The relationship between short term and long term interest rates is known as term structure of interest rates
- Yield curve: graph showing the relationship between bond yields and maturities

1 yr 8.0%

10 yr 11.4%

20 yr 12.7%

Interest

Rate

15

Maturity risk premium

10

Inflation premium

5

Real risk-free rate

Years to Maturity

0

1

20

10

Yield Curvee.g. Yield Curve for Government securities (DRP=LP=0)

Yield Curve can be Upward sloping, Downward sloping, or

Flat

Forward rates

Consider the following two investment alternatives for an investor who has a two-year

investment horizon.

Alternative 1: Buy a two-year zero-coupon instrument. (rate=s2)

Alternative 2: Buy a one-year zero-coupon instrument (rate=s1) and when it matures in one year, buy another one-year instrument.

Assume s1 8.000%

s2 8.995%

Note that:

In a world of certainty (future interest rates are known) both of these strategies must

yield identical final payoffs. Otherwise, no one holds either the two-year bond or the one

year bond

Given the price of zero-coupon bond, you can find the interest rate from the following formula

Pk=$1000/(1+sk)k

Forward rates

The interest rate that would need to prevail in the second year to make the short

and long-term investments equally attractive, ignoring risk is called the forward

rate.

approximately (s1+f1,2)/2=s2

or exactly (1+s1)(1+f1,2)=(1+s2)2

when you know s1 and s2, you can calculate f1,2

f1,2=9.99% approximately or 10% exactly

Forward rates

Now consider the case of uncertainty where future interest rates are uncertain.

Assume that E(s12)=10% same as the forward rate

P1-year=$1000/1.08=$925.93 P2-year= $1000/(1.08*1.1)=$841.75

So 2-year security is priced using E(s12). Note that this is consistent with the

s2=8.995%, $1000/(1.08995)2=$841.75

Forward rates

Consider a short-term investor who wishes to invest for one year

Under Alternative 2:the return is a riskless 8%

Under Alternative 1:the return is risky. If s12 turns out 10% as expected, the return

will be 8% since the bond price will be $1000/1.1=$909.09 in one year and

$841.75*(1.08)=$909.09. If s12 turns out different than 10%, the return will not be

8%.

Why should this investor buy the risky 2-year bond when its expected return is 8%,

no better than that of the risk-free one-year bond.

This requires the 2-year bond to sell at a price lower than the $841.75

Forward rates

Suppose all investors have short-term horizons and therefore are willing to hold

the 2-year bond only if its price falls to $819.

At this price, this year’s expected return on this bond is 11% ($909.09/$819=1.11).

This means a premium of 3% compared to the risk-free one-year bond.

In this environment, the forward rate f12 no longer equals E(s12). s2 now equals

10.5%((1000/819)1/2=1.105) and f12=13%.

- Investors require a premium to hold the two-year bond and be willing to hold the bond if E(s12) is less than f12.
- E(s12) < f12 means: since 2s2=s1+f1,2 then 2s2>s1+E(s1,2)

The change in s2 by 1.5% (10.5%-8.995%) denotes a positive MRP. It is the risk

premium given for holding long term bond.

Forward rates

We can also imagine a scenario in which long-term bonds can be perceived by

investors to be safer than short-term bonds.

Suppose all investors have long-term horizons (2-year). In this case, investing in

two-year bond is riskless and investing in one-year bond has reinvestment rate risk.

This would cause E(s12) to be more than f12.

In this case, we will have a negative MRP.

Term Structure Theories

try to explain the shape of yield curve

e.g. Pure Expectations Hypothesis

- The PEH argues that the shape of the yield curve depends on investor’s expectations about future short term interest rates.
- If short term interest rates are expected to increase, long-term rates will be higher than current short-term rates, and vice-versa. Thus, the yield curve can slope up, down, or even bow.

Assumptions of the PEH

- Assumes that the maturity risk premium for Treasury securities is zero.
- It states that f1,2 =E(s12). This implies that long-term rates are an average of current and expected future short-term rates. e.g. s2=[s1+E(s1,2)]/2
- If PEH is correct, you can use the yield curve to “back out” expected future interest rates.

Pure Expectations Hypothesis

Long-term rates are an average of current and expected

future short-term rates. For example:

s3=(s1+f12+f23)/3

To confirm

definition of f12 s2=(s1+f12)/2 f12=2 s2-s1

definition of f23 s3=(2s2+f23)/3 f23=3 s3-2s2

Plug into the first expression

s3=(s1+2 s2-s1+3 s3-2s2)/3= s3

PEH says s3=(s1+E(s12)+E(s23))/3 since E(s12)=f12 and E(s23)=f23

Pure Expectations Hypothesis

Also note that:

definition of f12 2s2=(s1+f12) f12=2 s2-s1

definition of f23 3s3=(2s2+f23) f23=3 s3-2s2

definition of f13 3s3=(s1+2f13) 2f13=3 s3-s1

Then f13=(f12+f23)/2

An example: Observed Treasury rates and the PEH

MaturityYield

1 year 6.0%

2 years 6.2%

3 years 6.4%

4 years 6.5%

5 years 6.5%

Upward sloping yield curve

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?

