Chapter 4
The Financial System
and Interest
SAVINGS AND INVESTMENT
Consumers save some of their incomes
Companies need funds for large projects
These needs are "happily coincidental"
Financial markets channel consumer savings to companies
for major projects through the sale of financial assets
The Term INVEST
To use a resource to better one's position in the future rather than for
current consumption. To earn a "return."
Individuals invest by putting savings in financial assets:
stocks, bonds, bank accounts.
Companies invest by purchasing or building assets used in business.
The funds available for business investment come from savings
put into financial assets by individuals.
Hence, in the economy, Savings Equals Investment
More precisely, (Consumer) Savings Equals (Business) Investment
FINANCIAL MARKETS
MONEY MARKET: Short term debt < one year
CAPITAL MARKET: Long term funds > one year
Stocks and long term debt
PRIMARY MARKET: The first sale of a security
Issuing company gets proceeds
SECONDARY MARKET:
Subsequent sales of the security
Between investors
Company not involved
FINANCIAL INTERMEDIARY
Pools the invested money of individuals
-Invests it in securities (primary securities)
-Issues its own security (secondary securities) to individual investors
Types of Financial Intermediary:
*Mutual funds *Pension funds
*Insurance companies *Banks
Financial Intermediaries are institutional investors
Have great influence in the financial markets
EXCHANGES
The New York Stock Exchange
(NYSE)
The American Stock Exchange
(AMEX)
Regional Exchanges
READING STOCK MARKET QUOTATIONS
1
2
3
52 Weeks
Hi Lo Stock
4
5
6
7
8
Yld
Vol
Sym Div % PE 100s
9
Hi
10
11
12
Net
Lo Close Chg
891/2 471/16 GenMotor GM 2.00 2.2 23 52058 92 887/8 8815/16 + 15/16
Trading in Stocks
Privately (closely) Held: Not generally available
Securities Newly Offered to the Public
Initial Public Offering (IPO)
Prospectus - Red Herring
SEC Approval
SEC Regulation aimed at Disclosure
Public: Available on the Over TheCounter (OTC) Market (NASDAQ)
Listed: Available on one or more exchanges
INTEREST
The Return on a Debt Investment.
Interest Drives the Price of Securities
A lower price => a higher return given a stream of cash flows
Security prices (both stocks and bonds)
adjust to changing interest rates by changing their prices in the opposite direction
Hence: Interest (among other things) drives the stock market
Interest Also Drives the Economy
Determines the feasibility of doing projects on borrowed money
THE COMPONENTS OF AN INTEREST RATE
Base Rate
k = kPR
+
Risk Premium
INFL
kPR =
INFL =
DR =
LR =
MR =
+
DR
+
LR
+ MR
Pure Interest Rate
Inflation Adjustment*
Default Risk Premium
Liquidity Risk Premium
Maturity Risk Premium
* Average planned inflation rate over life of the loan.
THE COMPONENTS OF AN INTEREST RATE
Default risk - Chance of not receiving full payment of principal and interest
Liquidity risk - Chance of not being able to sell at full price
Maturity risk - Chance of loss on price changes due to interest rate
movements -greater with longer maturities
Essentially zero for short-term debt
FEDERAL GOVERNMENT DEBT
DR = 0: Federal government can print money
LR effectively zero: Ready market exists
RISK FREE RATE
Base Rate
Rate on short term government debt - 90 day T-bills
REAL RATE
Without inflation adjustment
Fisher Effect
Interest rate has 2 components:
(1) real rate
(2) inflation premium
I = r+ IP
THE TERM STRUCTURE OF INTEREST RATE
THE YIELD CURVE
Term Structure of Interest Rates - defines the relationship between maturity &
annualized yield, holding other factors such as risk, taxes, etc., constant.
Graphic presentation is the yield curve.
Curve shifts and twists through time.
LEVEL OF INTEREST RATES
Fisher Effect
Interest rate has 2 components:
(3) real rate
(4) inflation premium
I = r+ IP
STRUCTURE OF INTEREST RATES
Four Basic Shapes:
Positive Yield Curve: upward sloping
Negative Yield Curve: downward sloping
Flat Yield Curve
Humped Yield Curve
Three alternative yield curves
Short-term rates fluctuate by more than long-term rates over the business cycle
Yields on U.S. government securities
©2000
2000Addison
AddisonW
Wesley
esleyLongm
Longman
an
©
Figure5.2
5.3
Figure
Level of Interest Rates:
Loanable Funds Theory -- market interest rate is determined by the factors that control
the supply of and demand for loanable funds.
