Chapter 8 Understanding Financial Markets and Institutions McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8 Learning Goals LG1: Differentiate between primary and secondary markets and between money and capital markets LG2: List the types of securities traded in money and capital markets LG3: Identify different types of financial institutions and the services that each financial institution provides LG4: Analyze specific factors that influence interest rates LG5: Offer different theories that explain the shape of the term structure of interest rates LG6: Demonstrate how forward interest rates derive from the term structure of interest rates 2 Financial Markets • Financial markets exist to manage the flow of funds from investors to borrowers • Financial markets can be distinguished along two dimensions: – Primary versus secondary markets – Money versus capital markets 3 Primary Markets • Provide a forum in which corporations and governments raise funds by issuing new financial instruments (stocks and bonds) • Because many companies and government entities can’t generate enough cash flow from internal sources to fund their needs, they must raise capital from external sources (households) 4 • Financial institutions called investment banks arrange most primary market transactions for businesses – Morgan Stanley – Goldman Sachs – Lehman Brothers • Investment banks provide a number of important services to businesses that need to raise capital – Advice – Pricing – Attracting investors 5 • One of the best-known types of primary market transactions is an initial public offering (IPO) – Company’s shares are publicly traded for the first time • When a firm that is already public issues new securities it is called a seasoned offering – Example: Procter & Gamble issues $500 million worth of stock 6 • Once a company’s bonds or shares of stock are issued in the primary market they trade among investors in the secondary market – NYSE – AMEX – NASDAQ • Secondary markets provide a centralized marketplace where economic agents know they can buy or sell securities quickly and efficiently 7 • Securities brokers such as Charles Schwab or other brokerage firms act as intermediaries in the secondary market • Note: the firm that originally issued the bond or stock is not involved in secondary transactions – If you buy shares of IBM through your broker, you are buying them from another investor. IBM has nothing to do with the transaction 8 • Secondary markets offer benefits to both investors and issuers – Investors gain liquidity and diversification benefits – Issuers gain information about the value of their securities • Publicly-traded firms can observe what investors think of their firm value and corporate decisions by tracking their stock price 9 • Trading volume in the secondary market is huge – On August 16, 2007, trading volume on the NYSE broke the all-time record at 5.8 billion shares – In contrast, in the 1980s a 250 million share day was considered a high-volume day 10 Money Markets versus Capital Markets • Money markets feature debt securities with maturities of one year or less – Because of the shorter maturity, fluctuations in secondary market prices are usually small – Money market securities are less risky than long-term instruments – Most money market securities trade overthe-counter 11 • Corporations and governmental entities issue a variety of money market securities to obtain short-term funds – Treasury bills – Federal funds – Repurchase agreements – Commercial paper – Negotiable CDs – Banker’s acceptances 12 13 • Stocks and long-term debt (with a maturity of greater than one year) trade in capital markets • Capital market instruments are subject to wider price fluctuations than money market instruments 14 • Capital market securities include: – U.S. Treasury notes and bonds – State and local government – U.S. government agency bonds – Mortgages and mortgage-backed securities – Corporate bonds – Corporate stocks 15 16 • Other Markets – Foreign Exchange Markets • Events in other countries affect U.S. firms’ performance • For example, in 2001 Argentina experienced an economic crisis that hurt U.S. stock prices. Coca Cola Co. attributed a 5 percent decline in operating profits to the unfavorable exchange rate movements between the dollar and Argentinian peso • Foreign exchange markets trade currency for immediate delivery (spot) or for some future delivery 17 • Firms that sell goods outside the U.S. receive cash flows that are subject to foreign exchange risk – Investors who deal in foreigndenominated securities face the same risk – If the foreign currency depreciates in value, the dollar value of the cash flows will fall • If the foreign currency appreciates in value, the dollar value of the cash flows will rise 18 • Derivative Markets – A derivative security is a financial security linked to another, underlying security such as a stock or currency • Futures contract • Option contract • Swap contract – Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future 19 – As the value of the underlying security changes, the value of the derivative security changes – Derivative contracts involve a high degree of leverage • The investor has to put up only a small amount of the value of the underlying commodity to control a large amount of the underlying commodity – Derivative markets are the newest and potentially the riskiest financial security market – Derivative are used both for hedging and speculating 20 Financial Institutions • Financial institutions include: – Banks – Thrifts – Insurance companies – Mutual funds • These institutions act to channel funds from those with surplus funds to those with a shortage of funds 21 22 • Without financial institutions, the flow of funds between suppliers of funds (households) and users of funds (corporations) would be low for several reasons: – Institutions efficiently monitor the users of funds – Institutions provide liquidity to suppliers of funds • Even though many financial claims feature a longterm financial commitment, institutions provide a means for suppliers to withdraw their cash as needed – Institutions can provide a means to lower the price risk and transactions costs compared to trading on secondary markets 23 • Financial institutions act as financial intermediaries between fund suppliers and fund users. – Fund suppliers and users use financial institutions because of their unique ability to reduce monitoring costs, liquidity costs, and price risk 24 Interest Rates • We often speak of the interest rate as if only one rate applies to all financial situations – In fact there are hundreds of different rates that are appropriate for various situations within the U.S. economy • The rates we actually observe in financial markets are called nominal interest rates, sometimes called the quoted rate • Because changes in interest rates have a profound impact on the value of security prices, financial managers and investors closely monitor these rates 25 • Factors that influence interest rates for individual securities – Inflation – The “real” interest rate – Default risk – Liquidity risk – Special provisions regarding use of funds – Term to maturity 26 27 • Inflation – Inflation is the percentage increase of a standardized basket of goods or services over a given period of time – Actual or Expected inflation rate • The higher the level of actual or expected inflation, the higher the interest rate • Investors want to at least maintain their purchasing power 28 • Real Interest Rates – The rate that a security would pay if no inflation were expected over its holding period – Measures society’s relative time preference for consuming today rather than in the future • Fisher Effect – Nominal interest rates must compensate investors for: • Inflation-related reduction in purchasing power • Forgoing present consumption (real rate) 29 • The Fisher Effect can be written as: i Expected (IP) RIR [Expected (IP) x RIR] • The last term will generally be very small for small values of Expected (IP) and RIR, so we often use an approximate formula for the Fisher Effect: i = Expected (IP) + RIR 30 • Example: The one-year Treasury bill rates in 2007 averaged 4.93 percent and inflation for the year was 1.80 percent. Calculate the real interest rate for 2007 according to the Fisher Effect. RIR = i – Expected (IP) = 4.93% - 1.80% = 3.13% 31 • Default or Credit Risk – Default risk it the risk that a security issuer may fail to make its promised interest and principal payments to its bondholders – The higher the default risk, the higher the interest rate demanded by investors to compensate them for the risk – U.S. Treasury securities are considered to be free of default risk – The difference between a quoted interest rate on a security j and a similar Treasury security is called a default risk premium DRPj = ijt - iTt 32 • Liquidity Risk – If an asset is highly liquid, the holder can convert it into cash at its fair market value on short notice – If a security is illiquid, investors add a liquidity risk premium to the interest rate on the security – A different type of liquidity risk premium may exist if investors dislike long-term securities because their prices react more to changes in interest rates • In this case, a liquidity risk premium may be added to long-term securities because of its greater exposure to price risk 33 • Special Provisions or Covenants – Some securities have special features attached to them that affect their interest rate relative to a similar security without the provisions – Examples include • Taxability (e.g. municipal bonds) • Convertibility (into stock at a preset price) • Callability 34 • Term to Maturity – The relationship between interest rates and maturity is called the term structure of interest rates, or the yield curve • Assumes all other characteristics, such as default risk, liquidity risk, are identical – In general, the longer the term to maturity the higher the required interest rate • Maturity premium 35 Figure 8.11A 36 Figure 8.11B 37 Figure 8.11C 38 Putting it Together • Putting together the factors that affect interest rates in different markets, we can use the following general equation for the fair interest rate: ij* = f(IP, RIR, DRPj, LRPj, SCPj, MPj) 39 Term Structure Theories • The three major theories to explain the shape of the yield curve are: – The unbiased expectation theory – The liquidity premium theory – The market segmentation theory 40 • Unbiased Expectations Theory – According to this theory, at any given point in time the yield curve reflects the market’s current expectations of future short-term rates – Intuition: • If an investor has a 4-year investment horizon they could – A) buy a 4-year bond and earn the current (spot) annual yield on a 4-year bond each year for four years – B) buy four successive 1-year bonds (of which they know only the current one-year spot rate, but they have expectations of the rates in years 2,3, and 4.) 41 • According to the unbiased expectation theory, the return from holding a 4-year bond to maturity should equal the expected return for investing in four successive 1-year bonds. – If not, then an arbitrage opportunity exists 42 – According to the unbiased expectations theory, an upwardly sloping yield curve indicates that future one-year rates will be higher than they are currently – The theory states that current long-term interest rates are geometric averages of current and expected future short-term interest rates – [insert equation 8-7] 43 44 • Liquidity Premium Theory – This theory builds on the unbiased expectations theory – It states that investors will hold long-term maturities only if these securities are offered at a premium to compensate for future uncertainty in the security’s value • Investors must be offered a liquidity premium to buy longer-term securities that carry higher capital loss risk 45 – The liquidity premium theory state that long-term interest rates are geometric averages of current and expected shortterm rates (just like the unbiased expectations theory) plus liquidity risk premiums that increase with the security’s maturity Equation 8-8 46 47 • Market Segmentation Theory – This theory states that investors have specific maturity preferences, and to encourage buyers to hold securities with maturities other than their most preferred maturity requires a higher interest rate (i.e. a maturity premium) • Investors don’t consider securities with different maturities to be perfect substitutes – Examples: banks may prefer short-term securities to match their short-term deposit liabilities, whereas insurance companies may prefer long-term bonds to match their longterm liabilities 48 Forecasting Interest Rates • Changes in interest rate affect the value of financial securities, so investors and firms have an incentive to try to predict interest rates • Using the unbiased expectations hypothesis, we can discern the market’s forecast for expected short-term rates, called forward rates – A forward rate is an implied rate on a shortterm security 49 – To find an implied forward rate on a oneyear security in the future we can re-write the unbiased expectations formula Equation 8-11 50 51