4 - 1

Lecture Two: Financial Markets

Financial markets

Types of financial institutions

Determinants of interest rates

Yield curves

4 - 2Saving/Investing or Borrowing/Lending ProcessAggregate Economic Sectors

Government SectorRegulates and supervises where Congress has granted authority (Political Process). Also it participates in the activities of the 3 sectors below.

Household SectorSaves/lends or

invests in financial assets

Business SectorBorrows/invests in real assets or

productive assets

Financial SectorCollects savings from small

units in the amounts, maturities, etc. , needed by the business sector. Also

provides market liquidity to stimulate

savings/investing/hedging

4 - 3Fundamental Functions of The Financial Sector

1. Transfer savings to investors: distribution or allocation of financial resources.

2. Provide medium of exchange: Money supply by commercial banks.

3. Provides liquidity by providing markets that are large, active, stable, resilient. It must therefore accommodate position takers, i.e... speculators.

4. Maintains healthy environment for hedging activity so that risk takers and risk avoiders can partake in the market so that the volume of real investment can be at a maximum.

4 - 4

Define these markets

Markets in general

Physical assets

Financial assets

Money vs. capital

Primary vs. secondary

Spot vs. future

4 - 5Financial Market

Real Asset Market

Capital Market

Money Market

Securities Mortgage Consumer

CreditCommercial

PaperEuro $

exchanges

brokers

Inv. Bkrs.

Ins. CO.

S & L

Com. Bks.

Fin. CO.

COs. COs. Indiv. Invest.

4 - 6

Direct transfer

Investment banking house

Financial intermediary

Three Primary Ways Capital Is Transferred Between Savers and

Borrowers

4 - 7Financial Institutions

• Investment Banks• Commercial Banks• Savings and Loans Associations• Mutual Savings Banks• Credit Unions• Life Insurance COs.• Mutual Funds

MoneyBondStocksDerivatives

• Pension Funds (generally administered by commercial banks or life insurance companies)

4 - 8Balance sheet of Commercial Bank v. a Manufacturing CO.

Commercial Bank

Govt. Sec.

Loans

---------------Fixed Assets

DD

TD

----------NW

Manufacturing Firm

CashARInv.

-----------Fixed Assets

Short Term Debt------------------Long Term Debt

--------------------NW = Equity

4 - 9Balance sheet of Insurance Company v. a Manufacturing CO.

Insurance Company

Stocks

Bonds

Mortgages

-------------Fixed Assets

Premiums

Other Debt

----------NW

CashARInv.

-----------Fixed Assets

Short Term Debt------------------Long Term Debt

--------------------NW = Equity

Manufacturing Firm

4 - 10

Organized Exchanges vs.Over-the-Counter Market

Auction market vs. dealer market (exchanges vs. OTC)

NYSE vs. NASDAQ system

Differences are narrowing

4 - 11

What 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= + .

4 - 12

What four factors affect the cost of money?

Production opportunities

Time preferences for consumption

Risk

Expected inflation

4 - 13

“Real” Versus “Nominal” Rates

k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%.

= Any nominal rate.

= Rate on Treasury securities.

k

kRF

4 - 14

k = k* + IP + DRP + LP + MRP.

Here:

k = Required rate of return on a debt security.

k* = Real risk-free rate.

IP = Inflation premium.

DRP = Default risk premium.

LP = Liquidity premium.

MRP = Maturity risk premium.

4 - 15

Premiums Added to k* for Different Types of Debt

S-T Treasury: only IP for S-T inflation

L-T Treasury: IP for L-T inflation, MRP

S-T corporate: S-T IP, DRP, LP

L-T corporate: IP, DRP, MRP, LP

4 - 16

What various types of risks arise when investing overseas?

Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment.

Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate.

4 - 17

Two Factors Lead to Exchange Rate Fluctuations

1. Changes in relative inflation will lead to changes in exchange rates.

2. An increase in country risk will also cause that country’s currency to fall.

4 - 18

What is the “term structure of interest rates”? What is a “yield curve”?

Term structure: the relationship between interest rates (or yields) and maturities.

A graph of the term structure is called the yield curve.

4 - 19

T-Bond Yield Curve

0

5

10

15

10 20 30

Years to Maturity

InterestRate (%)

1 yr 5.7% 5 yr 6.5%10 yr 6.7%30 yr 6.9%

Yield Curve(March 1997)

4 - 20

What are the 2 main factors that explain the shape of the yield curve?

4 - 21

1. Expectations

Shape of the yield curve depends on the 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 or down.

4 - 22

The Pure Expectations Hypothesis (PEH)

MRP = 0.

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 - 23

Assume that 1-year securities yield 6% today, and the market expects that 1-year securities will yield 7% in 1 year, and that 1-year securities will yield 8% in 2 years.

If the PEH is correct, the 2-year rate today should be 6.5% = (6% + 7%)/2.

If the PEH is correct, the 3-year rate today should be 7% = (6% + 7% + 8%)/3.

An Example

4 - 24

Some argue that the PEH isn’t correct, because securities of different maturities have different risk.

General view (supported by most evidence) is that lenders prefer S-T securities, and view L-T securities as riskier.

Thus, investors demand a MRP to get them to hold L-T securities (i.e., MRP > 0).

2. Risk

4 - 25

Example data:

Inflation for Yr 1 is 5%.

Inflation for Yr 2 is 6%.

Inflation for Yr 3 and beyond is 8%.

k* = 3%

MRPt = 0.1%(t - 1).

4 - 26

Yield Curve Construction

Step 1: Find the average expected inflation rate over years 1 to n:

n

INFLt

t = 1

nIPn = .

4 - 27

IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.5%.

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 - 28

Step 2: Find MRP based on this equation:

MRPt = 0.1%(t - 1).

MRP1 = 0.1% x 0 = 0.0%.

MRP10 = 0.1% x 9 = 0.9%.

MRP20 = 0.1% x 19 = 1.9%.

4 - 29

Step 3: Add the IPs and MRPs to k*:

kRFt = k* + IPt + MRPt .

kRF = Quoted market interestrate on treasury securities.

Assume k* = 3%:

kRF1= 3% + 5% + 0.0% = 8.0%.kRF10 = 3% + 7.5% + 0.9% = 11.4%.kRF20 = 3% + 7.75% + 1.9% = 12.7%.

4 - 30

Yield Curves

0

5

10

15

0 1 5 10 15 20

Years tomaturity

Interest Rate (%)

5.7%6.7% 6.8%

BB-RatedAAA-RatedTreasuryyield curve