The Financial Environment:: Markets, Institutions, and Interest Rates
The Financial Environment:: Markets, Institutions, and Interest Rates
The Financial Environment:: Markets, Institutions, and Interest Rates
Financial markets
Types of financial
institutions
Determinants of interest
rates 4-1
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.
4-2
Types of financial markets
Physical assets vs. Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Public vs. Private
4-3
How is capital transferred
between savers and borrowers?
Direct transfers
Investment
banking house
Financial
intermediaries
4-4
Types of financial
intermediaries
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Pension funds
Life insurance companies
Mutual funds
4-5
Physical location stock
exchanges vs. Electronic
dealer-based markets
Auction market
vs. Dealer market
(Exchanges vs.
OTC)
NYSE vs. Nasdaq
Differences are
narrowing
4-6
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.
4-7
What four factors affect the
cost of money?
Production
opportunities
Time preferences
for consumption
Risk
Expected inflation
4-8
“Nominal” vs. “Real” rates
k = represents any nominal rate
IP MR DRP LP
S-T Treasury P
L-T Treasury
S-T
Corporate
L-T
Corporate
4-11
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. 4-12
Hypothetical yield curve
Interest An upward
Rate (%)
sloping yield
15 Maturity risk premium
curve.
Upward slope due
10 Inflation premium
to an increase in
expected inflation
5 and increasing
Real risk-free rate maturity risk
0
premium.
Years to
1 10 20 Maturity
4-13
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.
4-14
Illustrating the relationship
between corporate and Treasury
yield curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%
Years to
0 Maturity
0 1 5 10 15 20
4-15
Other factors that influence
interest rate levels
Federal reserve policy
Federal budget surplus or deficit
Level of business activity
International factors
4-16
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
social environment. 4-17
Factors that cause exchange
rates to fluctuate
Changes in
relative
inflation
Changes in
country risk
4-18