Financial Markets
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A market is a place where goods and
services are exchanged.
A financial market is a place where
individuals and organizations who want
to borrow funds are brought together
with those having a surplus of funds.
1
We can classify markets
Based on:
Underlying asset
Delivery date
Maturity
Players
Physical/Financial/Derivatives
Spot/Futures
Money/Capital
Primary/Secondary
Private/Public
2
Examples
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London Gold Market
physical, spot
New York Stock Exchange
financial, spot, secondary, capital
Sale of commercial paper by HP
financial, money, primary
3
How is capital transferred between savers and
borrowers?
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Direct transfers
Investment banking house
Financial intermediaries
A firm’s selling its stock directly to
another firm/individual is an example of
direct transfer
4
Through Investment bankers
Investment banking firm helps a company in the
design and sale of securities. The investment
banker is also called the underwriter.
The agreement between the firm and
underwriter can be of two types:
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firm-commitment basis: underwriter bears all the risk
best-efforts basis: underwriter does not buy the issue
but acts as a selling agent
5
Through Investment bankers
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In general, the lead investment banker puts
together a purchase group and a selling group
purchase group underwrites the offering
(purchases securities from the issuing
corporation)
selling group contacts potential buyers and do
the selling on a commission basis
Examples of Investment Banking Firms:
Merrill Lynch, Salomon Smith Barney
6
Examples of financial intermediaries
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Commercial banks
Pension funds
Life insurance companies
Mutual funds
Financial intermediaries get savings from individuals by
creating new financial products
For example, commercial banks open checking and
saving accounts, life insurance companies sell policies
and mutual funds sell new shares and are ready to buy
back outstanding shares.
7
financial intermediaries
Strengths of financial intermediaries
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Economies of scale in analyzing
creditworthiness of potential borrowers
Pooling risk
8
Mutual funds
Mutual funds differ in their investment objectives, e.g.
 Pursue Aggressive growth
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Invest in Precious metals
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Invest in Global equity
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Turkish: type A minimum 25% investment in stocks, it may also
include fixed income securities. Type B investment only in fixed
income securities. Type B liquid funds limit maturity up to 90
days.
Ranking of Mutual Funds (US):
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Lipper Ranking
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Morningstar Ranking
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Each fund is ranked within the universe of funds similar in
investment objectives
9
Physical location stock exchanges vs. Electronic
dealer-based markets
Auction market vs. Dealer market (Exchanges vs. OTC)
Exchanges can have continuous trading, call auctions
or both
Mostly: Continuous-auction also contain opening call
How do they provide continuity: Limit Order Book
Liquidity:
conversion to cash
quickly, with low cost, and
for reasonable transaction sizes
10
Physical location stock exchanges vs. Electronic
dealer-based markets
Members have seats (e.g. NYSE ≈1400 members)
Only members can execute transactions
Over-the-counter (OTC) market
e.g. Nasdaq
Several dealers assigned to each stock
They quote bid/ask prices
Computerized system
Dealers hold inventory
11
Cost of Money
except social, strategic policies capital is allocated
through a price system
debt capital:
equity capital:
interest rate
dividend yield
capital gains
12
Four fundamental factors
Four fundamental factors
 Production opportunities
 Time preferences for consumption
 Risk
 Inflation
Different markets
 Interest rates differ due to differences in risk,
but the rates are interrelated
13
Determinants of Market Interest Rates
rate = k* + IP + DRP + LP + MRP
k*:
IP:
DRP:
LP:
MRP:
real risk-free rate
Inflation Premium
Default risk premium
Liquidity premium
Maturity risk premium
14
Determinants of Market Interest Rates
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Inflation is expected future inflation, not the past rate
Default: The borrower will not pay the interest or principal,
probably because of financial distress
Liquidity: being able to sell the security quickly at fair market
value
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Determinants of Market Interest Rates
Government securities e.g. T-bonds have basically no DRP and
little LP. They are only subject to IP and MRP
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Maturity risk premium: Extra return offered by securities with
longer time to maturity.
Bond prices are negatively related to interest rates. In other words,
as interest rate rises, bond price will fall.
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Simple example
A security that has a single payoff of $110 in one year.
If the market price of this security is $100, what is the
promised return?
r
$110  $100
 10%
$100
If the market price of this security is $90, what is the
promised return?
r
$110  $90
 22%
$90
So a decrease in price increases return.
17
For example
Interest rate (promised return)=10% and bond price=$920 now
I own this bond but I have just decided to sell it (I need cash).
If interest rate rises to 12% (market prices similar securities so
that their promised return rises to 12%), price of the bond will fall.
So I and other bondholders will have a loss due to a fall in price
when interest rates rise. This is called as the interest risk.
When I sell the bond at the new (lower) price, the buyer will have
a promised return of 12%.
The amount and the timing of payments made by the issuer of the
bond to bondholders are fixed. The market price is the only bond
feature that can change. So to raise the promised return from 10%
to 12%, the price of the bond has to fall.
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interest rate risk
For a given holding period, the interest rate risk as measured by
the price change at the end of your holding period increases
with the time to maturity of the bond.
