7 7 Chapter The Financial System and Interest Slides Developed by: Terry Fegarty Seneca College.

77Chapt

er

Chapt

er The Financial System and Interest

The Financial System and Interest

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 7 – Outline (1)• The Financial System

Raising and Spending Money in Business Term Financial Markets Capital and Money Markets Primary and Secondary Markets Transfer of Funds from Investors to Businesses Financial Intermediaries

• The Stock Market and Stock Exchanges Trading—The Role of Brokers Market Regulation Process of Going Public


Chapter 7 – Outline (2)• Interest

The Relationship Between Interest and the Stock Market

Interest and the Economy Supply and Demand for Money

• The Components of an Interest Rate Different Kinds of Lending Risk Putting the Pieces Together Risk Free and Real Rates The Risk-Free Rate The Real Rate of Interest Yield Curves—The Term Structure of Interest Rates


The Financial System

• Producers/Borrowers Companies need to raise money to finance

business activities

• Savers/investors People need a place to deposit their savings

and to earn a return

• The financial system facilitates the flow of savings from savers to borrowers


The Financial System

• Financial markets connect producers’ need for money with investors’ available savings Buyers and sellers of securities meet in

financial marketplace• Companies issue shares or bonds to raise money• Savers purchase these securities hoping to earn

return on their savings (investment)• Return comes as interest from bonds or

dividends and price appreciation from shares


Raising and Spending Money in Business• Businesses spend money on:

Day-to-day operations (inventory, wages, etc.)• Money for these operations comes from generating revenue

Capital investments (new capital assets such as new production line, expansion overseas, etc.)

• Money is raised for capital investments in the financial marketplace

• Borrowed money is debt financing• Money raised through the sale of shares is equity

financing


Term

• Term—length of time between now and end (or termination) of something

• Maturity matching Long-term projects (typically those lasting over 5-

10 years) are usually financed with long-term funds• Debt (bonds)• Equity

Short-term projects (typically those lasting less than 1 year) are usually financed with short-term funds

• Bank loans


Financial Markets

• Vehicles through which financial securities are bought, sold, and traded

• Financial markets may be classified as: Capital or money markets Primary or secondary markets


Capital and Money Markets

• Capital Markets Market for shares and long-term debt

• Money Markets Market for short-term, high-quality debt

securities with maturities of 1-year or less Marketable securities such as commercial

paper, notes, bills• Federal government issues Treasury bills


Primary and Secondary Markets

• Primary Market Issuers sell new securities to investors

• Secondary Market Investors sell existing securities to other

investors Most transactions occur in the secondary

market Corporations don’t raise money in the secondary

market


Transfer of Funds From Investors to Businesses • Primary market transactions can occur

Directly (issuing firm sells securities to investors through an investment dealer)

• Helps companies market their securities

Indirectly (issuing firm sells securities to an institutional investor—such as a mutual fund

• Mutual fund buys securities and sells shares in the fund to buyers)

• Mutual fund owns specific stocks/bonds • Investor in mutual fund owner owns shares in the fund


Figure 7.2: Transfer of Funds From Investors to Businesses


Financial Intermediaries

• Institutional investors Mutual funds and similar financial

intermediaries Play major role in financial markets

• Own ¼ of all stocks but make over ¾ of all trades

Examples include• Mutual funds• Pension funds• Insurance companies• Banks and trust companies


The Stock Market and Stock Exchanges

• Stock market—network of exchanges and brokers Exchange—physical or electronic

marketplace (TSX, OTC, NYSE) Brokers—individuals who assist people in

buying and selling securities• Work for brokerage firms


The Stock Market and Stock Exchanges • Security Exchanges (Example: TSX)

Financial marketplace with specific requirements for listing and trading securities

Often are associated with a market index (i.e. TSX, Dow Jones, S&P 500, NASDAQ)

• Over-the-counter (OTC) Market Public stock issues not traded on stock

exchange Dealers act as market makers


Trading—The Role of Brokers

• What brokers do… Investor will open an account with a broker

and place trades via telephone or online On TSX, buy and sell orders are matched

electronically by exchange’s computerized system

Specialists make markets in designated securities

Confirmation of trade is forwarded to local broker and investor


Market Regulation

• 10 provinces and three territories regulate own securities markets Ontario Securities Commission—the most

influential because it has the most investors and companies within its jurisdiction

• Securities law is primarily aimed at disclosure and prevention of unfair trading practices For example, unfair use of insider

information


Process of Going Public (1)

• Assume a business is successful and the owner decides to raise money for expansion selling shares to others Privately (closely) held companies—sale of

securities severely restricted by regulation

Publicly traded (public) companies—have received approval of the Securities Commission to offer securities to general public

• Process of obtaining approval and registration is known as ‘going public’



• The Prospectus Use investment dealer to determine

• If a market exists for shares of company• The likely issue price for shares

Develop prospectus—provides detailed information about company• Financial statements• Key executives/background

Provincial Securities Commission reviews prospectus• Prospectus not yet approved is called preliminary

or a red herring



• The IPO Once prospectus approved by SC, securities can be

sold to public• Initial sale is known as initial public offering (IPO)

• Market for IPOs very volatile and risky• Prices can rise (or fall) very dramatically

Investment dealers usually line up buyers prior to actual sale of securities

• Buyers are usually institutional investors (bought deal)

IPO occurs in primary market



• The OTC Market After company goes public, its shares are

usually traded in over-the-counter (OTC) market

Nation-wide computerized network of brokers dealing in shares of small companies• In U.S., The National Association of Securities

Dealers Automated Quotation System (NASDAQ)

