Brigham-financial Management Chapter2

8/17/2019 Brigham-financial Management Chapter2

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Chapter 2

The FinancialEnvironment

Markets

InstitutionsInterest Rates

© 2005 Thomson/South-estern


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The Financial Markets

!e"t versus e#uit$ markets!e"t markets % loansE#uit$ markets % stocks

Mone$ versus capital marketsMone$ market % &e"t ' ( $ear

Capital market % &e"t ) ( $ear * stocks+rimar$ versus secon&ar$ markets+rimar$ markets % ne, un&sSecon&ar$ markets % outstan&in. securities


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The Financial Markets+u"lic versus private markets+u"lic markets % li#ui& lo,-cost stan&ar&ie&

tra&es+rivate markets % specialie& &eals

Spot versus utures marketsSpot markets % assets tra&e& 1on the spotFutures markets % or &eliver$ at a later &ate

orl& national re.ional an& localmarketsorl&,i&e % 3e, 4ork Stock Echan.e6ocal % Chica.o Stock Echan.e


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Financial Institutions

!irect transers 3o interme&iaries7ten part o private market transactions

Investment "ankin. houses I-8ank % mi&&leman

I-8ank ma$ "u$ in hopes o sellin. so there is some risk Financial interme&iaries 8anks or mutual un&s Savers invest in one t$pe o pro&uct 9e:.: C!s or savin.s

accounts; 8ank then creates loans mort.a.es etc: to sell to "orro,ers

Fun&s are transerre& "et,een those ,ho haveun&s an& those ,ho nee& un&s "$ threeprocesses


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Financial Interme&iaries(==> ?lass-Stea.all @ct+rohi"ite& commercial "anks rom I-"ankin. activities Trie& to prohi"it 1conAict o interest situations

Result< Mor.an 8ank B+ Mor.an Chase Compan$ % commercial "ankMor.an Stanle$ % investment "ank

(=== ?ramm-6each-8lile$ @ctEpan&e& the po,ers o "anks@"olishe& maDor restrictions o the ?lass-Stea.all @ct

@llo,s "anks to &o<I-"ankin.insurance sales an& un&er,ritin.lo, risk non-nancial activities


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Financial Interme&iaries

The ?ramm-6each-8lile$ @ct "lurre& the&istinctions< Commercial "anks Savin.s an& loan associations

Cre&it unions +ension un&s 6ie insurance companies Mutual un&s


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Stock Markets

7l& classication 7r.anie& Securit$ Echan.es 34SE @ME an& re.ional

7TC 9over-the-counter markets;@ "roa&er net,ork o smaller &ealers

3e, classication+h$sical stock echan.es34SE @ME

7r.anie& Investment 3et,orks7TC 3as&a# electronic communication net,orks 9EC3;


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+h$sical StockEchan.es

@ ph$sical 1material entit$@ "uil&in.!esi.nate& mem"ers@ "oar& o .overnors

Seats are "ou.ht an& sol&

Recor& hi.h price % GHM 9(2/(/05;+rice in (=== % G2M

@uction marketsSell or&ers an& "u$ or&ers come to.ether


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7r.anie& Investment3et,orks

For securities not tra&e& on ph$sical stockechan.es@n intan.i"le tra&in. s$stem@ net,ork o "rokers an& &ealers 93@S!;!ealers make the market

The "i& price % ,hat the &ealer ,ill pa$ to "u$ The ask price % ,hat the &ealer ,ill take to sellSprea& % the &ealers prot

Electronic communications net,orks


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Four factors that aect the cost of

money

The Cost o Mone$

+ro&uction opportunitiesIs it ,orth investin. in ne, assetsJ

Time preerences or consumption

3o, or laterJ RiskKo, likel$ is it that this investment ,ont pan

outJ

Epecte& inAation

Ko, much ,ill prices increase over timeJ


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The Cost o Mone$

hat &o ,e call the price or cost o &e"tcapitalJ

The Interest Rate

hat &o ,e call the price or cost oe#uit$ capitalJ

Return on Equity =Dividends + Capital Gains


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Interest Rate 6evelsInterest Rates as a Function of upply andDemand

k B = 12

Interest Rate, k B

Market B:High-Risk Securities

%

Dollars0

S1

D1

Interest Rate, k A

Market A: o!-Risk Securities

k A= 10

"

0 Dollars

%

D1

D2

S1


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= real risk-ree rate:

T$picall$ 2L to HLT-bill for short term

T-bond for long term

!"

= an$ nominal rate % #uote& rat!

