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Fundamentals of Corporate Finance, 2/eRobert Parrino, Ph.D.David S. Kidwell, Ph.D.Thomas W. Bates, Ph.D.

Chapter 2: The Financial System and the Level of Interest Rates

Learning ObjectivesDescribe the role of the financial system in the economy and the two basic ways in which money flows through the system.Discuss direct financing and the important role that investment banks play in this process.Learning ObjectivesDescribe the primary, secondary, and money markets, explaining the special importance of secondary and money markets to business organizations.Explain what an efficient market is and why market efficiency is important to financial managers.Learning ObjectivesExplain how financial institutions serve the needs of consumers, small businesses, and corporations.Compute the nominal and the real rates of interest, differentiating between them.The Financial Systemfinancial markets and institutionsFinancial markets include markets for trading financial assets such as stocks and bondsFinancial institutions include banks, credit unions, insurance companies, and finance companiesThe Financial SystemThe Financial System at WorkThe financial system is competitiveMoney is borrowed in small amounts and loaned in large amountsThe system directs money to the best investment opportunities in the economyLenders earn profit from the spread between lending and borrowing rates7The Financial SystemMove Funds from Lender to BorrowerThe primary function of a financial system is to efficiently transfer funds from lender-savers to borrower-spendersBasic mechanisms by which funds are transferred in the financial systemDirect Financing Indirect Financing

8The Flow of Funds Through the Financial System

Direct FinancingDirect transfer of fundslender-saver contracts with a borrower-spenderminimum transaction $1 millioninvestment banks and money center banks help with origination, underwriting and distribution of new debt and equity

10Direct FinancingDirect transfer of fundsUnderwriting is a service to assist firms in selling their debt or equity securities in a direct financing market

11Types of Financial MarketsWholesale and Retail marketsPrimary Marketwholesale market where firms new securities are issued and sold for the first time Secondary Marketretail market where previously issued securities are resold (traded)

12Types of Financial MarketsMarketability and LiquidityMarketabilityease with which a seller or buyer for an asset can be foundLiquidityease with which an asset can be converted into cash without loss of value

13Types of Financial MarketsMarketability and LiquidityFinancial markets increase marketability and liquidity of securitiesFinancial markets lower the costs of making transactions and make participants more willing and able to pay higher prices

14Types of Financial MarketsBrokers and DealersA broker brings a seller and a buyer together but does not buy or sell in the transactionbroker does not take on riskA dealer participates in trades as a buyer or seller using her own inventory of securitiesdealer takes on risk

15Types of Financial MarketsExchanges & Over-the-Counter MarketsExchangelocation where sellers and buyers meet to conduct transactionsNew York Stock Exchange (NYSE)Chicago Board Options Exchange (CBOE)16Types of Financial MarketsExchanges & Over-the-Counter MarketsOver-the-Counter Marketdealers conduct transactions over the phone or via computer.National Association of Securities Dealers Automated Quotations (NASDAQ)17Types of Financial MarketsMoney and Capital MarketsMoney Marketmarket for low-risk securities with maturities of less than one year. Treasury Bills (T-bills)Commercial Paper18Types of Financial MarketsMoney and Capital MarketsCapital Marketmarket for securities with maturities longer than one yearbondscommon stock

19Selected Money Market and Capital Market Instruments June 2010

Market EfficiencyEfficient MarketCurrent prices of securities incorporate the knowledge and expectations of all participantsSecurity prices are correct: securities are not over-valued or under-valued. Participants are confident they pay or receive the intrinsic (fair) value of a security

21Market EfficiencyMarket EfficiencyOperational Efficiencyextent to which transaction costs are minimizedInformational Efficiencyextent to which security prices reflect all relevant information

22Market EfficiencyEfficient Market HypothesisA theory about how efficiently the stock market processes and incorporates information available fromprivate sources of informationpublic sources of informationhistorical stock prices

23Market EfficiencyEfficient Market HypothesisStrong-Form EfficiencySecurity prices always reflect all information, from every source. Even inside, or confidential information, is reflected.

24Market EfficiencyEfficient Market HypothesisSemistrong-Form EfficiencySecurity prices always reflect all public information. Inside, or confidential information, is not reflected.

25Market EfficiencyEfficient Market HypothesisWeak-Form EfficiencySecurity prices always reflect the information in past prices. No other information is reflected.

26Market EfficiencyEfficient Market HypothesisPublic markets, such as the NYSE are more efficient than private markets due to the information provided by a large number of participants and effective regulation

27Financial Institutions and Indirect Financingindirect financingAn institution is both a borrower and lenderborrows money from a saverlends money to a borrowermust repay funds to the saver whether or not it is repaid by the borrowerExamples: banks & insurance companies

28Financial Institutions and Indirect FinancingFinancial InstitutionsProvide lending and borrowing opportunities at the retail level for small customers and wholesale level for large customersEfficiently collect funds in small amounts and lend them in larger amountsTailor loan amounts and contract terms to fit the needs of consumers, corporations, and small businesses29Cash Flows Between the Firm and the Financial System

The Determinants of Interest Rate LevelsInterest RateThe fee for borrowing money expressed as a percentage of a loanreal rate of interestinterest rate that would exist in the absence of inflation (deflation)nominal ate of interestinterest rate adjusted for inflation (deflation)31The Determinants of Interest Rate LevelsReal Rate of InterestDeterminants of the real rate of interestexpected return on productive assetstime preference for consumption32The Determinants of Interest Rate LevelsEquilibrium Rate of InterestIs a function of supply and demandsavers supply more funds at higher ratesspenders borrow (demand) less at higher ratesIs the interest rate at which the quantity of funds supplied equals the quantity of funds demanded33The Determinants of the Equilibrium Rate of Interest

The Determinants of Interest Rate LevelsInflation and Loan ContractsLenders want the interest rates in loan contracts to include compensation for the inflation predicted to occur over the life of the contractCompensation for expected inflation adjusts loan rates to offset the higher prices for goods and services expected to exist when a loan is repaid and a lender spends the money35The Determinants of Interest Rate LevelsFisher Equation & Nominal Interest RateThe Fisher Equation Where: i = nominal interest rate r = real rate of interest Pe = expected annualized price-level change rPe = adjustment for expected price-level change

36The Determinants of Interest Rate LevelsFisher Equation & Nominal Interest RateSimplified Fisher Equation

37The Determinants of Interest Rate LevelsFisher Equation Example

38The Determinants of Interest Rate LevelsSimplified Fisher Equation Example

39The Determinants of Interest Rate LevelsReal Rate of Interest Example

40The Determinants of Interest Rate LevelsCyclical & Long-term Interest RatesInterest rates tend to rise and fall with changes in the rate of inflationRates tend to rise when the growth rate of the economy increases and tend to fall when the growth rate of the economy slows

41The Determinants of Interest Rate LevelsInterest Rate, Business Cycle & InflationInterest rates tend to follow the business cycleInterest rates tend to increase during an economic expansionInterest rates tend to decrease during an economic contraction42Relation Between Annual Inflation Rate and Long-Term Interest Rate