The Financial Systemand Interest

Chapter 5

2

Read Ch. 5 (ch. 4 in the 4th edition) Possible test questions handed out in lab Interesting books on investing

One Up On Wall Street : How To Use What You Already Know To Make Money In The Market by Peter Lynch, John Rothchild

Take On the Street: What Wall Street and Corporate America Don't Want You to Know by Arthur Levitt

3

Primary and Secondary Markets

Purpose of a financial market is to facilitate the flow of funds from savers to production sector (investment in business projects) This occurs in the:

Primary market (market in which securities are initially sold)

Investors trade securities between each other in the Secondary market

4

Primary and Secondary Markets

Corporations, even though they do not raise money in the secondary market, are interested in the stock’s price in the secondary market Goal: Max. Stock Price Influences how much money can be

raised in future stock issues Senior management’s compensation is

usually tied to the stock price

5

The Stock Market and Stock Exchanges

Stock market—a network of exchanges and brokers Exchange—a physical marketplace

(NYSE, AMEX, regional exchanges) Broker—individual whose job is to assist

people in buying and selling securities Work for brokerage firms Members of stock exchange

6

Exchanges

New York Stock Exchange (NYSE) Trades securities for 1,200 of largest, strongest

companies in U.S. Handles about 85% of trading activity

American Stock Exchange (AMEX) Handles slightly smaller, younger firms than NYSE

NASDAQ Regional stock exchanges (Philadelphia,

Chicago, San Francisco, etc.) Exchanges are linked electronically

7

Exchanges The Market

The stock market refers to the entire interconnected set of places, organizations and processes involved in trading stocks

Regulation Securities are regulated under state and federal

laws Securities Act of 1933

Required companies to disclose certain information Securities Act of of 1934

Set up Securities and Exchange Commission Securities law is primarily aimed at disclosure

8

Private, Public, and Listed Companies, and the NASDAQ Market

Assume a business is successful and the owner decides to raise money for expansion by incorporating and selling stock to others Privately held companies—can’t sell securities to

the general public (also, sale of securities is severely restricted by regulation)

Publicly traded companies—have received approval of the SEC to offer securities to the general public Process of obtaining approval and

registration is known as ‘going public’

9

Private, Public, and Listed Companies, and the NASDAQ Market

Process of ‘going public’ Use an investment banking firm (e.g., Goldman

Sachs or Morgan Stanley), to determine If a market exists for shares of your company The likely price for your firm’s stock

Develop a prospectus—provides detailed information about company Financial statements Key executives/background

SEC reviews prospectus An unapproved prospectus is call a ‘red herring’

10

Private, Public, and Listed Companies, and the OTC Market

The IPO Once prospectus is approved by SEC securities

can be sold to public Initial sale is known as an IPO or initial public

offering Market for IPOs is very volatile and risky

Prices can rise (or fall) very dramatically Investment banks usually line up buyers prior to

the actual sale of securities Buyers are usually institutional investors

IPO occurs in primary market, but once securities are placed with investors, trading begins in the secondary market

11

Company Name

Offer Date Exchange Industry UnderwriterDeal Size(US$MM)

Visa 03/18/08 NYSE Financial J.P. Morgan $17,864

ENEL SpA 11/01/99 NYSE Utilities Merrill Lynch $16,452

Facebook 05/17/12 NASDAQ Technology Morgan Stanley $16,007

General Motors

11/17/10 NYSE Capital Goods & Services

Morgan Stanley $15,774

Deutsche Telekom

11/17/96 NYSE Communications

Goldman Sachs $13,034

AT&T Wireless Group

04/26/00 NYSE Communications

Goldman Sachs $10,620

Kraft Foods 06/12/01 NYSE Consumer Credit Suisse $8,680

France Telecom

10/17/97 NYSE Communications

Merrill Lynch $7,289

Telstra Corporation

11/17/97 NYSE Communications

Credit Suisse $5,646

Swisscom 10/04/98 NYSE Communications

Warburg Dillon Read

$5,582

Largest all time IPOs. 2/7/2014

12

myths about IPOs The general perception is that IPOs are a

fail-safe way to make money and that if one invests money in an IPO returns are guaranteed. This is the greatest myth about IPOs. Many IPOs will result in losses for the investors, the prices of the same will go down because of several reasons like a weak company, over pricing, weak management or simply because the price fell along with the general markets.

