2-1 copyright (c) 2000 by harcourt, inc. all rights reserved. chapter 2 the financial environment:...
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2-1
Copyright (C) 2000 by Harcourt, Inc. All rights reserved.
Chapter 2
The FinancialEnvironment:
MarketsInstitutionsInterest Ratesand Taxes
Copyright © 2000 by Harcourt, Inc.
All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887-6777
2-2
Copyright (C) 2000 by Harcourt, Inc. All rights reserved.
The Financial Markets
Money and capital markets Primary and secondary markets Debt and equity markets Mortgage and consumer credit markets World, national, regional, and local markets Spot and future markets
2-3
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Three Primary Ways CapitalIs Transferred Between Savers and Borrowers:
Direct transfer
Investment banking house
Financial intermediary
2-4
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Financial Institutions
Commercial banks Savings and loan associations Credit unions Pension funds Life insurance companies Mutual funds
2-5
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The Stock Market
Organized Security Exchanges• NYSE, AMEX, and regional Actual physical locations
Over-the-Counter Market• Network of brokers and dealers• Auction market
2-6
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The Cost of Money
Production opportunities Time preferences for consumption Risk Expected inflation
Four factors that affect the cost of moneyFour factors that affect the cost of money
2-7
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What do we call the price, or cost, of
debt capital?
The Interest RateThe Interest Rate
What do we call the price, or cost, of
equity capital?
Return on Equity = Dividends + Capital GainsReturn on Equity = Dividends + Capital Gains
The Cost of Money
2-8
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Interest Rate Levels
kA = 10
kB = 12
8
0 Dollars Dollars
%Interest Rate, kA
Market A: Low-Risk SecuritiesInterest Rate, kB
Market B:High-Risk Securities
%
0
Interest Rates as a Function of Supply and Demand
S1
D1
D1
D2
S1
2-9
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= real risk-free rate.T-Bond rate if no inflation;1% to 4%.
k*
= any nominal rate.k
= Rate on T-securities.kRF
“Real” versus “Nominal” Rates
2-10
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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 Rates
Quoted Interest Rate = k = k* + IP + DRP + LP + MRP
2-11
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k = Quoted or nominal rate
kRF = Real risk-free rate plus a premium for expected inflation or k* + IP
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
The Determinants of Market Interest Rates
Quoted Risk-Free Rate = k = kRF + DRP + LP + MRP
2-12
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Premiums Added to k* forDifferent 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
IP = Inflation premiumDRP = Default risk premiumLP = Liquidity premiumMRP = Maturity risk premium
2-13
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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.
2-14
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U.S. Treasury Bond Interest Rates on Different Dates
16
14
12
10
8
6
4
2
0
Interest Rate (%)
1 5 10 20Short Term Intermediate Term Long Term
Term to Interest RateMaturity Mar 1980 Mar 19996 months 15.0% 4.6%1 year 14.0 4.95 years 13.5 5.210 years 12.8 5.520 years 12.5 5.9
Yield Curve for March 1980(Current rate of inflation: 12%
Yield Curve for March 1999(Current rate of inflation: 2%
2-15
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Three Explanations for the Shape of the Yield Curve
Term Structure Theories
Expectations Theory
Liquidity Preference Theory
Market Segmentation Theory
2-16
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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. Thus, the yield curve can slope up or down.
2-17
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Calculating Interest Rates under Expectations Theory:
Step 1: Find the average expected inflation rate over years 1 to N:
IP
INFLt = 1
N
N n =
t
2-18
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Example data: Inflation for Yr 1 is 5%. Inflation for Yr 2 is 6%. Inflation for Yr 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).
2-19
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Calculating Interest Rates under Expectations Theory:
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%
2-20
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Step 3: Add the IPs and MRPs to k*:
kRFt = k* + IPt + MRPt
kRF = Quoted market interest rate on treasury securities.
Assume k* = 3%.
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%
Calculating Interest Rates under Expectations Theory:
2-21
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Yield CurveYield Curve
0
5
10
15
0 1 5 10 15 20
Years tomaturity
Interest Rate (%)
8.0%
11.4%12.7%
Treasuryyield curve
2-22
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Lenders prefer S-T securities because they are less risky.
Thus, S-T rates should be low, and the yield curve should be upward sloping.
Liquidity Preference Theory
2-23
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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).
Market Segmentation Theory
2-24
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Other Factors that Influence Interest Rate Levels
Federal Reserve Policy – Controls the supply of money
Federal Deficits– Larger federal deficit means higher
interest rates Foreign Trade Balance
– Larger trade deficit means higher interest rates
Business Activity
2-25
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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
2-26
Real risk-free rate - is that rate of interest which would exist on default-free securities in the absence of inflation (k*)
Nominal risk-free rate - is equal to the real risk free rate plus an inflation premium which is equal to the average rate of expected inflation over the life of the investment (kRF)
Default Risk Premium- is a premium based on the probability that the issuer will default on the loan, and it is measured by the difference between the interest rate on a U.S. Treasury Bond and a corporate bond of equal maturity and marketability (liquidity)
Liquidity Premium is a premium added to the rate of interest on securities that are not liquid
A liquid asset is one that can be sold at a "fair" price, on short notice
Maturity Risk Premium - is a premium which reflects interest rate risk...
Interest rate risk is the risk of capital loss due to changing interest rates
Longer term securities have more interest rate risk than otherwise comparable shorter term securities
Definitions
2-27Interest Rate Calculation
Step 1 Find the average expected inflation rate over years 1-N
N=1 IP = 5.0%
N=5 IP = (5+6+8+8+8)/5 = 7.0%
N=10 IP = (5+6+8+8+8+...+8)/10 = 7.5%
N=20 IP = (5+6+8+8+8+...+8)/20 = 7.75%
Step 2 Find the maturity risk premium for each maturity
N=1 MRP = 0.0%
N=5 MRP = .1*4 = .4%
N=10 MRP = .1*9 = .9%
N=20 MRP = .1*19 = 1.9%
Step 3 Sum the IPs and the MRPs, and add to k* (real risk free rate)
N=1 kRF = 3% + 5% +0% = 8.0%
N=5 kRF = 3% + 7.0% + .4% = 10.4%
N=10 kRF = 3% + 7.5% + .9% = 11.4%
N=20 kRF = 3% + 7.75% + 1.9% = 12.65%