Transcript Chapter 2 - The Financial Environment: Markets

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
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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
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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
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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
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Financial Intermediaries
The Gramm-Leach-Bliley Act blurred the
distinctions:
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




Commercial banks
Savings and loan associations
Credit unions
Pension funds
Life insurance companies
Mutual funds
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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
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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
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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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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
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D1
D1
D2
0
Dollars
0
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Dollars
“Real” versus “Nominal” Rates
k*
= real risk-free rate.
Typically 2% to 4%
T-bill for short term
T-bond for long term
k
= 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
Quoted Interest Rate = k
k = Risk-free interest rate + risk premium
k = kRF + RP
k = kRF + [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%)
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Determinants of
Market Interest Rates
Quoted Risk-Free Rate = k = kRF + DRP + LP + MRP
k
kRF
= Quoted or nominal rate
= 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
DRP
LP
MRP
=
=
=
=
Inflation premium
Default risk premium
Liquidity premium
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
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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
Interest Rate (%)
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Abnormal
Flat = horizontal
Term to
Maturity
12
3 months
1 year
10
5 years
8 10 years
20 years
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Interest Rate
1980
March March
July
1980
2000
16.0%
6.1%
14.0
6.1
13.5
6.2
12.8
6.1
July
2000
12.3
6.2
July
2003
0.9%
1.0
2.3
3.3
4.3
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July 2003
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Normal
2
0
1
5
10
Short Term Intermediate Term
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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 taxes).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% + 0.0% = 8.0%
10-Yr: kRF10 = 3% + 7.5% + 0.9% = 11.4%
20-Yr: kRF20 = 3% + 7.75% + 1.9% = 12.7%
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Yield Curve
Interest
Rate (%)
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Treasury
12.7% yield curve
11.4%
8.0%
10
5
0
0
1
5
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
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
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