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Chapter 2 The Financial Environment Markets Institutions Interest Rates. © 2005 Thomson/South-Western. The Financial Markets. Debt versus equity markets Debt markets = loans Equity markets = stocks Money versus capital markets Money market = debt < 1 year

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chapter 2 the financial environment markets institutions interest rates

Chapter 2The Financial EnvironmentMarkets Institutions Interest Rates

© 2005 Thomson/South-Western

the financial markets
The Financial Markets
  • Debt versus equity markets
    • Debt markets = loans
    • Equity markets = stocks
  • Money versus capital markets
    • Money market = debt < 1 year
    • Capital market = debt > 1 year + stocks
  • Primary versus secondary markets
    • Primary markets = new funds
    • Secondary markets = outstanding securities
the financial markets1
The Financial Markets
  • Public versus private markets
    • Public markets = liquid, low-cost standardized trades
    • Private markets = specialized deals
  • Spot versus futures markets
    • Spot markets = assets traded “on the spot”
    • Futures markets = for delivery at a later date
  • World, national, regional, and local markets
    • Worldwide = New York Stock Exchange
    • Local = Chicago Stock Exchange
financial institutions
Financial Institutions

Funds are transferred between those who have funds and those who need funds by three processes:

  • Direct transfers
    • No intermediaries
    • Often part of private market transactions
  • Investment banking houses
    • I-Bank = middleman
    • I-Bank may buy in hopes of selling, so there is some risk
  • Financial intermediaries
    • Banks or mutual funds
    • Savers invest in one type of product (e.g., CDs or savings accounts)
    • Bank then creates loans, mortgages, etc. to sell to borrowers
financial intermediaries
Financial Intermediaries
  • 1993 Glass-Steagall Act
    • Prohibited commercial banks from I-banking activities
    • Tried to prohibit “conflict of interest situations”
    • Result: Morgan Bank
      • JP Morgan Chase & Company = commercial bank
      • Morgan Stanley = investment bank
  • 1999 Gramm-Leach-Bliley Act
    • Expanded the powers of banks
    • Abolished major restrictions of the Glass-Steagall Act
    • Allows banks to do:
      • I-banking
      • insurance sales and underwriting
      • low risk non-financial activities
financial intermediaries1
Financial Intermediaries
  • The Gramm-Leach-Bliley Act blurred the distinctions:
    • Commercial banks
    • Savings and loan associations
    • Credit unions
    • Pension funds
    • Life insurance companies
    • Mutual funds
stock markets
Stock Markets
  • Old classification
    • Organized Security Exchanges
      • NYSE, AMEX, and regional
    • OTC (over-the-counter markets)
      • A broader network of smaller dealers
  • New classification
    • Physical stock exchanges
      • NYSE, AMEX
    • Organized Investment Networks
      • OTC, Nasdaq, electronic communication networks (ECN)
physical stock exchanges
Physical Stock Exchanges
  • A physical, “material entity”
    • A building
    • Designated members
    • A board of governors
  • Seats are bought and sold
    • Record high price = $4M (12/1/05)
    • Price in 1999 = $2M
  • Auction markets
    • Sell orders and buy orders come together
organized investment networks
Organized Investment Networks
  • For securities not traded on physical stock exchanges
  • An intangible trading system
  • A network of brokers and dealers (NASD)
  • Dealers make the market
    • The bid price = what the dealer will pay to buy
    • The ask price = what the dealer will take to sell
    • Spread = the dealer’s profit
  • Electronic communications networks
the cost of money
The Cost of Money

Four factors that affect the cost of money

  • Production opportunities
    • Is it worth investing in new assets?
  • Time preferences for consumption
    • Now or later?
  • Risk
    • How likely is it that this investment won’t pan out?
  • Expected inflation
    • How much will prices increase over time?
the cost of money1
The Cost of Money
  • 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?

Return on Equity =Dividends + Capital Gains

interest rate levels

Market A: Low-Risk Securities

Market B:High-Risk Securities

Interest Rate, kA

Interest Rate, kB

S1

%

%

S1

kB = 12

kA = 10

8

D1

D1

D2

0

0

Dollars

Dollars

Interest Rate Levels

Interest Rates as a Function of Supply and Demand

real versus nominal rates

k

= any nominal rate = quoted rate

kRF

= Risk-free rate on T-securities

“Real” versus “Nominal” Rates

= real risk-free rate.

k*

Typically 2% to 4%

T-bill for short term

T-bond for long term

the determinants of market interest rates
The Determinants of Market Interest Rates

k = Quoted or nominal rate

k* = Real risk-free rate (“k-star”)

IP = Inflation premium

DRP = Default risk premium

LP = Liquidity premium

MRP = Maturity risk premium

the determinants of market interest rates1
The Determinants of Market Interest Rates

Quoted Interest Rate = k

k = Risk-free interest rate + risk premium

k = kRF + RP

k = kRF + [DRP + LP + MRP]

k = [k* + IP] + [DRP + LP + MRP]

the determinants of market interest rates2
The Determinants of Market Interest Rates

