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CHAPTER 4The Financial Environment: Markets,Institutions, and Interest Rates

Financial markets

Types of financial institutions

Determinants of interest rates

Yield curves

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What is a market?

A market is a venue where goods andservices are exchanged.

A financial market is a place where

individuals and organizations wantingto borrow funds are brought together

with those having a surplus of funds.

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Types of financial markets

Physical assets vs. Financial assets

Debt vs. Equity

Money vs. Capital

Primary vs. Secondary

IPO

Spot vs. Futures

Public vs. Private

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How is capital transferred between savers

and borrowers?

Direct transfers

Investment

banking house Financial

intermediaries

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Types of financial intermediaries

Commercial banks

Pension funds

Life insurance companies

Mutual funds

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Physical location stock exchanges vs.

Electronic dealer-based marketsAuction market vs.

Dealer market

Inventory to minimizetransaction cost

Bid-Ask Spread

(Exchanges vs.OTC)

Quantity driven vsprice driven

NYSE vs. Nasdaq

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The cost of money

The price, or cost, of debt capital is

the interest rate.

The price, or cost, of equity capital isthe required return. The required

return investors expect is composed of

compensation in the form of dividendsand capital gains.

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What four factors affect the cost of

money? Production

opportunities

Time preferencesfor consumption

Risk

Expected inflation

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Interest Rate levels

Interest Rate Levels

Function of Supply and Demand of Funds

Transfer of capital between markets.

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Determinants of interest rates

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

k = required return on a debt security

k* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premium

LP = liquidity premium

MRP = maturity risk premium Interest rate risk

Reinvestment rate risk

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Premiums added to k* for different

types of debt

IP MRP DRP LP

S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

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Term Structure of Interest Rates

Relationship between long term and short

term rates

Yield Curve Relationship between Yield and Maturity

Normal Yield Curve

Inverted Yield Curve

Humped Yield Curve

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Yield curve and the term structure of

interest rates Term structure

relationship betweeninterest rates (oryields) and maturities.

The yield curve is agraph of the termstructure.

A Treasury yield curvefrom October 2002can be viewed at theright.

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Hypothetical yield curve

An upward slopingyield curve.

Upward slope dueto an increase inexpected inflationand increasing

maturity riskpremium.

Years to

Maturity

Real risk-free rate

0

5

10

15

1 10 20

Interest

Rate (%)

Maturity risk premium

Inflation premium

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What is the relationship between the

Treasury yield curve and the yield curves for

corporate issues?

Corporate yield curves are higher than

that of Treasury securities, though not

necessarily parallel to the Treasurycurve.

The spread between corporate and

Treasury yield curves widens as thecorporate bond rating decreases.

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Illustrating the relationship between

corporate and Treasury yield curves

0

5

10

15

0 1 5 10 15 20

Years toMaturity

InterestRate (%)

5.2% 5.9%6.0%

Treasury

Yield Curve

BB-Rated

AAA-Rated

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Term Structure Theories

Pure Expectation Theory

Liquidity Preference Theory

Market Segmentation Theory

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Pure Expectations Hypothesis

The PEH contends that the shape of theyield curve depends on investors

expectations about future interest rates. If interest rates are expected to

increase, L-T rates will be higher thanS-T rates, and vice-versa. Thus, theyield curve can slope up, down, or evenbow.

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Assumptions of the PEH

Assumes that the maturity riskpremium for Treasury securities iszero.

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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An example:

Observed Treasury rates and the PEH

Maturity Yield1 year 6.0%2 years 6.2%

3 years 6.4%4 years 6.5%5 years 6.5%

If PEH holds, what does the market expect

will be the interest rate on one-yearsecurities, one year from now? Three-yearsecurities, two years from now?

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One-year forward rate

6.2% = (6.0% + x%) / 2

12.4% = 6.0% + x%

6.4% = x%

PEH says that one-year securities will yield 6.4%,one year from now.

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Three-year security, two years from

now

6.5% = [2(6.2%) + 3(x%) / 5

32.5% = 12.4% + 3(x%)

6.7% = x%

PEH says that one-year securities will yield 6.7%,one year from now.

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Conclusions about PEH

Some would argue that the MRP 0, andhence the PEH is incorrect.

Most evidence supports the general viewthat lenders prefer S-T securities, and viewL-T securities as riskier.

Thus, investors demand a MRP to getthem to hold L-T securities (i.e., MRP > 0).

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Other factors that influence interest rate

levels Federal reserve policy

Federal budget surplus or deficit

Level of business activity International factors

Trade deficit

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Risks associated with investing

overseas Exchange rate riskIf an

investment is denominated in acurrency other than U.S.

dollars, the investments valuewill depend on what happensto exchange rates.

Country riskArises from

investing or doing business in aparticular country and dependson the countrys economic,political, and socialenvironment.

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Income Tax

Individual Level Taxable Income

Progressive Tax

Marginal TaxAverage Tax

Tax on interest and dividends Income

Tax on Interest Paid Capital gains vs. Ordinary Income

Business vs. Personal Expense

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Corporate Income Tax

Tax in Interest and Dividend Income

Tax on Interest and Dividend Paid

Capital Gains

Capital loss carryback and carryover

Improper Accumulation

S Corporation

Depreciation