Transcript Chapter 2 - The Financial Environment: Markets
© 2005 Thomson/South-Western
Chapter 2 The Financial Environment
Markets Institutions Interest Rates
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 2
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 3
Financial Institutions
Funds are transferred between those who have funds and those who need funds by three processes: Direct transfers 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 4
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 5
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 6
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) 7
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 8
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 dealer’s profit Electronic communications networks 9
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 won’t 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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k A = 10 8
Interest Rate Levels
Interest Rates as a Function of Supply and Demand
Market A: Low-Risk Securities Interest Rate, k A % Market B:High-Risk Securities Interest Rate, k B % S 1 S 1 k B = 12 D 1 D 1 D 2 0 0 12 Dollars Dollars
“Real” versus “Nominal” Rates
k* k
= real risk-free rate.
Typically 2% to 4% T-bill for short term T-bond for long term = any nominal rate = quoted rate
k RF
= Risk-free rate on T-securities 13
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 14
The Determinants of Market Interest Rates
Quoted Interest Rate = k
k
= Risk-free interest rate + risk premium
k
= k RF + RP
k
= k RF + [DRP + LP + MRP]
k
= [k* + IP] + [DRP + LP + MRP]
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The Determinants of Market Interest Rates
Nominal Interest Rate = 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%) 16
Determinants of Market Interest Rates
Quoted Risk-Free Rate = k = k RF + DRP + LP + MRP
k = Quoted or nominal rate k RF LP = Real risk-free rate plus a premium for expected inflation or k RF = k* + IP DRP = Default risk premium = Liquidity premium MRP = Maturity risk premium 17
Premiums Added to k* for Different Types of Debt IP DRP = Default risk premium LP = Inflation premium = 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 Long-Term corporate: IP, DRP, MRP, LP 18
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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Abnormal Flat = horizontal
U.S. Treasury Bond Interest Rates on Different Dates
Interest Rate (%)
16 4 6 8 14 12 10
Term to Maturity 3 months 1 year 5 years 10 years 20 years March March 1980 1980 16.0% 14.0
13.5
12.8
12.3
2000 6.1% 6.1
6.2
6.1
July 2003 July 2003 0.9% 1.0
2.3
3.3
4.3
Normal
2 0 1 5 10
Short Term Intermediate Term Long Term
20 20
Three Explanations for the Shape of the Yield Curve
Liquidity Preference Theory Expectations Theory Market Segmentation Theory 21
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 22
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 24
Example:
Inflation for Year 1 is 5%.
Inflation for Year 2 is 6%.
Inflation for Year 3 and beyond is 8%.
k* = 3% MRP t = 0.1% (t-1) IP 1 IP 10 IP 20 = 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 taxes).
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Calculating Interest Rates under Expectations Theory:
MRP 1 MRP 10 MRP 20
Step 2: Find MRP based on this equation: MRP t = 0.1% (t - 1)
= 0.1% x 0 = 0.1% x 9 = 0.1% x 19 = 0.0% = 0.9% = 1.9%
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Calculating Interest Rates under Expectations Theory: Step 3: Add the IPs and MRPs to k*: k k RFt RF = k* + IP t + MRP t = Quoted market interest rate Assume k* = 3%.
1-Yr: k RF1 10-Yr: k RF10 20-Yr: k RF20 = 3% + 5.0% + 0.0% = 8.0% = 3% + 7.5% + 0.9% = 11.4%
Yield Curve
Interest Rate (%) 15 10 8.0% 11.4% 5 0 0 1 5 10 15 12.7% Treasury yield curve 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 29
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 firm’s 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 31
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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