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The Financial Environment: 4-1 Markets, Institutions, and Interest Rates
Financial markets Types of financial institutions Determinants of interest
What is a market? 4-2 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 markets 4-3 Physical assets vs. Financial assets Physical
markets deal with real assets such as wheats, automobiles, computers, etc.
Financial assets deal with stocks, bonds, notes,derivatives securities, etc.
Money vs. Capital Money markets are markets for short term, highly liquid debt
securities. Capital markets are for intermediate or long term debt or corporate
stocks. Primary vs. Secondary Primary markets are markets where corporations
raise new capital. Secondary Market are markets where existing or outstanding
securities are traded among investors.
Types of financial markets 4-4 Spot vs. Futures Spot markets are markets
where assets are bought or sold for ‘on the spot’ delivery. Futures markets are
markets in which participants agree today to buy or sell an asset at some future
date. Public vs. Private Private markets are markets where transaction are
between two parties. Public markets are markets where standardized contracts
are traded on organized exchange.
4-5 How is capital transferred between savers and borrowers? Direct transfers
Investment banking house Financial intermediaries
4-6 Types of financial intermediaries Commercial banks
Savings and loan associations
Pension funds
Life insurance companies
4-7 Physical location stock
exchanges vs. Electronic
dealer-based markets
Auction market vs. Dealer market
(Exchanges vs.
Bursa vs. Mesdaq
The cost of money 4-8 The price, or cost, of debt capital is the interest
rate. The price, or cost, of equity capital is the required return.
The required return investors
expect is composed of
compensation in the form of
dividends and capital gains.
4-9 What four factors affect the cost of money? Production opportunities Time
preferences for consumption Risk Expected inflation
Interest Rates & Required Returns 4-10 The interest rate or required return
represents the price of money. Interest rates act as a regulating device that
controls the flow of money between suppliers and demanders of funds. The
central bank, BNM, regularly asses economic conditions and, when
necessary, initiate actions to change
interest rates to control inflation and
economic growth.
4-11 Interest Rates & Required
Returns: Interest Rate
Interest rates represent the compensation that a demander of funds
must pay
a supplier.
When funds are lent, the cost of borrowing is the interest rate. When funds
are raised by issuing stocks or bonds, the cost the company must
pay is called the required return, which
reflects the suppliers expected level of
4-12 Interest Rates & Required Returns: The Real Rate of Interest The real
interest rate is the rate that creates an equilibrium between the supply of
savings and the demand for investment
funds in a
perfect world.
In this context, a perfect world is one in which there is no inflation, where
and demanders have no liquidity preference,
and where all outcomes are certain.
Thesupply-demand relationship that determines the real rate is shown in Figure
6.1 on the following slide.
4-13 Returns: The Real Rate of Interest (cont.)
4-14 Returns: Inflation and the Cost of Money Ignoring risk factors, the cost
of funds is closely tied to inflationary expectations. The risk-free rate of
interest, RF, which is typically measured by a 3-month Treasury bill (T-bill)
compensates investors only for the real rate of returnand for the expected rate
of inflation. The relationship between the annual rate of inflation and the
return on T-bills is shown on the following slide.
4-15 Inflation and the Cost of Money (cont.)
4-16 Nominal or Actual Rate of Interest (Return) The nominal rate of interest
is the actual rate of interest charged by the supplier of funds and paid by the
demander. The nominal rate differs from the real rate of interest, k* as a
result of two factors: Inflationary expectations reflected in an inflation
premium (IP), and Issuer and issue characteristics such as default risks and
contractual provisions as reflected in a risk premium (RP).
4-17 n eres a es equ re e urns: Nominal or Actual Rate of Interest (Return)
(cont.) Using this notation, the nominal rate of interest for security 1, k1 is
given in equation
6.1, and is further defined in equations 6.2 and
Determinants of interest rates 4-18 k = k* + IP + DRP + LP + MRP k = required
return on a debt security
k* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP= maturity risk premium
4-19 Premiums added to k* for different types of debt L-T Corporate
S-T Corporate L-T Treasury S-T Treasury LP DRP MR P IP
Term Structure of Interest Rates 4-20 The term structure of interest rates
relates the interest rate to the time to maturity for securities with a common
default risk profile. Typically, treasury securities are used to construct
yield curves since all have zero risk of default. However, yield curves could
also be constructed with AAA or BBB corporate bonds or other types of similar
4-21 Yield curve and the term structure of interest rates Term structure –
between interest
rates (or yields)
and maturities.
The yield curve is a graph of the term structure. A Treasury yield curve from
2002 can be
viewed at the right.
Hypothetical yield curve 4-22 An upward sloping yield curve. Upward slope due
to an increase in
expected inflation
and increasing
maturity risk
Years to Maturity Real risk-free rate 05 10 15 1 10 20 Interest Rate (%)
Maturity risk premium Inflation premium 4-23 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
4-24 Illustrating the relationship
between corporate and Treasury
yield curves
05 10 15 0 1 5 10 15 20 Years to Maturity Interest Rate (%) 5.2% 5.9%
6.0%Treasury Yield Curve BB-Rated AAA-Rated 4-25 Theories of Term Structure:
Expectations Theory This theory suggest that the shape of the yield curve
reflects investors expectations about the future direction of inflation and
interest rates. Therefore, an upward-sloping yield curve reflects expectations
of higher future inflation and interest rates. In general, the very strong
relationship between inflation and interest rates supports this theory. 4-26
Theories of Term Structure: Liquidity Preference Theory This theory contends
that long term interest rates tend to be
higher than short term rates for
two reasons:
long-term securities are perceived to be riskier than short-term securities
borrowers are generally willing to pay more for long-term funds because
they can lock in at a rate for a longer
period of time and avoid the need to
roll over the debt.
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