Transcript Document
Corporate Finance
Lecture 2
Selcuk Caner
Bilkent University
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1
Chapter 5 Outline
Financial markets
Types of financial institutions
Interest Rates and Determinants of
interest rates
Yield curves
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Financial Markets
Markets in general
Physical assets (commodities, real
estate)
Financial assets
Money (short term) vs. Capital
(medium and long term)
Primary vs. Secondary
Spot vs. Future
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Intermediation between Savers
and Creditors
Direct transfer (direct sale to investors,
no financial intermediaries)
Investment banking house
(underwriters)
Financial intermediary (banks or mutual
funds)
–
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Types of banking systems (Anglo American,
German, Japanese)
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OTC and Exchanges
Auction market vs. Dealer market
(Exchanges vs. OTC)
NYSE vs. Nasdaq system
ISE
Differences are narrowing
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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?
Required Dividend
Capital
=
+
return
yield
gain
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Cost of money is determined by demand for and
supply of funds
Cost (%)
Supply
Demand
Dollar
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Nominal Interest Rates
200
150
100
50
0
1993
1994 1995
1996
Turkey
Argentina
Russian Federation
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1997 1998
1999
2000 2001
U.S.
Germany
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Real Interest Rates
40.0%
20.0%
0.0%
-20.0%
1993 1994 1995 1996 1997 1998 1999 2000 2001
-40.0%
-60.0%
Turkey
U.S.
Argentina
Germany
Russian Federation
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Factors Affecting Cost of Money
Production opportunities
Available projects to make enough money.
Time preferences for consumption
Time preference for consumption is high when
population is poor. Savings would be low,
interest rates high, capital formation low.
Risk
Expected inflation
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“Real”
Versus
“Nominal”
Rates
“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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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
(bonds).
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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
L-T corporate: IP, DRP, MRP, LP
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When interest rates rise, the value of the
bond falls.
Assume no default risk (DR=0)
Inflation rates
Year 1 Year 2
8%
5%
Year 3
Year 4
Year 5
4%
4%
4%
2-year T-bonds yield 10%.
5-year T-bonds yield 10%.
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What is the difference in the maturity risk
premiums of the two bonds?
Nominal rate= real interest rate+IP+MRP
Two-year bond
IP2 = (8+5)/2=6.5%
IP5=(8+5+4+4+4)/5=5%
For the two-year bond,
– 10%=3+6.5+MRP2
– MRP2=0.5%
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For the five-year bond,
– 10%=3+5+MRP5
– MRP5=2%
MRP5-MRP2=2%-0.5%=1.5%
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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 (%)
15
1 yr
5 yr
10 yr
30 yr
5.2%
5.8%
5.9%
6.0%
Yield Curve
(August 1999)
10
5
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
IPn =
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INFL
````
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 = 7.5%.
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).
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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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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 = 3.0% + 5.0% + 0.0% = 8.0%.
kRF10 = 3.0% + 7.5% + 0.9% = 11.4%.
kRF20 = 3.00% + 7.75% + 1.90% = 12.65%.
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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
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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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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
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5
10
15
20
Years to
maturity
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The Expectations Hypothesis (EH)
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.
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EH assumes that MRP = 0.
Long-term rates are an average of
current and future short-term rates.
If EH 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 EH 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%.
EH tells us that one-year securities will
yield 6.4%, one year from now (x%).
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6.2%
0
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%.
EH tells us that three-year securities will
yield 6.7%, two years from now (x%).
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x%
2
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Liquidity Preference Theory
– Long term bonds yield should always
be higher because they are less liquid.
Market Segmentation Theory
– There is a different market every
maturing bond.
– Slope of the yield curve depends on the
demand and supply conditions in the
long term and short term bonds.
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Types of risks when investing
internationally
Country risk: Arises from investing or doing
business in a particular country. It
depends on the country’s economic,
political, and social environment.
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.
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Some Examples
Nominal yield on a 2-year T-bond is 4.5%.
Nominal yield on a one-year T-bond is 3%.
Real risk-free interest rate is one percent.
According to EH, what is the interest rate
on a one year bond one year from now?
k1 =3% and k2 4.5%
k2= (k1+k1 in year 2)/2= 4.5%.
So, k1 in year two is 6%.
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What is the expected inflation rate in
year one and two?
In year one,
– 3%= 1% + IP1
– So, IP1= 2%
In year two,
– IP2= 5%
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Problem 5-11: Inflation at 3%. Real risk-free
interest rate = 2%. Inflation is expected to be
higher than 3%.
3-year T-bond yields 2 percentage points above 1year T-bond. What is the expected inflation rate
after year 1?
k1=2+3=5
k3= 5+2=7
k=2+(3+2x)/3
x=6%
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