One-year forward rate

6.2% = (6.0% + x%) / 2

12.4% = 6.0% + x%

6.4% = x%

PEH says that one-year securities will yield 6.4%, one year from now.

Three-year security, two years from now

6.5% = [2(6.2%) + 3(x%)] / 5

32.5% = 12.4% + 3(x%)

6.7% = x%

PEH says that three-year securities will yield 6.7%, two years from now.

Calculating all the forward rates

In the calculation above we relied on the expression E(s25)=f25

Equivalently, we can use the fact that long term rate is arithmetic average of short term rates

three-year securities two years from now

E(s25)=[E(s23)+E(s34)+E(s45)]/3=[6.8%+6.8%+6.5%]/3

=6.7%

Conclusions about PEH

- Some would argue that the MRP ≠ 0, and hence the PEH is incorrect.
- Most evidence supports the general view 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).

Conclusions about PEH

recall that s2=(s1+f12)/2

If MRP≠0 and PEH is not correct

Recall definitions of s1 and s2

s2=k*+IP2+MRP2 and s1=k*+IP1 assuming MRP1=0

E(s12)=k*+IP12 so IP2=(IP1+IP12)/2

s2=k*+(E(s12)-k*+s1-k*)/2+MRP2

since f12= 2s2 - s1 then

f12= E(s12)+2MRP2

Conclusions about PEH

f12= E(s12)+2MRP2

If yield curve is upward sloping i.e. s2>s1, then since 2s2=s1+f12

it must be f12>s1

- If PEH is correct, then since f12= E(s12) it must be E(s12) >s1
- If MRP≠0 and PEH is not correct, then we get

E(s12)+2MRP2>s1

So it is not necessarily true thatE(s12) >s1,i.e. it can be that

E(s12) <s1 but E(s12)+2MRP2>s1

Example

Assume that the real risk free rate is 3% and that

inflation is expected to be 8% in year 1, 5% in year 2,

and 4% thereafter.

Assume that all treasury bonds are free ofdefault risk.

If 2-year and 5-year treasury bonds both yield 10%,

what is thedifference inmaturity risk premiums on the

two bonds?

Example

Assuming that real risk free rate and MRP stay constant over time

MRP5 = 10% - 8% = 2%.

MRP2 = 10% - 9.5% = 0.5%.

MRP5- MRP2 = (2% - 0.5%) = 1.5%.

Exact solution

Exact solution :

(1+3%+8%+MRP5)(1+3%+5%+MRP5)(1+3%+4%+MRP5)

(1+3%+4%+MRP5)(1+3%+4%+MRP5)=(1+10%)5

MRP5=2.011%

(1+3%+8%+MRP2) (1+3%+5%+MRP2)=(1+10%)2

MRP2=0.51%

Example

4-6 The real risk free rate is 3 percent. Inflation is expected to be 3 percent this year, 4 percent next year, and then 3.5 percent thereafter. The maturity risk premium is estimated to be 0.0005*(t-1), where t= number of years to maturity. What is the nominal interest rate on 7-year Treasury note?

MRP1= 0.0005*(1-1)=0, MRP2= 0.0005*(2-1)=0.05%

MRP7= 0.0005*(7-1)=0.3%

IP7=(3%+4%+5*3.5%)/7=24.5%/7=3.5%

S7=k*+IP7+MRP7=3%+3.5%+0.3%=6.8%

Example

4-12 The 5-year bonds on Cartwright Enterprises are yielding 7.75% per year. Treasury bonds with the same maturity are yielding 5.2 percent per year. The real risk free rate has not changed in recent years and is 2.3 percent. The average inflation premium is 2.5 percent, and the maturity risk premium takes the form: MRP=0.1%(t-1), where t= number of years to maturity. If the liquidity premium is 1 percent, what is the default risk premium on Cartwright’s corporate bonds?

MRP5= 0.1%(5-1)=0.4%

Treasury bonds: k*+IP5+ MRP5 =2.3%+2.5%+0.4%=5.2%

Cartwright’s corporate bonds k*+IP5+ MRP5 +LP+DRP

LP+DRP=7.75%-5.2%=2.55% so DRP=1.55%

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