Presentation on theme: "Chapter 4 The Financial Environment Markets Institutions Interest Rates."— Presentation transcript:
Chapter 4 The Financial Environment Markets Institutions Interest Rates
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
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: Direct transfers, Investment banking houses, or Financial intermediaries. Funds are transferred between those who have funds and those who need funds by three processes:
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
26 Four factors that affect the cost of money: The Cost of Money: Production opportunities Time preferences for consumption Risk Expected inflation
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 = 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 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 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 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.