CHAPTER 2

Financial Markets and InstitutionsThe Capital Allocation Process Financial markets Financial institutions Stock Markets and Returns Determinants of interest rates The term structure and yield curves

The Capital Allocation ProcessIn a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it. Suppliers of capital individuals and institutions with excess funds. These groups are saving money and looking for a rate of return on their investment. Demanders or users of capital individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

How is capital transferred between savers and borrowers?Direct transfers Investment banking house Financial intermediaries

What are three ways that capital is transferred between savers and borrowers?Direct transfer (e.g., corporation issues commercial paper to insurance company) Through an investment banking house (e.g., IPO, seasoned equity offering, or debt placement) Through a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company)

Transferring CapitalDirect Transfer of Funds Cash firm

saver

Securities

Transferring CapitalIndirect Transfer using Investment Banker Funds saver investment banker Securities Securities Funds

firm

Investment BankingHow do investment bankers help firms issue securities? Advising the firm. Underwriting the issue. Distributing the issue.

Transferring CapitalIndirect Transfer using a Financial Intermediary Funds Funds

saver

financial intermediary Firm Securities

firm

Intermediary Securities

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.

Types of financial marketsPhysical assets vs. Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Futures Public vs. Private

Physical assets vs. Financial assetsPhysical asset markets also called tangible or real asset markets, such as real estates, autos, computers and machinery. Financial asset markets deal with stocks, bonds, and other claims on assets are traded in the financial markets.

Money vs. CapitalMoney markets: The financial markets in which funds are borrowed or loaned for short period.Commercial paper, Treasury bill.

Capital markets are the markets for longterm debt and corporate stocks.The New York Stock Exchange is an example of a capital market.

Primary vs. SecondaryPrimary markets are markets in which corporations raise capital by issuing new securities Secondary markets are markets in which securities and other financial assets are traded among investors after they have been issued by corporations.

Spot vs. FuturesSpot markets are markets in which assets are bought or sold for on-thespot delivery Futures markets are markets in which participants agree today to buy or sell an asset at some future date.

Private vs. PublicPrivate markets, where transactions are worked out directly between two parties Public markets, where standardized contracts are traded on organized exchanges.

The importance of financial marketsWell-functioning financial markets facilitate the flow of capital from investors to the users of capital.Markets provide savers with returns on their money saved/invested, which provides them money in the future. Markets provide users of capital with the necessary funds to finance their investment projects.

Well-functioning markets promote economic growth. Economies with well-developed markets perform better than economies with poorly-functioning markets.

What are derivatives? How can they be used to reduce or increase risk?A derivative securitys value is derived from the price of another security (e.g., options and futures). Can be used to hedge or reduce risk. For example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens. Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk.

Financial IntermediaryAn organization that raises money from investors and provides financing for individuals, corporations, or other organizations.

Types of financial intermediariesCommercial banks Savings & Loans, mutual savings banks, and credit unions Life insurance companies Pension funds Mutual funds

Financial IntermediariesCommercial Banks in Malaysia

Financial Intermediaries Insurance companies

Pension fundInvestment plan set up by an employer to provide for employees retirement. Designed for long-run investment. Provide professional management & diversification. Tax advantage: contributions are taxdeductible, & investment returns inside the plan are not taxed until cash is finally withdrawn.

Pension fundsThe EPF is a scheme which provides retirement benefits for members through management of their savings in an efficient and reliable manner. The EPF also provides a convenient framework for employers to meet their statutory and moral obligations to their employees.

Mutual FundCorporations that pool investor funds to purchase financial instruments and thus reduce risks through diversification. Achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities. Different funds are designed to meet the objectives of different types of savers.5-24

QuestionAs an investor has two options:1. 2.

Buy bonds and stocks directly. Invest money in a mutual fund or a pension fund.

What are the advantages of the second option?

Answer

Physical location stock exchanges vs. Electronic dealer-based marketsAuction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq Differences are narrowing

Stock Market TransactionsApple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction?Since new shares of stock are being issued, this is a primary market transaction.

What if instead an investor buys existing shares of Apple stock in the open market is this a primary or secondary market transaction?Since no new shares are created, this is a secondary market transaction.

What is an IPO?An initial public offering (IPO) is where a company issues stock in the public market for the first time. Going public enables a companys owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market. Public companies are subject to additional regulations and reporting requirements.

