• Financial markets• Types of financial institutions• Determinants of interest rates• Yield curves

The Financial Environment:Markets, Institutions,and Interest

Rates

Define the following terms:Define the following terms:

• Financial vs. physical asset markets• Money vs. capital markets• Primary vs. secondary markets

Financial (Asset) Markets- the markets where financial assets are traded.

Physical Asset Markets- the markets where physical (real) assets are traded.

Financial VS Physical asset MarketsFinancial VS Physical asset Markets

Money Markets-The financial markets in which funds are borrowed or loaned for short periods (< or = 1 year).

Capital Markets- The financial markets for stocks and long-term debt (>1 year).

Money VS Capital MarketsMoney VS Capital Markets

Primary VS Secondary MarketsPrimary VS Secondary Markets

Primary Markets-Markets in which corporations raise funds by issuing new securities

Secondary Markets- Markets in which securities and other financial assets are traded among investors after they have been issued by corporations and public agencies such as municipalities.

Three Primary Ways Capital Is Three Primary Ways Capital Is Transferred Between Savers Transferred Between Savers

and Borrowersand Borrowers

• Direct transfer

• Investment banking house

• Financial intermediary

Commercial Banks Life insurance company

Mutual funds Financial company

Major Financial IntermediariesMajor Financial Intermediaries

Stock MarketStock Market

• NYSE

• Stock Exchange of Thailand

• What do we call the price, or cost, of debt capital?

The interest rateThe interest rate

• What do we call the price, or cost, of equity capital?

Required Dividend Capital return yield gain= + .

What four factors affect the What four factors affect the cost of money?cost of money?

• Production opportunities - Economic situation

• Time preferences for consumption • Risk - High risk, high cost

• Expected inflation - high inflation,high cost

“Real” Versus “Nominal” Rates

k* = Real risk-free rate. T-bill rate if no inflation; 1% to 4%.

= Any nominal rate.

= Rate on Treasury securities.

k

kRF

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.

Premiums Added to k* for Premiums Added to k* for Different Types of DebtDifferent 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

What is the “term structure of interest What is the “term structure of interest rates”? What is a “yield curve”?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.

InterestRate (%)

T-Bond Yield Curve

1 yr 6.1%5 yr 6.6%10 yr 7.0%20 yr 7.5%

Yield Curve(May 1999)

5

10

15

0 5 10 15 20

Years toMaturity

1-yr

k

Q

S

D

30-yr

k

Q

S

D

Yieldcurve

k

1 30

Maturity

Example data: • Inflation for Year 1 is 5%.• Inflation for Year 2 is 6%.• Inflation for Year 3 and beyond is 8%.

k* = 3%.

MRPt = 0.1%(t - 1).

Constructing the Yield Curve

Step 1: Find the average expected inflation rate over years 1 to n:

n

INFLt

t = 1

nIPn = .

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 vs. inflation; these IPs would permit you to earn k* (before taxes).

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%.

Step 3: Add the IPs and MRPs to k*:

kT = k* + IPt + MRPt.

kT = Quoted market interest rate on Treasury securities.

Assume k* = 3%:1-Yr: kT1

= 3% + 5% + 0.0% = 8.0%.

10-Yr: kT10= 3% + 7.5% + 0.9% = 11.4%.

20-Yr: kT20= 3% + 7.75% + 1.9% = 12.7%.

Yield Curve ExamplesYield Curve Examples

Years tomaturity

Interest Rate (%)

8.0%

11.4%12.7%

ContinentalAirlines (Junk)

Exxon (AAA)

Treasuryyield curve

5

10

15

0 1 5 10 15 20