Chapter 2 The Financial Environment Markets Institutions Interest Rates - PowerPoint PPT Presentation

1 / 31
About This Presentation
Title:

Chapter 2 The Financial Environment Markets Institutions Interest Rates

Description:

Chapter 2 The Financial Environment Markets Institutions Interest Rates 2 2 4 4 4 5 6 7 8 8 8 9 10 11 12 12 17 18 20 21 22 13 * The Financial Markets Debt versus ... – PowerPoint PPT presentation

Number of Views:278
Avg rating:3.0/5.0
Slides: 32
Provided by: SusanC195
Category:

less

Transcript and Presenter's Notes

Title: Chapter 2 The Financial Environment Markets Institutions Interest Rates


1
Chapter 2The Financial EnvironmentMarketsInst
itutionsInterest Rates
2
The Financial Markets
  • Debt versus equity markets
  • Debt markets loans
  • Equity markets stocks
  • Money versus capital markets
  • Money market debt lt 1 year
  • Capital market debt gt 1 year stocks
  • Primary versus secondary markets
  • Primary markets new funds
  • Secondary markets outstanding securities

3
The Financial Markets
  • Public versus private markets
  • Public markets liquid, low-cost standardized
    trades
  • Private markets specialized deals
  • Spot versus futures markets
  • Spot markets assets traded on the spot
  • Futures markets for delivery at a later date
  • World, national, regional, and local markets
  • Worldwide New York Stock Exchange
  • Local Chicago Stock Exchange

4
Financial Institutions
Funds are transferred between those who have
funds and those who need funds by three processes
  • Direct transfers
  • No intermediaries
  • Often part of private market transactions
  • Investment banking houses
  • I-Bank middleman
  • I-Bank may buy in hopes of selling, so there is
    some risk
  • Financial intermediaries
  • Banks or mutual funds
  • Savers invest in one type of product (e.g., CDs
    or savings accounts)
  • Bank then creates loans, mortgages, etc. to sell
    to borrowers

5
Financial Intermediaries
  • 1993 Glass-Steagall Act
  • Prohibited commercial banks from I-banking
    activities
  • Tried to prohibit conflict of interest
    situations
  • Result Morgan Bank
  • JP Morgan Chase Company commercial bank
  • Morgan Stanley investment bank
  • 1999 Gramm-Leach-Bliley Act
  • Expanded the powers of banks
  • Abolished major restrictions of the
    Glass-Steagall Act
  • Allows banks to do
  • I-banking
  • insurance sales and underwriting
  • low risk non-financial activities

6
Financial Intermediaries
  • The Gramm-Leach-Bliley Act blurred the
    distinctions
  • Commercial banks
  • Savings and loan associations
  • Credit unions
  • Pension funds
  • Life insurance companies
  • Mutual funds

7
Stock Markets
  • Old classification
  • Organized Security Exchanges
  • NYSE, AMEX, and regional
  • OTC (over-the-counter markets)
  • A broader network of smaller dealers
  • New classification
  • Physical stock exchanges
  • NYSE, AMEX
  • Organized Investment Networks
  • OTC, Nasdaq, electronic communication networks
    (ECN)

8
Physical Stock Exchanges
  • A physical, material entity
  • A building
  • Designated members
  • A board of governors
  • Seats are bought and sold
  • Record high price 4M (12/1/05)
  • Price in 1999 2M
  • Auction markets
  • Sell orders and buy orders come together

9
Organized Investment Networks
  • For securities not traded on physical stock
    exchanges
  • An intangible trading system
  • A network of brokers and dealers (NASD)
  • Dealers make the market
  • The bid price what the dealer will pay to buy
  • The ask price what the dealer will take to sell
  • Spread the dealers profit
  • Electronic communications networks

10
The Cost of Money
Four factors that affect the cost of money
  • Production opportunities
  • Is it worth investing in new assets?
  • Time preferences for consumption
  • Now or later?
  • Risk
  • How likely is it that this investment wont pan
    out?
  • Expected inflation
  • How much will prices increase over time?

