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Financial MarketsFinancial Marketsand Interest Ratesand Interest Rates

2/02/092/02/09

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Learning Objectives

Operation of U.S. financial system.Operation of U.S. financial system. Financial securities.Financial securities. Function of financial intermediaries.Function of financial intermediaries. Financial markets.Financial markets. Securities traded in the money and capital Securities traded in the money and capital

markets.markets. Interest rates. How they are determined; Interest rates. How they are determined;

factors that influence them; impact on factors that influence them; impact on financial marketsfinancial markets

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The Financial System

The purpose of the financial system is to The purpose of the financial system is to bring together individuals, businesses, and bring together individuals, businesses, and government entities (economic units) that government entities (economic units) that generate and spend funds. (Haves and have generate and spend funds. (Haves and have not’s)not’s) Surplus economic units Surplus economic units have funds left over have funds left over

after spending all they need to. Examples?after spending all they need to. Examples? Deficit economic units Deficit economic units need to acquire need to acquire

additional funds to sustain their operations.additional funds to sustain their operations.

Examples?Examples?

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Surplus/Deficit Units

Surplus units includeSurplus units include::HouseholdsHouseholdsCorporate businessCorporate businessForeign InvestorsForeign Investors

Deficit units includeDeficit units include::Corporate BusinessCorporate BusinessUS GovernmentUS GovernmentState and Local GovernmentState and Local GovernmentCollege students College students

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The Financial System

To enable funds (money) to move through To enable funds (money) to move through the financial system, funds are exchanged the financial system, funds are exchanged for for securitiessecurities..

Securities are documents that represent the Securities are documents that represent the right to receive money in the future right to receive money in the future

Examples are bonds, shares of stock, CDs, Examples are bonds, shares of stock, CDs, notes and accounts receivable, etc.notes and accounts receivable, etc.

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Financial Intermediaries

Financial intermediariesFinancial intermediaries (See below) often help to (See below) often help to facilitate this process. I. E., matching buyers and facilitate this process. I. E., matching buyers and sellers of securitiessellers of securities

Investment bankersInvestment bankers facilitate sale of corporate facilitate sale of corporate securities to the general publicsecurities to the general public

BrokersBrokers facilitate transactions between investors facilitate transactions between investors

DealersDealers buy and sell securities for their own good buy and sell securities for their own good

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Financial Markets

Classified according to the characteristics of Classified according to the characteristics of participants and securities involved.participants and securities involved.

The The primary marketprimary market is where economic is where economic units sell units sell new securitiesnew securities to raise needed to raise needed funds. Could be an Initial Public Offering funds. Could be an Initial Public Offering (IPO) or issue of new shares of an existing (IPO) or issue of new shares of an existing publicly traded company.publicly traded company.

Link to Bloomberg about Financial markets

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Securities

Funds

PrimaryPrimaryMarketMarket

Financial Markets

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Financial Markets

The The secondary marketsecondary market is where investors is where investors trade previously issued securities trade previously issued securities with each with each otherother. For example, when . For example, when youyou want to buy want to buy or sell shares of stockor sell shares of stock

Link to the NYSE

Link to the NASDAQ

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Securities

Funds

SecondarySecondaryMarketMarket

Financial Markets

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Financial Markets

Securities

Securities$$

$$

Intermediaries such as mutual funds, banks andinsurance companies help to facilitate theflow of funds in the financial marketplace.

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Market Efficiency

Market efficiency refers to the ease, speed, Market efficiency refers to the ease, speed, and cost of trading securities. (Axiom 6)and cost of trading securities. (Axiom 6) The The marketmarket for the securities of large for the securities of large

companies is generally efficient: Trades companies is generally efficient: Trades can be executed in a matter of seconds can be executed in a matter of seconds and commissions are very low.and commissions are very low.

By contrast, the By contrast, the real estate marketreal estate market is not is not generally efficient: It can take months to generally efficient: It can take months to sell a house and the commission is 6% of sell a house and the commission is 6% of the price.the price.

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Market Efficiency

The more efficient the market, the easier it The more efficient the market, the easier it is to transfer idle funds to those parties that is to transfer idle funds to those parties that need the funds. need the funds.

If funds remain idle, this results in lower If funds remain idle, this results in lower growth for the economy and higher growth for the economy and higher unemployment and lower profits.unemployment and lower profits.

Investors can adjust their portfolios easily Investors can adjust their portfolios easily and at low cost as their needs and and at low cost as their needs and preferences change.preferences change.

Why is market efficiency important?Why is market efficiency important?

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Financial Markets Money MarketMoney Market

Trade short term (1 year or less) debt Trade short term (1 year or less) debt instruments (e.g. T-Bills, Commercial instruments (e.g. T-Bills, Commercial Paper, Corp CD’s, Gov’t Agencies, etc.)Paper, Corp CD’s, Gov’t Agencies, etc.)

