Chapter 4The Financial EnvironmentMarkets Institutions Interest Rates
Chapter Outline: • Financial markets • Types of financial institutions • Determinants of interest rates
What is a Financial market? • A market is a venue where goods and services are exchanged. • A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.
Flow of Funds: • Funds flow indirectly from ultimate lenders [households] through financial intermediaries [banks or insurance companies] or directlythrough financial markets [stock exchange/bond markets] to ultimate borrowers [business firms, government, or other households]. • In order for financial system to function smoothly, must be adequate information about the markets and their operation.
Flow of Funds: • Financial system provides a transmission mechanism between saver-lenders and borrower-spenders. • Savers benefit—earn interest • Investors benefit—access to money otherwise not available • Economy benefits—efficient means of bringing savers and borrowers together
The Financial Markets: • Physical VS. Financial asset markets • Spot VS. future markets • Money VS. capital markets • Primary VS. secondary markets • Public VS. private markets
The Financial Markets: • Physical Asset Markets: It is a market for such products as wheat, autos, real estate, and machinery. • Financial Asset Markets: It deals with stocks, bonds, notes, mortgages, and derivatives.
The Financial Markets: • Spot Markets: It is a market in which assets are bought and sold for on the spot delivery. • Futures Markets: It is a market in which participants agree today to buy or sell an asset at some future date.
The Financial Markets: • The Money Market: • Exchange of short-term instruments—less than one year • Highly liquid, minimal risk • Commercial paper—short-term liabilities of prime business firms and finance companies • Bank Certificates of Deposits—liabilities of issuing bank, interest bearing to corporations that hold them • U.S. Treasury bills—short-term debts of US government
The Financial Markets: • The Capital Market: • Exchange of long-term securities—in excess of one year • Generally used to secure long-term financing for capital investment. • Stock market—Largest part of capital market and held by private and institutional investors • Residential and commercial mortgages—Held by commercial banks and life insurance companies • Corporate bond market—Held by insurance companies, pension and retirement funds
The Financial Markets: • Primary Markets: • Market for issuing a new security and distributing to saver-lenders. • Initial Public Offering Market (IPO). • Investment Banks—Information and marketing specialists for newly issued securities.
The Financial Markets: • Secondary Markets: • Market where existing securities can be exchanged • New York Stock Exchange • American Stock Exchange • Over-the-counter (OTC) markets (NASDAQ).
Financial Institutions: Funds are transferred between those who have funds and those who need funds by three processes: • Direct transfers, • Investment banking houses, or • Financial intermediaries.
Financial Intermediaries: • Commercial banks • Savings and loan associations • Credit unions • Pension funds • Life insurance companies • Mutual funds
Role of Financial Intermediaries: • Act as agents in transferring funds from savers-lenders to borrowers-spenders. • Acquire funds by issuing their liabilities to public and use money to purchase financial assets • Earn profits on difference between interest paid and earned • Diversify portfolios and minimize risk • Lower transaction costs
Commercial Banks: • Most prominent • Range in size from huge to small • Major source of funds used to be demand deposits of public, but now rely more on “other liabilities” • Also accept savings and time deposits—interest earning
Savings and Loan Associations [S&L’s]: • Traditionally acquired funds through savings deposits • Used funds to make home mortgage loans • Now perform same functions as commercial banks • issue checking accounts • make consumer and business loans
Credit Unions: • Organized as cooperatives for people with common interest • Members buy shares [deposits] and can borrow • Changes in the law in early 1980’s broadened their powers • checking [share] accounts • make long-term mortgage loans
Pension and Retirement Funds: • Concerned with long run • Receive funds from working individuals building “nest-egg” • Accurate prediction of future use of funds • Invest mainly in long-term corporate bonds and high-grade stock • Invest in wide variety of securities—minimize risk
Life Insurance Companies: • Insure against death • Receive funds in form of premiums • Use of funds is based on mortality statistics—predict when funds will be needed • Invest in long-term securities—high yield • Long-term corporate bonds • Long-term commercial mortgages
Mutual Funds: • Stock or bond market related institutions • Pool funds from many people • Invest in wide variety of securities—minimize risk
Physical location stock exchanges vs. Electronic dealer-based markets • Auction market vs. Dealer market (Exchanges vs. OTC) • NYSE vs. Nasdaq
The Stock Market: • Organized Security Exchanges: • NYSE, AMEX, and regional • Actual physical locations • Over-the-Counter Markets: • Network of brokers and dealers • Auction market • Organized Investment Network • Electronic Communications Networks
The Cost of Money: Four factors that affect the cost of money: • Production opportunities • Time preferences for consumption • Risk • Expected inflation
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
= real risk-free rate. k* T-Bond rate if no inflation; 2% to 4%. k = any nominal rate. kRF = Rate on T-securities—risk-free. “Real” versus “Nominal” Rates:
The Determinants of Market Interest Rates: Quoted Interest Rate = k = k* + IP + DRP + LP + MRP 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
Hypothetical yield curve: Interest Rate (%) 15 Maturity risk premium 10 Inflation premium 5 Real risk-free rate Years to Maturity 0 1 10 20
Other Factors that Influence Interest Rate Levels: • Federal Reserve Policy • Controls money supply • Federal Deficits • Larger federal deficits mean higher interest rates • Foreign Trade Balance • Larger trade deficits mean higher interest rates • Business Activity
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, and economic activity affects corporate profits
Risks associated with investing overseas: • Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates. • Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.