Demand Factors
Household:
y   installment debt 
r   installment debt 
Business:
n
CF t
NPV = - I + 
(1 + i )t
T =1
if i decrease _ NPV (?)
Government:
interest inelastic
1980: debt/GNP =25%
1987: debt/GNP=42%
Foreign
Foreign interest rates vs. U.S. rates
Supply
Households - largest suppliers
Very steep slope for supply. Why?
What happens if expect higher inflation?
Savers -
Supply and demand determines the interest rate
© 2000 Addison
Wesley Longman
Figure
4.1a
Liquidity Preference Theory - Market rate of interest is determined by
demand/supply of money balances.
Demand of Money
Transaction
Precautionary 
Speculative
+
f(y)
f(r)
Supply of Money
Fed basically determines supply
Few uncontrollable factors
(1) banks lending
(2) public's preference for cash
Letting D=S then solve for interest rate:
+
+ - _
r= f ( , , )
y m p
e
THEORIES OF THE SHAPE OF THE YIELD CURVE
Unbiased Expectations - shape of yield curve is determined solely by current &
expected future short-term interest rates.
Shape depends on expectations of future interest rates
A 2 year security should offer a return that is similar to the anticipated return from
investing in 2 consecutive one-year securities.
(1+t R 2 )2 = (1+t R1 )(1 +t+1 r 1 )
(1+t R3 )3 = (1+t R1 )(1+t+1 r 1 )(1 +t+2 r 1 )
t+1r1
 one year interest rate that is anticipated as of time t+1.
t+2r1
 one year interest rate that is anticipated as of time t+2.
R1 }
R2 } Known annualized rate on 1 year security, 2 year security, 3 year security.
R3 }
Eg.
If
.t R 2 = .10
.t R1 = .08
(1.1 )2
- 1  .12
.t +1 r 1 =
1.08
(1 + .1 )2 = (1.08)(1 +t+1 r 1 )
Expect interest rates to rise:
investor (saver) wants s-t security
borrowers want L-T security
Borrowers are the suppliers of securities (IOU's)
therefore
s-t demand > supply  P   r  we have an upward sloping curve.
Risk neutral
Liquidity Premium
Investor becomes risk averse prefer s-t security over L-T security.
Inducement to buy L-T must add premium.
Lenders prefer more liquid short term loans because:
1. Less exposure to price changes due to interest rate movements
2. Can wait out maturity if need money
An extra incentive is required to lend long so curve slopes up
Segmented Markets
Unlike first 2 theories which treat market as a whole - this theory treats market as
if made up of segments.
Investors/borrowers choose security with maturities that satisfy their forecasted
cash needs. Therefore, need rather than expectations of s-t rates determine where
a person invests.
Demand/Supply within segments drive rates.
Market segmented into many sub-markets by term
Supply and demand independent in each
Equilibrium rates can be anything relative to one another
so curve can slope up or down
│
rate│
│
Upward
│
Pension Life Ins.
│
Thrifts
│
│ Bank
└──────────────────────────────────────────────
Time
│
│
│
│
Downward
│ Bank
│
Thrifts
│
Pension
│
└──────────────────────────────────────────────
Demand for L-T   D>S 
P  r for L-T
Preferred Habitat
Combines Expectations & Segmented
Investors may have a preferred investment horizon (habitat) but their expectations on int.
rates move them within or even out of their habitat.
Which Theory is Correct?
Research by Meiselman on interest rate expectations found they strongly
influence on the term structure-- they have looked at how accurate forward rates
are--not very accurate--therefore other factors also influence interest rates
Kessel found that liquidity premium caused forward rates to have a positive bias
Other research on liquidity premium have found that the size of the premium
varies inversely with interest rate levels and yet others have found the opposite to
be true
Elliot and Echols have examined the segmented market idea--they found
discontinuities in the yield maturity relationship--may be due to supply and
demand of segments
All of the theories have some evidence on their validity
Integrating the theories
Example:
1. Borrowers and investors expect rates to rise they invest (expectation theory)
2. Borrowers need long term funds while investors prefer short-term
(segmentation theory)
3. Investors prefer more liquidity than less (liquidity premium theory)
In this example, all theories suggest an upward sloping curve ---domination of the
views would determine the slope--ie. If #1 was dominate but the expectation was
for declining rates then might have a slightly downward sloping curve