5 - 1 Copyright © 2002 by Harcourt, Inc. All rights reserved. CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates Financial.

5 - 1

Copyright © 2002 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


Define these markets

Markets in general

Markets for physical assets

Markets for financial assets

Money versus capital markets

Primary versus secondary markets

Spot versus future markets

5 - 3


Direct transfer

Through an investment banking house

Through a financial intermediary

Three Primary Ways Capital Is Transferred Between Savers and

Borrowers

5 - 4


The Top 5 Banking Companiesin the World, 1999

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

5 - 5


Organized Exchanges versusOver-the-Counter Market

Auction markets versus dealer markets (exchanges versus the OTC market)

NYSE versus Nasdaq system

Differences are narrowing

Nasdaq vs. true OTC

5 - 6


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 - 7


What four factors affect the costof money?

Production opportunities

Time preferences for consumption

Risk

Expected inflation

5 - 8


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 - 9


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 - 10


Premiums Added to k* for Different Types of Debt

ST Treasury: only IP for ST inflation

LT Treasury: IP for LT inflation, MRP

ST corporate: ST IP, DRP, LP

LT corporate: IP, DRP, MRP, LP

5 - 11


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 - 12


Treasury Yield Curve

0

5

10

15

10 20 30

Years to Maturity

InterestRate (%)

1 yr 6.3% 5 yr 6.7%10 yr 6.5%30 yr 6.2%

Yield Curve(May 2000)

5 - 13


Yield Curve Construction

Step 1: Find the average expected inflation rate over years 1 to n:

n

INFLt

t = 1

nIPn = .

5 - 14


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 versus inflation; that is, these IPs would permit you to earn k* (before taxes).

5 - 15


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 - 16


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% + 5% + 0.0% = 8.0%.kRF10 = 3% + 7.5% + 0.9% = 11.4%.kRF20 = 3% + 7.75% + 1.9% = 12.65%.

5 - 17


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 - 18


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 - 19


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 - 20


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 - 21


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 - 22


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 - 23


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 - 24


Observed Treasury Rates

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?

Maturity Yield

1 year 6.0%

2 years 6.2%

3 years 6.4%

4 years 6.5%

5 years 6.5%

5 - 25


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 - 26


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 - 27


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 - 28


What various types of risks arisewhen 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 - 29


Two Factors Lead to ExchangeRate Fluctuations

Changes in relative inflation will lead to changes in exchange rates.

An increase in country risk will also cause that country’s currency to fall.

5 - 1 Copyright © 2002 by Harcourt, Inc. All rights reserved. CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates Financial.

Documents

treasury curve

lp slide

rf slide

markets markets

constructed yield curve

corporate yield curves

yield curve construction

true otc slide