1. Understanding Financial Markets and Institutions
Chapter 8
Understanding Financial Markets and Institutions
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter 8 Learning Goals
LG1:
Differentiate between primary and secondary markets and between money and capital markets
LG2:
List the types of securities traded in money and capital markets
LG3:
Identify different types of financial institutions and the services that each financial institution provides
LG4:
Analyze specific factors that influence interest rates
LG5:
Offer different theories that explain the shape of the term structure of interest rates
LG6:
Demonstrate how forward interest rates derive from the term structure of interest rates

3. Financial Markets
Financial markets exist to manage the flow of funds from investors to borrowers
Financial markets can be distinguished along two dimensions:
Primary versus secondary markets
Money versus capital markets

4. Primary Markets
Provide a forum in which corporations and governments raise funds by issuing new financial instruments (stocks and bonds)
Because many companies and government entities can’t generate enough cash flow from internal sources to fund their needs, they must raise capital from external sources (households)

5. Financial institutions called investment banks arrange most primary market transactions for businesses
Morgan Stanley
Goldman Sachs
Lehman Brothers
Investment banks provide a number of important services to businesses that need to raise capital
Advice
Pricing
Attracting investors

6. One of the best-known types of primary market transactions is an initial public offering (IPO)
Company’s shares are publicly traded for the first time
When a firm that is already public issues new securities it is called a seasoned offering
Example: Procter & Gamble issues $500 million worth of stock

7. Once a company’s bonds or shares of stock are issued in the primary market they trade among investors in the secondary market
NYSE
AMEX
NASDAQ
Secondary markets provide a centralized marketplace where economic agents know they can buy or sell securities quickly and efficiently

8. Securities brokers such as Charles Schwab or other brokerage firms act as intermediaries in the secondary market
Note: the firm that originally issued the bond or stock is not involved in secondary transactions
If you buy shares of IBM through your broker, you are buying them from another investor. IBM has nothing to do with the transaction

9. Secondary markets offer benefits to both investors and issuers
Investors gain liquidity and diversification benefits
Issuers gain information about the value of their securities
Publicly-traded firms can observe what investors think of their firm value and corporate decisions by tracking their stock price

10. Trading volume in the secondary market is huge
On August 16, 2007, trading volume on the NYSE broke the all-time record at 5.8 billion shares
In contrast, in the 1980s a 250 million share day was considered a high-volume day

11. Money Markets versus Capital Markets
Money markets feature debt securities with maturities of one year or less
Because of the shorter maturity, fluctuations in secondary market prices are usually small
Money market securities are less risky than long-term instruments
Most money market securities trade over-the-counter

12. Corporations and governmental entities issue a variety of money market securities to obtain short-term funds
Treasury bills
Federal funds
Repurchase agreements
Commercial paper
Negotiable CDs
Banker’s acceptances

14. Stocks and long-term debt (with a maturity of greater than one year) trade in capital markets
Capital market instruments are subject to wider price fluctuations than money market instruments

15. Capital market securities include:
U.S. Treasury notes and bonds
State and local government
U.S. government agency bonds
Mortgages and mortgage-backed securities
Corporate bonds
Corporate stocks

17. Other Markets Foreign Exchange Markets
Events in other countries affect U.S. firms’ performance
For example, in 2001 Argentina experienced an economic crisis that hurt U.S. stock prices. Coca Cola Co. attributed a 5 percent decline in operating profits to the unfavorable exchange rate movements between the dollar and Argentinian peso
Foreign exchange markets trade currency for immediate delivery (spot) or for some future delivery

18. Firms that sell goods outside the U. S
Firms that sell goods outside the U.S. receive cash flows that are subject to foreign exchange risk
Investors who deal in foreign-denominated securities face the same risk
If the foreign currency depreciates in value, the dollar value of the cash flows will fall
If the foreign currency appreciates in value, the dollar value of the cash flows will rise

19. Derivative Markets
A derivative security is a financial security linked to another, underlying security such as a stock or currency
Futures contract
Option contract
Swap contract
Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future

20. Derivative contracts involve a high degree of leverage
As the value of the underlying security changes, the value of the derivative security changes
Derivative contracts involve a high degree of leverage
The investor has to put up only a small amount of the value of the underlying commodity to control a large amount of the underlying commodity
Derivative markets are the newest and potentially the riskiest financial security market
Derivative are used both for hedging and speculating

21. Financial Institutions
Financial institutions include:
Banks
Thrifts
Insurance companies
Mutual funds
These institutions act to channel funds from those with surplus funds to those with a shortage of funds

23. Without financial institutions, the flow of funds between suppliers of funds (households) and users of funds (corporations) would be low for several reasons:
Institutions efficiently monitor the users of funds
Institutions provide liquidity to suppliers of funds
Even though many financial claims feature a long-term financial commitment, institutions provide a means for suppliers to withdraw their cash as needed
Institutions can provide a means to lower the price risk and transactions costs compared to trading on secondary markets

24. Financial institutions act as financial intermediaries between fund suppliers and fund users.
Fund suppliers and users use financial institutions because of their unique ability to reduce monitoring costs, liquidity costs, and price risk

