Financial Market &Intrestrate

8/3/2019 Financial Market &Intrestrate

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Financial Marketsand Interest Rates

2/02/09


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Learning Objectives

Operation of U.S. financial system.

Financial securities.

Function of financial intermediaries. Financial markets.

Securities traded in the money and capital

markets.

Interest rates. How they are determined;

factors that influence them; impact on

financial markets


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The Financial System

The purpose of the financial system is tobring together individuals, businesses, andgovernment entities (economic units) that

generate and spend funds. (Haves and havenots)

Surplus economic units have funds left over

after spending all they need to. Examples? Deficit economic units need to acquire

additional funds to sustain their operations.

Examples?


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Surplus/Deficit Units

Surplus units include:

Households

Corporate business

Foreign Investors

Deficit units include:

Corporate Business

US GovernmentState and Local Government

College students


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The Financial System

To enable funds (money) to move through

the financial system, funds are exchanged

for securities. Securities are documents that represent the

right to receive money in the future

Examples are bonds, shares of stock, CDs,notes and accounts receivable, etc.


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Financial Intermediaries

Financial intermediaries (See below) often

help to facilitate this process. I. E., matching

buyers and sellers of securitiesInvestment bankers facilitate sale of corporate

securities to the general public

Brokers facilitate transactions betweeninvestors

Dealers buy and sell securities for their own

good


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Financial Markets

Classified according to the characteristics of

participants and securities involved.

The primary market is where economicunits sell new securities to raise needed

funds. Could be an Initial Public Offering

(IPO) or issue of new shares of an existing

publicly traded company.

Link to Bloomberg about Financial markets
http://www.bloomberg.com/http://www.bloomberg.com/


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Securities

Funds

PrimaryMarket

Financial Markets


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Financial Markets

The secondary market is where investors

trade previously issued securities with each

other. For example, when you want to buyor sell shares of stock

Link to the NYSE

Link to the NASDAQ
http://www.nyse.com/http://nasdaq.com/http://nasdaq.com/http://www.nyse.com/


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Securities

Funds

SecondaryMarket

Financial Markets


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Financial Markets

Securities

Securities$$

$$

Intermediaries such as mutual funds, banks andinsurance companies help to facilitate theflow of funds in the financial marketplace.


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Market Efficiency

Market efficiency refers to the ease, speed,and cost of trading securities. (Axiom 6)

The market for the securities of large

companies is generally efficient: Tradescan be executed in a matter of seconds

and commissions are very low.

By contrast, the real estate market is notgenerally efficient: It can take months to

sell a house and the commission is 6% of

the price.


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Market Efficiency

The more efficient the market, the easier

it is to transfer idle funds to those parties

that need the funds. If funds remain idle, this results in lower

growth for the economy and higher

unemployment and lower profits. Investors can adjust their portfolios easily

and at low cost as their needs and

preferences change.

Why is market efficiency important?


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Financial Markets

Money MarketTrade short term (1 year or less) debt

instruments (e.g. T-Bills, Commercial

Paper, Corp CDs, Govt Agencies, etc.)

Capital Market

Trades long term securities (Bonds,Stocks)

NYSE, AMEX, over-the-counter(NASDAQ and other OTC)


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Money Market Securities (short term)

Highly liquid, low risk

Treasury Bills (T-Bills)Certificates of Deposit (CDs)

Commercial Paper

Eurodollars

Bankers Acceptances

Securities in the Financial Market

T-Bills: are short-term securities issued by theFederal government.

After initial sale, they have an active secondarymarket.

They are bought at a discount and at maturitythe investor receives the full face value.

Essentially no risk, so very low return


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Money Market Securities (short term)

Highly liquid, low risk

Treasury Bills (T-Bills)Certificates of Deposit (CDs)

Commercial Paper (Corp IOUs)

Bankers Acceptances (guarantee) (LOC)



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Capital Market Securitiesmore than one year

Bonds

Bonds:are IOUs issued by the borrower andsold to investors.The issuer promises to repay the face amounton the maturity date and to payinterest each

year in the amount of thecoupon ratetimes theface value ($1,000). This is fixed for life of Bond

Bond values can vary depending on the marketrate of interest, so the rate of return on the bond

can differ widely from the coupon rate.


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Bonds

Treasury BondsMunicipal Bonds

Corporate Bonds

Treasury Bonds: are issued by the federalgovernment. Treasury Notes 1 to 10 years;Treasury Bonds 10 to 30 years

Municipal Bonds: are issued by state and localgovernments. Usually free of federal taxes

Corporate Bonds: are issued by corporations.More risky than Government or Municipal

bonds, higher yield; bonds are rated for risk

Capital Market Securities (long term)


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Stock

Companies can also raise funds by sellingshares of stock

Advantages: No guaranteed payments(like interest) and no specified paybackperiod

maturity date (like bonds)

Two types: Common Stock and Preferred

Capital Market Securities


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Stock

Common Stock Common stockholders:Individually, ownaportion of the company and can vote onmajor company decisions.

