1. 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

2. 5 - 2 Copyright © 2002 by Harcourt, Inc.All rights reserved. Define These Markets Markets in general Physical assets vs. Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Futures Public vs. Private

3. 5 - 3 Copyright © 2002 by Harcourt, Inc.All rights reserved. MONEY VS. CAPITAL MARKETS FUNCTION OF TIME TO MATURITY – 1 YEAR OR LESS, MONEY MARKET Lower risk, (not zero risk), Normally higher initial investments Includes Treasury bills, commercial paper, many derivatives, Eurodollars, Repos & Reverse Repos MORE THAN 1 YEAR – CAPITAL MARKET Higher risk, includes stocks, bonds, some derivatives

4. 5 - 4 Copyright © 2002 by Harcourt, Inc.All rights reserved. PRIMARY VS. SECONDARY MARKETS PrimaryMarket – First time a security is traded, issuer receives proceeds Investment banker is the intermediary. Includes Seasoned Offerings & IPO’s Secondary Market – Investor to investor transfers, issuer no longer involved in the process.

5. 5 - 5 Copyright © 2002 by Harcourt, Inc.All rights reserved. Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq system Differences are narrowing

6. 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 = +

7. 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

8. 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

9. 5 - 9 Copyright © 2002 by Harcourt, Inc.All rights reserved. k rf = k* + IP Here: k rf = rate of return on the risk- free security k*= real risk-free rate. IP= inflation premium.

10. 5 - 10 Copyright © 2002 by Harcourt, Inc.All rights reserved. k = k* + IP + DRP + LP + MRP + ISP 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. ISP = issue specific premium

11. 5 - 11 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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, ISP L-T corporate: IP, DRP, MRP, LP, ISP

12. 5 - 12 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.

13. 5 - 13 Copyright © 2002 by Harcourt, Inc.All rights reserved. Treasury Yield Curve 0 5 6 102030 Years to Maturity Interest Rate (%) 1 yr 4.8% 5 yr 4.9% 10 yr 5.2% 30 yr 5.6% Yield Curve (January 2001) 4

14. 5 - 14 Copyright © 2002 by Harcourt, Inc.All rights reserved. Yield Curve Construction Step 1:Find the average expected inflation rate over Years 1 to n: IP n =. n

15. 5 - 15 Copyright © 2002 by Harcourt, Inc.All rights reserved. Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP 1 = 5%/1.0 = 5.00%. IP 10 = [5 + 6 + 8(8)]/10 = 7.50%. IP 20 = [5 + 6 + 8(18)]/20 = 7.75%. Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).

16. 5 - 16 Copyright © 2002 by Harcourt, Inc.All rights reserved. Step 2: Find MRP Based on Returns of Similar Risk Securities with Different Maturities MRP 10 = 4.9-1.7=3.2% 4.9% = Return on 10 year Treasuries 1.7% = Return on 3 month T-Bills

17. 5 - 17 Copyright © 2002 by Harcourt, Inc.All rights reserved. Hypothetical Treasury Yield Curve 0 5 10 15 1 10 20 Years to Maturity Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% Real risk-free rate Maturity risk premium Inflation premium

18. 5 - 18 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.

19. 5 - 19 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.

20. 5 - 20 Copyright © 2002 by Harcourt, Inc.All rights reserved. Hypothetical Treasury and Corporate Yield Curves 0 5 10 15 015101520 Years to Maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury Yield Curve BB-Rated AAA-Rated

21. 5 - 21 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. ‘95 ‘96 ‘97 ‘98 ‘99 600 450 300 150 Gross U.S. Treasury Issuance (in blue) Investment Grade Corporate Bond Issuance (in red) Billions of dollars

22. 5 - 22 Copyright © 2002 by Harcourt, Inc.All rights reserved. The Pure Expectations Hypothesis (PEH) Shape of the yield curve depends on 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.

23. 5 - 23 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.

24. 5 - 24 Copyright © 2002 by Harcourt, Inc.All rights reserved. Observed Treasury Rates Maturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 6.2% 6.4% 6.5% 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?

25. 5 - 25 Copyright © 2002 by Harcourt, Inc.All rights reserved. 0125 6.0% 34 x% 6.2% PEH tells us that one-year securities will yield 6.4%, one year from now (x%). 6.2%= 12.4%= 6.0 + x% 6.4%= x%. (6.0% + x%) 2

26. 5 - 26 Copyright © 2002 by Harcourt, Inc.All rights reserved. 0125 6.2% 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%.

27. 5 - 27 Copyright © 2002 by Harcourt, Inc.All rights reserved. Some argue that the PEH isn’t correct, because securities of different maturities have different risk. Liquidity Preference Theory: 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). Other Theories on Term Structure

28. 5 - 28 Copyright © 2002 by Harcourt, Inc.All rights reserved. Liquidity preference only explains an upward sloping yield curve Market Segmentation: Each maturity of securities has its own market, I.e., short term, long term, intermediate term. Supply and demand will determine within each market what interest rates are, not rate or inflation expectations or a maturity risk premium. Other Theories on Term Structure

29. 5 - 29 Copyright © 2002 by Harcourt, Inc.All rights reserved. What various types of risks arise when investing overseas? 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. Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment.

30. 5 - 30 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

31. 5 - 31 Copyright © 2002 by Harcourt, Inc.All rights reserved. Which countries are the least and most risky? Safest countries 1. Switzerland 2. Germany 3. Netherlands 4. Luxembourg 5. France 6. United States Riskiest countries 141. Sudan 142. Liberia 143. Afghanistan 144. Sierra Leone 145. North Korea