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Chapter 4 The Financial Environment Markets Institutions Interest Rates.

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Presentation on theme: "Chapter 4 The Financial Environment Markets Institutions Interest Rates."— Presentation transcript:

1 Chapter 4 The Financial Environment Markets Institutions Interest Rates

2 2 The Financial Environment

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

4 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 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 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 7 Flow of funds from lenders to borrowers:

8 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

9 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 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 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 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 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 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 15 Financial Institutions:  Direct transfers,  Investment banking houses, or  Financial intermediaries. Funds are transferred between those who have funds and those who need funds by three processes:

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

17 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 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 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 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 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 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 23 Mutual Funds:  Stock or bond market related institutions  Pool funds from many people  Invest in wide variety of securities— minimize risk

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

25 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

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

27 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

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

29 29 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: Quoted Interest Rate = k = k* + IP + DRP + LP + MRP

30 30 Hypothetical yield curve: Years to Maturity Real risk-free rate 0 5 10 15 1 10 20 Interest Rate (%) Maturity risk premium Inflation premium

31 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 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 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 34 End of Chapter 4:

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