FNA 8111: FINANCIAL INSTITUTIONS AND MARKETS

Lecture no. 2: Fundamentals of Financial Markets:

Interest Rates and Market Efficiency

Saed A. Sulub, PhD ACCA

Reference: Mishkin, Frederic S. & Eakins, Stanely G. (2018). Financial Markets and Institutions. 9th Edition, Pearson Education Ltd
Course E-Classroom

2
Recap: Previous Lecture
Lecture Preview
■ Measuring Interest Rates
■ The Distinction Between Real and Nominal
Interest Rates
■ The Distinction Between Interest Rates and Returns
■ Why Interest rates change?
■ Factors affecting the risk structure of interest rates
■ Efficient Market Hypothesis.
Present Value Introduction
■ Different debt instruments have very different streams
of cash payments to the holder known as cash flows
(CF).

■ All else being equal, debt instruments are evaluated

against one another based on the amount of each
cash flow and the timing of each cash flow.

■ This evaluation, where the analysis of the amount

and timing of a debt instrument’s cash flows lead to
its yield to maturity or interest rate, is called present
value analysis.
Present Value Introduction
▪ Present discounted value is based on the
commonsense notion that a dollar of cash flow paid
to you one year from now is worth less than a dollar
paid to you today.

▪ Why?
Present Value Concept: Simple Loan Terms

▪ Loan Principal: the amount of funds the lender

provides to the borrower.

▪ Maturity Date: the date the loan must be repaid; the

Loan Term is from initiation to maturity date.

▪ Interest Payment: the cash amount that the borrower

must pay the lender for the use of the loan principal.

▪ Simple Interest Rate: the percentage of principal that

must be paid as interest to the lender. Convention is
to express on an annual basis, irrespective of the
loan term.
 Present Value Applications
There are four basic types of credit instruments
which incorporate present value concepts:

1. Simple Loan

2. Fixed Payment Loan

3. Coupon Bond

4. Discount Bond
Present Value Concept: Simple Loan

▪ What is the PV of $1 received one year from

now?
 Present Value of Cash Flows: Example

▪ What is the PV of $250 to be paid in two years if

the interest rate is 15%?

CF
PV =
(1+ i)^t
 Yield to Maturity: Loans
■ Yield to maturity = interest rate that equates
today's value (today’s price) with present value of
all future payments.

1. Simple Loan Interest Rate (i = 10%)

Yield to Maturity: Loans
2. Fixed Payment Loan (i = 12%)
 Yield to Maturity: Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
 Relationship Between Price and Yield to Maturity

▪ Three interesting facts in this table:

1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price is below par
value
 Distinction Between Real and Nominal Interest Rates

■ Real interest rate

1. Interest rate that is adjusted for expected

changes in the price level
■ ir = i – π

1. Real interest rate more accurately reflects true

cost of borrowing

2. When the real rate is low, there are greater

incentives to borrow and less to lend
 Distinction Between Real and Nominal Interest Rates

▪ If i = 5% and π = 0% then

▪ If i = 10% and π = 20% then

U.S. Real and Nominal Interest Rates
 Distinction Between Interest Rates and Returns

▪ Rate of Return: we can decompose returns

into two pieces:

where = current yield, and

= capital gains.
Changes in Interest Rate: Determinants of Asset Demand

▪ An asset is a piece of property that is a store of

value. Facing the question of whether to buy and hold
an asset or whether to buy one asset rather than
another, an individual must consider the following
factors:

1. Wealth, the total resources owned by the individual,

including all assets
2. Expected return (the return expected over the next period)
on one asset relative to alternative assets
3. Risk (the degree of uncertainty associated with the return)
on one asset relative to alternative assets
4. Liquidity (the ease and speed with which an asset can be
turned into cash) relative to alternative assets
EXAMPLE 1: Expected Return
 EXAMPLE : Expected Return
Suppose you are trying to decide whether to purchase
Apple Computer Stock and you expect the following one
year returns depending on the effectiveness of
competition and the state of the economy:

Event (state of nature) Probability (Pi) Return (Ri)

iOS 5 head to head w droid, Normal Growth 50% 10%

iOS 5 kills droid, Strong Growth 25% 25%

iOS 5 head to head w droid, Recession 20% 0%
iOS 5 causes cancer 5% -50%

R e = p 1R 1 + … + p 4R 4

Thus Re = (.5)(0.10) + (.25)(0.25) + (.20)(0.0) + (.05)(-.5) =.0875 = 8.75%

EXAMPLE : Standard Deviation

Consider the following two companies and their

forecasted returns for the upcoming year:
EXAMPLE: Standard Deviation

▪ How risky is the FBN or FOTG?