http://www.19.5degs.com/element/19427.php

13

The NASDAQ Market After a company goes public, its

shares are usually traded in the over-the-counter (OTC) market

Eventually a firm may wish to be listed on an exchange Loosely organized network of brokers

The National Association of Securities Dealers Automated Quotation System (NASDAQ) is the market’s computer system

14

The NASDAQ Market

The Nasdaq Stock Market is a computerized communication system that provides the bid and asked prices of more than 5,000 over-the-counter (OTC) stocks that have met the market's registration requirements.

Update. The current thinking is that Nasdaq is considered a stock exchange and its stocks are not OTC stocks.

15

Interest

Interest rates typically refer to the rate charged on a debt instrument There are MANY interest rates, including

the prime rate, the federal funds rate, etc. Interest rates tend to move in tandem

16

The Relationship Between Interest and the Stock Market

The stock market reacts to changes in interest rates (even though interest rates are related to the bond market) Stocks (equity) and bonds (debt) compete for

investor’s dollars Stocks offer higher returns but have more risk

If you could earn 10% by investing in a bond of IBM, what return would you want to invest in IBM’s stock? ANS. More than 10% because the stock is more

risky

17

The Relationship Between Interest and the Stock Market

If interest rates were to rise to 12% on IBM’s bonds, what would happen to your required rate of return on IBM’s stock? Your required return on IBM’s stock would rise

and therefore, the value of IBM’s stock would drop in the market

Interest rates and security prices move in opposite directions Good reason for us to have an interest in interest

rates

18

Interest and the Economy Would you be more likely to buy a

house/car when interest rates are high or low?

Interest rates have a significant effect on the economy Lower interest rates stimulate business and

economic activity Businesses and individuals use credit a great

deal Interest rates represent the cost of borrowing money

(credit)

19

This is a copy of a later slide (#33) Putting the Pieces Together

The factors that make up an interest rate, k, can be expanded to include the particular types of risk

K = KPure Interest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium

k = kpr + INFL + DR + LR + MR K is known as the nominal or quoted interest rate

20

The Components of an Interest Rate

Interest rates include base rates and risk premiums

Interest rate will be represented by the letter k k = base rate + risk premiums k = kpr + INFL + DR + LR + MR

21

Conceptual View for Interest Rates k = kpr + INFL + DR + LR + MR

Components of the Base Rate The base rate is pure interest plus expected

inflation The rate at which people lend money when

no risk is involved Pure interest rate is AKA earning power of money

An unobservable rate that would exist in the real world if there were no inflation and no risk

Generally considered to be between 2% and 4%

22

The Components of an Interest Rate

The Inflation Adjustment Inflation refers to a general increase in prices Refers to the fact that, if prices rise, $100 at the

beginning of the year will not buy as much at the end of the year

If you lent someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year Interest rates include estimates of average

annual inflation over loan periods

23

Risk Premiumsk = kpr + INFL + DR + LR + MR

Default risk in loans refers to the chance that the lender will not receive the full amount of principal and interest payments agreed upon

Some loans are more risky than others

Lenders demand a risk premium of extra interest for making risky loans

24

Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR

Bond losses can be associated with fluctuations in the prices of bonds as well as with the failure of borrowers to repay the loans

Default Risk The chance the borrower won't pay principal or

interest Losses can be the entire amount or anywhere in

between Investors demand a default risk premium which

depends on the investor's perception of the creditworthiness of the borrower Perception is based on the firm's financial

condition and credit record

25

Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR

Default Risk (continued) Premiums range from 0% to 6 or 8 %

Once a company's default risk becomes too high, they will be unable to borrow at any interest rate

