2 The Financial Markets Debt versus equity markets Debt markets = loans Equity markets = stocks Money versus capital markets Money market = debt < 1 year Capital market = debt > 1 year + stocks Primary versus secondary markets Primary markets = new funds Secondary markets = outstanding securities
3 The Financial Markets Public versus private markets Public markets = liquid, low-cost standardized trades Private markets = specialized deals Spot versus futures markets Spot markets = assets traded “on the spot” Futures markets = for delivery at a later date World, national, regional, and local markets Worldwide = New York Stock Exchange Local = Chicago Stock Exchange
4 Financial Institutions Direct transfers No intermediaries Often part of private market transactions Investment banking houses I-Bank = middleman I-Bank may buy in hopes of selling, so there is some risk Financial intermediaries Banks or mutual funds Savers invest in one type of product (e.g., CDs or savings accounts) Bank then creates loans, mortgages, etc. to sell to borrowers Funds are transferred between those who have funds and those who need funds by three processes:
5 Financial Intermediaries 1993 Glass-Steagall Act Prohibited commercial banks from I-banking activities Tried to prohibit “conflict of interest situations” Result: Morgan Bank JP Morgan Chase & Company = commercial bank Morgan Stanley = investment bank 1999 Gramm-Leach-Bliley Act Expanded the powers of banks Abolished major restrictions of the Glass-Steagall Act Allows banks to do: I-banking insurance sales and underwriting low risk non-financial activities
6 Financial Intermediaries The Gramm-Leach-Bliley Act blurred the distinctions: Commercial banks Savings and loan associations Credit unions Pension funds Life insurance companies Mutual funds
7 Stock Markets Old classification Organized Security Exchanges NYSE, AMEX, and regional OTC (over-the-counter markets) A broader network of smaller dealers New classification Physical stock exchanges NYSE, AMEX Organized Investment Networks OTC, Nasdaq, electronic communication networks (ECN)
8 Physical Stock Exchanges A physical, “material entity” A building Designated members A board of governors Seats are bought and sold Record high price = $4M (12/1/05) Price in 1999 = $2M Auction markets Sell orders and buy orders come together
9 Organized Investment Networks For securities not traded on physical stock exchanges An intangible trading system A network of brokers and dealers (NASD) Dealers make the market The bid price = what the dealer will pay to buy The ask price = what the dealer will take to sell Spread = the dealer’s profit Electronic communications networks
10 Four factors that affect the cost of money The Cost of Money Production opportunities Is it worth investing in new assets? Time preferences for consumption Now or later? Risk How likely is it that this investment won’t pan out? Expected inflation How much will prices increase over time?
11 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
12 Interest Rate Levels Interest Rates as a Function of Supply and Demand k B = 12 Interest Rate, k B Market B:High-Risk Securities % Dollars 0 S1S1 D1D1 Interest Rate, k A Market A: Low-Risk Securities k A = 10 8 0 Dollars % D1D1 D2D2 S1S1
13 = real risk-free rate. Typically 2% to 4% T-bill for short term T-bond for long term k* = any nominal rate = quoted rate k = Risk-free rate on T-securities k RF “Real” versus “Nominal” Rates
14 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 The Determinants of Market Interest Rates
15 The Determinants of Market Interest Rates Quoted Interest Rate = k k = Risk-free interest rate + risk premium k = k RF + RP k = k RF + [DRP + LP + MRP] k = [k* + IP] + [DRP + LP + MRP]
16 The Determinants of Market Interest Rates Nominal Interest Rate = k = [k* + IP] + [DRP + LP + MRP] IP = average rate of inflation expected in future DRP = risk that a borrower will default on a loan (difference between the T-bond interest rate and a corporate bond with same features) LP = premium if asset cannot be converted to cash quickly and at close to the original cost (2 – 5%) MRP = the interest rate risk associated with longer maturity periods (usually 1 – 2%)
17 Quoted Risk-Free Rate = k = k RF + DRP + LP + MRP k= Quoted or nominal rate k RF = Real risk-free rate plus a premium for expected inflation or k RF = k* + IP DRP= Default risk premium LP= Liquidity premium MRP= Maturity risk premium Determinants of Market Interest Rates
18 IP= Inflation premium DRP= Default risk premium LP= Liquidity premium MRP= Maturity risk premium Premiums Added to k* for Different Types of Debt Short-Term (S-T) Treasury: only IP for S-T inflation Long-Term (L-T) Treasury: IP for L-T inflation plus MRP Short-Term corporate: Short-Term IP, DRP, LP Long-Term corporate: IP, DRP, MRP, LP
19 The Term Structure of Interest Rates Term structure: the relationship between interest rates (or yields) and maturities A graph of the term structure is called the yield curve.
