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CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates

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Bank of America United States $618 billion. Bank of Tokyo Japan $580 billion ... Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets ... – PowerPoint PPT presentation

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Title: CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates


1
CHAPTER 5The Financial EnvironmentMarkets,
Institutions,and Interest Rates
  • Financial markets
  • Types of financial institutions
  • Determinants of interest rates
  • Yield curves

2
Define These Markets
  • Markets in general
  • Physical assets
  • Financial assets
  • Money vs. Capital
  • Primary vs. Secondary
  • Spot vs. Future

3
Three Primary Ways Capital Is Transferred Between
Savers and Borrowers
  • Direct transfer
  • Investment banking house
  • Financial intermediary

4
The Top 5 Banking Companiesin 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
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
  • 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
What four factors affect the cost of money?
  • Production opportunities
  • Time preferences for consumption
  • Risk
  • Expected inflation

8
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
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
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
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
Treasury Yield Curve
Interest Rate ()
1 yr 5.2 5 yr 5.8 10 yr 5.9 30 yr
6.0
15
Yield Curve (August 1999)
10
5
Years to Maturity
0
10
20
30
13
Yield Curve Construction
Step 1Find the average expected
inflation rate over Years 1 to n
IPn .
n
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
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.
16
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 3.0 5.0 0.0 8.0. kRF10
3.0 7.5 0.9 11.4. kRF20 3.00
7.75 1.90 12.65.
17
Hypothetical Treasury Yield Curve
Interest Rate ()
1 yr 8.0 10 yr 11.4 20 yr
12.65
15
Maturity risk premium
10
Inflation premium
5
Real risk-free rate
Years to Maturity
0
1
20
10
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
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.

20
Hypothetical Treasury and Corporate Yield Curves
Interest Rate ()
15
10
Treasury yield curve
6.0
5.9
5
5.2
Years to maturity
0
0
1
5
10
15
20
21
How does the volume of corporate bond issues
compare to that of Treasury securities?
Gross U.S. Treasury Issuance (in blue) Investment
Grade Corporate Bond Issuance (in red)
600 450 300 150
Billions of dollars
95 96 97
98 99
Recently, the volume of investment grade
corporate bond issues has overtaken Treasury
issues.
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
  • 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
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?
25
x
6.0
0
1
2
5
3
4
6.2
(6.0 x) 2
6.2 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
6.2
x
0
1
2
5
3
4
6.5
2(6.2) 3(x) 5
6.5 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
Conclusions about PEH
  • Some argue that the PEH isnt 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 gt 0).

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 countrys economic, political, and social
    environment.
  • Exchange rate risk If investment is denominated
    in a currency other than the dollar, the
    investments value will depend on what happens to
    exchange rate.

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 countrys currency to fall.
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