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Chapter 2

The Financial
Environment
Markets
Institutions
Interest Rates
2005 Thomson/South-Western

The Financial Markets


Debt versus equity markets
Debt markets = loans
Equity markets = stocks

Money versus capital markets


Money market = debt < 1 year
Capital market = debt > 1 year + stocks

Primary versus secondary markets


Primary markets = new funds
Secondary markets = outstanding securities

The Financial Markets


Public versus private markets
Public markets = liquid, low-cost standardized
trades
Private markets = specialized deals

Spot versus futures markets


Spot markets = assets traded on the spot
Futures markets = for delivery at a later date

World, national, regional, and local


markets
Worldwide = New York Stock Exchange
Local = Chicago Stock Exchange

Financial Institutions
Funds are transferred between those who have
funds and those who need funds by three
Direct transfers
processes:
No intermediaries
Often part of private market transactions

Investment banking houses


I-Bank = middleman
I-Bank may buy in hopes of selling, so there is some risk

Financial intermediaries
Banks or mutual funds
Savers invest in one type of product (e.g., CDs or savings
accounts)
Bank then creates loans, mortgages, etc. to sell to borrowers

Financial Intermediaries
1993 Glass-Steagall Act
Prohibited commercial banks from I-banking activities
Tried to prohibit conflict of interest situations
Result: Morgan Bank
JP Morgan Chase & Company = commercial bank
Morgan Stanley = investment bank

1999 Gramm-Leach-Bliley Act


Expanded the powers of banks
Abolished major restrictions of the Glass-Steagall Act
Allows banks to do:
I-banking
insurance sales and underwriting
low risk non-financial activities

Financial Intermediaries
The Gramm-Leach-Bliley Act blurred the
distinctions:

Commercial banks
Savings and loan associations
Credit unions
Pension funds
Life insurance companies
Mutual funds

Stock Markets
Old classification
Organized Security Exchanges
NYSE, AMEX, and regional

OTC (over-the-counter markets)


A broader network of smaller dealers

New classification
Physical stock exchanges
NYSE, AMEX

Organized Investment Networks


OTC, Nasdaq, electronic communication networks (ECN)

Physical Stock
Exchanges
A physical, material entity
A building
Designated members
A board of governors

Seats are bought and sold


Record high price = $4M (12/1/05)
Price in 1999 = $2M

Auction markets
Sell orders and buy orders come together

Organized Investment
Networks
For securities not traded on physical stock
exchanges
An intangible trading system
A network of brokers and dealers (NASD)
Dealers make the market
The bid price = what the dealer will pay to buy
The ask price = what the dealer will take to sell
Spread = the dealers profit

Electronic communications networks

The Cost of Money


Four factors that affect the cost of
money
Production opportunities
Is it worth investing in new assets?

Time preferences for consumption


Now or later?

Risk
How likely is it that this investment wont pan
out?

Expected inflation
How much will prices increase over time?

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The Cost of Money


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?
Return on Equity =Dividends + Capital Gains

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Interest Rate Levels


Interest Rates as a Function of Supply and
Demand
Market A: Low-Risk Securities
Interest Rate, kA
%

Market B:High-Risk Securities


Interest Rate, kB
%
S1

S1
kB = 12
kA = 10
8
D1

D1

D2

Dollars

12
Dollars

Real versus Nominal


Rates
k*

= real risk-free rate.


Typically 2% to 4%
Tbillforshortterm
Tbondforlongterm

any nominal rate = quoted rate

kRF

Risk-free rate on T-securities

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The Determinants of
Market Interest Rates
k=
k*
IP
DRP
LP
MRP

Quoted or nominal rate


= Real risk-free rate (k-star)
= Inflation premium
= Default risk premium
= Liquidity premium
= Maturity risk premium

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The Determinants of
Market Interest Rates
QuotedInterestRate=k
k=Riskfreeinterestrate+riskpremium
k=kRF+RP
k=kRF+[DRP+LP+MRP]
k=[k*+IP]+[DRP+LP+MRP]

