Principles of Business Finance Fin 510: Dr. Lawrence P. Shao Marshall University Spring 2002

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Principles of Business Finance Fin 510

Dr. Lawrence P. Shao Marshall University
Spring 2002
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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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Define these markets Financial assets Money vs. capital
Primary vs. secondary

Spot vs. future
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Three Primary Ways Capital Is Transferred Between Savers and Borrowers
Direct transfer
Investment banking house Financial intermediary
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Organized Exchanges vs. Over-the-Counter Market
Auction market vs. dealer market (exchanges vs. OTC)

NYSE vs. NASDAQ system Differences are narrowing
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What do we call the price, or cost, of debt capital? The interest rate
What do we call the price, or cost, of equity capital?
Required Dividend Capital + gain . return = yield
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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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Real Versus Nominal Rates
k*
= Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities.
k kRF
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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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Premiums Added to k* for Different Types of Debt
S-T Treasury: only IP for S-T inflation L-T Treasury: IP for L-T inflation, MRP S-T corporate: S-T IP, DRP, LP L-T corporate: IP, DRP, MRP, LP
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What is the term structure of interest rates? What is a yield curve?
Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.
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Treasury Yield Curve

Interest Rate (%)
15
1 yr 5 yr 10 yr 30 yr
5.4% 5.7% 5.7% 6.0%

Yield Curve (March 1998)
10
0 10 20
Years to Maturity
30
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What are the 2 main factors that explain the shape of the yield curve?
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1. Expectations Shape of the yield curve depends on the 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 or down.
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The Pure Expectations Hypothesis (PEH)
MRP = 0.
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 Assume that 1-year securities yield 6% today, and the market expects that 1year securities will yield 7% in 1 year, and that 1-year securities will yield 8% in 2 years. If the PEH is correct, the 2-year rate today should be 6.5% = (6% + 7%)/2. If the PEH is correct, the 3-year rate today should be 7% = (6% + 7% + 8%)/3.
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2. Risk Some argue that the PEH isnt correct, because securities of different maturities have different risk. General view (supported by most evidence) is 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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Example data:
Inflation for Year 1 is 5%.

Inflation for Year 2 is 6%. Inflation for Year 3 and beyond is 8%. k* = 3% MRPt = 0.1%(t - 1).
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Yield Curve Construction
Step 1:Find the average expected inflation rate over years 1 to n:
IPn =
t=1
S INFLt
n .
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IP1 = 5%/1.0 = 5.00%.
IP10 = [5 + 6 + 8(8)]/10 = 7.50%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%. Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).
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Step 2: Find MRP based on this equation: MRPt = 0.1%(t - 1).

MRP1 = 0.1% x 0 = 0.0%. MRP10 = 0.1% x 9 = 0.9%. MRP20 = 0.1% x 19 = 1.9%.
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Step 3: Add the IPs and MRPs to k*: kRFt = k* + IPt + MRPt . kRF = Quoted market interest rate on treasury securities.
Assume k* = 3%: kRF1 = 3.0% + 5.0% + 0.0% = 8.0%. kRF10 = 3.0% + 7.5% + 0.9% = 11.4%. kRF20 = 3.00% + 7.75% + 1.90% = 12.65%.
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Yield Curves
Interest Rate (%)
15
10
5.4%
5.7%
BB-Rated AAA-Rated Treasury 6.0% yield curve
0 0 1 5 10 15 20
Years to maturity

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4-1

Principles of Business Finance Fin 510

Determinants of interest rates

Define these markets Financial assets Money vs. capital

Primary vs. secondary

Three Primary Ways Capital Is Transferred Between Savers and Borrowers

Organized Exchanges vs. Over-the-Counter Market

Auction market vs. dealer market (exchanges vs. OTC)

What do we call the price, or cost, of equity capital?

Required Dividend Capital + gain . return = yield

What four factors affect the cost of money?

Time preferences for consumption

Real Versus Nominal Rates

Premiums Added to k* for Different Types of Debt

What is the term structure of interest rates? What is a yield curve?

Treasury Yield Curve

5.4% 5.7% 5.7% 6.0%

The Pure Expectations Hypothesis (PEH)

Long-term rates are an average of current and future short-term rates.

Inflation for Year 1 is 5%.

Yield Curve Construction

Step 1:Find the average expected inflation rate over years 1 to n:

IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.50%.

Step 2: Find MRP based on this equation: MRPt = 0.1%(t - 1).

BB-Rated AAA-Rated Treasury 6.0% yield curve

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