4-1
Lecture Two: Financial Markets
Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves
Saving/Investing or Borrowing/Lending Process 4 - 2
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
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
Business Sector
Borrows/invests
in real assets or
productive assets
Fundamental Functions of The Financial Sector 4 - 3
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 - 5Asset
Real
Market
Financial
Market
Capital
Market
Securities
e
x
c
h
a
n
g
e
s
b
r
o
k
e
r
s
Money
Market
Mortgage
Inv.
Bkr
s.
Consumer
Credit
Com.
Bks.
Ins.
CO.
S&L
Fin.
CO.
Commercial
Paper
COs.
Euro $
COs.
Indiv.
Invest.
4-6
Three Primary Ways Capital Is
Transferred Between Savers and
Borrowers
Direct transfer
Investment banking house
Financial intermediary
Financial Institutions
•
•
•
•
•
•
•
4-7
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)
Balance sheet of Commercial Bank v. a Manufacturing CO.
4-8
Manufacturing Firm
Commercial Bank
Govt. Sec.
DD
Loans
TD
--------------- ---------Fixed Assets NW
Cash
AR
Inv.
Short Term Debt
-----------------Long Term Debt
----------- -------------------Fixed
NW = Equity
Assets
4 -CO.
9
Balance sheet of Insurance Company v. a Manufacturing
Insurance Company
Stocks
Premiums
Manufacturing Firm
Cash
AR
Inv.
Short Term Debt
-----------------Long Term Debt
Bonds
----------- -------------------Fixed
NW = Equity
Assets
Mortgages
Other Debt
------------Fixed Assets
---------NW
4 - 10
Organized Exchanges vs.
Over-the-Counter Market
Auction market vs. dealer
market (exchanges vs. OTC)
NYSE vs. NASDAQ system
Differences are narrowing
4 - 11
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
+ gain .
return = yield
4 - 12
What four factors affect the cost of
money?
Production opportunities
Time preferences for consumption
Risk
Expected inflation
4 - 13
“Real” Versus “Nominal” Rates
k*
= Real risk-free rate.
T-bond rate if no inflation;
1% to 4%.
k
= Any nominal rate.
kRF
= Rate on Treasury securities.
4 - 14
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.
4 - 15
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
4 - 16
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.
4 - 17
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.
4 - 18
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.
4 - 19
T-Bond Yield Curve
Interest
Rate (%)
15
1 yr
5 yr
10 yr
30 yr
5.7%
6.5%
6.7%
6.9%
Yield Curve
(March 1997)
10
5
Years to Maturity
0
10
20
30
4 - 20
What are the 2 main factors that
explain the shape of the yield curve?
4 - 21
1. 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.
4 - 22
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.
4 - 23
An Example
Assume that 1-year securities yield 6%
today, and the market expects that 1year 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.
4 - 24
2. Risk
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).
4 - 25
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).
4 - 26
Yield Curve Construction
Step 1: Find the average expected
inflation rate over years 1 to n:
n
S INFLt
IPn =
t=1
n
.
4 - 27
IP1 = 5%/1.0 = 5.00%.
IP10 = [5 + 6 + 8(8)]/10 = 7.5%.
IP20 = [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).
4 - 28
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%.
4 - 29
Step 3: Add the IPs and MRPs to k*:
kRFt = k* + IPt + MRPt .
kRF = Quoted market interest
rate on treasury securities.
Assume k* = 3%:
kRF1= 3% + 5% + 0.0% = 8.0%.
kRF10 = 3% + 7.5% + 0.9% = 11.4%.
kRF20 = 3% + 7.75% + 1.9% = 12.7%.
4 - 30
Yield Curves
Interest
Rate (%)
15
10
5.7%
5
6.8%
6.7%
0
0
1
5
10
15
20
BB-Rated
AAA-Rated
Treasury
yield curve
Years to
maturity