1. 5-1
CHAPTER 5
The Financial Environment:
Markets, Institutions,
and Interest Rates
Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves
2. 5-2
Define These Markets
Markets in general
Physical assets
Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Future
3. 5-3
Three Primary Ways Capital Is
Transferred Between Savers and
Borrowers
Direct transfer
Investment banking house
Financial intermediary
4. 5-4
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. 5-5
Physical Location Stock Exchanges
vs. Electronic Dealer-Based Markets
Auction market vs. Dealer
market (Exchanges vs. OTC)
NYSE vs. Nasdaq system
Differences are narrowing
6. 5-6
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?
Required Dividend Capital
return = yield + gain
7. 5-7
What four factors affect the cost of
money?
Production opportunities
Time preferences for consumption
Risk
Expected inflation
8. 5-8
“Real” Versus “Nominal” Rates
k* = Real risk-free rate.
T-bond rate if no inflation;
1% to 4%.
k = Any nominal rate.
kRF = Rate on Treasury securities.
9. 5-9
k = k* + IP + DRP + LP + MRP.
Here:
k = required rate of return on a
debt security.
k* = real risk-free rate.
IP = inflation premium.
DRP = default risk premium.
LP = liquidity premium.
MRP = maturity risk premium.
10. 5 - 10
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
11. 5 - 11
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.
12. 5 - 12
Treasury Yield Curve
Interest 1 yr 5.2%
Rate (%) 5 yr 5.8%
15
10 yr 5.9%
30 yr 6.0%
10 Yield Curve
(August 1999)
5
0 Years to Maturity
10 20 30
13. 5 - 13
Yield Curve Construction
Step 1:Find the average expected
inflation rate over Years 1 to n:
n
∑ INFL
t =1
t
IPn = n .
14. 5 - 14
Suppose, that inflation is expected to
be 5% next year, 6% the following year,
and 8% thereafter.
IP1 = 5%/1.0 = 5.00%.
IP10 = [5 + 6 + 8(8)]/10 = 7.50%.
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).
15. 5 - 15
Step 2: Find MRP Based on This
Equation:
MRPt = 0.1%(t – 1).
MRP1 = 0.1% x 0 = 0.0%.
MRP10 = 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.
17. 5 - 17
Hypothetical Treasury Yield Curve
Interest
Rate (%) 1 yr 8.0%
15 Maturity risk premium 10 yr 11.4%
20 yr 12.65%
10 Inflation premium
5
Real risk-free rate
0 Years to Maturity
1 10 20
18. 5 - 18
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.
19. 5 - 19
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.
21. 5 - 21
How does the volume of corporate
bond issues compare to that of
Treasury securities?
Gross U.S. Treasury Issuance (in blue)
Billions of dollars
600 Investment Grade Corporate Bond
Issuance (in red)
450
300
150
‘95 ‘96 ‘97 ‘98 ‘99
Recently, the volume of investment grade corporate
bond issues has overtaken Treasury issues.
22. 5 - 22
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.
23. 5 - 23
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.
24. 5 - 24
Observed Treasury Rates
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 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?
25. 5 - 25
x%
6.0%
0 1 2 3 4 5
6.2% (6.0% + x%)
6.2% = 2
12.4% = 6.0 + x%
6.4% = x%.
PEH tells us that one-year securities will
yield 6.4%, one year from now (x%).
26. 5 - 26
6.2% x%
0 1 2 3 4 5
6.5%
[ 2(6.2%) + 3(x%) ]
6.5% =
5
32.5% = 12.4% + 3(x%)
20.1% = 3(x%)
6.7% = x%.
PEH tells us that three-year securities
will yield 6.7%, two years from now (x%).
27. 5 - 27
Conclusions about PEH
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.
Thus, investors demand a MRP to get
them to hold L-T securities (i.e., MRP
> 0).
28. 5 - 28
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.
29. 5 - 29
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.
