Ffm905

transcript

CHAPTER 5The Financial Environment:

Markets, Institutions,and Interest Rates

Financial markets

Types of financial institutions

Determinants of interest rates

Yield curves

Define These Markets

Markets in general

Physical assets

Financial assets

Money vs. Capital

Primary vs. Secondary

Spot vs. Future

Direct transfer

Investment banking house

Financial intermediary

Three Primary Ways Capital Is Transferred Between Savers and

Borrowers

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

The Top 5 Banking Companiesin the World, 1999

Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets

Auction market vs. Dealer market (Exchanges vs. OTC)

NYSE vs. Nasdaq system

Differences are narrowing

THE COST OF MONEY

The interest rate is the price paid to borrow debt capital. With equity capital, investors expect to receive dividends and capital gains, whose sum is the cost of equity money.

The four most fundamental factors affecting the cost of money:

(1)production opportunities,

(2) time preferences for consumption, (3) risk, and

(4) inflation.

Production Opportunities

The returns available within an economy from investments in productive (cash-generating) assets.

Time Preferences for Consumption

The preferences of consumers for current consumption as opposed to saving for future consumption.

In a financial market context, the chance that an investment will provide a low or negative return.

Inflation:-

The amount by which prices increase over time

Interest Rates as a Function of Supply and Demand for Funds

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 cost of money?

Production opportunities

Time preferences for consumption

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.

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

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

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

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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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Treasury Yield Curve

10 20 30

Years to Maturity

InterestRate (%)

1 yr 5.2% 5 yr 5.8%10 yr 5.9%30 yr 6.0%

Yield Curve(August 1999)

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Yield Curve Construction

Step 1:Find the average expected

inflation rate over Years 1 to n:

IPn = .

1ttINFL

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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).

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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 interestrate 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%.

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Hypothetical Treasury Yield Curve

1 10 20

Years to Maturity

InterestRate (%) 1 yr 8.0%

10 yr 11.4%20 yr 12.65%

Real risk-free rate

Inflation premium

Maturity risk premium

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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.

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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.

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Hypothetical Treasury and Corporate Yield Curves

0 1 5 10 15 20

Years tomaturity

Interest Rate (%)

5.2%5.9%

6.0%Treasuryyield curve

BB-Rated

AAA-Rated

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How does the volume of corporate bond issues compare to that of

Treasury securities?

Recently, the volume of investment grade corporate bond issues has overtaken Treasury issues.

‘95 ‘96 ‘97 ‘98 ‘99

Gross U.S. Treasury Issuance (in blue)Investment Grade Corporate Bond

Issuance (in red)

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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.

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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.

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Observed Treasury Rates

Maturity1 year2 years3 years4 years5 years

Yield6.0%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?

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0 1 2 5

PEH tells us that one-year securities will yield 6.4%, one year from now (x%).

6.2% =

12.4% = 6.0 + x%

6.4% = x%.

(6.0% + x%)2

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0 1 2 5

6.5%[ 2(6.2%) + 3(x%) ]

PEH tells us that three-year securities will yield 6.7%, two years from now (x%).

6.5% =

32.5% = 12.4% + 3(x%)

20.1% = 3(x%)

6.7% = x%.

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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 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 > 0).

Conclusions about PEH

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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 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 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 country’s currency to fall.

Ffm905

Economy & Finance