Nominal Interest Rate = k = [k* + IP] + [DRP + LP + MRP]

  • IP = average rate of inflation expected in future
  • DRP = risk that a borrower will default on a loan (difference between the T-bond interest rate and a corporate bond with same features)
  • LP = premium if asset cannot be converted to cash quickly and at close to the original cost (2 – 5%)
  • MRP = the interest rate risk associated with longer maturity periods (usually 1 – 2%)
determinants of market interest rates
Determinants of Market Interest Rates

Quoted Risk-Free Rate = k = kRF + DRP + LP + MRP

k = Quoted or nominal rate

kRF = Real risk-free rate plus a premium for expected inflation or kRF = k* + IP

DRP = Default risk premium

LP = Liquidity premium

MRP = Maturity risk premium

premiums added to k for different types of debt
Premiums Added to k* forDifferent Types of Debt

IP = Inflation premium

DRP = Default risk premium

LP = Liquidity premium

MRP = Maturity risk premium

  • Short-Term (S-T) Treasury: only IP for S-T inflation
  • Long-Term (L-T) Treasury:
    • IP for L-T inflation plus MRP
  • Short-Term corporate: Short-Term IP, DRP, LP
  • Long-Term corporate: IP, DRP, MRP, LP
the term structure of interest rates
The Term Structure of Interest Rates
  • Term structure: the relationship between interest rates (or yields) and maturities
  • A graph of the term structure is called the yield curve.
slide20

Interest Rate (%)

16

14

12

10

8

6

4

2

0

March 1980

July 2000

July 2003

1 5 10 20

Short Term Intermediate Term Long Term

U.S. Treasury Bond Interest Rates on Different Dates

Abnormal

Interest RateTerm to March July July Maturity 1980 2000 2003 3 months 16.0% 6.1% 0.9%1 year 14.0 6.1 1.05 years 13.5 6.2 2.310 years 12.8 6.1 3.320 years 12.3 6.2 4.3

Flat = horizontal

Normal

three explanations for the shape of the yield curve
Three Explanations for the Shape of the Yield Curve
  • Liquidity Preference Theory
  • Expectations Theory
  • Market Segmentation Theory
liquidity preference theory
Liquidity Preference Theory
  • Lenders prefer to make short-term loans
    • Less interest-rate risk
    • More liquid
  • Lenders lend short-term funds at lower rates
  • Says MRP > 0
  • Results in “normal” curve
expectations theory
Expectations Theory
  • Shape of curve depends on investors’ expectations about future inflation rates.
  • If inflation is expected to increase, S-T rates will be low, L-T rates high, and vice versa.
  • The yield curve can slope up OR down.
slide24

Calculating Interest Rates under Expectations Theory

Step 1:Find the Inflation Premium, the average expected inflation rate over years 1 to N

example
Example:
  • 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)

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 vs. inflation;these IPs would permit you to earn k* (before taxes).

step 2 find mrp based on this equation mrp t 0 1 t 1
Step 2: Find MRP based on this equation: MRPt = 0.1% (t - 1)

Calculating Interest Rates under Expectations Theory:

MRP1 = 0.1% x 0 = 0.0%

MRP10 = 0.1% x 9 = 0.9%

MRP20 = 0.1% x 19 = 1.9%

slide27

Step 3: Add the IPs and MRPs to k*:

kRFt = k* + IPt + MRPt

kRF = Quoted market interest rate on treasury securities.

Assume k* = 3%.

Calculating Interest Rates under Expectations Theory:

1-Yr: kRF1 = 3% + 5.0% + 0.0% = 8.0%

10-Yr: kRF10 = 3% + 7.5% + 0.9% = 11.4%

20-Yr: kRF20 = 3% + 7.75% + 1.9% = 12.7%

yield curve

Interest

Rate (%)

Treasury

yield curve

12.7%

15

11.4%

8.0%

10

5

Years to

maturity

0

0

1

5

10

15

20

Yield Curve
market segmentation theory
Market Segmentation Theory
  • Borrowers and lenders have preferred maturities
  • Slope of yield curve depends on supply and demand for funds in both the L-T and S-T markets
  • Curve could be flat, upward, or downward sloping
other factors that influence interest rate levels
Other Factors that Influence Interest Rate Levels
  • Federal Reserve Policy
    • Controls money supply; impacts S-T interest rates
  • Federal Deficits
    • Larger federal deficits mean higher interest rates
  • Foreign Trade Balance
    • Larger trade deficits mean higher interest rates
  • Business Activity
    • Does the Federal Reserve need to stimulate activity?
interest rate levels and stock prices
Interest Rate Levels and Stock Prices
  • The higher the rate of interest, the lower a firm’s profits
  • Interest rates affect the level of economic activity . . . which affects corporate profits
    • If interest rates rise . . .

Investors turn to the bond market, sell stock, and decrease stock prices

    • If interest rates decline . . .

Investors turn to the stock market, sell bonds, and increase stock prices

for next class
For Next Class:

Chapter 2 Homework problems

Review Chapters 1 and 2

Prepare for Chapter 1-2 quiz

Read Chapter 3