So other things being equal, a bond with 20 year time-tomaturity will have larger MRP than that of a 10 year bond.
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reinvestment rate risk
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We did ignore another type of risk, the
reinvestment rate risk from the discussion
above. Actually, MRP is the net effect of
interest rate and reinvestment rate risks.
We will return to this discussion after we
cover the Time Value of Money concept.
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Ratings
Bond Rating Agencies:
Moody’s and S&P
Attributes associated with
better ratings
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Lower financial leverage
 Larger firm size
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Larger and steadier profits
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Larger cash flows
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Lack of subordination to
other debt issues
21
Term Structure of Interest Rates
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The relationship between short term
and long term interest rates is known as
term structure of interest rates
Yield curve: graph showing the
relationship between bond yields and
maturities
22
Yield Curve
e.g. Yield Curve for Government securities (DRP=LP=0)
TTM
1 yr
10 yr
20 yr
Interest
Rate
15
rate/year
8.0%
11.4%
12.7%
Maturity risk premium
10
Yield Curve can be
Upward sloping,
Downward sloping, or
Flat
Inflation premium
5
Real risk-free rate
0
1
10
Years to Maturity
20
23
Forward rates
Consider the following two investment alternatives for an investor who has a two-year
investment horizon.
Alternative 1:
Alternative 2:
Assume
Buy a two-year zero-coupon instrument. (rate=s2)
Buy a one-year zero-coupon instrument (rate=s1) and when it
matures in one year, buy another one-year instrument.
s1 8.000%
s2 8.995%
Given the price of zero-coupon bond, you can
find the interest rate from the following formula
Pk=$1000/(1+sk)k
Note that:
In a world of certainty (future interest rates are known) both of these strategies must
yield identical final payoffs. Otherwise, no one holds either the two-year bond or the one
year bond
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Forward rates
The interest rate that would need to prevail in the second year to make the short
and long-term investments equally attractive, ignoring risk is called the forward
rate.
approximately (s1+f1,2)/2=s2
or exactly (1+s1)(1+f1,2)=(1+s2)2
when you know s1 and s2, you can calculate f1,2
f1,2=9.99% approximately or 10% exactly
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Forward rates
Now consider the case of uncertainty where future interest rates are uncertain.
Assume that E(s12)=10% same as the forward rate
P1-year=$1000/1.08=$925.93
P2-year= $1000/(1.08*1.1)=$841.75
So 2-year security is priced using E(s12). Note that this is consistent with the
s2=8.995%, $1000/(1.08995)2=$841.75
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Forward rates
Consider a short-term investor who wishes to invest for one year
Under Alternative 2:the return is a riskless 8%
Under Alternative 1:the return is risky. If s12 turns out 10% as expected, the return
will be 8% since the bond price will be $1000/1.1=$909.09 in one year and
$841.75*(1.08)=$909.09. If s12 turns out different than 10%, the return will not be
8%.
Why should this investor buy the risky 2-year bond when its expected return is 8%,
no better than that of the risk-free one-year bond.
This requires the 2-year bond to sell at a price lower than the $841.75
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Forward rates
Suppose all investors have short-term horizons and therefore are willing to hold
the 2-year bond only if its price falls to $819.
At this price, this year’s expected return on this bond is 11% ($909.09/$819=1.11).
This means a premium of 3% compared to the risk-free one-year bond.
In this environment, the forward rate f12 no longer equals E(s12). s2 now equals
10.5%((1000/819)1/2=1.105) and f12=13%.
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Investors require a premium to hold the two-year bond and be willing to hold
the bond if E(s12) is less than f12.
E(s12) < f12 means: since 2s2=s1+f1,2 then 2s2>s1+E(s1,2)
The change in s2 by 1.5% (10.5%-8.995%) denotes a positive MRP. It is the risk
premium given for holding long term bond.
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Forward rates
We can also imagine a scenario in which long-term bonds can be perceived by
investors to be safer than short-term bonds.
Suppose all investors have long-term horizons (2-year). In this case, investing in
two-year bond is riskless and investing in one-year bond has reinvestment rate risk.
This would cause E(s12) to be more than f12.
In this case, we will have a negative MRP.
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Term Structure Theories
try to explain the shape of yield curve
e.g. Pure Expectations Hypothesis
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The PEH argues that the shape of the yield curve
depends on investor’s expectations about future short
term interest rates.
If short term interest rates are expected to increase,
long-term rates will be higher than current short-term
rates, and vice-versa. Thus, the yield curve can slope
up, down, or even bow.
30
Assumptions of the PEH
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Assumes that the maturity risk premium for Treasury
securities is zero.
It states that f1,2 =E(s12). This implies that long-term
rates are an average of current and expected future
short-term rates. e.g. s2=[s1+E(s1,2)]/2
If PEH is correct, you can use the yield curve to
“back out” expected future interest rates.
