chapter 5 the financial environment: markets, institutions, and interest rates

5 - 1

Copyright © 2001 by Harcourt, Inc. All rights reserved.

CHAPTER 5The Financial Environment:

Markets, Institutions,and Interest Rates

Financial markets

Types of financial institutions

Determinants of interest rates

Yield curves

5 - 2


The Role of the Financial SystemTwo general categories:

Those with excess cash (“savers”)

• Normally households, but can be others

Those with needs for cash (“borrowers”)

• Normally companies & governments, but can be others

The financial system includes a series of institutions that:aggregate funds

find counterparties for various transactions

In general, connect savers w/ borrowers

5 - 3


Define These Markets

Markets in general

Physical assets

Financial assets

Money vs. Capital

Primary vs. Secondary

Spot vs. Future

5 - 4


Money Vs. Capital Markets

Money MarketsShort term (< 1 yr.)

Debt

Low Risk, Low Return

InstrumentsTreasury Bills

Commercial Paper

Capital Markets - everything elseVarious maturities

Debt or Equity

Various risks, returns

InstrumentsStocks

Bonds

5 - 5


Primary vs. Secondary Markets

Primary

New instruments

New Bonds

Initial Stocks (IPOs, SEOs)

Cash Flow goes from investor to company

Secondary

“Used” instruments

Existing Bonds

Existing Stocks

Cash flow goes from investor to investor.

5 - 6


Direct transfer

Investment banking house

Financial intermediary

Three Primary Ways Capital Is Transferred Between Savers and

Borrowers

5 - 7


What’s an Investment Banker and what do they do???

Not really investors or bankers, per se

They consult and assist with primary market transactions - what they do:Advise companies on issuances

File with S.E.C.

Establish pricing & distribution

Make lots of money (Great job, but VERY high pressure!)

5 - 8


Financial Intermediaries

Play the largest role in the economy

Include:

Commercial banks

Credit unions

Life insurance companies

Pension funds

Mutual funds

5 - 9


Bank Name Country Total assets

Deutsche Bank AG Germany $735 billion

UBS Group Switzerland $687 billion

Citigroup United States $669 billion

Bank of America United States $618 billion

Bank of Tokyo Japan $580 billion

The Top 5 Banking Companiesin the World, 1999

5 - 10


Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets

Auction market vs. Dealer market (Exchanges vs. OTC)

NYSE vs. Nasdaq system

Differences are narrowing

5 - 11


Costs of Financing

Companies need money to operate, but this financing always comes at a cost

For bonds (i.e., debt):

Primary cost = stated interest rate

Add’l cost = loss of flexibility

• Must disgorge cash on a regular basis

• Many inhibitive bond covenants regarding levels of various financial ratios that must be maintained

5 - 12


Costs of Financing (cont.) For stocks (i.e., equity):

No explicit payments required

So, greater flexibility for company

BUT – investors expect co. to perform and the value of their shares, or they will sell off

And Stocks are riskier than bonds

need to earn more for S/H than for B/H to keep them happy

How much more? To be discussed later …

5 - 13


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= +

5 - 14


Cost of Debt

We will have more to say about the cost of equity later (a lot more, in fact)

but first, more about interest rates

Interest rates = one of the most important measures and determinants of financial activity

Interest rate = “rent on borrowed money”

5 - 15


What four factors affect the cost of money?

Production opportunities

Time preferences for consumption

Risk

Expected inflation

5 - 16


Additional Factors

Federal Reserve policy

At least in short term

Federal government deficits

International factors

E.g., Japanese purchases of U.S. debt

Business activity

Interest rates as economy heats up

5 - 17


“Real” Versus “Nominal” Rates

k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%.

= Any nominal rate.

= Rate on Treasury securities.

k

kRF

5 - 18


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.

5 - 19


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

5 - 20


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.

5 - 21


Treasury Yield Curve

0

5

10

15

10 20 30

Years to Maturity

InterestRate (%)

1 yr 5.2% 5 yr 5.8%10 yr 5.9%30 yr 6.0%

Yield Curve(August 1999)

5 - 22


Normal/Abnormal Yield Curve

Most frequent:

“normal” or upward sloping curve.

Current:

relatively flat

More unique:

downward sloping (1981-1983)

also seen last year

5 - 23


Yield Curve Construction

Step 1:Find the average expected

inflation rate over Years 1 to n:

IPn = .

n

1ttINFL

n

5 - 24


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).

5 - 25


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%.

5 - 26


Step 3: Add the IPs and MRPs to k*:

kRFt = k* + IPt + MRPt .

kRF = Quoted market interestrate 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%.

5 - 27


Hypothetical Treasury Yield Curve

0

5

10

15

1 10 20

Years to Maturity

InterestRate (%) 1 yr 8.0%

10 yr 11.4%20 yr 12.65%

Real risk-free rate

Inflation premium

Maturity risk premium

5 - 28


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.

5 - 29


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 neces-sarily parallel to the Treasury curve.

The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.

5 - 30


Hypothetical Treasury and Corporate Yield Curves

0

5

10

15

0 1 5 10 15 20

Years tomaturity

Interest Rate (%)

5.2%5.9%

6.0%Treasuryyield curve

BB-Rated

AAA-Rated

5 - 31


How does the volume of corporate bond issues compare to that of

Treasury securities?

Recently, the volume of investment grade corporate bond issues has overtaken Treasury issues.

‘95 ‘96 ‘97 ‘98 ‘99

600

450

300

150

Gross U.S. Treasury Issuance (in blue)Investment Grade Corporate Bond

Issuance (in red)

Bil

lio

ns

of

do

llar

s

5 - 32


The Pure Expectations Hypothesis (PEH)

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.

5 - 33


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.

5 - 34


Observed Treasury Rates

Maturity1 year2 years3 years4 years5 years

Yield6.0%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?

5 - 35


0 1 2 5

6.0%

3 4

x%

6.2%

PEH tells us that one-year securities will yield 6.4%, one year from now (x%).

6.2% =

12.4% = 6.0 + x%

6.4% = x%.

(6.0% + x%)2

5 - 36


0 1 2 5

6.2%

3 4

x%

6.5%[ 2(6.2%) + 3(x%) ]

5

PEH tells us that three-year securities will yield 6.7%, two years from now (x%).

6.5% =

32.5% = 12.4% + 3(x%)

20.1% = 3(x%)

6.7% = x%.

5 - 37


Some argue that the PEH isn’t correct, because securities of different maturities have different risk.

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).

Conclusions about PEH

5 - 38


What various types of risks arise when investing overseas?

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.

5 - 39


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.

chapter 5 the financial environment: markets, institutions, and interest rates

Documents