The Financial System and Interest

1. The Financial Systemand Interest Chapter 5

2. Read Ch. 5 (ch. 4 in the 4th edition) • Possible test questions handed out in lab • Interesting books on investing • One Up On Wall Street : How To Use What You Already Know To Make Money In The Marketby Peter Lynch, John Rothchild • Take On the Street: What Wall Street and Corporate America Don't Want You to Know by Arthur Levitt

3. Primary and Secondary Markets • Purpose of a financial market is to facilitate the flow of funds from savers to production sector (investment in business projects) • This occurs in the: • Primary market (market in which securities are initially sold) • Investors trade securities between each other in the • Secondary market

4. Primary and Secondary Markets • Corporations, even though they do not raise money in the secondary market, are interested in the stock’s price in the secondary market • Goal: Max. Stock Price • Influences how much money can be raised in future stock issues • Senior management’s compensation is usually tied to the stock price

5. The Stock Market and Stock Exchanges • Stock market—a network of exchanges and brokers • Exchange—a physical marketplace (NYSE, AMEX, regional exchanges) • Broker—individual whose job is to assist people in buying and selling securities • Work for brokerage firms • Members of stock exchange

6. Exchanges • New York Stock Exchange (NYSE) • Trades securities for 1,200 of largest, strongest companies in U.S. • Handles about 85% of trading activity • American Stock Exchange (AMEX) • Handles slightly smaller, younger firms than NYSE • NASDAQ • Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc.) • Exchanges are linked electronically

7. Exchanges • The Market • The stock market refers to the entire interconnected set of places, organizations and processes involved in trading stocks • Regulation • Securities are regulated under state and federal laws • Securities Act of 1933 • Required companies to disclose certain information • Securities Act of of 1934 • Set up Securities and Exchange Commission • Securities law is primarily aimed at disclosure

8. Private, Public, and Listed Companies, and the NASDAQ Market • Assume a business is successful and the owner decides to raise money for expansion by incorporating and selling stock to others • Privately held companies—can’t sell securities to the general public (also, sale of securities is severely restricted by regulation) • Publicly traded companies—have received approval of the SEC to offer securities to the general public • Process of obtaining approval and registration is known as ‘going public’

9. Private, Public, and Listed Companies, and the NASDAQ Market • Process of ‘going public’ • Use an investment banking firm (e.g., Goldman Sachs or Morgan Stanley), to determine • If a market exists for shares of your company • The likely price for your firm’s stock • Develop a prospectus—provides detailed information about company • Financial statements • Key executives/background • SEC reviews prospectus • An unapproved prospectus is call a ‘red herring’

10. Private, Public, and Listed Companies, and the OTC Market • The IPO • Once prospectus is approved by SEC securities can be sold to public • Initial sale is known as an IPO or initial public offering • Market for IPOs is very volatile and risky • Prices can rise (or fall) very dramatically • Investment banks usually line up buyers prior to the actual sale of securities • Buyers are usually institutional investors • IPO occurs in primary market, but once securities are placed with investors, trading begins in the secondary market

11. Largest all time IPOs. 2/7/2014

12. myths about IPOs • The general perception is that IPOs are a fail-safe way to make money and that if one invests money in an IPO returns are guaranteed. This is the greatest myth about IPOs. Many IPOs will result in losses for the investors, the prices of the same will go down because of several reasons like a weak company, over pricing, weak management or simply because the price fell along with the general markets. • http://www.19.5degs.com/element/19427.php

13. The NASDAQ Market • After a company goes public, its shares are usually traded in the over-the-counter (OTC) market • Eventually a firm may wish to be listed on an exchange • Loosely organized network of brokers • The National Association of Securities Dealers Automated Quotation System (NASDAQ) is the market’s computer system

14. The NASDAQ Market • The Nasdaq Stock Market is a computerized communication system that provides the bid and asked prices of more than 5,000 over-the-counter (OTC) stocks that have met the market's registration requirements. • Update. The current thinking is that Nasdaq is considered a stock exchange and its stocks are not OTC stocks.

15. Interest • Interest rates typically refer to the rate charged on a debt instrument • There are MANY interest rates, including the prime rate, the federal funds rate, etc. • Interest rates tend to move in tandem

16. The Relationship Between Interest and the Stock Market • The stock market reacts to changes in interest rates (even though interest rates are related to the bond market) • Stocks (equity) and bonds (debt) compete for investor’s dollars • Stocks offer higher returns but have more risk • If you could earn 10% by investing in a bond of IBM, what return would you want to invest in IBM’s stock? • ANS. More than 10% because the stock is more risky

17. The Relationship Between Interest and the Stock Market • If interest rates were to rise to 12% on IBM’s bonds, what would happen to your required rate of return on IBM’s stock? • Your required return on IBM’s stock would rise and therefore, the value of IBM’s stock would drop in the market • Interest rates and security prices move in opposite directions • Good reason for us to have an interest in interest rates

18. Interest and the Economy • Would you be more likely to buy a house/car when interest rates are high or low? • Interest rates have a significant effect on the economy • Lower interest rates stimulate business and economic activity • Businesses and individuals use credit a great deal • Interest rates represent the cost of borrowing money (credit)

19. This is a copy of a later slide (#33) Putting the Pieces Together • The factors that make up an interest rate, k, can be expanded to include the particular types of risk • K = KPureInterest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium • k = kpr + INFL + DR + LR + MR • K is known as the nominal or quoted interest rate

