Mar 02, 2012
CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates
Types of financial institutions
Determinants of interest rates
Define These Markets
Three Primary Ways Capital Is Transferred Between Savers and Borrowers
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
Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets Auction market vs. Dealer market (Exchanges vs. OTC)
Differences are narrowing
THE COST OF MONEY 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. The four most fundamental factors affecting the cost of money: production opportunities ,
(2) time preferences for consumption, (3) risk, and
The returns available within an economy from investments in productive (cash-generating) assets. Time Preferences for Consumption The preferences of consumers for current consumption as opposed to saving for future consumption. In a ﬁnancial market context, the chance that an investment will provide a low or negative return.
The amount by which prices increase over time
Interest Rates as a Function of Supply and Demand for Funds
What do we call the price, or cost, of debt capital? Required Dividend Capital return yield gain = +
What do we call the price, or cost, of equity capital?
What four factors affect the cost of money?
Time preferences for consumption
“ 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
k = k* + IP + DRP + LP + MRP. k = required rate of return on a debt security. k* = real risk-free rate. DRP = default risk premium.
MRP = maturity risk premium.
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”? Term structure : the relationship between interest rates (or yields) and maturities.
A graph of the term structure is called the yield curve .
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)
Yield Curve Construction Step 1:Find the average expected inflation rate over Years 1 to n: IP n = . n
Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP 10 = [5 + 6 + 8(8)]/10 = 7.50%. Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).
IP 20 = [5 + 6 + 8(18)]/20 = 7.75%.
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%.
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%.
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
What factors can explain the shape of this yield curve? This constructed yield curve is upward sloping.
This is due to increasing expected inflation and an increasing maturity risk premium.
What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues? Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not neces-sarily parallel to the Treasury curve.
The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.
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
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
The Pure Expectations Hypothesis (PEH) 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.
PEH assumes that 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.
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?
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
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%.
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. Conclusions about PEH
Thus, investors demand a MRP to get them to hold L-T securities (i.e., MRP > 0).
What various types of risks arise when investing overseas? Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment.
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.
Two Factors Lead to Exchange Rate Fluctuations 1. Changes in relative inflation will lead to changes in exchange rates.
2. An increase in country risk will also cause that country’s currency to fall.