Historical stock market performance, S&P 500 (1968-2004)

Where can you find a stock quote, and what does one look like?Stock quotes can be found in a variety of print sources (Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).

Source: finance.yahoo.com

Interest Rate DeterminantsInterest Rates

The cost of moneyWhat 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 = + . return yield gain

What four factors affect the level of interest rates?Production opportunities Time preferences for consumption Risk Expected inflation

What four factors affect the level of interest rates?1.

Production opportunitiesThe returns available within an economy from investment in productive (cash-generating) assets.

2.

Time preferences for consumptionThe preferences of consumers for current consumption as opposed to saving for future consumption.

3.

RiskThe chance that an investment will provide a low or negative return.

4.

Expected InflationThe higher the expected rate of inflation, the larger the required return.5-35

Nominal vs. Real ratesr = represents any nominal rate r* = represents the real risk-free rate of interest. Like a T-bill rate, if there was no inflation. Typically ranges from 1% to 4% per year. rRF = represents the rate of interest on Treasury securities.

Determinants of interest ratesr = r* + IP + DRP + LP + MRP r = r* = IP = DRP = LP = MRP = required return on a debt security real risk-free rate of interest inflation premium default risk premium liquidity premium maturity risk premium

Premiums added to r* for different types of debtIP S-T Treasury L-T Treasury S-T Corporate L-T Corporate MRP DRP LP

Yield curve and the term structure of interest ratesTerm structure relationship between interest rates (or yields) and maturities. The yield curve is a graph of the term structure. The November 2005 Treasury yield curve is shown at the right.Yield (%) 6 5 4 3 2 1 0 0.25

0.5

2

5

10

30

Maturity (years)

Constructing the yield curve: InflationStep 1 Find the average expected inflation rate over years 1 to N:

IPN =

INFLt =1

N

t

N

Constructing the yield curve: InflationAssume 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.

Constructing the yield curve: Maturity RiskStep 2 Find the appropriate maturity risk premium (MRP). For this example, the following equation will be used find a securitys appropriate maturity risk premium.

MRPt = 0.1% ( t - 1 )

Constructing the yield curve: Maturity RiskUsing 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 as the time to maturity increases, as it should be.

Add the IPs and MRPs to r* to find the appropriate nominal ratesStep 3 Adding the premiums to r*. rRF, t = r* + IPt + MRPt Assume r* = 3%, rRF, 1 = 3% + 5.0% + 0.0% = 8.0% rRF, 10 = 3% + 7.5% + 0.9% = 11.4% rRF, 20 = 3% + 7.75% + 1.9% = 12.65%

Hypothetical yield curveInterest Rate (%) 15Maturity risk premium

10

Inflation premium

5Real risk-free rate

An upward sloping yield curve. Upward slope due to an increase in expected inflation and increasing maturity risk premium.Years to 20 Maturity

0 1 10

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.

Illustrating the relationship between corporate and Treasury yield curvesInterest Rate (%)15

BB-Rated10

AAA-Rated 5.9% Treasury 6.0% Yield Curve

5

5.2%

0 0 1 5 10 15 20

Years toMaturity

Pure Expectations HypothesisThe PEH contends that the shape of the yield curve depends on 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, down, or even bow.

Assumptions of the PEHAssumes 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.

An example: Observed Treasury rates and the PEHMaturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 6.2% 6.4% 6.5% 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?

One-year forward rate6.0% 0 1 6.2% x% 2

(1.062)2 1.12784/1.060 6.4004%

= (1.060) (1+x) = (1+x) =x

PEH says that one-year securities will yield 6.4004%, one year from now. Notice, if an arithmetic average is used, the answer is still very close. Solve: 6.2% = (6.0% + x)/2, and the result will be 6.4%.

Three-year security, two years from now6.2% 0 1 2 6.5% 3 x% 4 5

(1.065)5 = (1.062)2 (1+x)3 1.37009/1.12784 = (1+x)3 6.7005% = x PEH says that three-year securities will yield 6.7005%, two years from now.

Conclusions about PEHSome would argue that the MRP 0, and hence the PEH is incorrect. Most evidence supports the general view that lenders prefer S-T securities, and view L-T securities as riskier.Thus, investors demand a premium to persuade them to hold L-T securities (i.e., MRP > 0).