They receive a return on their investment inthe form of dividends and/or appreciation inthe value of the stock.



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Stock

Common StockPreferred Stock

Preferred stockholdersdo not generally have

voting rights, but have priority in receivingdividends and are paid dividends at a pre-setrate. Often they get paid dividends in arrears(later) if dividends are not paid for a while.



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Interest Rates

Real Rate of Interest

Expected Inflation

Maturity Risk

Default Risk

Liquidity Risk

Link to Financial Web

Nominal (Prevailing) Interest Rates,

Determined by:
http://www.financialweb.com/markethttp://www.financialweb.com/market


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Interest Rates

Compensates for the lenders lostopportunity to consume.

The minimum rate Im willing to acceptin this market (over and above inflation)that convinces me to invest rather thanspend my money.

The real rate of interest, by definition,would be risk free .

In this market, risk free can drive the real

rate of interest to zero.

Real Rate of Interest


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Interest Rates Expected Inflation (Axiom 1)

Inflation erodes the purchasing power of

money.

Example: If you loan someone $1,000 and

they pay it back one year later with 10%

interest, you will have $1,100. But if

prices have increased by 5%, thensomething that would have cost $1,000 at

the outset of the loan will now cost

$1,000(1.05) = $1,050.


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Nominal Risk-Free Rate

The real rate of interest, plus

The inflation risk premium

Example: The T-BillCurrent Yield: 2.125%

So, if inflation rate is 1.80%, then

Real Rate of return is 2.1251.80 or .325%


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Interest Ratesother risks

Maturity Risk If interest rates rise, lenders may find that their

loans are earning rates that are lower than what they

could get on new loans.

The risk of this occurring is higher for longer

maturity loans.

Lenders will demand a premium to cover this riskdepending on if they think long term rates will go

up or down.

10 years Treasury Note yielding 2.84% (0.7%

premium over T-Bill rate)


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Interest RatesOther risks

For most securities, there is some risk thatthe borrower will not repay the interestand/or principal on time, or at all.

The greater the chance of default, thegreater the interest rate the investordemands and the issuer must pay.

(risk/return trade-off)Example: Junk bonds have a high risk of

default and requires a high default risk

premium. Current yield 12.20%

Default Risk


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Interest Rates

Liquidity Risk Premium Investments that are easy to sell without

losing value are more liquid.

Illiquid securities have a higher interest

rate premium to compensate the lender

for the inconvenience of not being able to

sell the bond easily.

Mortgage backed securities became

illiquid! Cause of market collapse!


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k = the nominal, or observed rateon security

k* = real rate of interest

IRP = Inflation Risk Premium

MP = Maturity Premium (for Bonds)

DRP = Default Risk Premium (Corps)

LP = Liquidity Premium

k = k* + IRP + MP + DRP + LP

Determination of Rates


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Determination of Interest Rate

If the Real Rate of return is 0.325% and Inflationis 1.80%, then the risk free rate would be 2.125%,i.e. a T-Bill

Add a Maturity risk premium of, say 0.72% and

you would have a Government long-term securityrate of 2.84%

Add a Default risk premium 3.74% and you wouldhave a Corporate Bond rate of 6.58%

Add an additional 5.62 to for junk bond risk andyou would have a rate of 12.20%

If the bond is not liquid, you might add anotherfew 10ths of a % premium for liquidity.


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Interest Rates

Term Structure

Relationship between long and short

term interest rates. Which direction ratesare expected to go in the future.

Yield curves follow

Compare to current yield curve


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8.00%7.50%7.00%6.50%

6.00%

5.00%

5.50%

4.50%4.00%3.50% 3 6 1 2 3 5 7 2

010mos

.

yr. maturities

Treasury Yield Curve

Jan 10, 2000


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8.00%7.50%7.00%6.50%

6.00%

5.00%

5.50%

4.50%4.00%3.50% 3 6 1 2 3 5 7 2

010mos

.

yr. maturities

Treasury Yield Curve

Jan 10, 2000

March 22,1995


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Term Structure of Interest Rates

YIELD COMPARISONS

2/04/08 9/05/08 1/30/09T-Bill 1.75 3.25 0.0

Treasury10 yr 3.60 3.65 2.84

CorporateDJ 5.28 5.91 6.58

High-yield Corporate 8.92 9.94 12.20

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Financial Market &Intrestrate