CHAPTER 2
The Financial Environment: Markets,
Institutions, and interest rates
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



Importance & Functions of Financial
Markets
Classification of Financial Markets
Financial Institutions
Determinants of Interest rates
Yield Curves
2-1
Functions of Financial Markets
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Bridging the gap between net borrowers and net
savers. Net borrowers or investors are the deficit sector.
They demand loan. Net savers are surplus sector. They
supply loan. The two groups do not know each other,
financial market brings them together. (Slide 3)
Providing the equilibrium interest rate. Net savers like
to get more interest and net borrowers like to pay less
interest. Financial market provides the equilibrium rate.
(Slide 4)
Separation principle: Financial institutions separate the
pattern of current consumption from the pattern of current
income by means of intertemporal consumption function.
People in need of more current consumption than current
income borrow money. People who like to defer
consumption lend money. (Slide 5)
2-2
Bridging the gap
.
Net
savers:
Surplus
sector
Financial
Market
Net
Borrowers:
Deficit
sector
2-3
Equilibrium interest rate:
(Loanable Fund Theory)
i
S (Savings)
i
D (Investment)
Quantity of Loanable Fund
2-4
Intertemporal consumption
.
C1
210
Lending
100
Borrowing
100
190.9
Co
2-5
Types of Financial Markets
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Debt vs. Equity Markets. Debt includes bond, debenture, bank
loan, mortgage, commercial and consumer credit. Equity
refers to the claim of ordinary stock. Interest on debt is a
compulsory payment but dividend is not. Cost of debt is
usually less than cost of equity.
Money vs. Capital Markets. Money market deals in short term
loan to provide firm’s liquidity. Capital market deals in long
term debt of different types, preferred stock and ordinary
stock
Primary vs. Secondary Markets. In the primary market, the
firm directly sells stock to the applicant of the share. In the
secondary market, shares are traded among stock holders.
2-6
The concept of cost of money


In case of debt capital, cost of
money refers to the interest rate.
In case of equity capital, cost of
money is the required return. This
is the return expected by the
shareholders to leave the share
price unchanged.
2-7
What four factors affect
the cost of money?

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Production opportunities: More attractive production
opportunity shifts the demand curve right. Cost increases.
Time preferences for consumption: If present
consumption gets more priority than deferred
consumption, then supply curve shifts left. Cost increases.
Risk: Increased risk makes savings less attractive, supply
curve shifts left. Risk and return are proportional.
Increased risk leads to an upward shift of demand curve.
Cost increases. (Figure in the next slide)
Expected inflation: If expected inflation increases savers
demand more return, supply curve shifts left. Cost
increases.
2-8
Effects of increased risk on cost of
Money: Loanable Fund Theory
i
S1
S (Savings)
k1
k
D1
D (Investment)
Quantity of Loanable Fund
2-9
“Nominal” vs. “Real” rates
kRF= k*+IP
k* = represents the “real” risk-free rate
of interest. Like a T-bill rate, if
there was no inflation. Typically
ranges from 1% to 4% per year.
kRF = represents the rate of interest on
Treasury securities.
IP= Inflation premium
2-10
Determinants of interest rates
k = k* + IP + DRP + LP + MRP
k = required return on a debt security
k* = real risk-free rate of interest
IP = expected inflation premium
DRP = default risk premium
LP = liquidity premium
MRP= maturity risk premium
2-11
Concepts of risk premium
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Inflation Premium refers to the additional interest to
cover the loss due to inflation.
Default risk premium is the addition in the interest rate to
compensate the possibility that the borrower may fail to
pay interest and principal.
Liquidity risk premium is the addition to compensate the
possibility that the security may not be sold within a
short notice.
Maturity risk premium covers the possibility of price
fluctuation of bond. The price depends on market interest
rate. Bonds of longer maturity assumes more maturity
risk premium.
n
Interestt Facevalue
PB  

t
t
(
1

r
)
(
1

r
)
t 1
2-12
Risk-Return trade-off
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k=kRF + Risk Premium (RP)
E(R) = Rf + RP
RP=DRP+LP+MRP
Return
Rf
Risk
2-13
Yield Curve:
Relation between interest and time

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Normal
Abnormal
Flat
k
Maturity
2-14
Theories of Yield Curves
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Liquidity Preference Theory: Lenders to prefer to
make short term loan than long term loan. Yield
curve should be positive.
Expectations Theory: Yield curve depends on
the expectation about inflation. If inflation is
expected to rise in future, then yield curve
should be positive.
Market Segmentation Theory: The short term
market and the long term market are different
from one another. Yield curve should not have a
definite pattern.
2-15