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Time Value of Money
Time Value of Money
CHAPTER 5
The Financial Environment:
Markets, Institutions,
and Interest Rates
Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves
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5-2
Markets in general
Physical assets vs. Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Public vs. Private
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5-3
Direct transfer
Investment banking house
Financial intermediary
Production opportunities
Time preferences for consumption
Risk
Expected inflation
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.
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5 - 11
4
0 Years to Maturity
10 20 30
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5 - 14
INFL
t 1
t
IPn = n .
BB-Rated
10
AAA-Rated
Treasury
6.0%
5 5.9% Yield Curve
5.2%
Years to
0
Maturity
0 1 5 10 15 20
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5 - 22
How does the volume of corporate
bond issues compare to that of
Treasury securities?
Gross U.S. Treasury Issuance (in blue)
Billions of dollars
300
150
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 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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x%
6.0%
0 1 2 3 4 5
0 1 3 2
4 5
6.5%
[ 2(6.2%) + 3(x%) ]
6.5% =
5
32.5% = 12.4% + 3(x%)
20.1% = 3(x%)
6.7% = x%.
PEH tells us that three-year securities
will yield 6.7%, two years from now (x%).
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