Lecture 2
CHAPTER 4
The Financial Environment Markets, Institutions, and Interest Rates
KEY CONCEPTS
 Financial markets
 Types of financial institutions
 Determinants of interest rates
 Yield curves
Basically we have discussed that finance has 3 broad areas
 Money & Capital Markets
 Investments
 Financial Management
What are Financial Markets?
• 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
(bringing buyers and sellers of financial instruments together)
• The purpose of financial markets is to efficiently allocate savings to ultimate
users.
• So it acts as a medium between sources & uses of funds.
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Types of Financial Markets
• Physical assets markets vs. financial assets
Physical markets are tangible or real asset markets while financial asset markets
deal with stocks, bonds, notes, mortgages and other claims on real assets.
• Money vs. Capital
Money markets are markets for short term, highly liquid debt securities
(markets where funds are borrowed or loaned for short periods). Whereas
financial markets for stocks and for long term debt are capital markets.
• Primary vs. Secondary
Markets where corporate raise capital by issuing new securities are primary
markets & the markets where securities and financial assets are traded among
investors after they have been issued by corporations.
• Spot vs. Futures
Spot markets and the futures markets are terms that refer to whether assets are
being bought or sold for “on the spot” delivery or for delivery at some future
date.
• Public vs. Private
Transactions are worked out directly between two parties are private markets
whereas standardized contracts traded on organized exchanges are referred to as
public markets.
A healthy economy is dependent on efficient transfers of funds from people
who are net savers to firms and individuals who need capital. Efficient transfer
is a crucial factor.
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Financial Institutions
Transfer of capital between savers and those who need capital take place in three
different ways:
A. Direct Trans fers
B. Indirect Transfers through Investment Bankers
C. Indirect Transfers through a Financial Intermediary
Now these direct transfers are taking at a price known as “cost of money”
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The Cost of Money
 Capital in the free economy is allocated through the price system.
 There are two main sources of capital
o Debt
o Equity
Interest rate is the price paid to borrow debt capital. With equity
capital, investors expect to receive dividends and capital gains, & these
are the components whose sum is the cost of equity money.
Factors affecting cost of money include:
• Production opportunities: The returns available within an economy from
investments in productive (Cash generating) assets.
• Time preferences for consumption: Preferences of consumers for current
consumption as opposed to saving for future consumption.
• Risk: Chance that an investment will provide low or negative return.
• Expected inflation: Amount by which prices increase over time.
Bottom line: The interest rate paid to savers depends in a basic way on:
1.
2.
3.
4.
Rate of return producers expect to earn on invested capital
Savers time preference for current versus future consumption
Riskiness of loan.
Expected Future rate of inflation.
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THE DETERMINANTS OF MARKET INTEREST RATES
In general, quoted (nominal) interest rate on debt security is composed of:
1. Real risk free rate of interest
2. Premiums that reflect:
a. Inflation
b. Riskiness of the security
c. Security’s marketability (liquidity)
k = k* + IP + DRP + LP + MRP
k = kRF + DRP + LP + MRP
Here
K = the quoted or nominal rate of interest on a given security.
k* = the real risk free rate of interest. The rate on riskless security if zero inflation
is expected.
kRF = k* + IP. Quoted risk free rate on a security which is very liquid and also free
of most risks.
IP = Inflation premium. Its equal to the average expected inflation over the life of
security.
DRP = Default risk premium.
LP = liquidity or marketability premium
MRP = Maturity risk premium.
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DISCUSSION OF EXPECTATIONS THEORY
Yield curve depends on expectations of investors about future interest rates. Long
term interest rates are weighted average of current and expected future short term
interest rates.
Examples:
1. The real risk free rate of interest is 3%. Inflation is expected to be 2% this
year and 4% during next two years. Assume that maturity risk premium is
zero. What is the yield on 2 year treasury security?
B. Yield on 3 year treasury security?
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2. A treasury bond which matures in 10 years has a yield of 6%. A 10 year
corporate bond has a yield of 8%. Assume that liquidity premium on
corporate bond is 0.5%. What is the default risk premium on corporate
bond?
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3. The real risk free rate is 3%, and inflation is expected to be 3% for next two
years. A 2 year treasury security yields 6.2%. What is maturity risk premium
for 2 year security?
4. Interest rates on 4 year treasury securities are currently 7%, while interest
rates on 6 year treasury securities are currently 7.5%. If pure expectations
theory is correct, what does market believe that 2 year securities will be
yielding 4 years from now?
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