Ffm905

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Ffm905

  1. 1. CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates <ul><li>Financial markets </li></ul><ul><li>Types of financial institutions </li></ul><ul><li>Determinants of interest rates </li></ul><ul><li>Yield curves </li></ul>
  2. 2. Define These Markets <ul><li>Markets in general </li></ul><ul><li>Physical assets </li></ul><ul><li>Financial assets </li></ul><ul><li>Money vs. Capital </li></ul><ul><li>Primary vs. Secondary </li></ul><ul><li>Spot vs. Future </li></ul>
  3. 3. <ul><li>Direct transfer </li></ul><ul><li>Investment banking house </li></ul><ul><li>Financial intermediary </li></ul>Three Primary Ways Capital Is Transferred Between Savers and Borrowers
  4. 4. The Top 5 Banking Companies in the World, 1999 Bank Name Country Total assets Deutsche Bank AG Germany $735 billion UBS Group Switzerland $687 billion Citigroup United States $669 billion Bank of America United States $618 billion Bank of Tokyo Japan $580 billion
  5. 5. Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets <ul><li>Auction market vs. Dealer market (Exchanges vs. OTC) </li></ul><ul><li>NYSE vs. Nasdaq system </li></ul><ul><li>Differences are narrowing </li></ul>
  6. 6. THE COST OF MONEY <ul><li>The interest rate is the price paid to borrow debt capital. With equity capital, investors expect to receive dividends and capital gains, whose sum is the cost of equity money. </li></ul><ul><li>The four most fundamental factors affecting the cost of money: </li></ul><ul><li>production opportunities , </li></ul><ul><li>(2) time preferences for consumption, (3) risk, and </li></ul><ul><li>(4) inflation. </li></ul>
  7. 7. <ul><li>Production Opportunities </li></ul><ul><li>The returns available within an economy from investments in productive (cash-generating) assets. </li></ul><ul><li>Time Preferences for Consumption </li></ul><ul><li>The preferences of consumers for current consumption as opposed to saving for future consumption. </li></ul><ul><li>Risk </li></ul><ul><li>In a financial market context, the chance that an investment will provide a low or negative return. </li></ul><ul><li>Inflation:- </li></ul><ul><li>The amount by which prices increase over time </li></ul>
  8. 8. Interest Rates as a Function of Supply and Demand for Funds
  9. 9. <ul><li>What do we call the price, or cost, of debt capital? </li></ul><ul><li>The interest rate </li></ul><ul><li>What do we call the price, or cost, of equity capital? </li></ul>Required Dividend Capital return yield gain = +
  10. 10. What four factors affect the cost of money? <ul><li>Production opportunities </li></ul><ul><li>Time preferences for consumption </li></ul><ul><li>Risk </li></ul><ul><li>Expected inflation </li></ul>
  11. 11. “ Real” Versus “Nominal” Rates k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. k k RF
  12. 12. k = k* + IP + DRP + LP + MRP. <ul><li>Here: </li></ul><ul><li>k = required rate of return on a debt security. </li></ul><ul><li>k* = real risk-free rate. </li></ul><ul><li>IP = inflation premium. </li></ul><ul><li>DRP = default risk premium. </li></ul><ul><li>LP = liquidity premium. </li></ul><ul><li>MRP = maturity risk premium. </li></ul>
  13. 13. Premiums Added to k* for Different Types of Debt <ul><li>S-T Treasury: only IP for S-T inflation </li></ul><ul><li>L-T Treasury: IP for L-T inflation, MRP </li></ul><ul><li>S-T corporate: S-T IP, DRP, LP </li></ul><ul><li>L-T corporate: IP, DRP, MRP, LP </li></ul>
  14. 14. What is the “term structure of interest rates”? What is a “yield curve”? <ul><li>Term structure : the relationship between interest rates (or yields) and maturities. </li></ul><ul><li>A graph of the term structure is called the yield curve . </li></ul>
  15. 15. Treasury Yield Curve 0 5 10 15 10 20 30 Years to Maturity Interest Rate (%) 1 yr 5.2% 5 yr 5.8% 10 yr 5.9% 30 yr 6.0% Yield Curve (August 1999)
