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

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

- Financial markets
- Types of financial institutions
- Determinants of interest rates
- Yield curves

Define these markets

- Markets in general
- Markets for physical assets
- Markets for financial assets
- Money versus capital markets
- Primary versus secondary markets
- Spot versus future markets

Three Primary Ways Capital Is Transferred Between Savers and Borrowers

- Direct transfer
- Through an investment banking house
- Through a financial intermediary

Organized Exchanges versusOver-the-Counter Market

- Auction markets versus dealer markets (exchanges versus the OTC market)
- NYSE versus Nasdaq system
- Differences are narrowing
- Nasdaq vs. true OTC

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

= + .

What four factors affect the costof money?

- Production opportunities
- Time preferences for consumption
- Risk
- Expected inflation

T-bond rate if no inflation;

1% to 4%.

= Any nominal rate.

= Rate on Treasury securities.

k*

k

kRF

Real versus Nominal Rates

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.

Premiums Added to k* for Different Types of Debt

- ST Treasury: only IP for ST inflation
- LT Treasury: IP for LT inflation, MRP
- ST corporate: ST IP, DRP, LP
- LT corporate: IP, DRP, MRP, LP

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.

Interest

Rate (%)

1 yr 6.3%

5 yr 6.7%

10 yr 6.5%

30 yr 6.2%

15

Yield Curve

(May 2000)

10

5

Years to Maturity

0

10

20

30

Yield Curve Construction

Step 1: Find the average expected inflation rate over years 1 to n:

n

INFLt

t = 1

n

IPn = .

IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.5%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.

Must earn these IPs to break even versus inflation; that is, these IPs would permit you to earn k* (before taxes).

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%.

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% + 5% + 0.0% = 8.0%.

kRF10 = 3% + 7.5% + 0.9% = 11.4%.

kRF20 = 3% + 7.75% + 1.9% = 12.65%.

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

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.

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.

AAA-Rated

Hypothetical Treasury and Corporate Yield CurvesInterest

Rate (%)

15

10

Treasury

yield curve

6.0%

5.9%

5

5.2%

Years to

maturity

0

0

1

5

10

15

20

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.

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.

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.

Observed Treasury Rates

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?

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%).

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%).

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).

What various types of risks arisewhen 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.

Two Factors Lead to ExchangeRate Fluctuations

- Changes in relative inflation will lead to changes in exchange rates.
- An increase in country risk will also cause that country’s currency to fall.

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