CHAPTER 4 The Financial Environment: Markets,

Institutions, and Interest Rates

Financial markets Types of financial institutions Determinants of interest rates Yield curves
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What is a market?
A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

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Types of financial markets

Physical assets vs. Financial assets Debt vs. Equity Money vs. Capital Primary vs. Secondary

IPO

Spot vs. Futures Public vs. Private

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Major Market Instruments

Money Market US Treasury Bills Commercial paper Certificate of deposit (CDs) Money market mutual funds Eurodollar Deposit Capital Market US Treasury notes and Bonds Mortgage Corporate bonds Leases Preferred stocks Common Stocks Derivatives

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How is capital transferred between savers and borrowers?

Direct transfers Investment banking house Financial intermediaries

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Types of financial intermediaries

Commercial banks Pension funds Life insurance companies Mutual funds

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Physical location stock exchanges vs. Electronic dealer-based markets

Auction market vs. Dealer market

Inventory to minimize transaction cost Bid-Ask Spread

(Exchanges vs. OTC) Quantity driven vs price driven NYSE vs. Nasdaq

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The cost of money

The price, or cost, of debt capital is the interest rate. The price, or cost, of equity capital is the required return. The required return investors expect is composed of compensation in the form of dividends and capital gains.

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What four factors affect the cost of money?

Production opportunities Time preferences for consumption Risk Expected inflation

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Interest Rate levels

Interest Rate Levels

Function of Supply and Demand of Funds Transfer of capital between markets.

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Nominal vs. Real rates

k = represents any nominal rate

k* = represents the real risk-free rate of interest. Like a T-bill rate, if there was no inflation. kRF = represents the rate of interest on Treasury securities.
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Determinants of interest rates

k = k* + IP + DRP + LP + MRP k = required return on a debt security k* = real risk-free rate of interest IP = inflation premium DRP = default risk premium LP = liquidity premium MRP = maturity risk premium Interest rate risk Reinvestment rate risk
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Premiums added to k* for different types of debt

IP S-T Treasury L-T Treasury MRP DRP LP

S-T Corporate
L-T Corporate

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Term Structure of Interest Rates

Relationship between long term and short term rates Yield Curve
Relationship between Yield and Maturity

Normal Yield Curve Inverted Yield Curve Humped Yield Curve

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Yield curve and the term structure of interest rates

Term structure relationship between interest rates (or yields) and maturities. The yield curve is a graph of the term structure. A Treasury yield curve from October 2002 can be viewed at the right.

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Hypothetical yield curve

Interest Rate (%) 15

Maturity risk premium

10
Inflation premium

5
Real risk-free rate

An upward sloping yield curve. Upward slope due to an increase in expected inflation and increasing maturity risk premium.
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0 1 10

Years to 20 Maturity

What is the relationship between the Treasury yield curve and the yield curves for corporate issues?

Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve. The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.

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Illustrating the relationship between corporate and Treasury yield curves

Interest Rate (%)
15

BB-Rated
10

AAA-Rated 5.9% Treasury 6.0% Yield Curve

5.2%

0
0 1 5 10 15 20

Years to
Maturity
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Term Structure Theories

Pure Expectation Theory Liquidity Preference Theory Market Segmentation Theory

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Pure Expectations Hypothesis

The PEH contends that the shape of the yield curve depends on 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, down, or even bow.

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Assumptions of the PEH

Assumes that the maturity risk premium for Treasury securities is zero. 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.

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An example: Observed Treasury rates and the PEH

Maturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 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?
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One-year forward rate

6.2% = (6.0% + x%) / 2 12.4% = 6.0% + x% 6.4% = x% PEH says that one-year securities will yield 6.4%, one year from now.
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Three-year security, two years from now

6.5% = [2(6.2%) + 3(x%) / 5 32.5% = 12.4% + 3(x%) 6.7% = x% PEH says that one-year securities will yield 6.7%, one year from now.
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Conclusions about PEH

Some would argue that the MRP 0, and hence the PEH is incorrect. Most evidence supports the general view 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).

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Other factors that influence interest rate levels Federal reserve policy Federal budget surplus or deficit Level of business activity International factors
Trade deficit

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Risks associated with investing overseas

Exchange rate risk If an investment is denominated in a currency other than U.S. dollars, the investments value will depend on what happens to exchange rates. Country risk Arises from investing or doing business in a particular country and depends on the countrys economic, political, and social environment.
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Income Tax

Individual Level
Taxable Income Progressive Tax Marginal Tax Average Tax Tax on interest and dividends Income Tax on Interest Paid Capital gains vs. Ordinary Income Business vs. Personal Expense
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Corporate Income Tax

Tax in Interest and Dividend Income Tax on Interest and Dividend Paid Capital Gains Capital loss carryback and carryover Improper Accumulation S Corporation Depreciation

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