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Pure Expectations Hypothesis
Long-term rates are an average of current and expected
future short-term rates. For example:
s3=(s1+f12+f23)/3
To confirm
definition of f12 s2=(s1+f12)/2  f12=2 s2-s1
definition of f23 s3=(2s2+f23)/3  f23=3 s3-2s2
Plug into the first expression
s3=(s1+2 s2-s1+3 s3-2s2)/3= s3
PEH says s3=(s1+E(s12)+E(s23))/3 since E(s12)=f12 and E(s23)=f23
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Pure Expectations Hypothesis
Also note that:
definition of f12 2 s2=(s1+f12)  f12=2 s2-s1
definition of f23 3s3=(2s2+f23)  f23=3 s3-2s2
definition of f13 3 s3=(s1+2f13)  2f13=3 s3-s1
Then f13=(f12+f23)/2
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An example: Observed Treasury rates and the PEH
Maturity
1 year
2 years
3 years
4 years
5 years
Yield
6.0%
6.2%
6.4%
6.5%
6.5%
Upward sloping yield curve
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?
34
One-year forward rate
6.2%
= (6.0% + x%) / 2
12.4%
= 6.0% + x%
6.4% = x%
PEH says that one-year securities will yield
6.4%, one year from now.
35
Three-year security, two years from now
6.5%
= [2(6.2%) + 3(x%)] / 5
32.5% = 12.4% + 3(x%)
6.7%
= x%
PEH says that three-year securities will
yield 6.7%, two years from now.
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Calculating all the forward rates
In the calculation above we relied on the expression E(s25)=f25
Equivalently, we can use the fact that long term rate is
arithmetic average of short term rates
s1 6.0%
s2 6.2% f12
6.4% =2s2-s1
s3 6.4% f23
6.8% =3s3-2s2
s4 6.5% f34
6.8% =4s4-3s3
s5 6.5% f45
6.5% =5s5-4s4
three-year securities two years from now
E(s25)=[E(s23)+E(s34)+E(s45)]/3=[6.8%+6.8%+6.5%]/3
=6.7%
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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).
38
Conclusions about PEH
recall that s2=(s1+f12)/2
If MRP≠0 and PEH is not correct
Recall definitions of s1 and s2
s2=k*+IP2+MRP2
E(s12)=k*+IP12
and s1=k*+IP1
assuming MRP1=0
so IP2=(IP1+IP12)/2
s2=k*+(E(s12)-k*+s1-k*)/2+MRP2
since
f12= 2s2 - s1
then
f12= E(s12)+2MRP2
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Conclusions about PEH
f12= E(s12)+2MRP2
If yield curve is upward sloping i.e. s2>s1, then since 2s2=s1+f12
it must be f12>s1
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If PEH is correct, then since f12= E(s12) it must be E(s12) >s1
If MRP≠0 and PEH is not correct, then we get
E(s12)+2MRP2>s1
So it is not necessarily true that E(s12) >s1, i.e. it can be that
E(s12) <s1 but E(s12)+2MRP2>s1
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Example
Assume that the real risk free rate is 3% and that
inflation is expected to be 8% in year 1, 5% in year 2,
and 4% thereafter.
Assume that all treasury bonds are free of default risk.
If 2-year and 5-year treasury bonds both yield 10%,
what is the difference in maturity risk premiums on the
two bonds?
41
Example
Assuming that real risk free rate and MRP stay constant over time
MRP5 = 10% - 8% = 2%.
MRP2 = 10% - 9.5% = 0.5%.
MRP5- MRP2 = (2% - 0.5%) = 1.5%.
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Exact solution
Exact solution :
(1+3%+8%+MRP5)(1+3%+5%+MRP5)(1+3%+4%+MRP5)
(1+3%+4%+MRP5)(1+3%+4%+MRP5)=(1+10%)5
MRP5=2.011%
(1+3%+8%+MRP2) (1+3%+5%+MRP2)=(1+10%)2
MRP2=0.51%
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Example
4-6 The real risk free rate is 3 percent. Inflation is expected to be 3
percent this year, 4 percent next year, and then 3.5 percent
thereafter. The maturity risk premium is estimated to be
0.0005*(t-1), where t= number of years to maturity. What is
the nominal interest rate on 7-year Treasury note?
MRP1= 0.0005*(1-1)=0, MRP2= 0.0005*(2-1)=0.05%
MRP7= 0.0005*(7-1)=0.3%
IP7=(3%+4%+5*3.5%)/7=24.5%/7=3.5%
S7=k*+IP7+MRP7=3%+3.5%+0.3%=6.8%
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Example
4-12
The 5-year bonds on Cartwright Enterprises are yielding
7.75% per year. Treasury bonds with the same maturity
are yielding 5.2 percent per year. The real risk free rate
has not changed in recent years and is 2.3 percent. The
average inflation premium is 2.5 percent, and the maturity
risk premium takes the form: MRP=0.1%(t-1), where t=
number of years to maturity. If the liquidity premium is 1
percent, what is the default risk premium on Cartwright’s
corporate bonds?
MRP5= 0.1%(5-1)=0.4%
Treasury bonds: k*+IP5+ MRP5 =2.3%+2.5%+0.4%=5.2%
Cartwright’s corporate bonds k*+IP5+ MRP5 +LP+DRP
LP+DRP=7.75%-5.2%=2.55% so DRP=1.55%
45