20 U.S. Treasury Bond Interest Rates on Different Dates Interest Rate Term to March July July Maturity1980 2000 2003 3 months 16.0% 6.1%0.9% 1 year 14.0 6.11.0 5 years 13.5 6.22.3 10 years 12.8 6.13.3 20 years 12.3 6.24.3 Short Term Intermediate Term Long Term 151020 16 14 12 10 8 6 4 2 0 Interest Rate (%) March 1980 July 2000 July 2003 Abnormal Flat = horizontal Normal
21 Three Explanations for the Shape of the Yield Curve Liquidity Preference Theory Expectations Theory Market Segmentation Theory
22 Liquidity Preference Theory Lenders prefer to make short-term loans Less interest-rate risk More liquid Lenders lend short-term funds at lower rates Says MRP > 0 Results in “normal” curve
23 Expectations Theory Shape of curve depends on investors’ expectations about future inflation rates. If inflation is expected to increase, S-T rates will be low, L-T rates high, and vice versa. The yield curve can slope up OR down.
24 Calculating Interest Rates under Expectations Theory Step 1:Find the Inflation Premium, the average expected inflation rate over years 1 to N
25 Inflation for Year 1 is 5%. Inflation for Year 2 is 6%. Inflation for Year 3 and beyond is 8%. k* = 3% MRP t = 0.1% (t-1) IP 1 = 5%/ 1.0 = 5.00% IP 10 = [ 5 + 6 + 8(8)] / 10 = 7.5% IP 20 = [ 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). Example:
26 Step 2: Find MRP based on this equation: MRP t = 0.1% (t - 1) MRP 1 = 0.1% x 0= 0.0% MRP 10 = 0.1% x 9= 0.9% MRP 20 = 0.1% x 19= 1.9% Calculating Interest Rates under Expectations Theory:
27 Calculating Interest Rates under Expectations Theory: 1-Yr: k RF1 = 3% + 5.0% + 0.0% = 8.0% 10-Yr: k RF10 = 3% + 7.5% + 0.9% = 11.4% 20-Yr: k RF20 = 3% + 7.75% + 1.9% = 12.7% k RFt = k* + IP t + MRP t k RF = Quoted market interest rate on treasury securities. Assume k* = 3%. Step 3: Add the IPs and MRPs to k*:
29 Market Segmentation Theory Borrowers and lenders have preferred maturities Slope of yield curve depends on supply and demand for funds in both the L-T and S-T markets Curve could be flat, upward, or downward sloping
30 Other Factors that Influence Interest Rate Levels Federal Reserve Policy Controls money supply; impacts S-T interest rates Federal Deficits Larger federal deficits mean higher interest rates Foreign Trade Balance Larger trade deficits mean higher interest rates Business Activity Does the Federal Reserve need to stimulate activity?
31 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... which affects corporate profits If interest rates rise... Investors turn to the bond market, sell stock, and decrease stock prices If interest rates decline... Investors turn to the stock market, sell bonds, and increase stock prices
32 For Next Class: Chapter 2 Homework problems Review Chapters 1 and 2 Prepare for Chapter 1-2 quiz Read Chapter 3