11
The Cost of Money
  • 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?
  • Return on Equity Dividends Capital Gains

12
Interest Rate Levels
Interest Rates as a Function of Supply and Demand
13
Real versus Nominal Rates
real risk-free rate.
k
Typically 2 to 4 T-bill for short term T-bond
for long term
14
The Determinants of Market Interest Rates
  • 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

15
The Determinants of Market Interest Rates
Quoted Interest Rate k k Risk-free
interest rate risk premium k kRF RP k
kRF DRP LP MRP k k IP DRP
LP MRP
16
The Determinants of Market Interest Rates
Nominal Interest Rate k k IP DRP
LP MRP
  • IP average rate of inflation expected in future
  • DRP risk that a borrower will default on a loan
    (difference between the T-bond interest rate and
    a corporate bond with same features)
  • LP premium if asset cannot be converted to cash
    quickly and at close to the original cost (2
    5)
  • MRP the interest rate risk associated with
    longer maturity periods (usually 1 2)

17
Determinants of Market Interest Rates
Quoted Risk-Free Rate k kRF DRP LP MRP
  • k Quoted or nominal rate
  • kRF Real risk-free rate plus a premium
    for expected inflation or kRF k IP
  • DRP Default risk premium
  • LP Liquidity premium
  • MRP Maturity risk premium

18
Premiums Added to k forDifferent Types of Debt
IP Inflation premium DRP Default risk
premium LP Liquidity premium MRP Maturity
risk premium
  • Short-Term (S-T) Treasury only IP for S-T
    inflation
  • Long-Term (L-T) Treasury
  • IP for L-T inflation plus MRP
  • Short-Term corporate Short-Term IP, DRP, LP
  • Long-Term corporate IP, DRP, MRP, LP

19
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.

20
U.S. Treasury Bond Interest Rates on Different
Dates
Interest RateTerm to March July July
Maturity 1980 2000 2003 3 months 16.0
6.1 0.91 year 14.0 6.1 1.05 years
13.5 6.2 2.310 years 12.8 6.1 3.320
years 12.3 6.2 4.3
Abnormal
Flat horizontal
Normal
21
Three Explanations for the Shape of the Yield
Curve
  • Liquidity Preference Theory
  • Expectations Theory
  • Market Segmentation Theory

22
Liquidity Preference Theory
  • Lenders prefer to make short-term loans
  • Less interest-rate risk
  • More liquid
  • Lenders lend short-term funds at lower rates
  • Says MRP gt 0
  • Results in normal curve

23
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.
  • The yield curve can slope up OR down.

24
Calculating Interest Rates under Expectations
Theory
Step 1 Find the Inflation Premium, the average
expected inflation rate over years 1 to N
25
Example
  • Inflation for Year 1 is 5.
  • Inflation for Year 2 is 6.
  • Inflation for Year 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.
inflationthese IPs would permit you to earn k
(before taxes).
26
Step 2 Find MRP based on this equation MRPt
0.1 (t - 1)
Calculating Interest Rates under Expectations
Theory
MRP1 0.1 x 0 0.0 MRP10 0.1 x 9
0.9 MRP20 0.1 x 19 1.9
27
Calculating Interest Rates under Expectations
Theory
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
28
Yield Curve
29
Market Segmentation Theory
  • 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

30
Other Factors that Influence Interest Rate Levels
  • Federal Reserve Policy
  • Controls money supply impacts S-T interest rates
  • Federal Deficits
  • Larger federal deficits mean higher interest
    rates
  • Foreign Trade Balance
  • Larger trade deficits mean higher interest rates
  • Business Activity
  • Does the Federal Reserve need to stimulate
    activity?

31
Interest Rate Levels and Stock Prices
  • The higher the rate of interest, the lower a
    firms profits
  • Interest rates affect the level of economic
    activity . . . which affects corporate profits
  • If interest rates rise . . .
  • Investors turn to the bond market, sell stock,
    and decrease stock prices
  • If interest rates decline . . .
  • Investors turn to the stock market, sell bonds,
    and increase stock prices
Write a Comment
User Comments (0)
About PowerShow.com