= Risk-ree rate on T-securities! RF

1Real versus 13ominalRates


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k % uote& or nominal ratekN % Real risk-ree rate 91k-star;

I+ % InAation premium

!R+ % !eault risk premium6+ % 6i#ui&it$ premium

MR+ % Maturit$ risk premium

The !eterminants o

Market Interest Rates


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The !eterminants o

Market Interest Rates

Quoted Interest Rate = k

k = Risk-free interest rate + risk premium

k = kRF + RP

k = kRF + [DRP + LP + MRP]

k = [k* + IP] + [DRP + LP + MRP]


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The !eterminants o

Market Interest RatesNominal Interest Rate = k = [k* + IP] + [DRP + LP + MRP]

I+ % avera.e rate o inAation epecte& in uture

!R+ % risk that a "orro,er ,ill &eault on a loan 9&iOerence"et,een the T-"on& interest rate an& a corporate "on& ,ithsame eatures;

6+ % premium i asset cannot "e converte& to cash #uickl$an& at close to the ori.inal cost 92 P 5L;

MR+ % the interest rate risk associate& ,ith lon.er maturit$perio&s 9usuall$ ( P 2L;


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#uoted Ris!$Free Rate = ! = ! RF + DR% + &% +

'R%

k % uote& or nominal ratekRF % Real risk-ree rate plus apremium or epecte& inAation

or kRF % kN * I+

!R+% !eault risk premium6+ % 6i#ui&it$ premium

MR+ % Maturit$ risk premium

!eterminants oMarket Interest Rates


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I+ % InAation premium!R+ % !eault risk premium6+ % 6i#ui&it$ premiumMR+ % Maturit$ riskpremium

+remiums @&&e& to kN or!iOerent T$pes o !e"t

Short-Term 9S-T; Treasur$< onl$ I+ or S-T

inAation

6on.-Term 96-T; Treasur$< I+ or 6-T inAation plus MR+

Short-Term corporate< Short-Term I+ !R+ 6+

6on.-Term corporate< I+ !R+ MR+ 6+


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The Term Structure oInterest Rates

Term structure< the relationship"et,een interest rates 9or $iel&s;an& maturities

@ .raph o the term structure iscalle& the $iel& curve:


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Q:S: Treasur$ 8on& Interest

Rates on !iOerent !ates

Interest RateTerm to 'arch (uly (uly'aturity )*, -,,, -,,.

. months )/0,1 /0)1 ,0*1) year )20, /0) )0,3 years ).03 /0- -0.), years )-0 /0) .0.-, years )-0. /0- 20.

hort Term Intermediate Term &on4 Term

1 # 10 20

1$

1

12

10

"

$

2

0

Interest Rate516

'arch)*,

(uly -,,,

(uly -,,.

Abnormal

Flat = horizontal

Normal


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Three Eplanations or theShape o the 4iel& Curve

6i#ui&it$ +reerence Theor$

Epectations Theor$

Market Se.mentation Theor$


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6i#ui&it$ +reerence Theor$

6en&ers preer to make short-term loans6ess interest-rate riskMore li#ui&

6en&ers len& short-term un&s at lo,er

rates Sa$s MR+ ) 0

Results in 1normal curve


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Epectations Theor$

Shape o curve &epen&s on investorsepectations a"out uture inAation rates:

I inAation is epecte& to increase S-T

rates ,ill "e lo, 6-T rates hi.h an& viceversa:

The $iel& curve can slope up 7R &o,n:


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Calculatin. Interest Ratesun&er Epectations Theor$

Step (< Fin& the InAation +remiumthe avera.e epecte& inAationrate over $ears ( to 3


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InAation or 4ear ( is 5L:

InAation or 4ear 2 is L:

InAation or 4ear > an& "e$on& is L:

kN % >L

MR+t % 0:(L 9t-(;

I+( % 5L/ (:0 % 5:00L

I+(0 % 5 * * 9;U / (0 % V:5L

I+20 % 5 * * 9(;U / 20 % V:V5L

Must earn these I+s to "reak even vs: inAationW

these I+s ,oul& permit $ou to earn kN 9"eore

Eample<


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Step 2


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Calculatin. Interest Ratesun&er Epectations Theor$<

)$8r9 ! RF) = .1 + 30,1 + ,0,1 = 0,1

),$8r9 ! RF), = .1 + :031 + ,0*1 = ))021

-,$8r9 ! RF-, = .1 + :0:31 + )0*1 = )-0:1

kRFt % kN * I+t * MR+tkRF % uote& market interest rateon treasur$ securities:

@ssume kN % >L:

Step >


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4iel& Curve

0

5

10

15

0 1 5 10 15 20

8ears tomaturity

InterestRate 516

0,1

))021 )-0:1

Treasury

yield curve


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Market Se.mentation Theor$

8orro,ers an& len&ers have preerre&maturities

Slope o $iel& curve &epen&s on suppl$an& &eman& or un&s in "oth the 6-T

an& S-T markets Curve coul& "e Aat up,ar& or

&o,n,ar& slopin.


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7ther Factors thatInAuenceInterest Rate 6evels

Fe&eral Reserve +olic$Controls mone$ suppl$W impacts S-T interest rates

Fe&eral !ecits6ar.er e&eral &ecits mean hi.her interest rates

Forei.n Tra&e 8alance6ar.er tra&e &ecits mean hi.her interest rates 8usiness @ctivit$!oes the Fe&eral Reserve nee& to stimulate activit$J


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Interest Rate 6evelsan& Stock +rices

The hi.her the rate o interest the lo,er a rms

prots Interest rates aOect the level o economic activit$ : :

: ,hich aOects corporate protsIf interest rates rise 0 0 0

Investors turn to the "on& market sell stock an&&ecrease stock prices

If interest rates decline 0 0 0

Investors turn to the stock market sell "on&s an&increase stock prices


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For 3et Class<

Chapter 2 Kome,ork pro"lemsRevie, Chapters ( an& 2

+repare or Chapter (-2 #uiRea& Chapter >

Documents

Brigham-financial Management Chapter2