4 - 1 Lecture Two: Financial Markets Financial markets Types of financial institutions Determinants of interest rates Yield curves

4 - 2 Saving/Investing or Borrowing/Lending Process Aggregate Economic Sectors Government Sector Regulates and supervises where Congress has granted authority (Political Process). Also it participates in the activities of the 3 sectors below. Household Sector Saves/lends or invests in financial assets Business Sector Borrows/invests in real assets or productive assets Financial Sector Collects savings from small units in the amounts, maturities, etc., needed by the business sector. Also provides market liquidity to stimulate savings/investing/hedging

4 - 3 Fundamental Functions of The Financial Sector 1. Transfer savings to investors: distribution or allocation of financial resources. 2. Provide medium of exchange: Money supply by commercial banks. 3. Provides liquidity by providing markets that are large, active, stable, resilient. It must therefore accommodate position takers, i.e... speculators. 4. Maintains healthy environment for hedging activity so that risk takers and risk avoiders can partake in the market so that the volume of real investment can be at a maximum.

4 - 4 Define these markets Markets in general Physical assets Financial assets Money vs. capital Primary vs. secondary Spot vs. future

4 - 5 Financial Market Real Asset Market Capital Market Money Market Securities Mortgage Consumer Credit Commercial Paper Euro $ exchangesexchanges brokersbrokers Inv. Bkr s. Ins. CO. S & L Com. Bks. Fin. CO. COs. Indiv. Invest.

4 - 6 Direct transfer Investment banking house Financial intermediary Three Primary Ways Capital Is Transferred Between Savers and Borrowers

4 - 7 Financial Institutions Investment Banks Commercial Banks Savings and Loans Associations Mutual Savings Banks Credit Unions Life Insurance COs. Mutual Funds Money Bond Stocks Derivatives Pension Funds (generally administered by commercial banks or life insurance companies)

4 - 8 Balance sheet of Commercial Bank v. a Manufacturing CO. Commercial Bank Govt. Sec. Loans Fixed Assets DD TD NW Manufacturing Firm Cash AR Inv Fixed Assets Short Term Debt Long Term Debt NW = Equity

4 - 9 Balance sheet of Insurance Company v. a Manufacturing CO. Insurance Company Stocks Bonds Mortgages Fixed Assets Premiums Other Debt NW Cash AR Inv Fixed Assets Short Term Debt Long Term Debt NW = Equity Manufacturing Firm

Organized Exchanges vs. Over-the-Counter Market Auction market vs. dealer market (exchanges vs. OTC) NYSE vs. NASDAQ system Differences are narrowing

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 = +.

What four factors affect the cost of money? Production opportunities Time preferences for consumption Risk Expected inflation

“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

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.

Premiums Added to k* for Different Types of Debt S-T Treasury: only IP for S-T inflation L-T Treasury: IP for L-T inflation, MRP S-T corporate: S-T IP, DRP, LP L-T corporate: IP, DRP, MRP, LP

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 country’s economic, political, and social environment. Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate.

Two Factors Lead to Exchange Rate Fluctuations 1.Changes in relative inflation will lead to changes in exchange rates. 2.An increase in country risk will also cause that country’s currency to fall.

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.

T-Bond Yield Curve Years to Maturity Interest Rate (%) 1 yr5.7% 5 yr6.5% 10 yr6.7% 30 yr6.9% Yield Curve (March 1997)

What are the 2 main factors that explain the shape of the yield curve?

Expectations 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.

The Pure Expectations Hypothesis (PEH) 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.

Assume that 1-year securities yield 6% today, and the market expects that 1- year securities will yield 7% in 1 year, and that 1-year securities will yield 8% in 2 years. If the PEH is correct, the 2-year rate today should be 6.5% = (6% + 7%)/2. If the PEH is correct, the 3-year rate today should be 7% = (6% + 7% + 8%)/3. An Example

Some argue that the PEH isn’t 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). 2. Risk

Example data: Inflation for Yr 1 is 5%. Inflation for Yr 2 is 6%. Inflation for Yr 3 and beyond is 8%. k* = 3% MRP t = 0.1%(t - 1).

Yield Curve Construction Step 1:Find the average expected inflation rate over years 1 to n: n  INFL t t = 1 n IP n =.

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 vs. inflation; these IPs would permit you to earn k* (before taxes).

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%.

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% = 12.7%.

Yield Curves Years to maturity Interest Rate (%) 5.7% 6.7% 6.8% BB-Rated AAA-Rated Treasury yield curve