CHAPTER 2 & 6
The Financial Environment: Markets, Institutions, and Interest Rates
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Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves
What is a market?
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A market is a venue where goods and services are exchanged.
A financial market is a place where individuals and organizations wanting to
borrow funds are brought together with those having a surplus of funds.
Financial Markets
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What is the role of financial markets in Finance?
Cash flows to and from the Firm
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SECURITIES - STOCKS AND BONDS REPRESENTING OBLIGATIONS OF THE
ISSUER TO PROVIDE THE PURCHASER AN EXPECTED RETURN ON THE
INVESTMENT
Types of financial markets
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Physical assets vs. Financial assets – (Physical: wheat, real estate, machinery)
Money vs. Capital – (Money Market: where funds are borrowed or loaned for
less than one year) Financial Market: stocks and long term debt trade
Primary vs. Secondary
PRIMARY MARKET - NEW ISSUES OF SECURITIES ARE SOLD
PUBLICLY FOR THE FIRST TIME
SECONDARY MARKETS MARKET WHERE SHARES OF STOCKS AND
BONDS WHICH WERE PREVIOUSLY ISSUED TRADE
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Public vs. Private (Public: Market in which standardized contracts are traded
on an organized exchange)
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How is capital transferred between savers and borrowers?
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Direct transfers
Investment banking house
Financial intermediaries
Types of financial intermediaries
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Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Pension funds
Life insurance companies
Mutual funds
Physical location stock exchanges vs. Electronic dealer-based markets
 Auction market vs. Dealer market (Exchanges vs. OTC)
 NYSE vs. Nasdaq
Organized Exchanges - Trading takes place in a location with face to face
trading (auction market)
New York Stock Exchange - NYSE (1792): Before 2006 the NYSE was a nonprofit corporation with 1366 seats. In 2006 it became a publicly traded company
(ticker symbol: NYX). Membership seats are replaced by annual trading licenses.
Then in April 4, 2007 NYSE-Euronext is formed, merging NYSE with major
European exchanges. 2800 stocks listed on NYSE
Specialist - Specialists are people on the trading floor of the exchange of the
NYSE who hold inventories of particular stocks. A specialist's job is not only to
match buyers and sellers, but also to keep an inventory for him or herself that can
be used to shift the market during a period of illiquidity
1. Auctioneer – Shows best bids and offers, becoming a market maker
2. Catalyst – Keeps track of the interests of different buyers and sellers and continually
updates them.
3. Agent – Places electronically routed orders on behalf of clients. Floor brokers can leave
an order with a specialist, freeing themselves up to take on other orders. Specialists then
take on the responsibilities of a broker.
4. Principal – Acts as the major party to a transaction - specialists are responsible for
keeping the market in equilibrium, they are required to execute all customer orders ahead
of their own.
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The specialists at the NYSE are employed by seven firms. Companies listed on certain
exchanges will interview employees of the specialist firms, seeking out suitable people to
represent them (by holding inventories of the companies' stocks). Here are the seven
NYSE specialist firms: Bear Wagner Specialist LLC., Fleet Specialist, Inc., LaBranche &
Co., LLC.,, Performance Specialist Group, LLC., Spear, Leeds & Kellogg Specialists
LLC.,SIG Specialists, Inc.,Van der Moolen Specialists USA, LLC.
Floor broker – (commission brokers) execute customer orders (working for
brokerage houses) 500 floor brokers at NYSE- use electronic trading system
(SuperDOT) to place orders through specialist
Independent brokers – don’t work for brokerage house but place trades for
customers of brokerage firms. Collect fee for service
SuperDot system – orders transmitted directly to specialists – especially
Small orders
NASDAQ – National Association of Security Dealers
Automated Quotation system
OTC Market – Over the Counter market – when securities market is characterized by
dealers (market makers) who buy and sell securities for their inventories – NASDAQ is
an OTC market
NASDAQ – Composed of two separate markets –
NASDAQ National Market – lists 4000 securities (larger companies)
NASDAQ Capital Market – for smaller companies lists 1000 companies
ECN – Electric Communication Network – late 1990s investors trade directly with each
other through order book – buy sell order are placed in ECN and then transmitted to
NASDAQ and displayed (fourth market) - Instinet, Island, Tradebook (trade stocks and
currencies)
THIRD Market - Trading of exchange listed stocks occur off exchange through
independent securities firms
FOURTH Market – Instinet, Tradebook – investors trade among themselves. Big for
after hours trading
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Orders
Market Order - An order to buy or sell a stated quantity of a security at the current
market price.
Limit Order - An order to buy or sell a security at a specific price or better. A buy limit
order is placed below the market price. A sell limit order is place above the market price.
Additional limit order instructions: Day-order; Good Til Cancelled
Stop Order - An order to buy or sell at the current market price once the stock has traded
at, or through, the specified stop price. A sell stop or stop loss order is used to protect a
profit or limit a loss in the event of a decline the security's market price.
The cost of money
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The price, or cost, of debt capital is the interest rate.
