Finance Chapter 4 The financial environment: markets, institutions, & interest rates

Financial environment  Financial environment  Financial markets  Financial institutions  Tax & regulatory policies  State of the economy

Types of financial markets  Physical asset vs. financial asset markets  E.g., wheat vs. bonds  Spot markets – “on-the-spot” delivery  Futures markets – agreement to buy/sell an asset at some future date  Money markets – loan/borrow funds < 1 year  Capital markets – loan/borrow funds > 1 year  Primary markets – selling new securities  Secondary markets – securities trading by investors after issuance by corporations

Types of financial markets  Initial public offering (IPO) market – where firms “go public” by offering shares to the public  Private markets – transaction between 2 parties  Public markets – standardized contracts are traded on organized exchanges

Major market instruments See Table 4-1, pages  U.S. Treasury bills  U.S. Treasury notes & bonds  Money market funds  Consumer credit loans  Mortgages  Corporate bonds  Leases  Preferred stocks  Common stocks

Derivatives  Any financial asset (contract) whose value is derived from the value of some other underlying asset Uses:  Speculate (anticipating an increased return)  Hedge (reduce risk)

Transfers of capital  Direct transfers  Transfers through investment banking houses  Transfers through financial intermediaries which create new securities  Stock markets  Physical location (NYSE)  Electronic (NASDAQ and over-the-counter market)  Capital is allocated through a price system  Lenders receive “rent” (interest)  Investors receive dividends & capital gains

Cost of money  Fundamental factors affecting the cost of money: 1. Production opportunities – returns from investments in cash-generating assets 2. Time preferences for consumption – preference of consumers for current vs. future consumption (savings) 3. Risk of low or negative return 4. Inflation – the amount prices increase over time

Cost of money  Risk-free rate of interest, k RF The real risk-free rate, k*, plus an inflation premium, IP  k RF = k* + IP  The nominal (quoted) interest rate also includes default risk (DRP), liquidity (LP), & maturity risk (MRP)  k RF = k* + IP + DRP + LP + MRP  Effecting the cost of money:  The real rate and inflation change over time  Central bank money supply management  International currency flows

Cost of money  Effecting the cost of money:  The real rate and inflation change over time  Central bank money supply management & International currency flows also lead to interest rate changes  Because interest rate levels are difficult to predict, sound financial policy calls for using a mix of short- and long-term debt