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The Determinants of
Market Interest Rates
NominalInterestRate=k=[k*+IP]+[DRP+LP+MRP]
IP = average rate of inflation expected in future
DRP = risk that a borrower will default on a loan (difference
between the T-bond interest rate and a corporate bond with
same features)
LP = premium if asset cannot be converted to cash quickly
and at close to the original cost (2 5%)
MRP = the interest rate risk associated with longer maturity
periods (usually 1 2%)

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Determinants of
Market Interest Rates
Quoted Risk-Free Rate = k = kRF + DRP + LP +
MRP

k
= Quoted or nominal rate
kRF = Real risk-free rate plus a
premium for expected inflation
or kRF = k* + IP
DRP= Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium

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Premiums Added to k* for


Different Types of Debt
IP
= Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk
premium

Short-Term (S-T) Treasury: only IP for S-T


inflation
Long-Term (L-T) Treasury:
IP for L-T inflation plus MRP

Short-Term corporate: Short-Term IP, DRP, LP


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Long-Term corporate: IP, DRP, MRP, LP

The Term Structure of


Interest Rates
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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U.S. Treasury Bond Interest


Rates on Different Dates
Abnormal

Flat=horizontal

Interest Rate
(%)16

Interest Rate
Term to
MarchMarch
July
1980
Maturity 1980
2000
12
3 months 16.0%
6.1%
1 year
14.0
6.1
10
5 years
13.5
6.2
10 years
12.8
6.1
8
July
2000
20 years
12.3
6.2
14

July
2003
0.9%
1.0
2.3
3.3
4.3

July 2003

Normal

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Short Term Intermediate Term

20
Long Term

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Three Explanations for the


Shape of the Yield Curve
Liquidity Preference Theory
Expectations Theory
Market Segmentation Theory

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Liquidity Preference
Theory
Lenders prefer to make short-term loans
Less interest-rate risk
More liquid

Lenders lend short-term funds at lower


rates
Says MRP > 0
Results in normal curve

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Expectations Theory
Shape of curve depends on investors
expectations about future inflation rates.
If inflation is expected to increase, S-T
rates will be low, L-T rates high, and vice
versa.
The yield curve can slope up OR down.

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Calculating Interest Rates


under Expectations Theory
Step 1: Find the Inflation Premium,
the average expected inflation
rate over years 1 to N

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Example:
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)

IP1
IP10
IP20

= 5%/ 1.0 = 5.00%


= [ 5 + 6 + 8(8)] / 10 = 7.5%
= [ 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 25

Calculating Interest Rates


under Expectations Theory:
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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Calculating Interest Rates


under Expectations Theory:
Step 3: Add the IPs and MRPs to k*:
kRFt = k* + IPt + MRPt
kRF = Quoted market interest rate
on treasury securities.
Assume k* = 3%.
1-Yr: kRF1 = 3% + 5.0%
10-Yr: kRF10 = 3% + 7.5%
20-Yr: kRF20 = 3% + 7.75%

+ 0.0% = 8.0%
+ 0.9% = 11.4%
+
1.9% = 12.7%
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Yield Curve
Interest
Rate (%)
15

Treasury
12.7% yield curve

11.4%

10

8.0%

5
0
0

10

15

20

Years to
maturity

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Market Segmentation
Theory
Borrowers and lenders have preferred
maturities
Slope of yield curve depends on supply
and demand for funds in both the L-T
and S-T markets
Curve could be flat, upward, or
downward sloping

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Other Factors that


Influence
Interest Rate Levels

Federal Reserve Policy

Controls money supply; impacts S-T interest rates

Federal Deficits
Larger federal deficits mean higher interest rates

Foreign Trade Balance


Larger trade deficits mean higher interest rates

Business Activity
Does the Federal Reserve need to stimulate activity?

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Interest Rate Levels


and Stock Prices
The higher the rate of interest, the lower a firms
profits
Interest rates affect the level of economic activity . .
. which affects corporate profits
If interest rates rise . . .
Investors turn to the bond market, sell stock, and
decrease stock prices
If interest rates decline . . .
Investors turn to the stock market, sell bonds, and
increase stock prices

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For Next Class:


Chapter 2 Homework problems
Review Chapters 1 and 2
Prepare for Chapter 1-2 quiz
Read Chapter 3

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