20. The Components of an Interest Rate • Interest rates include base rates and risk premiums • Interest rate will be represented by the letter k • k = base rate + risk premiums • k = kpr + INFL + DR + LR + MR

21. Conceptual View for Interest Rates k = kpr + INFL + DR + LR + MR • Components of the Base Rate • The base rate is pure interest plus expected inflation • The rate at which people lend money when no risk is involved • Pure interest rate is AKA earning power of money • An unobservable rate that would exist in the real world if there were no inflation and no risk • Generally considered to be between 2% and 4%

22. The Components of an Interest Rate • The Inflation Adjustment • Inflation refers to a general increase in prices • Refers to the fact that, if prices rise, $100 at the beginning of the year will not buy as much at the end of the year • If you lent someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year • Interest rates include estimates of average annual inflation over loan periods

23. Risk Premiumsk = kpr + INFL + DR + LR + MR • Default risk in loans refers to the chance that the lender will not receive the full amount of principal and interest payments agreed upon • Some loans are more risky than others • Lenders demand a risk premium of extra interest for making risky loans

24. Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR • Bond losses can be associated with fluctuations in the prices of bonds as well as with the failure of borrowers to repay the loans • Default Risk • The chance the borrower won't pay principal or interest • Losses can be the entire amount or anywhere in between • Investors demand a default risk premium which depends on the investor's perception of the creditworthiness of the borrower • Perception is based on the firm's financial condition and credit record

25. Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR • Default Risk (continued) • Premiums range from 0% to 6 or 8 % • Once a company's default risk becomes too high, they will be unable to borrow at any interest rate • Default doesn't actually have to occur for problems to exist • If investors realize that a firm is having difficulty making interest payments (although it is still making them) the bond's price will probably fall • A time dimension is involved in the risk of default • The longer the time period involved with the debt instrument the more likely that the firm will face financial difficulty

26. Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR • Liquidity Risk • Associated with being unable to sell the bond of an little known issuer • Debt of small firms are particularly hard to market • Said to be illiquid • Sellers must reduce their prices to encourage investors to buy the illiquid securities • Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk • Very short-term securities usually bear little liquidity risk

27. Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR • Maturity Risk • Bond prices and interest rates move in opposite directions • Long-term bond prices change more with interest rate swings than short-term bond prices • Gives rise to maturity risk • Investors demand a maturity risk premium • Ranges from 0% to 2% or more for long-term issues

28. Putting the Pieces Together • The factors that make up an interest rate, k, can be expanded to include the particular types of risk • K = KPure Interest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium • k = kpr + INFL + DR + LR + MR • K is known as the nominal or quoted interest rate • “Setting” Interest Rates • Interest rates are set by the forces of supply and demand • Thus the interest rate model above is only an economic model of reality • Represents an explanation of what generally has to be behind the interest rate needs of investors

29. Federal Government Securities, Risk Free and Real Rates • Federal Government Securities • Cities, states and federal governments issue long-term bonds • Federal treasury also issues short-term securities • Known as Treasury securities • Treasury bills have terms from 90 days to a year • Treasury notes have terms from 1 to 10 years • No default risk associated with federal government debt • Can print money to pay off all of its debt • No liquidity risk for federal government debt • Always an active market

30. The Risk-Free Rate • The risk-free rate is approximately the yield on short-term Treasury bills • Includes the pure rate and an allowance for inflation • Same as the base rate discussed earlier • Viewed as a conceptual floor for the structure of interest rates • Denoted as kRF

31. The Real Rate of Interest • Real refers to values that have the effects of inflation removed • Tells investors by how much they are getting ahead • If you earn a real rate of 8% on an investment and inflation turns out to be 10%, you are losing purchasing power on your investment • There are periods in time when the real rate of interest has been negative • Because we don't really know what the rate of inflation will be at the point in time when nominal rates are set • The Real Risk-Free Rate • Implies that both the inflation adjustment and the risk premium is zero

32. Yield Curves—The Term Structure of Interest Rates • The relationship between interest rates and the term of debt is known as the term structure of interest rates • The yield curve is a graphical representation of the term structure of interest rates • Most of the time short-term rates are lower than long-term rates • However at times the opposite is true • Known as an inverted yield curve

33. Figure 4.10: Yield Curves

34. Yield Curves—The Term Structure of Interest Rates • Theories have developed attempting to explain the term structure of interest rates • Expectations theory • Today's rates rise or fall with term as future rates are expected to rise or fall • Liquidity preference theory • Investors prefer shorter term securities and must be induced to make longer loans • Market segmentation theory • Loan terms define independent segments of the debt market which set separate rates

35. 27. You have been assigned to estimate the interest rates that your company may have to pay when borrowing money in the near future. The following information is available. a. Calculate the inflation adjustment (INFL) for a 5-year loan. b. Calculate the appropriate interest rate for a 5-year loan. kPR = 2% MR = .1% for a 1 year loan increasing by .1% for each additional year • k = kpr + INFL + DR + LR + MR

36. LR = .05% for a 1 year loan increasing by .05% for each additional year DR = 0 for a 1 year loan, .2% for a 2-year loan, increasing.1% for each additional year Expected Inflation Rates Year 1 = 7% Year 2 = 5% Year 3 and thereafter = 3%  a. INFL = (7% + 5% + 3% + 3% + 3%)/5 = 4.2% • k = kpr + INFL + DR + LR + MR b. k= 2% + 4.2% + .5% + .25% + .5% = 7.45%