Capital MarketCapital Market Trades long term securities (Bonds, Trades long term securities (Bonds,

Stocks)Stocks) NYSE, AMEX, over-the-counter NYSE, AMEX, over-the-counter

(NASDAQ and other OTC)(NASDAQ and other OTC)

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Money Market Securities (short term)Money Market Securities (short term) Highly liquid, low riskHighly liquid, low risk Treasury Treasury BillsBills (T-Bills) (T-Bills) Certificates of Deposit (CDs)Certificates of Deposit (CDs) Commercial PaperCommercial Paper EurodollarsEurodollars Banker’s AcceptancesBanker’s Acceptances

Securities in the Financial Market

• T-Bills:T-Bills: are short-term securities issued by the Federal government.

•After initial sale, they have an active secondary market.

•They are bought at a discount and at maturity the investor receives the full face value.

•Essentially no risk, so very low return

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Money Market Securities (short term)Money Market Securities (short term) Highly liquidHighly liquid, , low risklow risk Treasury Bills (T-Bills)Treasury Bills (T-Bills) Certificates of Deposit (CDs)Certificates of Deposit (CDs) Commercial Paper (Corp IOU’s)Commercial Paper (Corp IOU’s) Banker’s Acceptances (guarantee) (LOC)Banker’s Acceptances (guarantee) (LOC)

Securities in the Financial Market

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Securities in the Financial Market

Capital Market Securities – more than one yearCapital Market Securities – more than one year BondsBonds

•Bonds:Bonds: are “IOUs” issued by the borrower and sold to investors.

•The issuer promises to repay the face amount on the maturity date and to pay interest each year in the amount of the coupon rate times the face value ($1,000). This is fixed for life of Bond

Bond values can vary depending on the market rate of interest, so the rate of return on the bond can differ widely from the coupon rate.

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Securities in the Financial Market

BondsBondsTreasury BondsTreasury BondsMunicipal BondsMunicipal BondsCorporate BondsCorporate Bonds

• Treasury Treasury BondsBonds:: are issued by the federal government. Treasury Notes 1 to 10 years; Treasury Bonds 10 to 30 years

• Municipal Bonds:Municipal Bonds: are issued by state and local governments. Usually free of federal taxes

• Corporate Bonds:Corporate Bonds: are issued by corporations. More risky than Government or Municipal bonds, higher yield; bonds are rated for risk

Capital Market Securities (long term)Capital Market Securities (long term)

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Securities in the Financial Market

StockStock•Companies can also raise funds by selling shares of stock

•Advantages: No guaranteed payments (like interest) and no specified payback period – maturity date (like bonds)

•Two types: Common Stock and Preferred

Capital Market SecuritiesCapital Market Securities

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Securities in the Financial Market

StockStockCommon StockCommon Stock

• Common stockholders:Common stockholders: Individually, own a portion of the company and can vote on major company decisions.

•They receive a return on their investment in the form of dividends and/or appreciation in the value of the stock.

Capital Market SecuritiesCapital Market Securities

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Securities in the Financial Market

StockStockCommon StockCommon StockPreferred StockPreferred Stock

• Preferred stockholdersPreferred stockholders do not generally have voting rights, but have priority in receiving dividends and are paid dividends at a pre-set rate. Often they get paid dividends in arrears (later) if dividends are not paid for a while.

Capital Market SecuritiesCapital Market Securities

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Interest Rates

Real Rate of InterestReal Rate of Interest Expected InflationExpected Inflation Maturity RiskMaturity Risk Default RiskDefault Risk Liquidity RiskLiquidity Risk

Link to Financial Web

Nominal (Prevailing) Interest Rates, Nominal (Prevailing) Interest Rates, Determined by:Determined by:

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Interest Rates

Compensates for the lender’s lost Compensates for the lender’s lost opportunity to consume.opportunity to consume. The minimum rate I’m willing to accept The minimum rate I’m willing to accept

in this market (over and above inflation) in this market (over and above inflation) that convinces me to invest rather than that convinces me to invest rather than spend my money.spend my money.

The real rate of interest, by definition, The real rate of interest, by definition, would be risk free .would be risk free .

In this market, risk free can drive the real In this market, risk free can drive the real rate of interest to zero.rate of interest to zero.

Real Rate of InterestReal Rate of Interest

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Interest Rates Expected Inflation (Axiom 1)Expected Inflation (Axiom 1)

Inflation erodes the purchasing power of Inflation erodes the purchasing power of money.money.

Example: If you loan someone $1,000 and Example: If you loan someone $1,000 and they pay it back one year later with 10% they pay it back one year later with 10% interest, you will have $1,100. But if interest, you will have $1,100. But if prices have increased by 5%, then prices have increased by 5%, then something that would have cost $1,000 at something that would have cost $1,000 at the outset of the loan will now cost the outset of the loan will now cost $1,000(1.05) = $1,050.$1,000(1.05) = $1,050.

