5 - 1 copyright © 2002 by harcourt, inc.all rights reserved. chapter 5 the financial environment:...

5 - 1

Copyright © 2002 by Harcourt, Inc. All rights reserved.

CHAPTER 5The Financial Environment:

Markets, Institutions,and Interest Rates

Financial markets

Types of financial institutions

Determinants of interest rates

Yield curves

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Define These Markets

Markets in general

Physical assets vs. Financial assets

Money vs. Capital

Primary vs. Secondary

Spot vs. Futures

Public vs. Private

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MONEY VS. CAPITAL MARKETS

FUNCTION OF TIME TO MATURITY – 1 YEAR OR LESS, MONEY MARKET

Lower risk, (not zero risk), Normally higher initial investments

Includes Treasury bills, commercial paper, many derivatives, Eurodollars, Repos & Reverse Repos

MORE THAN 1 YEAR – CAPITAL MARKET

Higher risk, includes stocks, bonds, some derivatives

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PRIMARY VS. SECONDARY MARKETS

Primary Market – First time a security is traded, issuer receives proceeds

Investment banker is the intermediary.

Includes Seasoned Offerings & IPO’s

Secondary Market – Investor to investor transfers, issuer no longer involved in the process.

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Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets

Auction market vs. Dealer market (Exchanges vs. OTC)

NYSE vs. Nasdaq system

Differences are narrowing

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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= +

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What four factors affect the cost of money?

Production opportunities

Time preferences for consumption

Risk

Expected inflation

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“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

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krf= k* + IP

Here:

krf = rate of return on the risk-

free security

k* = real risk-free rate.

IP = inflation premium.

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

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.

ISP = issue specific premium

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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, ISP

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

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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.

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Treasury Yield Curve

0

5

6

10 20 30Years to Maturity

InterestRate (%)

1 yr 4.8% 5 yr 4.9%10 yr 5.2%30 yr 5.6%

Yield Curve(January 2001)

4

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Yield Curve Construction

Step 1:Find the average expected

inflation rate over Years 1 to n:

IPn = .

n

1ttINFL

n

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Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter.

IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.50%.

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).

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Step 2: Find MRP Based on Returns of Similar Risk Securities with

Different Maturities

MRP10 = 4.9-1.7=3.2%

4.9% = Return on 10 year

Treasuries

1.7% = Return on 3 month T-Bills

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Hypothetical Treasury Yield Curve

0

5

10

15

1 10 20

Years to Maturity

InterestRate (%) 1 yr 8.0%

10 yr 11.4%20 yr 12.65%

Real risk-free rate

Maturity risk premium

Inflation premium

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What factors can explain the shape of this yield curve?

This constructed yield curve is upward sloping.

This is due to increasing expected inflation and an increasing maturity risk premium.

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What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues?

Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not neces-sarily parallel to the Treasury curve.

The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.

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Hypothetical Treasury and Corporate Yield Curves

0

5

10

15

0 1 5 10 15 20

Years toMaturity

Interest Rate (%)

5.2%5.9%

6.0%TreasuryYield Curve

BB-Rated

AAA-Rated

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How does the volume of corporate bond issues compare to that of

Treasury securities?

Recently, the volume of investment grade corporate bond issues has overtaken Treasury issues.

‘95 ‘96 ‘97 ‘98 ‘99

600

450

300

150

Gross U.S. Treasury Issuance (in blue)Investment Grade Corporate Bond

Issuance (in red)

Bil

lio

ns

of

do

llar

s

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The Pure Expectations Hypothesis (PEH)

Shape of the yield curve depends on 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.

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PEH assumes that 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.

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Observed Treasury Rates

Maturity1 year2 years3 years4 years5 years

Yield6.0%6.2%6.4%6.5%6.5%

If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?

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0 1 2 5

6.0%

3 4

x%

6.2%

PEH tells us that one-year securities will yield 6.4%, one year from now (x%).

6.2% =

12.4% = 6.0 + x%

6.4% = x%.

(6.0% + x%)2

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0 1 2 5

6.2%

3 4

x%

6.5%[ 2(6.2%) + 3(x%) ]

5

PEH tells us that three-year securities will yield 6.7%, two years from now (x%).

6.5% =

32.5% = 12.4% + 3(x%)

20.1% = 3(x%)

6.7% = x%.

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

Liquidity Preference Theory: 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).

Other Theories on Term Structure

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Liquidity preference only explains an upward sloping yield curve

Market Segmentation: Each maturity of securities has its own market, I.e., short term, long term, intermediate term. Supply and demand will determine within each market what interest rates are, not rate or inflation expectations or a maturity risk premium.

Other Theories on Term Structure

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What various types of risks arise when investing overseas?

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.

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

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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.

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Which countries are the leastand most risky?

Safest countries

1. Switzerland

2. Germany

3. Netherlands

4. Luxembourg

5. France

6. United States

Riskiest countries

141. Sudan

142. Liberia

143. Afghanistan

144. Sierra Leone

145. North Korea

5 - 1 copyright © 2002 by harcourt, inc.all rights reserved. chapter 5 the financial environment:...

Documents

isp slide

rf slide

markets markets

private slide

st ip

st inflation

tbond rate

inflation premium