Default doesn't actually have to occur for problems to exist If investors realize that a firm is having difficulty making

interest payments (although it is still making them) the bond's price will probably fall

A time dimension is involved in the risk of default The longer the time period involved with the debt

instrument the more likely that the firm will face financial difficulty

26

Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR

Liquidity Risk Associated with being unable to sell the bond of

an little known issuer Debt of small firms are particularly hard to

market Said to be illiquid

Sellers must reduce their prices to encourage investors to buy the illiquid securities

Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk

Very short-term securities usually bear little liquidity risk

27

Different Kinds of Lending Riskk = kpr + INFL + DR + LR + MR

Maturity Risk Bond prices and interest rates move in opposite

directions Long-term bond prices change more with

interest rate swings than short-term bond prices Gives rise to maturity risk

Investors demand a maturity risk premium Ranges from 0% to 2% or more for long-term

issues

28

Putting the Pieces Together The factors that make up an interest rate, k, can be

expanded to include the particular types of risk K = KPure Interest Rate + Inflation + Default Risk Premium +

Liquidity Risk Premium + Maturity Risk Premium

k = kpr + INFL + DR + LR + MR K is known as the nominal or quoted interest rate

“Setting” Interest Rates Interest rates are set by the forces of supply and

demand Thus the interest rate model above is only an economic

model of reality Represents an explanation of what generally has to be

behind the interest rate needs of investors

29

Federal Government Securities, Risk Free and Real Rates

Federal Government Securities Cities, states and federal governments issue

long-term bonds Federal treasury also issues short-term securities

Known as Treasury securities Treasury bills have terms from 90 days to a year Treasury notes have terms from 1 to 10 years

No default risk associated with federal government debt Can print money to pay off all of its debt

No liquidity risk for federal government debt Always an active market

30

The Risk-Free Rate

The risk-free rate is approximately the yield on short-term Treasury bills Includes the pure rate and an allowance

for inflation Same as the base rate discussed earlier

Viewed as a conceptual floor for the structure of interest rates

Denoted as kRF

31

The Real Rate of Interest Real refers to values that have the effects of inflation

removed Tells investors by how much they are getting ahead

If you earn a real rate of 8% on an investment and inflation turns out to be 10%, you are losing purchasing power on your investment

There are periods in time when the real rate of interest has been negative Because we don't really know what the rate of

inflation will be at the point in time when nominal rates are set

The Real Risk-Free Rate Implies that both the inflation adjustment and the risk

premium is zero

32

Yield Curves—The Term Structure of Interest Rates

The relationship between interest rates and the term of debt is known as the term structure of interest rates The yield curve is a graphical

representation of the term structure of interest rates

Most of the time short-term rates are lower than long-term rates However at times the opposite is true

Known as an inverted yield curve

33

Figure 4.10: Yield Curves

34

Yield Curves—The Term Structure of Interest Rates

Theories have developed attempting to explain the term structure of interest rates Expectations theory

Today's rates rise or fall with term as future rates are expected to rise or fall

Liquidity preference theory Investors prefer shorter term securities and

must be induced to make longer loans Market segmentation theory

Loan terms define independent segments of the debt market which set separate rates

27. You have been assigned to estimate the interest rates that your company may have to pay when borrowing money in the near future. The following information is available.

a. Calculate the inflation adjustment (INFL) for a 5-year loan.

b. Calculate the appropriate interest rate for a 5-year loan.

kPR = 2%

MR = .1% for a 1 year loan increasing by .1% for each additional year

35k = kpr + INFL + DR + LR + MR

LR = .05% for a 1 year loan increasing by .05% for each additional year

DR = 0 for a 1 year loan, .2% for a 2-year loan, increasing.1% for each additional year

Expected Inflation RatesYear 1 = 7%Year 2 = 5%Year 3 and thereafter = 3%

 a. INFL = (7% + 5% + 3% + 3% + 3%)/5 = 4.2%

36

k = kpr + INFL + DR + LR + MR

b. k= 2% + 4.2% + .5% + .25% + .5% = 7.45%