  16. 16. Yield Curve Construction Step 1:Find the average expected inflation rate over Years 1 to n: IP n = . n
  17. 17. Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. <ul><li>IP 1 = 5%/1.0 = 5.00%. </li></ul><ul><li>IP 10 = [5 + 6 + 8(8)]/10 = 7.50%. </li></ul><ul><li>IP 20 = [5 + 6 + 8(18)]/20 = 7.75%. </li></ul>Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).
  18. 18. Step 2: Find MRP Based on This Equation: MRP t = 0.1%(t – 1). MRP 1 = 0.1% x 0 = 0.0%. MRP 10 = 0.1% x 9 = 0.9%. MRP 20 = 0.1% x 19 = 1.9%.
  19. 19. Step 3: Add the IPs and MRPs to k*: k RF t = k* + IP t + MRP t . k RF = Quoted market interest rate on treasury securities. Assume k* = 3%: k RF1 = 3.0% + 5.0% + 0.0% = 8.0%. k RF10 = 3.0% + 7.5% + 0.9% = 11.4%. k RF20 = 3.00% + 7.75% + 1.90% = 12.65%.
  20. 20. Hypothetical Treasury Yield Curve 0 5 10 15 1 10 20 Years to Maturity Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% Real risk-free rate Inflation premium Maturity risk premium
  21. 21. What factors can explain the shape of this yield curve? <ul><li>This constructed yield curve is upward sloping. </li></ul><ul><li>This is due to increasing expected inflation and an increasing maturity risk premium. </li></ul>
  22. 22. What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues? <ul><li>Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not neces-sarily parallel to the Treasury curve. </li></ul><ul><li>The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases. </li></ul>
  23. 23. Hypothetical Treasury and Corporate Yield Curves 0 5 10 15 0 1 5 10 15 20 Years to maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury yield curve BB-Rated AAA-Rated
  24. 24. How does the volume of corporate bond issues compare to that of Treasury securities? Recently, the volume of investment grade corporate bond issues has overtaken Treasury issues. ‘ 95 ‘96 ‘97 ‘98 ‘99 600 450 300 150 Gross U.S. Treasury Issuance (in blue) Investment Grade Corporate Bond Issuance (in red) Billions of dollars
  25. 25. The Pure Expectations Hypothesis (PEH) <ul><li>Shape of the yield curve depends on the investors’ expectations about future interest rates. </li></ul><ul><li>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. </li></ul>
  26. 26. <ul><li>PEH assumes that MRP = 0. </li></ul><ul><li>Long-term rates are an average of current and future short-term rates. </li></ul><ul><li>If PEH is correct, you can use the yield curve to “back out” expected future interest rates. </li></ul>
  27. 27. Observed Treasury Rates Maturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 6.2% 6.4% 6.5% 6.5% If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?
  28. 28. 0 1 2 5 6.0% 3 4 x% 6.2% PEH tells us that one-year securities will yield 6.4%, one year from now (x%). 6.2% = 12.4% = 6.0 + x% 6.4% = x%. (6.0% + x%) 2
  29. 29. 0 1 2 5 6.2% 3 4 x% 6.5% [ 2(6.2%) + 3(x%) ] 5 PEH tells us that three-year securities will yield 6.7%, two years from now (x%). 6.5% = 32.5% = 12.4% + 3(x%) 20.1% = 3(x%) 6.7% = x%.
  30. 30. <ul><li>Some argue that the PEH isn’t correct, because securities of different maturities have different risk. </li></ul><ul><li>General view (supported by most evidence) is that lenders prefer S-T securities, and view L-T securities as riskier. </li></ul><ul><li>Thus, investors demand a MRP to get them to hold L-T securities (i.e., MRP > 0). </li></ul>Conclusions about PEH
  31. 31. What various types of risks arise when investing overseas? <ul><li>Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment. </li></ul><ul><li>Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate. </li></ul>
  32. 32. Two Factors Lead to Exchange Rate Fluctuations <ul><li>1. Changes in relative inflation will lead to changes in exchange rates. </li></ul><ul><li>2. An increase in country risk will also cause that country’s currency to fall. </li></ul>

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