OTC trades are secondary market transactions



• Stock Exchange Listing Eventually firm may wish to be listed on a

stock exchange (ex; TSX) Easier to sell future share issues Must meet exchange’ requirements for size

and length of time in business Becomes listed company


Figure 7.5: Stock Market Quotation for CIBC, Tuesday, June 22, 2004


Interest

• Interest rates—the return on a debt instrument (for example, a bond) Issuer of bond (borrower) pays interest to

investor (lender) There are many interest rates, including the

prime rate, the bank rate, etc. • Interest rates tend to move in tandem

Debt instruments are loans with a specified term (maturity date)


The Relationship Between Interest and the Stock Market • The stock market reacts to changes in interest

rates • Shares (equity) and bonds (debt) compete for

investor’s dollars Shares offer higher returns but have more risk

• If interest rates go up, bonds become more attractive

• The required return on shares would rise and therefore the price of shares would drop in the market Interest rates and share prices move in opposite

directions


Interest and the Economy

• Would you be more likely to buy a house/car when interest rates are high or low?

• Interest rates have significant effect on the economy Interest rates represent the cost of borrowing

money (credit) Lower interest rates stimulate business and

economic activity


Supply and Demand for Money

• Interest rates set by supply and demand in debt markets

• Supply—funds from those willing to lend money Lenders (investors) buy debt securities

such as bills, notes and bonds Supply of borrowed funds depends on their

willingness to invest their savings• Affected by changes in the economy



• Demand—people, companies and governments desiring to borrow money Borrowers sell bonds, etc.

• Demand for borrowed funds depends on Opportunities available to use these funds Attitudes of people and businesses about

using credit• If people feel good about the economy they will go

on vacation, buy houses and cars, etc.• Businesses will borrow for expansion and new

projects



• The price—the interest rate Borrowers will borrow more when interest

rates low Lenders will lend more (buy more bonds)

when interest rates high


The Components of an Interest Rate• Interest rates include base rates and risk

premiums• Interest rate = k

k = base rate + risk premium

• Base Rate Pure interest rate Inflation adjustment

• Premium for Lender’s risk Default risk Liquidity risk Maturity risk


The Components of an Interest Rate • The Base Rate

Base rate is pure interest plus expected inflation• Rate at which people lend money when no risk is

involved

Pure interest rate is rent paid to lenders for the use of their money• An abstract rate that would exist in a perfect

economy with no inflation or risk• Generally considered to be between 2% and 4%


The Components of an Interest Rate • The Inflation Adjustment

Inflation—general increase in prices• Money loses some of its value

If you loaned someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year

Lender must charge interest rate higher than inflation rate• Interest rates include estimates of average annual

inflation over loan periods


The Components of an Interest Rate• Risk Premiums

Some loans are more risky than others Lenders demand a risk premium of extra

interest for making risky loans


Different Kinds of Lending Risk

• Default Risk The chance the borrower won't pay principal

or interest, or will repay late• Losses can be portion of or entire amount

Lenders demand a default risk premium which depends on lender’s perception of creditworthiness of the borrower• Perception is based on the borrower’s financial

condition and credit record


Different Kinds of Lending Risk

• Liquidity Risk Bond lending losses can be associated with

fluctuations in prices of bonds Associated with being unable to sell the bond of

little known issuer Sellers may have to reduce their prices to encourage

investors to buy the illiquid securities Liquidity risk premium is extra interest demanded

by lenders as compensation for bearing liquidity risk Very short-term securities (ex; commercial paper)

usually bear little liquidity risk


Different Kinds of Lending Risk• Maturity Risk

Bond prices and interest rates move in opposite directions

If interest rates increase after an investor purchases a bond, its price will decline

• The investor will take a loss if he or she sells before maturity Long-term bond prices change more with interest

rate swings than short-term bond prices• Gives rise to maturity risk

Investors demand a maturity risk premium• Ranges from 0% for short-term securities to 2% or more for

long-term issues


Putting the Pieces Together

• The Interest Rate Model k = kPure Interest Rate + Inflation + Default Risk

Premium + Liquidity Risk Premium + Maturity Risk Premium

k—the nominal or quoted interest rate Model explains interest rate needs of

investors However, rates set by supply and demand


Risk-Free and Real Rates

• Federal Government Securities Federal government issues many short-term

securities• Treasury bills and short-term bonds

• Treasury bills have terms from 90 days to a year• ST bonds have terms from 1 to 10 years

No default risk associated with federal government debt

• Can print money to pay off its debt

No liquidity risk for federal government debt• Always an active market


The Risk-Free Rate

• The risk-free rate is approximately the yield on short-term Treasury bills Includes the pure rate and an allowance for

inflation• Same as the base rate discussed earlier

• Viewed as current minimum interest rate No investment that does have risk can offer a

lower rate


The Real Rate of Interest

• The real interest rate is current interest rate less inflation adjustment

• Tells investors whether or not they are getting ahead If you earn a real rate of 8% on investment and

inflation is 10%, you are losing purchasing power on investment

• The Real Risk-Free Rate Implies that both the inflation adjustment and the

risk premium are zero = the pure interest rate


Yield Curves—The Term Structure of Interest Rates• Interest rates generally vary with term of debt

The relationship is known as the term structure of interest rates

The yield curve is a graph of interest rates compared to terms for similar loans

• Most of the time short-term rates are lower than long-term rates (normal yield curve) At times opposite is true

• Known as an inverted yield curve


Figure 7.6: Yield Curves


Yield Curves—The Term Structure of Interest Rates

• Theories to explain the term structure of interest rates Expectations theory

• Today's rates rise or fall with term as future rates are expected to rise or fall

Liquidity preference theory• Lenders prefer shorter term loans and must receive higher

interest rates to make longer loans

Market segmentation theory• Loan terms define independent segments of the debt market

which set separate rates

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7 7 Chapter The Financial System and Interest Slides Developed by: Terry Fegarty Seneca College.

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