Académique Documents
Professionnel Documents
Culture Documents
Saving/Investing or Borrowing/Lending Process 4 - 2 Aggregate Economic Sectors Government Sector Regulates and supervises where Congress has granted authority (Political Process). Also it participates in the activities of the 3 sectors below.
Financial Sector Collects savings from small units in the amounts, maturities, etc. , needed by the business sector. Also provides market liquidity to stimulate savings/investing/hedging
Fundamental Functions of The Financial Sector 4 - 3 1. Transfer savings to investors: distribution or allocation of financial resources.
4-4
Markets in general
Physical assets
Financial assets
Financial Market
Money Market
e x c h a n g e s
b r o k e r s
Consumer Credit
Com. Bks.
Commercial Paper
Euro $
S&L
Fin. CO.
COs.
COs.
Indiv. Invest.
4-6
Direct transfer
Investment banking house Financial intermediary
Financial Institutions
4-7
Investment Banks Commercial Banks Savings and Loans Associations Mutual Savings Banks Credit Unions Life Insurance COs. Mutual Funds Money Bond Stocks Derivatives Pension Funds (generally administered by commercial banks or life insurance companies)
Balance sheet of Commercial Bank v. a Manufacturing CO. 4-8 Commercial Bank Govt. Sec. DD Cash AR Inv. Manufacturing Firm Short Term Debt -----------------Long Term Debt
Loans TD
4 -CO. 9 Balance sheet of Insurance Company v. a Manufacturing Insurance Company Stocks Premiums Bonds ----------- -------------------Fixed NW = Equity Assets Other Debt Manufacturing Firm Cash AR Inv. Short Term Debt -----------------Long Term Debt
Mortgages
------------Fixed Assets
---------NW
4 - 10
4 - 11
What do we call the price, or cost, of debt capital? The interest rate
4 - 12
Production opportunities
Expected inflation
4 - 13
k*
= Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities.
k kRF
4 - 14
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.
4 - 15
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
4 - 16
Country risk: Arises from investing or doing 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 than the dollar, the investments value will depend on what happens to exchange rate.
4 - 17
1. Changes in relative inflation will lead to changes in exchange rates. 2. An increase in country risk will also cause that countrys currency to fall.
4 - 18
Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.
4 - 19
1 yr 5 yr 10 yr 30 yr
10
0 10 20
Years to Maturity
30
4 - 20
What are the 2 main factors that explain the shape of the yield curve?
4 - 21
1. Expectations 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.
4 - 22
MRP = 0.
4 - 23
An Example Assume that 1-year securities yield 6% today, and the market expects that 1year securities will yield 7% in 1 year, and that 1-year securities will yield 8% in 2 years. If the PEH is correct, the 2-year rate today should be 6.5% = (6% + 7%)/2. If the PEH is correct, the 3-year rate today should be 7% = (6% + 7% + 8%)/3.
4 - 24
2. Risk Some argue that the PEH isnt 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).
4 - 25
Example data:
4 - 26
IPn =
t=1
S INFLt
n .
4 - 27
4 - 28
4 - 29
Step 3: Add the IPs and MRPs to k*: kRFt = k* + IPt + MRPt . kRF = Quoted market interest rate 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% = 12.7%.
4 - 30
Yield Curves
Interest Rate (%)
15
10
5.7%
6.7%
6.8%
0 0 1 5 10 15 20
Years to maturity