Chapter 5
The Financial System
and Interest
 Read Ch. 5 (ch. 4 in the 4th edition)
 Possible test questions handed out in lab
 Interesting books on investing
 One Up On Wall Street : How To Use What You
Already Know To Make Money In The Market by
Peter Lynch, John Rothchild
 Take On the Street: What Wall Street and
Corporate America Don't Want You to Know by
Arthur Levitt
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Primary and Secondary Markets
 Purpose of a financial market is to facilitate
the flow of funds from savers to production
sector (investment in business projects)
 This occurs in the:
 Primary market (market in which securities are
initially sold)
 Investors trade securities between each
other in the
 Secondary market
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Primary and Secondary Markets
 Corporations, even though they do
not raise money in the secondary
market, are interested in the stock’s
price in the secondary market
 Goal: Max. Stock Price
 Influences how much money can be
raised in future stock issues
 Senior management’s compensation is
usually tied to the stock price
4
The Stock Market and Stock
Exchanges
 Stock market—a network of
exchanges and brokers
 Exchange—a physical marketplace
(NYSE, AMEX, regional exchanges)
 Broker—individual whose job is to assist
people in buying and selling securities
 Work for brokerage firms
 Members of stock exchange
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Exchanges
 New York Stock Exchange (NYSE)
 Trades securities for 1,200 of largest, strongest
companies in U.S.
 Handles about 85% of trading activity
 American Stock Exchange (AMEX)
 Handles slightly smaller, younger firms than
NYSE
 NASDAQ
 Regional stock exchanges (Philadelphia,
Chicago, San Francisco, etc.)
 Exchanges are linked electronically
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Exchanges
 The Market
 The stock market refers to the entire
interconnected set of places, organizations and
processes involved in trading stocks
 Regulation
 Securities are regulated under state and federal
laws
 Securities Act of 1933
 Required companies to disclose certain information
 Securities Act of of 1934
 Set up Securities and Exchange Commission
 Securities law is primarily aimed at disclosure
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Private, Public, and Listed Companies,
and the NASDAQ Market
 Assume a business is successful and the
owner decides to raise money for expansion
by incorporating and selling stock to others
 Privately held companies—can’t sell securities to
the general public (also, sale of securities is
severely restricted by regulation)
 Publicly traded companies—have received
approval of the SEC to offer securities to the
general public
 Process of obtaining approval and
registration is known as ‘going public’
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Private, Public, and Listed Companies,
and the NASDAQ Market
 Process of ‘going public’
 Use an investment banking firm (e.g., Goldman
Sachs or Morgan Stanley), to determine
 If a market exists for shares of your company
 The likely price for your firm’s stock
 Develop a prospectus—provides detailed
information about company
 Financial statements
 Key executives/background
 SEC reviews prospectus
 An unapproved prospectus is call a ‘red herring’
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Private, Public, and Listed
Companies, and the OTC Market
 The IPO
 Once prospectus is approved by SEC securities
can be sold to public
 Initial sale is known as an IPO or initial public
offering
 Market for IPOs is very volatile and risky
 Prices can rise (or fall) very dramatically
 Investment banks usually line up buyers prior to
the actual sale of securities
 Buyers are usually institutional investors
 IPO occurs in primary market, but once
securities are placed with investors, trading
begins in the secondary market
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Largest all time IPOs. 2/7/2014
Company
Name
Offer Date
Exchange
Industry
Underwriter
Deal Size
(US$MM)
Visa
03/18/08
NYSE
Financial
J.P. Morgan
$17,864
ENEL SpA
11/01/99
NYSE
Utilities
Merrill Lynch
$16,452
Facebook
05/17/12
NASDAQ
Technology
Morgan Stanley $16,007
General
Motors
11/17/10
NYSE
Capital Goods &
Morgan Stanley $15,774
Services
Deutsche
Telekom
11/17/96
NYSE
Communication
Goldman Sachs $13,034
s
AT&T Wireless
04/26/00
Group
NYSE
Communication
Goldman Sachs $10,620
s
Kraft Foods
06/12/01
NYSE
Consumer
Credit Suisse
$8,680
France
Telecom
10/17/97
NYSE
Communication
Merrill Lynch
s
$7,289
Telstra
Corporation
11/17/97
NYSE
Communication
Credit Suisse
s
$5,646
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myths about IPOs
 The general perception is that IPOs are a
fail-safe way to make money and that if
one invests money in an IPO returns are
guaranteed. This is the greatest myth
about IPOs. Many IPOs will result in losses
for the investors, the prices of the same will
go down because of several reasons like a
weak company, over pricing, weak
management or simply because the price
fell along with the general markets.
