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Lecture Two: Financial Markets. Financial markets Types of financial institutions Determinants of interest rates Yield curves. Saving/Investing or Borrowing/Lending Process Aggregate Economic Sectors. Government Sector

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Lecture two financial markets
Lecture Two: Financial Markets

  • Financial markets

  • Types of financial institutions

  • Determinants of interest rates

  • Yield curves


Saving/Investing or Borrowing/Lending Process

Aggregate Economic Sectors

Government Sector

Regulates and supervises where Congress has granted authority (Political Process). Also it participates in the activities of the 3 sectors below.

Household Sector

Saves/lends or invests in financial assets

Business Sector

Borrows/invests in real assets or productive assets

Financial Sector

Collects savings from small units in the amounts, maturities, etc. , needed by the business sector. Also provides market liquidity to stimulate savings/investing/hedging


Fundamental Functions of The Financial Sector

1. Transfer savings to investors: distribution or allocation of financial resources.

2. Provide medium of exchange: Money supply by commercial banks.

3. Provides liquidity by providing markets that are large, active, stable, resilient. It must therefore accommodate position takers, i.e... speculators.

4. Maintains healthy environment for hedging activity so that risk takers and risk avoiders can partake in the market so that the volume of real investment can be at a maximum.


Define these markets
Define these markets

  • Markets in general

  • Physical assets

  • Financial assets

  • Money vs. capital

  • Primary vs. secondary

  • Spot vs. future


Real Asset Market

Financial Market

Capital Market

Money Market

Mortgage

Securities

Consumer Credit

Commercial Paper

Euro $

exchanges

brokers

Inv. Bkrs.

Com. Bks.

Indiv. Invest.

COs.

COs.

Fin. CO.

Ins. CO.

S & L


Three primary ways capital is transferred between savers and borrowers
Three Primary Ways Capital Is Transferred Between Savers and Borrowers

  • Direct transfer

  • Investment banking house

  • Financial intermediary


Financial Institutions Borrowers

  • Investment Banks

  • Commercial Banks

  • Savings and Loans Associations

  • Mutual Savings Banks

  • Credit Unions

  • Life Insurance COs.

  • Mutual Funds

  • Money

  • Bond

  • Stocks

  • Derivatives

  • Pension Funds (generally administered by commercial banks or life insurance companies)


Balance sheet of Commercial Bank v. a Manufacturing CO. Borrowers

Manufacturing Firm

Commercial Bank

Govt. Sec.

Loans

---------------

Fixed Assets

DD

TD

----------

NW

Cash

AR

Inv.

-----------

Fixed Assets

Short Term Debt

------------------

Long Term Debt

--------------------

NW = Equity


Balance sheet of Insurance Company v. a Manufacturing CO. Borrowers

Manufacturing Firm

Insurance Company

Stocks

Bonds

Mortgages

-------------

Fixed Assets

Premiums

Other Debt

----------

NW

Cash

AR

Inv.

-----------

Fixed Assets

Short Term Debt

------------------

Long Term Debt

--------------------

NW = Equity


Organized exchanges vs over the counter market
Organized Exchanges vs. BorrowersOver-the-Counter Market

  • Auction market vs. dealer market (exchanges vs. OTC)

  • NYSE vs. NASDAQ system

  • Differences are narrowing


Required Dividend Capital

return yield gain

= + .


What four factors affect the cost of money
What four factors affect the cost of money? Borrowers

  • Production opportunities

  • Time preferences for consumption

  • Risk

  • Expected inflation


= BorrowersReal risk-free rate.

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
k = k* + IP + DRP + LP + MRP. Borrowers

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
Premiums Added to k* for Different Types of Debt Borrowers

  • 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


What various types of risks arise when investing overseas
What various types of risks arise when investing overseas? Borrowers

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 exchange rate fluctuations
Two Factors Lead to Exchange Rate Fluctuations Borrowers

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.


What is the term structure of interest rates what is a yield curve
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.


T-Bond Yield Curve a “yield curve”?

Interest

Rate (%)

1 yr 5.7%

5 yr 6.5%

10 yr 6.7%

30 yr 6.9%

15

Yield Curve

(March 1997)

10

5

Years to Maturity

0

10

20

30



1 expectations
1. Expectations yield curve?

  • 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.


The pure expectations hypothesis peh
The Pure Expectations Hypothesis (PEH) yield curve?

  • 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.


An example
An Example yield curve?

  • Assume that 1-year securities yield 6% today, and the market expects that 1-year securities will yield 7% in 1 year, and that 1-year securities will yield 8% in 2 years.

  • If the PEH is correct, the 2-year rate today should be 6.5% = (6% + 7%)/2.

  • If the PEH is correct, the 3-year rate today should be 7% = (6% + 7% + 8%)/3.


2 risk
2. Risk yield curve?

  • 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).


Example data
Example data: yield curve?

  • Inflation for Yr 1 is 5%.

  • Inflation for Yr 2 is 6%.

  • Inflation for Yr 3 and beyond is 8%.

    k* = 3%

    MRPt = 0.1%(t - 1).


Yield curve construction
Yield Curve Construction yield curve?

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

n

SINFLt

t = 1

n

IPn = .


IP yield curve?1 = 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 vs. inflation; these IPs would permit you to earn k* (before taxes).


Step 2 find mrp based on this equation
Step 2: Find MRP based on this equation: yield curve?

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*: yield curve?

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% = 12.7%.


Yield curves
Yield Curves yield curve?

Interest

Rate (%)

15

BB-Rated

10

AAA-Rated

Treasury

yield curve

6.8%

6.7%

5.7%

5

Years to

maturity

0

0

1

5

10

15

20


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