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Nominal Risk-Free Rate

The real rate of interest, plusThe real rate of interest, plus The inflation risk premiumThe inflation risk premium Example: The T-BillExample: The T-Bill

Current Yield: 2.125%Current Yield: 2.125%

So, if inflation rate is 1.80%, thenSo, if inflation rate is 1.80%, then

Real Rate of return is 2.125 – 1.80 or .325%Real Rate of return is 2.125 – 1.80 or .325%

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Interest Rates – other risks

Maturity RiskMaturity Risk If interest rates rise, lenders may find that their If interest rates rise, lenders may find that their

loans are earning rates that are lower than what loans are earning rates that are lower than what they could get on new loans.they could get on new loans.

The risk of this occurring is higher for longer The risk of this occurring is higher for longer maturity loans.maturity loans.

Lenders will demand a premium to cover this risk Lenders will demand a premium to cover this risk depending on if they think long term rates will go depending on if they think long term rates will go up or down.up or down.

10 years Treasury Note yielding 2.84% (0.7% 10 years Treasury Note yielding 2.84% (0.7% premium over T-Bill rate)premium over T-Bill rate)

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Interest Rates – Other risks

For most securities, there is some risk that For most securities, there is some risk that the borrower will not repay the interest the borrower will not repay the interest and/or principal on time, or at all.and/or principal on time, or at all.

The greater the chance of default, the The greater the chance of default, the greater the interest rate the investor greater the interest rate the investor demands and the issuer must pay. demands and the issuer must pay. (risk/return trade-off)(risk/return trade-off)

Example: Junk bonds have a high risk of Example: Junk bonds have a high risk of default and requires a high default risk default and requires a high default risk premium. Current yield 12.20%premium. Current yield 12.20%

Default RiskDefault Risk

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Interest Rates

Liquidity Risk PremiumLiquidity Risk Premium Investments that are easy to sell without Investments that are easy to sell without

losing value are more liquid.losing value are more liquid. Illiquid securities have a higher interest Illiquid securities have a higher interest

rate premium to compensate the lender rate premium to compensate the lender for the inconvenience of not being able to for the inconvenience of not being able to sell the bond easily.sell the bond easily.

Mortgage backed securities became Mortgage backed securities became illiquid! Cause of market collapse!illiquid! Cause of market collapse!

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kk == the nominal, or observed the nominal, or observed rate rate on securityon security

k*k* == real rate of interestreal rate of interestIRPIRP == Inflation Risk PremiumInflation Risk PremiumMPMP == Maturity Premium (for Maturity Premium (for

Bonds)Bonds)DRP = Default Risk Premium (Corps)DRP = Default Risk Premium (Corps)LPLP == Liquidity Premium Liquidity Premium

k = k* + IRP + MP + DRP + LPk = k* + IRP + MP + DRP + LP

Determination of Rates

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Determination of Interest Rate If the Real Rate of return is 0.325% and Inflation If the Real Rate of return is 0.325% and Inflation

is 1.80%, then the risk free rate would be 2.125%, is 1.80%, then the risk free rate would be 2.125%, i.e. a T-Billi.e. a T-Bill

Add a Maturity risk premium of, say 0.72% and Add a Maturity risk premium of, say 0.72% and you would have a Government long-term security you would have a Government long-term security rate of 2.84%rate of 2.84%

Add a Default risk premium 3.74% and you would Add a Default risk premium 3.74% and you would have a Corporate Bond rate of 6.58%have a Corporate Bond rate of 6.58%

Add an additional 5.62 to for junk bond risk and Add an additional 5.62 to for junk bond risk and you would have a rate of 12.20%you would have a rate of 12.20%

If the bond is not liquid, you might add another If the bond is not liquid, you might add another few 10ths of a % premium for liquidity.few 10ths of a % premium for liquidity.

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Interest Rates

Term StructureTerm Structure Relationship between long and short Relationship between long and short

term interest rates. Which direction rates term interest rates. Which direction rates are expected to go in the future.are expected to go in the future.

Yield curves followYield curves follow Compare to current yield curveCompare to current yield curve

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8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities

Treasury Yield CurveTreasury Yield Curve

Jan 10, 2000

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8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities

Treasury Yield CurveTreasury Yield Curve

Jan 10, 2000

March 22,1995

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Term Structure of Interest Rates

YIELD COMPARISONS2/04/08 9/05/08 1/30/09

T-Bill 1.75 3.25 0.0

Treasury 10 yr 3.60 3.65 2.84

Corporate DJ 5.28 5.91 6.58

High-yield Corporate 8.92 9.94 12.20