▪ A common measure of risk for an individual

asset is the variance (or more typically the
standard deviation) of its return.

▪ The question is, of these two stocks, which is

riskier?
EXAMPLE: Standard Deviation
EXAMPLE: Standard Deviation
Defining Risk

For Symmetric
Distributions
▪ 2/3rds of all values lie
within 1 standard deviation
of the mean (expected
return)
▪ 95% of all values lie
within 2 standard deviations
of the mean
▪ A standard deviation is
the square root of the
variance.
Relative Risk
Relative Risk
 Determinants of Asset Demand
The quantity demanded of an asset differs by factor.
1. Wealth: Holding everything else constant, an increase in wealth
raises the quantity demanded of an asset

2. Expected return: An increase in an asset’s expected return

relative to that of an alternative asset, holding everything else
unchanged, raises the quantity demanded of the asset

3. Risk: Holding everything else constant, if an asset’s risk rises

relative to that of alternative assets, its quantity demanded
will fall

4. Liquidity: The more liquid an asset is relative to alternative

assets, holding everything else unchanged, the more desirable it
is, and the greater will be the quantity demanded
Determinants of Asset Demand
Derivation of Demand Curve
Summary of Shifts in the Demand for Bonds

1. Wealth: in a business cycle expansion with

growing wealth, the demand for bonds rises,
conversely, in a recession, when income and
wealth are falling, the demand for bonds falls

2. Expected returns: higher expected interest

rates in the future decrease the demand for
long-term bonds, conversely, lower expected
interest rates in the future increase the
demand for long-term bonds
 Summary of Shifts in the Demand for Bonds

3. Risk: an increase in the riskiness of bonds

causes the demand for bonds to fall,
conversely, an increase in the riskiness of
alternative assets (like stocks) causes the
demand for bonds to rise

4. Liquidity: increased liquidity of the bond

market results in an increased demand for
bonds, conversely, increased liquidity of
alternative asset markets (like the stock
market) lowers the demand for bonds
Determinants of Shifts in the Supply of Bonds

1. Expected Profitability of Investment

Opportunities: in a business cycle expansion, the
supply of bonds increases, conversely, in a
recession, when there are far fewer expected
profitable investment opportunities, the supply of
bonds falls

2. Expected Inflation: an increase in expected

inflation causes the supply of bonds to increase

3. Government Activities: higher government deficits

increase the supply of bonds, conversely,
government surpluses decrease the supply of bonds
Factors Affecting the Risk Structure of Interest Rates

Default Risk occurs when the issuer of the bond is

unable or unwilling to make interest payments when
promised.

■ Risk Premium
Credit Ratings
Factors Affecting the Risk Structure of Interest Rates

▪ Liquidity Risk A liquid asset is one that can be

quickly and cheaply converted into cash.

▪ The more liquid an asset is, the more desirable

it is (higher demand), holding everything else
constant.

■ Liquidity Premium
 Efficient Market Hypothesis

▪ Recall that the rate of return for any position is the

sum of the capital gains (Pt+1 – Pt) plus any cash
payments (C):

▪ At the start of a period, the unknown element is

the future price: Pt+1. But, investors do have some
expectation of that price, thus giving us an
expected rate of return.
Efficient Market Hypothesis
■ The Efficient Market Hypothesis views the
expectations as equal to optimal forecasts
using all available information. This implies:

Assuming the market is in equilibrium:

Re = R*

Put these ideas together: efficient market

hypothesis
Rof = R*
Efficient Market Hypothesis

▪ Efficient Market

▪ Semi-efficient Markets

▪ Inefficient Markets
We Covered…

■ Yield to maturity as a measure of Interest Rates

■ The Difference Between Real and Nominal Interest
Rates
■ The Difference Between Interest Rates and Returns
■ Changes in interest rates
■ How default risk and liquidity risk affects interest rates
■ When markets efficient?