Transcript CHAPTER 4 The Financial Environment: Markets, Institutions

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CHAPTER 5
The 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
Physical assets vs. Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Public vs. Private
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MONEY VS. CAPITAL MARKETS
 FUNCTION OF TIME TO MATURITY – 1
YEAR OR LESS, MONEY MARKET
Lower risk, (not zero risk), Normally
higher initial investments
Includes Treasury bills, commercial
paper, many derivatives, Eurodollars,
Repos & Reverse Repos
 MORE THAN 1 YEAR – CAPITAL
MARKET
Higher risk, includes stocks, bonds,
some derivatives
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PRIMARY VS. SECONDARY MARKETS
 Primary Market – First time a security is
traded, issuer receives proceeds
Investment banker is the intermediary.
Includes Seasoned Offerings & IPO’s
 Secondary Market – Investor to investor
transfers, issuer no longer involved in
the process.
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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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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 cost of
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%.
k
= Any nominal rate.
kRF
= Rate on Treasury securities.
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krf= k* + IP
Here:
krf = rate of return on the riskfree security
k* = real risk-free rate.
IP = inflation premium.
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k = k* + IP + DRP + LP + MRP + ISP
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.
ISP = issue specific premium
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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, ISP
L-T corporate: IP, DRP, MRP, LP, ISP
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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
Interest
Rate (%)
Yield Curve
(January 2001)
6
1 yr
5 yr
10 yr
30 yr
5
4.8%
4.9%
5.2%
5.6%
4
Years to Maturity
0
10
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30
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Yield Curve Construction
Step 1:Find the average expected
inflation rate over Years 1 to n:
n
 INFL
IPn =
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t 1
n
t
.
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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 Returns of
Similar Risk Securities with
Different Maturities
MRP10 = 4.9-1.7=3.2%
4.9% = Return on 10 year
Treasuries
1.7% = Return on 3 month T-Bills
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Hypothetical Treasury Yield Curve
Interest
Rate (%)
15
Maturity risk premium
10
Inflation premium
1 yr
10 yr
20 yr
8.0%
11.4%
12.65%
5
Real risk-free rate
Years to Maturity
0
1
10
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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 necessarily 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
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
5
Treasury
6.0%
Yield Curve
5.9%
5.2%
0
0
1
5
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10
15
20
Years to
Maturity
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Billions of dollars
How does the volume of corporate
bond issues compare to that of
Treasury securities?
Gross U.S. Treasury Issuance (in blue)
Investment Grade Corporate Bond
Issuance (in red)
600
450
300
150
‘95
‘96
‘97
‘98
‘99
Recently, the volume of investment grade corporate
bond issues has overtaken Treasury issues.
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The Pure Expectations Hypothesis
(PEH)
Shape of the yield curve depends
on 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
Maturity
1 year
2 years
3 years
4 years
5 years
Yield
6.0%
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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x%
6.0%
0
1
6.2%
2
3
4
5
(6.0% + x%)
6.2% =
2
12.4% = 6.0 + x%
6.4% = x%.
PEH tells us that one-year securities will
yield 6.4%, one year from now (x%).
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6.2%
0
1
x%
2
3
4
5
6.5%
[ 2(6.2%) + 3(x%) ]
6.5% =
5
32.5% = 12.4% + 3(x%)
20.1% = 3(x%)
6.7% = x%.
PEH tells us that three-year securities
will yield 6.7%, two years from now (x%).
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Other Theories on Term Structure
Some argue that the PEH isn’t correct,
because securities of different
maturities have different risk.
Liquidity Preference Theory: 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).
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Other Theories on Term Structure
Liquidity preference only explains an
upward sloping yield curve
Market Segmentation: Each maturity
of securities has its own market, I.e.,
short term, long term, intermediate
term. Supply and demand will
determine within each market what
interest rates are, not rate or inflation
expectations or a maturity risk
premium.
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What various types of risks arise when
investing overseas?
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.
Country risk: Arises from investing or
doing business in a particular country.
It depends on the country’s economic,
political, and social environment.
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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.
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Which countries are the least
and most risky?
Safest countries
Riskiest countries
1. Switzerland
141. Sudan
2. Germany
142. Liberia
3. Netherlands
143. Afghanistan
4. Luxembourg
144. Sierra Leone
5. France
145. North Korea
6. United States
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