5 - 1 Copyright © 2001 by Harcourt, Inc.All rights reserved. CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates Financial markets Types of financial institutions Determinants of interest rates Yield curves

5 - 2 Copyright © 2001 by Harcourt, Inc.All rights reserved. The Role of the Financial System Two general categories: Those with excess cash (“savers”) Normally households, but can be others Those with needs for cash (“borrowers”) Normally companies & governments, but can be others The financial system includes a series of institutions that: aggregate funds find counterparties for various transactions In general, connect savers w/ borrowers

5 - 3 Copyright © 2001 by Harcourt, Inc.All rights reserved. Define These Markets Markets in general Physical assets Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Future

5 - 4 Copyright © 2001 by Harcourt, Inc.All rights reserved. Money Vs. Capital Markets Money Markets Short term (< 1 yr.) Debt Low Risk, Low Return Instruments Treasury Bills Commercial Paper Capital Markets - everything else Various maturities Debt or Equity Various risks, returns Instruments Stocks Bonds

5 - 5 Copyright © 2001 by Harcourt, Inc.All rights reserved. Primary vs. Secondary Markets Primary New instruments New Bonds Initial Stocks (IPOs, SEOs) Cash Flow goes from investor to company Secondary “Used” instruments Existing Bonds Existing Stocks Cash flow goes from investor to investor.

5 - 6 Copyright © 2001 by Harcourt, Inc.All rights reserved. Direct transfer Investment banking house Financial intermediary Three Primary Ways Capital Is Transferred Between Savers and Borrowers

5 - 7 Copyright © 2001 by Harcourt, Inc.All rights reserved. What’s an Investment Banker and what do they do??? Not really investors or bankers, per se They consult and assist with primary market transactions - what they do: Advise companies on issuances File with S.E.C. Establish pricing & distribution Make lots of money (Great job, but VERY high pressure!)

5 - 8 Copyright © 2001 by Harcourt, Inc.All rights reserved. Financial Intermediaries Play the largest role in the economy Include: Commercial banks Credit unions Life insurance companies Pension funds Mutual funds

5 - 9 Copyright © 2001 by Harcourt, Inc.All rights reserved. Bank NameCountryTotal assets Deutsche Bank AGGermany$735 billion UBS GroupSwitzerland$687 billion CitigroupUnited States$669 billion Bank of AmericaUnited States$618 billion Bank of TokyoJapan$580 billion The Top 5 Banking Companies in the World, 1999

Copyright © 2001 by Harcourt, Inc.All rights reserved. Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq system Differences are narrowing

Copyright © 2001 by Harcourt, Inc.All rights reserved. Costs of Financing Companies need money to operate, but this financing always comes at a cost For bonds (i.e., debt): Primary cost = stated interest rate Add’l cost = loss of flexibility Must disgorge cash on a regular basis Many inhibitive bond covenants regarding levels of various financial ratios that must be maintained

Copyright © 2001 by Harcourt, Inc.All rights reserved. Costs of Financing (cont.) For stocks (i.e., equity): No explicit payments required So, greater flexibility for company BUT – investors expect co. to perform and  the value of their shares, or they will sell off And Stocks are riskier than bonds  need to earn more for S/H than for B/H to keep them happy How much more? To be discussed later …

Copyright © 2001 by Harcourt, Inc.All rights reserved. What do we call the price, or cost, of debt capital? The interest rate What do we call the price, or cost, of equity capital? Required Dividend Capital return yield gain = +

Copyright © 2001 by Harcourt, Inc.All rights reserved. Cost of Debt We will have more to say about the cost of equity later (a lot more, in fact) but first, more about interest rates Interest rates = one of the most important measures and determinants of financial activity Interest rate = “rent on borrowed money”

Copyright © 2001 by Harcourt, Inc.All rights reserved. What four factors affect the cost of money? Production opportunities Time preferences for consumption Risk Expected inflation

Copyright © 2001 by Harcourt, Inc.All rights reserved. Additional Factors Federal Reserve policy At least in short term Federal government deficits International factors E.g., Japanese purchases of U.S. debt Business activity Interest rates  as economy heats up

Copyright © 2001 by Harcourt, Inc.All rights reserved. “Real” Versus “Nominal” Rates k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. k k RF

