BH Chapter 4 The Financial Environment: Markets, Institutions,& Interest Rates 1

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1 Topics Financial markets Types of financial institutions Determinants of interest rates Yield curves BH Chapter 4 The Financial Environment: Markets, Institutions,& Interest Rates 1 2 Different Financial Market Classifications: Direct Transfer from saver-toborrower Money vs. Capital Short-term (money) financial securities vs. Long-term financial securities Spot vs. Future Private vs. Public vs. Secondary The market for new financing vs. already issued securities. How does primary market work? Borrowers 3 4

2 Indirect Transfer through Investment Banking House Indirect Transfer through Financial Intermediary(FI) Investment Banks Borrowers &/or Secondary Financial Intermediary: Banks & Thrifts Mutual Fund Co. s Pension Insurance Co. s Finance Co. s Borrowers 5 6 Different Financial Intermediaries Some Specific Financial Markets Commercial Banks, Savings & Loans, Credit Unions generally lend money to individuals and businesses (assets), find deposits to fund these loans (liabilities) Insurance Companies Pension Mutual Load vs. No-load U.S. Stock Markets New York Stock Exchange(NYSE) American Stock Exchange (AMEX) Brokered trading system with specialists/market makers Over-the-counter market=nasdaq Dealer system with Bid and Ask prices International Stock Markets U.S. Bond Markets Mostly over the counter (Treasuries) Open-ended vs. Closed-ended 7 8 New York and American Bond Exchanges

3 The cost of money 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. Why are these rates different? 3-month Treasury Bill 4.49% 5-year Treasury Note 4.52% 5-year AAA Corporate Bond 5.10% 10-year Treasury bond 4.57% 10-year AAA Corporate Bond 5.22% 30-year Treasury bond 4.66% 9 10 What four factors affect the cost of money? Production Opportunities affects demand for money Time Preferences for Consumption affects the supply of money Risk Expected Inflation Real (or vacuum world) rate 11 Real versus nominal rates k* = real risk-free rate. T-Bond rate if no inflation; 1% to 4%. k k RF = any nominal rate. = Rate on T-securities. Known as the nominal risk-free rate. 12

4 Premiums added to k* for different types of debt k = k* + IP + DRP + LP + MRP Here: k* = Real risk-free rate IP = Inflation premium DRP = Default risk premium LP = Liquidity premium MRP = Maturity risk premium 13 S-T Treasury L-T Treasury S-T Corporate L-T Corporate IP MRP DR P LP 14 Federal Reserve/Monetary Policy effects on interest rates Direct action by FED - raising/lowering Fed Discount Rate, which affects the Fed rate, which effects Prime Rate and other bank loan rates. Indirect action by FED - Open Market Operations: the Fed buys/sells US Treasury securities in open market. Buying by Fed increases demand and price of securities - lower interest rate. Selling by Fed increases supply/lowers price - Yield curve and the term structure of interest rates Term structure relationship between interest rates (or yields) and maturities. The yield curve is a graph of the term structure. increases interest rate 15 16

5 Recent Yield Curve Hypothetical yield curve Yield Maturity Time to Maturity Time to Maturity Interest Rate (%) Maturity risk premium Inflation premium Real risk-free rate An upward sloping yield curve. Upward slope due to an increase in expected inflation and increasing maturity risk premium. Years to Pure Expectations Hypothesis (PEH): Shape of curve depends on investors expectations about future inflation rates. If inflation is expected to increase, S-T rates will be low, L-T rates high, and vice versa. Thus, the yield curve can slope up or down. Why does this theory say this? 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

6 Expectations Hypothesis Result Conclusions about PEH Assumes investors are indifferent between maturity lengths over their desired holding period as long as their return is expected to be the same over this time period. Investor with a 2-yr holding period can buy two one-yr bonds or one 2-yr bond. 1-yr bond: 6%, 2-yr bond: 7%. Total 2-yr bond return = 2 x 7% = 14% one-yr rate a year from today = 2(7) = 8% 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). 22