 http://www.19.5degs.com/element/19427.
php
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The NASDAQ Market
 After a company goes public, its
shares are usually traded in the overthe-counter (OTC) market
 Eventually a firm may wish to be
listed on an exchange
 Loosely organized network of brokers
 The National Association of Securities
Dealers Automated Quotation System
(NASDAQ) is the market’s computer system
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The NASDAQ Market
 The Nasdaq Stock Market is a
computerized communication system
that provides the bid and asked prices of
more than 5,000 over-the-counter
(OTC) stocks that have met the
market's registration requirements.
 Update. The current thinking is that
Nasdaq is considered a stock exchange
and its stocks are not OTC stocks.
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Interest
 Interest rates typically refer to the
rate charged on a debt instrument
 There are MANY interest rates, including
the prime rate, the federal funds rate,
etc.
 Interest rates tend to move in tandem
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The Relationship Between
Interest and the Stock Market
 The stock market reacts to changes in
interest rates (even though interest rates
are related to the bond market)
 Stocks (equity) and bonds (debt) compete for
investor’s dollars
 Stocks offer higher returns but have more risk
 If you could earn 10% by investing in a
bond of IBM, what return would you want
to invest in IBM’s stock?
 ANS. More than 10% because the stock is more
risky
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The Relationship Between
Interest and the Stock Market
 If interest rates were to rise to 12% on
IBM’s bonds, what would happen to your
required rate of return on IBM’s stock?
 Your required return on IBM’s stock would rise
and therefore, the value of IBM’s stock would
drop in the market
 Interest rates and security prices move in
opposite directions
 Good reason for us to have an interest in
interest rates
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Interest and the Economy
 Would you be more likely to buy a
house/car when interest rates are high or
low?
 Interest rates have a significant effect on
the economy
 Lower interest rates stimulate business and
economic activity
 Businesses and individuals use credit a great
deal
 Interest rates represent the cost of borrowing
money (credit)
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This is a copy of a later slide (#33)
Putting the Pieces Together
 The factors that make up an interest rate, k, can be
expanded to include the particular types of risk
 K = KPure Interest Rate + Inflation + Default
Risk Premium + Liquidity Risk Premium
+ Maturity Risk Premium
 k = kpr + INFL + DR + LR + MR
 K is known as the nominal or quoted interest rate
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The Components of an Interest
Rate
 Interest rates include base rates and risk
premiums
 Interest rate will be represented by the
letter k
 k = base rate + risk premiums
 k = kpr + INFL + DR + LR + MR
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Conceptual View for Interest Rates
k = kpr + INFL + DR + LR + MR
 Components of the Base Rate
 The base rate is pure interest plus expected
inflation
 The rate at which people lend money when
no risk is involved
 Pure interest rate is AKA earning power of
money
 An unobservable rate that would exist in
the real world if there were no inflation
and no risk
 Generally considered to be between 2%
and 4%
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The Components of an Interest
Rate
 The Inflation Adjustment
 Inflation refers to a general increase in prices
 Refers to the fact that, if prices rise, $100 at the
beginning of the year will not buy as much at
the end of the year
 If you lent someone $100 at the beginning of
the year, you need to be compensated for what
you expect inflation to be during the year
 Interest rates include estimates of average
annual inflation over loan periods
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Risk Premiums
k = kpr + INFL + DR + LR + MR
 Default risk in loans refers to the
chance that the lender will not receive
the full amount of principal and
interest payments agreed upon
 Some loans are more risky than
others
 Lenders demand a risk premium of
extra interest for making risky loans
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Different Kinds of Lending Risk
k = kpr + INFL + DR + LR + MR
 Bond losses can be associated with
fluctuations in the prices of bonds as well
as with the failure of borrowers to repay
the loans
 Default Risk
 The chance the borrower won't pay principal or
interest
 Losses can be the entire amount or anywhere in
between
 Investors demand a default risk premium which
depends on the investor's perception of the
creditworthiness of the borrower
 Perception is based on the firm's financial
condition and credit record
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Different Kinds of Lending Risk
k = kpr + INFL + DR + LR + MR
 Default Risk (continued)
 Premiums range from 0% to 6 or 8 %
 Once a company's default risk becomes too high, they
will be unable to borrow at any interest rate
 Default doesn't actually have to occur for problems to
exist
