1. Chapter 4 The Financial Environment. Markets. Institutions
Chapter 4 The Financial Environment Markets Institutions Interest Rates 1

2. The Financial Environment

3. Chapter Outline: Financial markets Types of financial institutions
Determinants of interest rates

4. What is a Financial market?
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.

5. Flow of Funds:
Funds flow indirectly from ultimate lenders [households] through financial intermediaries [banks or insurance companies] or directly through financial markets [stock exchange/bond markets] to ultimate borrowers [business firms, government, or other households].
In order for financial system to function smoothly, must be adequate information about the markets and their operation.

6. Flow of Funds:
Financial system provides a transmission mechanism between saver-lenders and borrower-spenders.
Savers benefit—earn interest
Investors benefit—access to money otherwise not available
Economy benefits—efficient means of bringing savers and borrowers together

7. Flow of funds from lenders to borrowers:

8. The Financial Markets:
Physical VS. Financial asset markets
Spot VS. future markets
Money VS. capital markets
Primary VS. secondary markets
Public VS. private markets 2

9. The Financial Markets:
Physical Asset Markets:
It is a market for such products as wheat, autos, real estate, and machinery.
Financial Asset Markets:
It deals with stocks, bonds, notes, mortgages, and derivatives.

10. The Financial Markets:
Spot Markets:
It is a market in which assets are bought and sold for on the spot delivery.
Futures Markets:
It is a market in which participants agree today to buy or sell an asset at some future date.

11. The Financial Markets:
The Money Market:
Exchange of short-term instruments—less than one year
Highly liquid, minimal risk
Commercial paper—short-term liabilities of prime business firms and finance companies
Bank Certificates of Deposits—liabilities of issuing bank, interest bearing to corporations that hold them
U.S. Treasury bills—short-term debts of US government

12. The Financial Markets:
The Capital Market:
Exchange of long-term securities—in excess of one year
Generally used to secure long-term financing for capital investment.
Stock market—Largest part of capital market and held by private and institutional investors
Residential and commercial mortgages—Held by commercial banks and life insurance companies
Corporate bond market—Held by insurance companies, pension and retirement funds

13. The Financial Markets:
Primary Markets:
Market for issuing a new security and distributing to saver-lenders.
Initial Public Offering Market (IPO).
Investment Banks—Information and marketing specialists for newly issued securities.

14. The Financial Markets:
Secondary Markets:
Market where existing securities can be exchanged
New York Stock Exchange
American Stock Exchange
Over-the-counter (OTC) markets (NASDAQ).

15. Financial Institutions:
Funds are transferred between those who have funds and those who need funds by three processes:
Direct transfers,
Investment banking houses, or
Financial intermediaries.

16. Financial Intermediaries:
Commercial banks
Savings and loan associations
Credit unions
Pension funds
Life insurance companies
Mutual funds

17. Role of Financial Intermediaries:
Act as agents in transferring funds from savers-lenders to borrowers-spenders.
Acquire funds by issuing their liabilities to public and use money to purchase financial assets
Earn profits on difference between interest paid and earned
Diversify portfolios and minimize risk
Lower transaction costs

18. Commercial Banks: Most prominent Range in size from huge to small
Major source of funds used to be demand deposits of public, but now rely more on “other liabilities”
Also accept savings and time deposits—interest earning

19. Savings and Loan Associations [S&L’s]:
Traditionally acquired funds through savings deposits
Used funds to make home mortgage loans
Now perform same functions as commercial banks
issue checking accounts
make consumer and business loans

20. Credit Unions:
Organized as cooperatives for people with common interest
Members buy shares [deposits] and can borrow
Changes in the law in early 1980’s broadened their powers
checking [share] accounts
make long-term mortgage loans

21. Pension and Retirement Funds:
Concerned with long run
Receive funds from working individuals building “nest-egg”
Accurate prediction of future use of funds
Invest mainly in long-term corporate bonds and high-grade stock
Invest in wide variety of securities—minimize risk

22. Life Insurance Companies:
Insure against death
Receive funds in form of premiums
Use of funds is based on mortality statistics—predict when funds will be needed
Invest in long-term securities—high yield
Long-term corporate bonds
Long-term commercial mortgages

23. Mutual Funds: Stock or bond market related institutions
Pool funds from many people
Invest in wide variety of securities—minimize risk

24. Physical location stock exchanges vs. Electronic dealer-based markets
Auction market vs. Dealer market (Exchanges vs. OTC)
NYSE vs. Nasdaq

25. The Stock Market: Organized Security Exchanges:
NYSE, AMEX, and regional
Actual physical locations
Over-the-Counter Markets:
Network of brokers and dealers
Auction market
Organized Investment Network
Electronic Communications Networks 4

26. The Cost of Money: Four factors that affect the cost of money:
Production opportunities
Time preferences for consumption
Risk
Expected inflation 5

27. The Cost of Money:
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?
Return on Equity =Dividends +Capital Gains 6

28. “Real” versus “Nominal” Rates:
= real risk-free rate.
T-Bond rate if no inflation;
2% to 4%. k*
= any nominal rate. k
= Rate on T-securities—risk-free.
kRF 7

29. The Determinants of Market Interest Rates:
Quoted Interest Rate = k = k* + IP + DRP + LP + MRP
k = Quoted or nominal rate
k* = Real risk-free rate (“k-star”)
IP = Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium 8

30. Hypothetical yield curve:
Years to
Maturity
Real risk-free rate 5 10 15
Interest
Rate (%)
Maturity risk premium
Inflation premium

31. Other Factors that Influence Interest Rate Levels:
Federal Reserve Policy
Controls money supply
Federal Deficits
Larger federal deficits mean higher interest rates
Foreign Trade Balance
Larger trade deficits mean higher interest rates
Business Activity

32. Interest Rate Levels and Stock Prices:
The higher the rate of interest, the lower a firm’s profits
Interest rates affect the level of economic activity, and economic activity affects corporate profits

33. Risks associated with investing overseas:
Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates.
Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.

34. End of Chapter 4: