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Chapter 2 The Financial Environment Markets Institutions Interest Rates

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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

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Title: Chapter 2 The Financial Environment Markets Institutions Interest Rates


1
Chapter 2 The Financial Environment Markets Inst
itutions Interest 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 for Different 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 Rate Term to March July July
Maturity 1980 2000 2003 3 months 16.0
6.1 0.9 1 year 14.0 6.1 1.0 5 years
13.5 6.2 2.3 10 years 12.8 6.1 3.3 20
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.
inflation these 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
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