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Chapter 2 The Financial Environment: Markets Institutions Interest Rates and Taxes
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The Financial Markets
Money and capital markets
Primary and secondary markets
Debt and equity markets
Mortgage and consumer credit markets
World, national, regional, and local markets
Spot and future markets
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Three Primary Ways Capital Is Transferred Between Savers and Borrowers:
Direct transfer
Investment banking house
Financial intermediary
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4. Financial Institutions
Commercial banks
Savings and loan associations
Credit unions
Pension funds
Life insurance companies
Mutual funds
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The Stock Market
Organized Security Exchanges
NYSE, AMEX, and regional
Actual physical locations
Over-the-Counter Market
Network of brokers and dealers
Auction market
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The Cost of Money
Four factors that affect the cost of money
Production opportunities
Time preferences for consumption
Risk
Expected inflation
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The Cost of Money
What do we call the price, or cost, of
debt capital?
The Interest Rate
equity capital?
Return on Equity = Dividends + Capital Gains
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Interest Rate Levels
Interest Rates as a Function of Supply and Demand
Market A: Low-Risk Securities
Market B:High-Risk Securities
Interest Rate, kA
Interest Rate, kB % % S1 S1
kB = 12
kA = 10 8 D1 D1 D2
Dollars
Dollars
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“Real” versus “Nominal” Rates
= real risk-free rate.
T-Bond rate if no inflation;
1% to 4%. k*
= any nominal rate. k
= Rate on T-securities.
kRF
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10. The Determinants of Market Interest Rates
Quoted Interest Rate = k = k* + IP + DRP + LP + MRP
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
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The Determinants of Market Interest Rates
Quoted Risk-Free Rate = k = kRF + DRP + LP + MRP
k = Quoted or nominal rate
kRF = Real risk-free rate plus a premium for expected inflation or k* + IP
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
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12. Premiums Added to k* for Different Types of Debt:
IP = Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
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
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13. The Term Structure of Interest Rates
Term structure: the relationship between interest rates (or yields) and maturities.
A graph of the term structure is called the yield curve.
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U.S. Treasury Bond Interest Rates on Different Dates
Term to Interest Rate Maturity Mar 1980 Mar months % % 1 year years years years 16 14 12 10 8 6 4 2
Interest Rate (%)
Yield Curve for March 1980 (Current rate of inflation: 12%
Yield Curve for March 1999 (Current rate of inflation: 2%
Short Term Intermediate Term Long Term
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15. Three Explanations for the Shape of the Yield Curve
Term Structure Theories
Three Explanations for the Shape of the Yield Curve
Expectations Theory
Liquidity Preference Theory
Market Segmentation Theory
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Expectations Theory
Shape of curve depends on investors’ expectations about future inflation rates.
If inflation is expected to increase, S-T rates will be low, L-T rates high, and vice versa. Thus, the yield curve can slope up or down.
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Calculating Interest Rates under Expectations Theory:
Step 1: Find the average expected inflation rate over years 1 to N:
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Example data:
Inflation for Yr 1 is 5%.
Inflation for Yr 2 is 6%.
Inflation for Yr 3 and beyond is 8%.
k* = 3%
MRPt = 0.1% (t-1)
IP1 = 5%/ 1.0 = 5.00%
IP10 = [ (8)] / 10 = 7.5%
IP20 = [ (18)] / 20 = 7.75%
Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).
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19. Step 2: Find MRP based on this equation: MRPt = 0.1% (t - 1)
Calculating Interest Rates under Expectations Theory:
Step 2: Find MRP based on this equation: MRPt = 0.1% (t - 1)
MRP1 = 0.1% x 0 = 0.0%
MRP10 = 0.1% x 9 = 0.9%
MRP20 = 0.1% x 19 = 1.9%
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Calculating Interest Rates under Expectations Theory:
Step 3: Add the IPs and MRPs to k*:
kRFt = k* + IPt + MRPt
kRF = Quoted market interest rate on treasury securities.
Assume k* = 3%.
1-Yr: kRF1 = 3% + 5.0% % = 8.0%
10-Yr: kRF10 = 3% + 7.5% % = 11.4%
20-Yr: kRF20 = 3% % + 1.9% = 12.7%
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Yield Curve
Interest
Rate (%)
Treasury
yield curve
12.7%
11.4%
8.0%
Years to
maturity
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Liquidity Preference Theory
Lenders prefer S-T securities because they are less risky.
Thus, S-T rates should be low, and the yield curve should be upward sloping.
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23. Market Segmentation Theory
Borrowers and lenders have preferred maturities.
Slope of yield curve depends on supply and demand for funds in both the L-T and S-T markets (curve could be flat, upward, or downward sloping).
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24. Other Factors that Influence Interest Rate Levels
Federal Reserve Policy
Controls the supply of money
Federal Deficits
Larger federal deficit means higher interest rates
Foreign Trade Balance
Larger trade deficit means higher interest rates
Business Activity
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25. 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
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26. Definitions
Real risk-free rate - is that rate of interest which would exist on default-free securities in the absence of inflation (k*)
Nominal risk-free rate - is equal to the real risk free rate plus an inflation premium which is equal to the average rate of expected inflation over the life of the investment (kRF)
Default Risk Premium- is a premium based on the probability that the issuer will default on the loan, and it is measured by the difference between the interest rate on a U.S. Treasury Bond and a corporate bond of equal maturity and marketability (liquidity)
Liquidity Premium is a premium added to the rate of interest on securities that are not liquid
A liquid asset is one that can be sold at a "fair" price, on short notice
Maturity Risk Premium - is a premium which reflects interest rate risk...
Interest rate risk is the risk of capital loss due to changing interest rates
Longer term securities have more interest rate risk than otherwise comparable shorter term securities

27. Interest Rate Calculation
Step 1 Find the average expected inflation rate over years 1-N
N=1 IP = 5.0%
N=5 IP = ( )/5 = 7.0%
N=10 IP = ( )/10 = 7.5%
N=20 IP = ( )/20 = 7.75%
Step 2 Find the maturity risk premium for each maturity
N=1 MRP = 0.0%
N=5 MRP = .1*4 = .4%
N=10 MRP = .1*9 = .9%
N=20 MRP = .1* = 1.9%
Step 3 Sum the IPs and the MRPs, and add to k* (real risk free rate)
N=1 kRF = 3% + 5% +0% = 8.0%
N=5 kRF = 3% + 7.0% + .4% = 10.4%
N=10 kRF = 3% + 7.5% + .9% = 11.4%
N=20 kRF = 3% % + 1.9% = 12.65%