Copyright © 2001 by Harcourt, Inc.All rights reserved. k = k* + IP + DRP + LP + MRP. Here: k=required rate of return on a debt security. k*= real risk-free rate. IP= inflation premium. DRP= default risk premium. LP= liquidity premium. MRP= maturity risk premium.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Premiums Added to k* for Different Types of Debt S-T Treasury: only IP for S-T inflation L-T Treasury: IP for L-T inflation, MRP S-T corporate: S-T IP, DRP, LP L-T corporate: IP, DRP, MRP, LP

Copyright © 2001 by Harcourt, Inc.All rights reserved. What is the “term structure of interest rates”? What is a “yield curve”? Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Treasury Yield Curve Years to Maturity Interest Rate (%) 1 yr 5.2% 5 yr 5.8% 10 yr 5.9% 30 yr 6.0% Yield Curve (August 1999)

Copyright © 2001 by Harcourt, Inc.All rights reserved. Normal/Abnormal Yield Curve Most frequent: “normal” or upward sloping curve. Current: relatively flat More unique: downward sloping ( ) also seen last year

Copyright © 2001 by Harcourt, Inc.All rights reserved. Yield Curve Construction Step 1:Find the average expected inflation rate over Years 1 to n: IP n =. n

Copyright © 2001 by Harcourt, Inc.All rights reserved. Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP 1 = 5%/1.0 = 5.00%. IP 10 = [ (8)]/10 = 7.50%. IP 20 = [ (18)]/20 = 7.75%. Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).

Copyright © 2001 by Harcourt, Inc.All rights reserved. Step 2: Find MRP Based on This Equation: MRP t = 0.1%(t – 1). MRP 1 = 0.1% x 0= 0.0%. MRP 10 = 0.1% x 9= 0.9%. MRP 20 = 0.1% x 19= 1.9%.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Step 3: Add the IPs and MRPs to k*: k RF t = k* + IP t + MRP t. k RF =Quoted market interest rate on treasury securities. Assume k* = 3%: k RF1 = 3.0% + 5.0% + 0.0% = 8.0%. k RF10 = 3.0% + 7.5% + 0.9% = 11.4%. k RF20 = 3.00% % % = 12.65%.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Hypothetical Treasury Yield Curve Years to Maturity Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% Real risk-free rate Inflation premium Maturity risk premium

Copyright © 2001 by Harcourt, Inc.All rights reserved. What factors can explain the shape of this yield curve? This constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium.

Copyright © 2001 by Harcourt, Inc.All rights reserved. What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues? Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not neces- sarily parallel to the Treasury curve. The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Hypothetical Treasury and Corporate Yield Curves Years to maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury yield curve BB-Rated AAA-Rated

Copyright © 2001 by Harcourt, Inc.All rights reserved. How does the volume of corporate bond issues compare to that of Treasury securities? Recently, the volume of investment grade corporate bond issues has overtaken Treasury issues. ‘95 ‘96 ‘97 ‘98 ‘ Gross U.S. Treasury Issuance (in blue) Investment Grade Corporate Bond Issuance (in red) Billions of dollars

Copyright © 2001 by Harcourt, Inc.All rights reserved. The Pure Expectations Hypothesis (PEH) Shape of the yield curve depends on the investors’ expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates and vice versa. Thus, the yield curve can slope up or down.

Copyright © 2001 by Harcourt, Inc.All rights reserved. PEH assumes that MRP = 0. 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.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Observed Treasury Rates Maturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 6.2% 6.4% 6.5% 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?

Copyright © 2001 by Harcourt, Inc.All rights reserved % 34 x% 6.2% PEH tells us that one-year securities will yield 6.4%, one year from now (x%). 6.2%= 12.4%= x% 6.4%= x%. (6.0% + x%) 2

Copyright © 2001 by Harcourt, Inc.All rights reserved % 34 x% 6.5% [ 2(6.2%) + 3(x%) ] 5 PEH tells us that three-year securities will yield 6.7%, two years from now (x%). 6.5%= 32.5%= 12.4% + 3(x%) 20.1%= 3(x%) 6.7%= x%.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Some argue that the PEH isn’t correct, because securities of different maturities have different risk. General view (supported by most evidence) is 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). Conclusions about PEH

Copyright © 2001 by Harcourt, Inc.All rights reserved. What various types of risks arise when investing overseas? Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment. Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Two Factors Lead to Exchange Rate Fluctuations 1.Changes in relative inflation will lead to changes in exchange rates. 2.An increase in country risk will also cause that country’s currency to fall.