5 - 1 Copyright © 2002 by Harcourt, Inc. All rights reserved. CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates Financial markets Types of financial institutions Determinants of interest rates Yield curves

5 - 2 Copyright © 2002 by Harcourt, Inc. All rights reserved. Define these markets Markets in general Markets for physical assets Markets for financial assets Money versus capital markets Primary versus secondary markets Spot versus future markets

5 - 3 Copyright © 2002 by Harcourt, Inc. All rights reserved. Direct transfer Through an investment banking house Through a financial intermediary Three Primary Ways Capital Is Transferred Between Savers and Borrowers

5 - 4 Copyright © 2002 by Harcourt, Inc. All rights reserved. The Top 5 Banking Companies in the World, 1999 Bank NameCountryTotal assets Deutsche Bank AGGermany$735 billion UBS GroupSwitzerland$687 billion CitigroupUnited States$669 billion Bank of AmericaUnited States$618 billion Bank of TokyoJapan$580 billion

5 - 5 Copyright © 2002 by Harcourt, Inc. All rights reserved. Organized Exchanges versus Over-the-Counter Market Auction markets versus dealer markets (exchanges versus the OTC market) NYSE versus Nasdaq system Differences are narrowing Nasdaq vs. true OTC

5 - 6 Copyright © 2002 by Harcourt, Inc. All rights reserved. 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? Required Dividend Capital return yield gain = +.

5 - 7 Copyright © 2002 by Harcourt, Inc. All rights reserved. What four factors affect the cost of money? Production opportunities Time preferences for consumption Risk Expected inflation

5 - 8 Copyright © 2002 by Harcourt, Inc. All rights reserved. Real versus Nominal Rates k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. k k RF

5 - 9 Copyright © 2002 by Harcourt, Inc. All rights reserved. k = k* + IP + DRP + LP + MRP. Here: k=Required rate of return on a debt security. k*= Real risk-free rate. IP= Inflation premium. DRP= Default risk premium. LP= Liquidity premium. MRP= Maturity risk premium.

Copyright © 2002 by Harcourt, Inc. All rights reserved. Premiums Added to k* for Different Types of Debt ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: ST IP, DRP, LP LT corporate: IP, DRP, MRP, LP

Copyright © 2002 by Harcourt, Inc. All rights reserved. What is the term structure of interest rates? What is a yield curve? Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.

Copyright © 2002 by Harcourt, Inc. All rights reserved. Treasury Yield Curve Years to Maturity Interest Rate (%) 1 yr6.3% 5 yr6.7% 10 yr6.5% 30 yr6.2% Yield Curve (May 2000)

Copyright © 2002 by Harcourt, Inc. All rights reserved. Yield Curve Construction Step 1:Find the average expected inflation rate over years 1 to n: n INFL t t = 1 n IP n =.

Copyright © 2002 by Harcourt, Inc. All rights reserved. IP 1 = 5%/1.0 = 5.00%. IP 10 = [ (8)]/10 = 7.5%. IP 20 = [ (18)]/20 = 7.75%. Must earn these IPs to break even versus inflation; that is, these IPs would permit you to earn k* (before taxes).

Copyright © 2002 by Harcourt, Inc. All rights reserved. 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%.

Copyright © 2002 by Harcourt, Inc. All rights reserved. Step 3: Add the IPs and MRPs to k*: k RF t = k* + IP t + MRP t. k RF =Quoted market interest rate on treasury securities. Assume k* = 3%: k RF1 = 3% + 5% + 0.0% = 8.0%. k RF10 = 3% + 7.5% + 0.9% = 11.4%. k RF20 = 3% % + 1.9% = 12.65%.

Copyright © 2002 by Harcourt, Inc. All rights reserved. Hypothetical Treasury Yield Curve Years to Maturity Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% Real risk-free rate Inflation premium Maturity risk premium

Copyright © 2002 by Harcourt, Inc. All rights reserved. What factors can explain the shape of this yield curve? This constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium.

Copyright © 2002 by Harcourt, Inc. All rights reserved. What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues? Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not neces- sarily parallel to the Treasury curve. The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.

Copyright © 2002 by Harcourt, Inc. All rights reserved. Hypothetical Treasury and Corporate Yield Curves Years to maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury yield curve BB-Rated AAA-Rated

Copyright © 2002 by Harcourt, Inc. All rights reserved. How does the volume of corporate bond issues compare to that of Treasury securities? Recently, the volume of investment grade corporate bond issues has overtaken Treasury issues Gross U.S. Treasury Issuance (in blue) Investment Grade Corporate Bond Issuance (in red) Billions of dollars

Copyright © 2002 by Harcourt, Inc. All rights reserved. The Pure Expectations Hypothesis (PEH) Shape of the yield curve depends on the investors expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates and vice versa. Thus, the yield curve can slope up or down.

Copyright © 2002 by Harcourt, Inc. All rights reserved. PEH assumes that MRP = 0. Long-term rates are an average of current and future short-term rates. If PEH is correct, you can use the yield curve to back out expected future interest rates.

Copyright © 2002 by Harcourt, Inc. All rights reserved. Observed Treasury Rates If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now? MaturityYield 1 year6.0% 2 years6.2% 3 years6.4% 4 years6.5% 5 years6.5%

Copyright © 2002 by Harcourt, Inc. All rights reserved % 34 x% 6.2% PEH tells us that one-year securities will yield 6.4%, one year from now (x%). 6.2%= 12.4%= x% 6.4%= x%. (6.0% + x%) 2

Copyright © 2002 by Harcourt, Inc. All rights reserved % 34 x% 6.5% [ 2(6.2%) + 3(x%) ] 5 PEH tells us that three-year securities will yield 6.7%, two years from now (x%). 6.5%= 32.5%= 12.4% + 3(x%) 20.1%= 3(x%) 6.7%= x%.

Copyright © 2002 by Harcourt, Inc. All rights reserved. Some argue that the PEH isnt correct, because securities of different maturities have different risk. General view (supported by most evidence) is that lenders prefer S-T securities, and view L-T securities as riskier. Thus, investors demand a MRP to get them to hold L-T securities (i.e., MRP > 0). Conclusions about PEH

Copyright © 2002 by Harcourt, Inc. All rights reserved. What various types of risks arise when investing overseas? Country risk: Arises from investing or doing business in a particular country. It depends on the countrys economic, political, and social environment. Exchange rate risk: If investment is denominated in a currency other than the dollar, the investments value will depend on what happens to exchange rate.

Copyright © 2002 by Harcourt, Inc. All rights reserved. Two Factors Lead to Exchange Rate Fluctuations Changes in relative inflation will lead to changes in exchange rates. An increase in country risk will also cause that countrys currency to fall.