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Principles of Business Finance Fin 510. Dr. Lawrence P. Shao Marshall University Spring 2002. CHAPTER 4 The Financial Environment: Markets, Institutions, and Interest Rates. Financial markets Types of financial institutions Determinants of interest rates Yield curves. Define these markets.

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slide1

Principles of Business FinanceFin 510

Dr. Lawrence P. Shao

Marshall University

Spring 2002

chapter 4 the financial environment markets institutions and interest rates
CHAPTER 4The Financial Environment:Markets, Institutions,and Interest Rates
  • Financial markets
  • Types of financial institutions
  • Determinants of interest rates
  • Yield curves
define these markets
Define these markets
  • Financial assets
  • Money vs. capital
  • Primary vs. secondary
  • Spot vs. future
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
organized exchanges vs over the counter market
Organized Exchanges vs.Over-the-Counter Market
  • Auction market vs. dealer market (exchanges vs. OTC)
  • NYSE vs. NASDAQ system
  • Differences are narrowing
slide6
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 cost of money
What four factors affect the cost of money?
  • Production opportunities
  • Time preferences for consumption
  • Risk
  • Expected inflation
slide8

= Real 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.

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
  • 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 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.
slide12

Treasury Yield Curve

Interest

Rate (%)

1 yr 5.4%

5 yr 5.7%

10 yr 5.7%

30 yr 6.0%

15

Yield Curve

(March 1998)

10

5

Years to Maturity

0

10

20

30

1 expectations
1. Expectations
  • 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)
  • 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
  • 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
  • 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:
  • Inflation for Year 1 is 5%.
  • Inflation for Year 2 is 6%.
  • Inflation for Year 3 and beyond is 8%.

k* = 3%

MRPt = 0.1%(t - 1).

yield curve construction
Yield Curve Construction

Step 1:Find the average expected

inflation rate over years 1 to n:

n

SINFLt

t = 1

n

IPn = .

ip 1 5 1 0 5 00
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).

step 2 find mrp based on this equation
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%.

slide22

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%.

yield curves
Yield Curves

Interest

Rate (%)

15

BB-Rated

10

AAA-Rated

Treasury

yield curve

6.0%

5.7%

5

5.4%

Years to

maturity

0

0

1

5

10

15

20

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