The Financial Environment

Markets, Institutions, and Interest Rates

 

Financial markets Types of financial institutions Determinants of interest rates


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.

Types of financial markets

Physical assets vs. Financial assets
 

Physical markets deal with real assets such as wheats, automobiles, computers, etc. Financial assets deal with stocks, bonds, notes,derivatives securities, etc. Money markets are markets for short term, highly liquid debt securities. Capital markets are for intermediate or long term debt or corporate stocks. Primary markets are markets where corporations raise new capital. Secondary Market are markets where existing or outstanding securities are traded among investors. 4-3

Money vs. Capital
 

Primary vs. Secondary
 

Types of financial markets

Spot vs. Futures
 

Spot markets are markets where assets are bought or sold for ‘on the spot’ delivery. Futures markets are markets in which participants agree today to buy or sell an asset at some future date. Private markets are markets where transaction are between two parties. Public markets are markets where standardized contracts are traded on organized exchange.

Public vs. Private
 

How is capital transferred between savers and borrowers?
 

Direct transfers Investment banking house Financial intermediaries


Types of financial intermediaries
   

Commercial banks Savings and loan associations Pension funds Life insurance companies


Physical location stock exchanges vs. Electronic dealer-based markets

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


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.

What four factors affect the cost of money?

 

Production opportunities Time preferences for consumption Risk Expected inflation


Interest Rates & Required Returns
 

The interest rate or required return represents the price of money. Interest rates act as a regulating device that controls the flow of money between suppliers and demanders of funds. The central bank, BNM, regularly asses economic conditions and, when necessary, initiate actions to change interest rates to control inflation and economic growth. 4-10

Interest Rates & Required Returns: Interest Rate Fundamentals

Interest rates represent the compensation that a demander of funds must pay a supplier. When funds are lent, the cost of borrowing is the interest rate. When funds are raised by issuing stocks or bonds, the cost the company must pay is called the required return, which reflects the suppliers expected level 4-11 of

Interest Rates & Required Returns: The Real Rate of Interest

The real interest rate is the rate that creates an equilibrium between the supply of savings and the demand for investment funds in a perfect world. In this context, a perfect world is one in which there is no inflation, where suppliers and demanders have no liquidity preference, and where all outcomes are certain. The supply-demand relationship that determines the real rate is shown in Figure 4-12 6.1 on the following slide.

Interest Rates & Required Returns: The Real Rate of Interest (cont.)


Interest Rates & Required Returns: Inflation and the Cost of Money

Ignoring risk factors, the cost of funds is closely tied to inflationary expectations. The risk-free rate of interest, RF, which is typically measured by a 3-month Treasury bill (T-bill) compensates investors only for the real rate of return and for the expected rate of inflation. The relationship between the annual rate of inflation and the return on T-bills is shown on the following slide.

Interest Rates & Required Returns: Inflation and the Cost of Money (cont.)


Interest Rates & Required Returns: Nominal or Actual Rate of Interest (Return)

The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by the demander. The nominal rate differs from the real rate of interest, k* as a result of two factors:

Inflationary expectations reflected in an inflation premium (IP), and Issuer and issue characteristics such as default risks and contractual provisions as reflected in a risk premium (RP).

Interest Rates & Required Returns: Nominal or Actual Rate of Interest (Return) (cont.)

Using this notation, the nominal rate of interest for security 1, k1 is given in equation 6.1, and is further defined in equations 6.2 and 6.3.


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

Premiums added to k* for different types of debt
IP S-T Treasury L-T Treasury S-T Corporate L-T Corporate      MR DRP LP P     

Term Structure of Interest Rates

The term structure of interest rates relates the interest rate to the time to maturity for securities with a common default risk profile. Typically, treasury securities are used to construct yield curves since all have zero risk of default. However, yield curves could also be constructed with AAA or BBB corporate bonds or other types of similar risk 4-20

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.


Hypothetical yield curve
Interest Rate (%) 15
Maturity risk premium


Inflation premium

Real risk-free rate

0 1 10

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

Illustrating the relationship between corporate and Treasury yield curves
Interest Rate (%)


BB-Rated AAA-Rated 5.9% Treasury 6.0% Yield Curve



0 0 1 5 10 15 20

Years to

Theories of Term Structure: Expectations Theory

This theory suggest that the shape of the yield curve reflects investors expectations about the future direction of inflation and interest rates. Therefore, an upward-sloping yield curve reflects expectations of higher future inflation and interest rates. In general, the very strong relationship between inflation and interest rates supports this theory.


Theories of Term Structure: Liquidity Preference Theory

This theory contends that long term interest rates tend to be higher than short term rates for two reasons:

long-term securities are perceived to be riskier than short-term securities borrowers are generally willing to pay more for long-term funds because they can lock in at a rate for a longer period of time and avoid the need to 4-26 roll over the debt.

Theories of Term Structure: Market Segmentation Theory

This theory suggests that the market for debt at any point in time is segmented on the basis of maturity. As a result, the shape of the yield curve will depend on the supply and demand for a given maturity at a given point in time.

Other factors that influence interest rate levels
   

reserve policy budget surplus or deficit Level of business activity International factors


Risks associated with investing overseas

Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s 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 country’s economic, political, and 4-29 social environment.

Factors that cause exchange rates to fluctuate

Changes in relative inflation Changes in country risk


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