Financial market and Institutions

Jahid Hasan| ID-46 | MBA-63D | Lecture-5| Date: 25/08/2022

Credit rating is a useful tool for assessing default risk. A company's credit rating is mentioned at the
outset of its annual report and is indicated by letters such as AAA, AA, A, BB, and B. Companies rated
AAA have the lowest default risk. The rates go from AA to A to BB and so forth as the risk increases. The
risk of being unable to convert one asset into another is referred to as the liquidity risk. The most liquid
assets can be converted with ease, whereas the least liquid ones can be challenging. For instance, an
automobile has greater liquidity than a plot of land. There is an inverse link between liquidity and risk
because the most difficult assets to convert are also the least liquid. Investors demand higher returns
from less liquid financial assets because of this.

Investors are more interested in financial assets with little or no tax burdens, if the tax status is anything
to go by. The after-tax yield is what investors are most interested in as that is what they will actually
receive.

The relationship between annualized interest rate and term to maturity at a certain point in time is
displayed by term structure of interest rate. The Yield Curve is a graph that illustrates this relationship.
The yield curve's x-axis and y-axis are the time to maturity and the interest rate, respectively.

Yield curve can predict an upcoming recession to some extent.

Investors choose to purchase short-term securities for greater liquidity when there is a sudden
expectation of an increase in interest rates so they can easily get their money back quickly and reinvest
when the interest rate increases. As a result, the short-term market experiences an increase in the flow
or supply of funds, and the supply curve S1 swings right to S2. Instead, to avoid having to pay a higher
interest rate later, corporate finance managers of diverse organizations will prefer to acquire funds as
long-term securities. As a result, their demand for short-term funds declines and the demand curve
shifts to the left, which causes the interest rate on the short-term securities market to decline.

When we look at the long-term security market, the fund flow in the long-term market declines and the
supply curve changes to the left because investors are investing in the short-term market. On the other
side, demand will rise since financial managers want individuals to invest in long-term funds. The long-
term market's interest rate will therefore increase as a result. As a result, the yield curve will generally
be upward-sloping.

A downward sloping yield curve will be visible in the opposite scenario, which is when there is a
possibility that interest rates may decline in the future.

Interest rate structure can be explained by one of three ideas:

1. Pure Expectations Theory

2. Liquidity Preference/Premium Theory

3. Segmented Market Theory