financial environment (markets, institutions & interest rate)

8/3/2019 Financial Environment (Markets, Institutions & Interest Rate)

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THE FINANCIAL ENVIRONMENT:MARKETS, INSTITUTIONS &

INTEREST RATE


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Financial Markets

Businesses, individuals and governments oftenneed to raise capital.

Example: Engro fertilizers forecasts increase in thedemand for urea and the company decides to build anew production plant. They dont have sufficientmoney so they need to raise capital from financialmarket.

On the other hand, some individuals and firms

have incomes that are greater than their currentexpenditure, so they have funds available toinvest.


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Types of Markets

People and organizations wanting to borrowmoney are brought together with thosehaving surplus funds in the Financial Markets.

Each market deals with some what differenttype of financial instruments in terms ofinstruments maturity and the assets backing

it. Also different market serves different

customers.


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Types of Markets

1. Physical asset vs Financial asset markets

2. Spot vs Future markets

3. Money Vs Capital markets4. Primary vs Secondary markets

5. Private vs Public markets


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A healthy economy is dependent on efficient

transfers of funds from people who are net

savers to firms and individuals who need

capital.

Without efficient transfers the economy

simply could not function.

What consequences economy have to bear if

engro fertilizers cannot raise capital?


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Role of Financial Institutions

Transfers of capital between savers and those who needcapital take place in the three different ways.

1. Direct transfer of money and securities

Business sells its stocks and bonds directly to savers2. Indirect transfers through investment banks

Investment banks underwrites the issue.

3. Indirect transfers through financial intermediary

e.g a saver might give $$ to banks receiving from it a CoD, andthen the bank might lend the money to business in form ofmortgage loan.

Existence of intermediaries greatly increase the efficiency ofmoney and capital markets.


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Role of Financial Institutions

Investment Banking House

an organization that underwrites and distributes new

investment securities and helps businesses obtain

financing.

Financial Intermediaries

specialized financial firms that facilitates the transferof funds from savers to demanders of capital.


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Financial Intermediaries

Major Classes of intermediaries:

1. Commercial banks (department stores of finance, serve awide variety of savers and borrowers)

2. Credit unions (members have a common bond such asemployee of same firm, members savings are loaned only to othermember s for auto purchase or home mortgage)

3. Pension funds (invest primarily in bonds, stocks, real estateand administered by the trust department of banks, insurancecompanies)

4. Life insurance companies (taking savings in form ofpremiums and invest in stocks, bonds, real estate etc)

5. Mutual Funds (accept money from savers and use to buystocks, long term bonds, or short term debt instruments)


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Cost of Money

There are four fundamental factors affecting the cost

of money:

1. Production opportunities (returns available within an

economy from investments in productive assets)2. Time preferences for consumption (preference of

consumers for current consumption as opposed to savings for

future consumption)

3. Risk (the chances that an investment will provide a low ornegative return)

4. Inflation (the amount by which the prices increase over time)


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Determinants of Market Interest

rates

In general, the quoted or nominal interest rate is

composed of a real risk free rate of interest, plus

several premiums

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


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rates

Real Risk Free Rate of Interest

rate of interest that would exist on default free treasurysecurities if no inflation were expected

Inflation Premium

is equal to average expected inflation rate over the life ofsecurity

Default Risk Premium

the difference between the interest rate on a treasurybond and a corporate bond of equal maturity andmarketability


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rates

Liquidity Premium

a premium charged by lenders to reflect the fact that

some securities cannot be converted to cash on

short notice at a reasonable price.

Maturity Risk Premium

long term bonds even treasury bonds are exposed to

a significant risk of price declines, and a MRP is

charged by lenders to reflect this risk.


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Term Structure of Interest Rates

It describes the relationship between bond yields

and maturities

Term structure is important to

Corporate treasurers who decide whether to borrow by

issuing long or short term debt instruments

Investors who decide whether to invest in long or short

term debt securities


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To answer treasurer and investor its important to

understand

1. How long term and short term rates relate to each other

2. What causes shifts in their relative position


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Yield curve is a graph that shows relationship

between bond yields and maturities.

Yield curve changes both in position and in slope

over time. Yield curve could be

1. Normal yield curve

2. Inverted (abnormal) yield curve

3. Humped yield curve


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1. Normal yield curve

an upward sloping yield curve.

historically in most years long term rates have been

above short term rates so yield curve usually slopesupward

Q.) Why an upward slope is a normal situation??

A.) Short term securities have less interest rate risk thanlonger term securities, hence they have smaller maturity

risk premium. Therefore short term rates are normally

lower than long term rates


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2. Inverted (Abnormal) yield curve

a downward slopping yield curve

when short term rates are higher than the long term

rates

3. Humped yield curve

when interest rates on medium term maturities are

higher than rates on both short and long term maturities


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Determinants of Shape of Yield

Curve

Expected inflation has important effect on the

yield curve shape.

Treasury security have no default risk or liquidity

risk, therefore

k= k* + IP + MRP


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Curve

Upward slopping yield curve the long term bonds willhave higher yields because:

1. Inflation is expected to be higher in future

2. Positive maturity risk premium

Downward slopping yield curve is an indication ofeconomic downturn because:

1. weak economic conditions are correlated withdeclining inflation

2. and lower long term rates


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Curve

Yield for any corporate bond is

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

Note that corporate bonds will have a yieldhigher than treasury bonds for the samematurities because:

corporate bonds are subject to default andliquidity risks

financial environment (markets, institutions & interest rate)

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