25. Interest Rates
We often speak of the interest rate as if only one rate applies to all financial situations
In fact there are hundreds of different rates that are appropriate for various situations within the U.S. economy
The rates we actually observe in financial markets are called nominal interest rates, sometimes called the quoted rate
Because changes in interest rates have a profound impact on the value of security prices, financial managers and investors closely monitor these rates

26. Factors that influence interest rates for individual securities
Inflation
The “real” interest rate
Default risk
Liquidity risk
Special provisions regarding use of funds
Term to maturity

28. Inflation
Inflation is the percentage increase of a standardized basket of goods or services over a given period of time
Actual or Expected inflation rate
The higher the level of actual or expected inflation, the higher the interest rate
Investors want to at least maintain their purchasing power

29. Real Interest Rates Fisher Effect
The rate that a security would pay if no inflation were expected over its holding period
Measures society’s relative time preference for consuming today rather than in the future
Fisher Effect
Nominal interest rates must compensate investors for:
Inflation-related reduction in purchasing power
Forgoing present consumption (real rate)

30. The Fisher Effect can be written as:
The last term will generally be very small for small values of Expected (IP) and RIR, so we often use an approximate formula for the Fisher Effect:
i = Expected (IP) + RIR

31. Example: The one-year Treasury bill rates in 2007 averaged 4
Example: The one-year Treasury bill rates in 2007 averaged 4.93 percent and inflation for the year was 1.80 percent. Calculate the real interest rate for 2007 according to the Fisher Effect.
RIR = i – Expected (IP)
= 4.93% %
= 3.13%

32. DRPj = ijt - iTt Default or Credit Risk
Default risk it the risk that a security issuer may
fail to make its promised interest and principal payments to its bondholders
The higher the default risk, the higher the interest rate demanded by investors to compensate them for the risk
U.S. Treasury securities are considered to be free of default risk
The difference between a quoted interest rate on
a security j and a similar Treasury security is
called a default risk premium
DRPj = ijt - iTt

33. Liquidity Risk
If an asset is highly liquid, the holder can convert it into cash at its fair market value on short notice
If a security is illiquid, investors add a liquidity risk premium to the interest rate on the security
A different type of liquidity risk premium may exist if investors dislike long-term securities because their prices react more to changes in interest rates
In this case, a liquidity risk premium may be added to long-term securities because of its greater exposure to price risk

34. Special Provisions or Covenants
Some securities have special features attached to them that affect their interest rate relative to a similar security without the provisions
Examples include
Taxability (e.g. municipal bonds)
Convertibility (into stock at a preset price)
Callability

35. Term to Maturity
The relationship between interest rates and maturity is called the term structure of interest rates, or the yield curve
Assumes all other characteristics, such as default risk, liquidity risk, are identical
In general, the longer the term to maturity the higher the required interest rate
Maturity premium

36. Figure 8.11A

37. Figure 8.11B

38. Figure 8.11C

39. ij* = f(IP, RIR, DRPj, LRPj, SCPj, MPj)
Putting it Together
Putting together the factors that affect interest rates in different markets, we can use the following general equation for the fair interest rate:
ij* = f(IP, RIR, DRPj, LRPj, SCPj, MPj)

40. Term Structure Theories
The three major theories to explain the shape of the yield curve are:
The unbiased expectation theory
The liquidity premium theory
The market segmentation theory

41. Unbiased Expectations Theory
According to this theory, at any given point in time the yield curve reflects the market’s current expectations of future short-term rates
Intuition:
If an investor has a 4-year investment horizon they could
A) buy a 4-year bond and earn the current (spot) annual yield on a 4-year bond each year for four years
B) buy four successive 1-year bonds (of which they know only the current one-year spot rate, but they have expectations of the rates in years 2,3, and 4.)

42. According to the unbiased expectation theory, the return from holding a 4-year bond to maturity should equal the expected return for investing in four successive 1-year bonds.
If not, then an arbitrage opportunity exists

43. According to the unbiased expectations theory, an upwardly sloping yield curve indicates that future one-year rates will be higher than they are currently
The theory states that current long-term interest rates are geometric averages of current and expected future short-term interest rates
[insert equation 8-7]

45. Liquidity Premium Theory
This theory builds on the unbiased expectations theory
It states that investors will hold long-term maturities only if these securities are offered at a premium to compensate for future uncertainty in the security’s value
Investors must be offered a liquidity premium to buy longer-term securities that carry higher capital loss risk

46. The liquidity premium theory state that long-term interest rates are geometric averages of current and expected short-term rates (just like the unbiased expectations theory) plus liquidity risk premiums that increase with the security’s maturity
Equation 8-8

48. Market Segmentation Theory
This theory states that investors have specific maturity preferences, and to encourage buyers to hold securities with maturities other than their most preferred maturity requires a higher interest rate (i.e. a maturity premium)
Investors don’t consider securities with different maturities to be perfect substitutes
Examples: banks may prefer short-term securities to match their short-term deposit liabilities, whereas insurance companies may prefer long-term bonds to match their long-term liabilities

49. Forecasting Interest Rates
Changes in interest rate affect the value of financial securities, so investors and firms have an incentive to try to predict interest rates
Using the unbiased expectations hypothesis, we can discern the market’s forecast for expected short-term rates, called forward rates
A forward rate is an implied rate on a short-term security

50. To find an implied forward rate on a one-year security in the future we can re-write the unbiased expectations formula
Equation 8-11