CHAPTER 4 The Financial Environment
CHAPTER 4 The Financial Environment
CHAPTER 4 The Financial Environment
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 MRP DRP LP
S-T Treasury
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
Constructing the yield curve:
Inflation
Step 1 – Find the average expected
inflation rate over years 1 to n:
n
∑ INFL t
IPn = t=1
n
4-13
Constructing the yield curve:
Inflation
Suppose, that inflation is expected to be 5% next
year, 6% the following year, and 8% thereafter.
IP1 = 5% / 1 = 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).
4-14
Constructing the yield curve:
Inflation
Step 2 – Find the appropriate maturity
risk premium (MRP). For this example,
the following equation will be used find
a security’s appropriate maturity risk
premium.
MRPt = 0.1% ( t - 1 )
4-15
Constructing the yield curve:
Maturity Risk
Using the given equation:
MRP1 = 0.1% x (1-1) = 0.0%
MRP10 = 0.1% x (10-1) = 0.9%
MRP20 = 0.1% x (20-1) = 1.9%
Notice that since the equation is linear,
the maturity risk premium is increasing
in the time to maturity, as it should be.
4-16
Add the IPs and MRPs to k* to
find the appropriate nominal
rates
Step 3 – Adding the premiums to k*.
kRF, t
= k* + IPt + MRPt
Assume k* = 3%,
kRF, 1 = 3% + 5.0% + 0.0% = 8.0%
kRF, 10 = 3% + 7.5% + 0.9% = 11.4%
kRF, 20 = 3% + 7.75% + 1.9% = 12.65%
4-17
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
4-18
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.
4-19
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
4-20
Pure Expectations
Hypothesis
The PEH contends that the shape of the
yield curve depends on investor’s
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.
4-21
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.
4-22
An example:
Observed Treasury rates and the
PEH
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?
4-23
One-year forward rate
4-27
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.
4-28
Factors that cause exchange
rates to fluctuate
Changes in
relative
inflation
Changes in
country risk
4-29