4 - 1 copyright © 1999 by the dryden pressall rights reserved. chapter 4 the financial environment:...

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Copyright © 1999 by The Dryden Press All rights reserved.

CHAPTER 4The Financial Environment:

Markets, Institutions,and Interest Rates

Financial markets

Types of financial institutions

Determinants of interest rates

Yield curves

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Define these markets

Markets in general

Markets for physical assets

Markets for financial assets

Money versus capital markets

Primary versus secondary markets

Spot versus future markets

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Direct transfer

Through an investment banking house

Through a financial intermediary

Three Primary Ways Capital Is Transferred Between Savers and

Borrowers

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Organized Exchanges versusOver-the-Counter Market

Auction markets versus dealer markets (exchanges versus the OTC market)

NYSE versus NASDAQ system

Differences are narrowing

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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= + .

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What four factors affect the costof money?

Production opportunities

Time preferences for consumption

Risk

Expected inflation

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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

kRF

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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.

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Premiums Added to k* for Different Types of Debt

ST Treasury: only IP for ST inflation

LT Treasury: IP for LT inflation, MRP

ST corporate: ST IP, DRP, LP

LT corporate: IP, DRP, MRP, LP

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What various types of risks arisewhen 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.

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Two Factors Lead to ExchangeRate Fluctuations

Changes in relative inflation will lead to changes in exchange rates.

An increase in country risk will also cause that country’s currency to fall.

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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.

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T-Bond Yield Curve

0

5

10

15

10 20 30

Years to Maturity

InterestRate (%)

1 yr=5.5% 5 yr=5.9%10 yr=6.1%30 yr=6.4%

Yield Curve(October 1997)

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Yield Curves

0

5

10

15

0 1 5 10 15 20

Years tomaturity

Interest Rate (%)

5.5%6.1% 6.4%

BB-RatedAAA-RatedTreasuryyield curve

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What are the two main factors that explain the shape of the yield curve?

Inflation expectations

Risk

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Expectations Theory

Shape of the yield curve depends on the investors’ expectations about future interest rates.

If interest rates are expected to increase, long-term rates will be higher than short-term rates, and vice versa. Thus, the yield curve can slope up or down.

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The Pure Expectations Hypothesis (PEH)

MRP = 0.

Long-term rates are an average of current and expected future short-term rates.

If PEH is correct, you can use the yield curve to back out expected future interest rates.

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Assume that 1-year securities yield 6% today, and the market expects that 1-year securities will yield 7% in 1 year, and that 1-year securities will yield 8% in 2 years.

If the PEH is correct, the 2-year rate today should be (6% + 7%)/2 = 6.5%.

If the PEH is correct, the 3-year rate today should be (6% + 7% + 8%)/3 = 7%.

Example

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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 short-term securities because they view long-term securities as riskier.

Thus, investors demand a MRP to buy long-term securities (i.e., MRP > 0).

Risk

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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).

Combining Risk and Expectations

(More…)

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n

INFLt

t = 1

Yield Curve Construction

Step 1:

Find the average expected inflation rate over years 1 to n:

IPn =

n

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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 versus inflation; that is, these IPs would permit you to earn k* (before taxes).

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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%.

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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%:

kRF1 = 3% + 5% + 0.0% = 8.0%.kRF10 = 3% + 7.5% + 0.9% = 11.4%.kRF20 = 3% + 7.75% + 1.9% = 12.7%.

4 - 1 copyright © 1999 by the dryden pressall rights reserved. chapter 4 the financial environment:...

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