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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 for physical assets
Markets for financial assets
Money versus capital markets
Primary versus secondary markets
Spot versus future markets
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Direct transfer
Through an investment banking house
Through a financial intermediary
Three Primary Ways Capital Is Transferred Between Savers and
Borrowers
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The Top 5 Banking Companiesin the World, 1999
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
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Organized Exchanges versusOver-the-Counter Market
Auction markets versus dealer markets (exchanges versus the OTC market)
NYSE versus Nasdaq system
Differences are narrowing
Nasdaq vs. true OTC
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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 costof money?
Production opportunities
Time 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, LP
LT 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
InterestRate (%)
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 even versus inflation; that is, 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% + 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
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
5
10
15
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
600
450
300
150
Gross U.S. Treasury Issuance (in blue)Investment Grade Corporate Bond
Issuance (in red)
Bil
lio
ns
of
do
llar
s
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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
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?
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
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0 1 2 5
6.0%
3 4
x%
6.2%
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
6.2%
3 4
x%
6.5%[ 2(6.2%) + 3(x%) ]
5
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 arisewhen 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 ExchangeRate Fluctuations
Changes in relative inflation will lead to changes in exchange rates.
An increase in country risk will also cause that country’s currency to fall.