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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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Principles of business finance fin 510

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


Principles of business finance fin 510

  • 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


Principles of business finance fin 510

= 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.


Principles of business finance fin 510

Treasury Yield Curve

Interest

Rate (%)

1 yr5.4%

5 yr5.7%

10 yr5.7%

30 yr6.0%

15

Yield Curve

(March 1998)

10

5

Years to Maturity

0

10

20

30


What are the 2 main factors that explain the shape of the yield curve

What are the 2 main factors that explain the shape of the yield curve?


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%.


Principles of business finance fin 510

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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