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CHAPTER 5The Financial Environment:Markets, Institutions,
and Interest Rates
Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves
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Define these markets
Markets in general
Markets forphysical assetsMarkets forfinancial assets
Money versus capital markets
Primary versus secondary markets
Spot versus future markets
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Direct transfer
Through an investment banking
houseThrough a financial intermediary
Three Primary Ways Capital Is
Transferred Between Savers andBorrowers
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The Top 5 Banking Companies
in the World, 1999
$580 billionJapanBank of Tokyo
$618 billionUnited StatesBank of America
$669 billionUnited StatesCitigroup
$687 billionSwitzerlandUBS Group$735 billionGermanyDeutsche Bank AG
Total assetsCountryBank Name
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What do we call the price, or cost,ofdebt capital?
The interest rate
What do we call the price, or cost,ofequity capital?
Required Dividend Capitalreturn yield gain
= + .
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What four factors affect the cost
of money?
Production opportunitiesTime preferences for consumption
Risk
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.
k
kRF
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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.
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Premiums Added to k* for Different
Types of Debt
ST Treasury: only IP for ST inflation
LT Treasury: IP for LT inflation, MRP
ST corporate: ST IP, DRP, LPLT 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
0
5
10
15
10 20 30
Years to Maturity
Interest
Rate (%)1 yr 6.3%
5 yr 6.7%
10 yr 6.5%
30 yr 6.2%Yield Curve
(May 2000)
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Yield Curve Construction
Step 1: Find the average expected
inflation rate over years 1 to n:n
INFLt t = 1
nIPn = .
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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 evenversus inflation; that is, these IPswould permit you to earn k* (beforetaxes).
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Step 2: Find MRP based on thisequation:
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% + 5% + 0.0% = 8.0%.
kRF10 = 3% + 7.5% + 0.9% = 11.4%.
kRF20 = 3% + 7.75% + 1.9% = 12.65%.
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Hypothetical Treasury Yield Curve
0
5
10
15
1 10 20
Years to Maturity
Interest
Rate (%)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 isupward sloping.
This is due to increasing expectedinflation and an increasing
maturity risk premium.
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What kind of relationship existsbetween the Treasury yield curve andthe yield curves for corporate issues?
Corporate yield curves are higher thanthat of the Treasury bond. However,corporate yield curves are not neces-sarily parallel to the Treasury curve.
The spread between a corporate yieldcurve and the Treasury curve widensas the corporate bond ratingdecreases.
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Hypothetical Treasury and
Corporate Yield Curves
0
5
10
15
0 1 5 10 15 20
Years to
maturity
InterestRate (%)
5.2% 5.9%
6.0%Treasury
yield curve
BB-Rated
AAA-Rated
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How does the volume of corporatebond issues compare to that of
Treasury securities?
Recently, the volume of investment grade corporatebond issues has overtaken Treasury issues.
95 96 97 98 99
600
450
300
150
Gross U.S. Treasury Issuance (in blue)
Investment Grade Corporate Bond
Issuance (in red)
Billionsofdo
llars
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The Pure Expectations Hypothesis
(PEH)
Shape of the yield curve depends
on the investors expectationsabout future interest rates.
If interest rates are expected to
increase, L-T rates will be higherthan S-T rates and vice versa.Thus, the yield curve can slope upor down.
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PEH assumes that MRP = 0.
Long-term rates are an average ofcurrent and future short-term rates.
If PEH is correct, you can use theyield curve to back out expectedfuture interest rates.
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Observed Treasury Rates
If PEH holds, what does the market expectwill be the interest rate on one-yearsecurities, one year from now? Three-yearsecurities, two years from now?
6.5%5 years6.5%4 years6.4%3 years
6.2%2 years6.0%1 yearYieldMaturity
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0 1 2 5
6.0%
3 4
x%
6.2%
PEH tells us that one-year securities willyield 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
6.2%
3 4
x%
6.5%[ 2(6.2%) + 3(x%) ]
5
PEH tells us that three-year securitieswill 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 isnt correct,because securities of differentmaturities have different risk.
General view (supported by mostevidence) is that lenders prefer S-Tsecurities, 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 ordoing 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 thanthe dollar, the investments value willdepend on what happens to exchangerate.
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Two Factors Lead to Exchange
Rate Fluctuations
Changes in relative inflation willlead to changes in exchange rates.
An increase in country risk will
also cause that countrys currencyto fall.