chapter 4 the financial environment:

8/14/2019 CHAPTER 4 the Financial Environment:

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CHAPTER 4

The Financial Environment:Markets, Institutions, and InterestRates

Financial markets

Types of financialinstitutions

Determinants of interest

rates



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What is a market? A market is a venue where goods

and services are exchanged.

A financial market is a place whereindividuals and organizationswanting to borrow funds are

brought together with those havinga surplus of funds.



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Types of financial markets Physical assets vs. Financial assets

Money vs. Capital

Primary vs. Secondary

Spot vs. Futures

Public vs. Private



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How is capital transferred

between savers and borrowers? Direct transfers

Investment

banking house Financial

intermediaries



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Types of financial

intermediaries Commercial banks

Savings and loan associations

Mutual savings banks

Credit unions

Pension funds Life insurance companies

Mutual funds



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Physical location stockexchanges vs. Electronic

dealer-based markets Auction market

vs. Dealer market

(Exchanges vs.OTC)

NYSE vs. Nasdaq

Differences arenarrowing


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The cost of money The price, or cost, of debt capital

is the interest rate.

The price, or cost, of equitycapital is the required return.

The required return investors

expect is composed of compensation in the form of dividends and capital gains.



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What four factors affect the

cost of money? Production

opportunities

Time preferencesfor consumption

Risk

Expected inflation



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“Nominal” vs. “Real” ratesk = represents any nominal rate

k* = represents the “real” risk-freerate of interest. Like a T-bill rate,if there was no inflation. Typicallyranges from 1% to 4% per year.

kRF = represents the rate of interest

on Treasury securities.



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Determinants of interest

ratesk = k* + IP + DRP + LP + MRP

k = required return on a debt security

k* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premiumLP = liquidity premium

MRP= maturity risk premium



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Premiums added to k* for

different types of debt

IP MRP DRP LP

S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate



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Yield curve and the term

structure of interest rates Term structure –

relationship betweeninterest rates (or

yields) and maturities. The yield curve is a

graph of the termstructure.

A Treasury yield curvefrom October 2002can be viewed at theright.



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Constructing the yield curve:

Inflation Step 1 – Find the average expected

inflation rate over years 1 to n:

n

INFL

IP

n

1t

t

n

∑==



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InflationSuppose, that inflation is expected to be 5% nextyear, 6% the following year, and 8% thereafter.

IP1 = 5% / 1 = 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).



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Inflation Step 2 – Find the appropriate maturity

risk premium (MRP). For this example,the following equation will be used finda security’s appropriate maturity riskpremium.

)1-t(0.1%MRPt =



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Maturity RiskUsing the given equation:

MRP1 = 0.1% x (1-1) = 0.0%

MRP10 = 0.1% x (10-1) = 0.9%

MRP20 = 0.1% x (20-1) = 1.9%

Notice that since the equation is linear,

the maturity risk premium is increasingin the time to maturity, as it should be.



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Add the IPs and MRPs to k* tofind the appropriate nominal

ratesStep 3 – Adding the premiums to k*.

kRF, t

= k* + IPt+ MRP

t

Assume k* = 3%,

kRF, 1 = 3% + 5.0% + 0.0% = 8.0%

kRF, 10 = 3% + 7.5% + 0.9% = 11.4%kRF, 20 = 3% + 7.75% + 1.9% = 12.65%



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Hypothetical yield curve An upward

sloping yield

curve. Upward slope due

to an increase inexpected inflation

and increasingmaturity riskpremium. Years to

Maturity

Real risk-free rate

0

5

10

15

1 10 20

Interest

Rate (%)

Maturity risk premium

Inflation premium



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What is the relationship betweenthe Treasury yield curve and the

yield curves for corporate issues? Corporate yield curves are higher

than that of Treasury securities,

though not necessarily parallel tothe Treasury curve.

The spread between corporate and

Treasury yield curves widens asthe corporate bond ratingdecreases.



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Illustrating the relationshipbetween corporate and Treasury

yield curves

0

5

10

15

0 1 5 10 15 20

Years toMaturity

InterestRate (%)

5.2% 5.9%6.0%

Treasury

Yield Curve

BB-Rated

AAA-Rated



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Pure Expectations

Hypothesis The PEH contends that the shape of the

yield curve depends on investor’sexpectations about future interest rates.

If interest rates are expected toincrease, L-T rates will be higher thanS-T rates, and vice-versa. Thus, the yield

curve can slope up, down, or even bow.



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Assumptions of the PEH Assumes that the maturity risk

premium for Treasury securities is

zero. Long-term rates are an average of

current and future short-term rates.

If PEH is correct, you can use theyield curve to “back out” expectedfuture interest rates.



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An example:Observed Treasury rates and the

PEHMaturity 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 expectwill be the interest rate on one-yearsecurities, one year from now? Three-yearsecurities, two years from now?



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One-year forward rate

6.2% = (6.0% + x%) / 2

12.4% = 6.0% + x%

6.4% = x%

PEH says that one-year securities will yield6.4%, one year from now.



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Three-year security, two years

from now

6.5% = [2(6.2%) + 3(x%) / 5

32.5% = 12.4% + 3(x%)

6.7% = x%

PEH says that one-year securities will yield 6.7%,one year from now.



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Conclusions about PEH Some would argue that the MRP ≠ 0,

and hence the PEH is incorrect.

Most evidence supports the generalview that lenders prefer S-Tsecurities, and view L-T securities asriskier.

Thus, investors demand a MRP to getthem to hold L-T securities (i.e., MRP> 0).



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Other factors that influence

interest rate levels Federal reserve policy

Federal budget surplus or deficit

Level of business activity

International factors



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Risks associated with investing

overseas Exchange rate risk – If an

investment is denominated ina currency other than U.S.

dollars, the investment’s valuewill depend on what happensto exchange rates.

Country risk – Arises frominvesting or doing business in

a particular country anddepends on the country’seconomic, political, and socialenvironment.



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Factors that cause exchange

rates to fluctuate Changes in

relative

inflation Changes in

country risk

chapter 4 the financial environment:

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