 If investors realize that a firm is having difficulty
making interest payments (although it is still making
them) the bond's price will probably fall
 A time dimension is involved in the risk of default
 The longer the time period involved with the debt
instrument the more likely that the firm will face
financial difficulty
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Different Kinds of Lending Risk
k = kpr + INFL + DR + LR + MR
 Liquidity Risk
 Associated with being unable to sell the bond of
an little known issuer
 Debt of small firms are particularly hard to
market
 Said to be illiquid
 Sellers must reduce their prices to encourage
investors to buy the illiquid securities
 Liquidity risk premium is the extra interest
demanded by lenders as compensation for
bearing liquidity risk
 Very short-term securities usually bear little
liquidity risk
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Different Kinds of Lending Risk
k = kpr + INFL + DR + LR + MR
 Maturity Risk
 Bond prices and interest rates move in opposite
directions
 Long-term bond prices change more with
interest rate swings than short-term bond prices
 Gives rise to maturity risk
 Investors demand a maturity risk premium
 Ranges from 0% to 2% or more for long-term
issues
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Putting the Pieces Together
 The factors that make up an interest rate, k, can be
expanded to include the particular types of risk
 K = KPure Interest Rate + Inflation + Default Risk Premium
+ Liquidity Risk Premium + Maturity Risk Premium
 k = kpr + INFL + DR + LR + MR
 K is known as the nominal or quoted interest rate
 “Setting” Interest Rates
 Interest rates are set by the forces of supply and
demand
 Thus the interest rate model above is only an economic
model of reality

Represents an explanation of what generally has to be
behind the interest rate needs of investors
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Federal Government Securities,
Risk Free and Real Rates
 Federal Government Securities
 Cities, states and federal governments issue
long-term bonds
 Federal treasury also issues short-term
securities
 Known as Treasury securities
 Treasury bills have terms from 90 days to a year
 Treasury notes have terms from 1 to 10 years
 No default risk associated with federal
government debt
 Can print money to pay off all of its debt
 No liquidity risk for federal government debt
 Always an active market
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The Risk-Free Rate
 The risk-free rate is approximately
the yield on short-term Treasury bills
 Includes the pure rate and an allowance
for inflation
 Same as the base rate discussed earlier
 Viewed as a conceptual floor for the
structure of interest rates
 Denoted as kRF
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The Real Rate of Interest
 Real refers to values that have the effects of inflation
removed
 Tells investors by how much they are getting ahead
 If you earn a real rate of 8% on an investment and
inflation turns out to be 10%, you are losing
purchasing power on your investment
 There are periods in time when the real rate of
interest has been negative
 Because we don't really know what the rate of
inflation will be at the point in time when nominal
rates are set
 The Real Risk-Free Rate
 Implies that both the inflation adjustment and the
risk premium is zero
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Yield Curves—The Term
Structure of Interest Rates
 The relationship between interest
rates and the term of debt is known
as the term structure of interest rates
 The yield curve is a graphical
representation of the term structure of
interest rates
 Most of the time short-term rates are
lower than long-term rates
 However at times the opposite is true
 Known as an inverted yield curve
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Figure 4.10: Yield Curves
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Yield Curves—The Term
Structure of Interest Rates
 Theories have developed attempting to
explain the term structure of interest rates
 Expectations theory
 Today's rates rise or fall with term as future
rates are expected to rise or fall
 Liquidity preference theory
 Investors prefer shorter term securities and
must be induced to make longer loans
 Market segmentation theory
 Loan terms define independent segments of the
debt market which set separate rates
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27. You have been assigned to estimate
the interest rates that your company
may have to pay when borrowing
money in the near future. The
following information is available.
a. Calculate the inflation adjustment
(INFL) for a 5-year loan.
b. Calculate the appropriate interest rate
for a 5-year loan.
kPR = 2%
MR = .1% for a 1 year loan increasing by
.1% for each additional year
k = kpr + INFL + DR + LR + MR
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LR = .05% for a 1 year loan increasing
by .05% for each additional year
DR = 0 for a 1 year loan, .2% for a 2year loan, increasing.1% for each
additional year
Expected Inflation Rates
Year 1 = 7%
Year 2 = 5%
Year 3 and thereafter = 3%
a. INFL = (7% + 5% + 3% + 3% + 3%)/5 = 4.2%
k = kpr + INFL + DR + LR + MR
b. k= 2% + 4.2% + .5% + .25% + .5% = 7.45%
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