The price, or cost, of equity capital is the required return. The required return
investors expect is composed of compensation in the form of dividends and
capital gains.
What four factors affect the cost of money?
“Nominal” vs. “Real” rates
r
= represents any nominal rate
r*
= 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.
rRF
= represents the rate of interest on Treasury securities.
Determinants of interest rates
r = r* + IP + DRP + LP + MRP
r
r*
IP
DRP
LP
MRP
=
=
=
=
=
=
required return on a debt security
real risk-free rate of interest
inflation premium
default risk premium
liquidity premium
maturity risk premium
Premiums added to k* for different types of debt
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Yield curve and the term structure of interest rates
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Term structure – relationship between interest rates (or yields) and maturities.
The yield curve is a graph of the term structure.
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Step 1 – Find the average expected inflation rate over years 1 to n:
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Constructing the yield curve:
Inflation
Suppose, that inflation is expected to be 5% next year, 6% the following year,
and 8% thereafter.
IP1 = 5% / 1 = 5.00%
IP10= [5% + 6% + 8%(8)] / 10 = 7.50%
IP20= [5% + 6% + 8%(18)] / 20 = 7.75%
Must earn these IPs to break even vs. inflation; these IPs would permit you to
earn r* (before taxes).
Constructing the yield curve: Inflation
Step 2 – Find the appropriate maturity risk premium (MRP). For this example,
the following equation will be used find a security’s appropriate maturity risk
premium.
Constructing the yield curve: Maturity Risk
Using the given equation:
MRP1 = 0.1% x (1-1) = 0.0%
MRP10 = 0.1% x (10-1) = 0.9%
MRP20 = 0.1% x (20-1) = 1.9%
Notice that since the equation is linear, the maturity risk premium is increasing in
the time to maturity, as it should be.
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Add the IPs and MRPs to k* to find the appropriate nominal rates
Step 3 – Adding the premiums to k*.
rRF, t = r* + IPt + MRPt
Assume r* = 3%,
rRF, 1 = 3% + 5.0% + 0.0% = 8.0%
rRF, 10 = 3% + 7.5% + 0.9% = 11.4%
rRF, 20 = 3% + 7.75% + 1.9% = 12.65%
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1.
Maturity risk
premium
The real risk-free rate. is 3 percent, and inflation is expected to be 3 percent for the
next 2 years. A 2-year Treasury security yields 6.2 percent. What is the maturity
risk premium for the 2-year security?
Hypothetical yield curve
An upward sloping yield curve.
 Upward slope due to an increase in expected inflation and increasing maturity
risk premium.
What is the relationship between the Treasury yield curve and the yield curves
for corporate issues?
 Corporate yield curves are higher than that of Treasury securities, though not
necessarily parallel to the Treasury curve.
 The spread between corporate and Treasury yield curves widens as the
corporate bond rating decreases.
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Illustrating the relationship between corporate and Treasury yield curves
Pure Expectations Hypothesis
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The PEH contends that the shape of the yield curve depends on investor’s
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, down, or even
bow.
Assumptions of the PEH
 Assumes that the maturity risk premium for Treasury securities is zero.
 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.
Average annual rate = r = [(1 + r1) (1 + r2)..( 1 + rn)]1/n - 1
Geometric average of individual one year rates
2.
One-year Treasury securities yield 5 percent. The market anticipates that 1 year
Expected rate from now, l-year Treasury securities will yield 6 percent. If the pure expectations
of interest
theory is correct, what should be the yield today for 2-year Treasury securities?
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3.
Expected rate
of interest
4.
Expected rate
of interest
Interest rates on 4-year Treasury securities are currently 7 percent, while interest
rates on 6-year Treasury securities are currently 7.5 percent. If the pure
expectations
theory is correct, what does the market believe that 2-year securities will be
yielding 4 years from now?
Suppose the annual yield on a 2-year Treasury bond is 4.5 percent, while that on a
1-year bond is 3 percent. r* is 1 percent, and the maturity risk premium is zero.
a. Using the expectations theory, forecast the interest rate on a 1-year bond during
the second year. (Hint: Under the expectations theory, the yield on a 2-year
bond is equal to the average yield on 1-year bonds in Years 1 and 2.)
b. What is the expected inflation rate in Year 1? Year 2?
An example:
Observed Treasury rates and the PEH
Maturity
Yield
1 year
6.0%
2 years
6.2%
3 years
6.4%
average annual rates
4 years
6.5%
5 years
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?
One-year forward rate
.062 = [(1.06)(1 + x)]1/2 - 1
(1.062)2/1.06 = (1 + x)
x = 6.4%
PEH says that one-year securities will yield 6.4%, one year from now.
Three-year security, two years from now
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Conclusions about PEH
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Some would argue that the MRP ≠ 0, and hence the PEH is incorrect.
Most evidence supports the general view 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 factors that influence interest rate levels
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Federal reserve policy
Federal budget surplus or deficit
Level of business activity
International factors
Risks associated with investing overseas
Factors that cause exchange rates to fluctuate
 Changes in relative inflation
 Changes in country risk
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