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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
Define These Markets
Markets in general
Physical assets
Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Future
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Direct transfer
Investment banking house
Financial intermediary
Three Primary Ways Capital Is Transferred Between Savers and
Borrowers
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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
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Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets
Auction market vs. Dealer market (Exchanges vs. OTC)
NYSE vs. Nasdaq system
Differences are narrowing
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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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.
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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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.
Risk
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
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Copyright © 2001 by Harcourt, Inc. All rights reserved.
Interest Rates as a Function of Supply and Demand for Funds
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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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
What four factors affect the cost of money?
Production opportunities
Time preferences for consumption
Risk
Expected inflation
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Copyright © 2001 by Harcourt, Inc. All rights reserved.
“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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
Treasury Yield Curve
0
5
10
15
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
Yield Curve Construction
Step 1:Find the average expected
inflation rate over Years 1 to n:
IPn = .
n
1ttINFL
n
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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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
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
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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Copyright © 2001 by Harcourt, Inc. All rights reserved.
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 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.