Chapter 2 The Financial Environment Markets Institutions Interest Rates © 2005 Thomson/South-Western

2 The Financial Markets  Debt versus equity markets  Debt markets = loans  Equity markets = stocks  Money versus capital markets  Money market = debt < 1 year  Capital market = debt > 1 year + stocks  Primary versus secondary markets  Primary markets = new funds  Secondary markets = outstanding securities

3 The Financial Markets  Public versus private markets  Public markets = liquid, low-cost standardized trades  Private markets = specialized deals  Spot versus futures markets  Spot markets = assets traded “on the spot”  Futures markets = for delivery at a later date  World, national, regional, and local markets  Worldwide = New York Stock Exchange  Local = Chicago Stock Exchange

4 Financial Institutions  Direct transfers  No intermediaries  Often part of private market transactions  Investment banking houses  I-Bank = middleman  I-Bank may buy in hopes of selling, so there is some risk  Financial intermediaries  Banks or mutual funds  Savers invest in one type of product (e.g., CDs or savings accounts)  Bank then creates loans, mortgages, etc. to sell to borrowers Funds are transferred between those who have funds and those who need funds by three processes:

5 Financial Intermediaries  1993 Glass-Steagall Act  Prohibited commercial banks from I-banking activities  Tried to prohibit “conflict of interest situations”  Result: Morgan Bank  JP Morgan Chase & Company = commercial bank  Morgan Stanley = investment bank  1999 Gramm-Leach-Bliley Act  Expanded the powers of banks  Abolished major restrictions of the Glass-Steagall Act  Allows banks to do:  I-banking  insurance sales and underwriting  low risk non-financial activities

6 Financial Intermediaries  The Gramm-Leach-Bliley Act blurred the distinctions:  Commercial banks  Savings and loan associations  Credit unions  Pension funds  Life insurance companies  Mutual funds

7 Stock Markets  Old classification  Organized Security Exchanges  NYSE, AMEX, and regional  OTC (over-the-counter markets)  A broader network of smaller dealers  New classification  Physical stock exchanges  NYSE, AMEX  Organized Investment Networks  OTC, Nasdaq, electronic communication networks (ECN)

8 Physical Stock Exchanges  A physical, “material entity”  A building  Designated members  A board of governors  Seats are bought and sold  Record high price = $4M (12/1/05)  Price in 1999 = $2M  Auction markets  Sell orders and buy orders come together

9 Organized Investment Networks  For securities not traded on physical stock exchanges  An intangible trading system  A network of brokers and dealers (NASD)  Dealers make the market  The bid price = what the dealer will pay to buy  The ask price = what the dealer will take to sell  Spread = the dealer’s profit  Electronic communications networks

10 Four factors that affect the cost of money The Cost of Money  Production opportunities  Is it worth investing in new assets?  Time preferences for consumption  Now or later?  Risk  How likely is it that this investment won’t pan out?  Expected inflation  How much will prices increase over time?

11 The Cost of Money  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? Return on Equity =Dividends + Capital Gains

12 Interest Rate Levels Interest Rates as a Function of Supply and Demand k B = 12 Interest Rate, k B Market B:High-Risk Securities % Dollars 0 S1S1 D1D1 Interest Rate, k A Market A: Low-Risk Securities k A = Dollars % D1D1 D2D2 S1S1

13 = real risk-free rate. Typically 2% to 4% T-bill for short term T-bond for long term k* = any nominal rate = quoted rate k = Risk-free rate on T-securities k RF “Real” versus “Nominal” Rates

14 k= Quoted or nominal rate k*= Real risk-free rate (“k-star”) IP= Inflation premium DRP= Default risk premium LP= Liquidity premium MRP= Maturity risk premium The Determinants of Market Interest Rates

15 The Determinants of Market Interest Rates Quoted Interest Rate = k k = Risk-free interest rate + risk premium k = k RF + RP k = k RF + [DRP + LP + MRP] k = [k* + IP] + [DRP + LP + MRP]

16 The Determinants of Market Interest Rates Nominal Interest Rate = k = [k* + IP] + [DRP + LP + MRP]  IP = average rate of inflation expected in future  DRP = risk that a borrower will default on a loan (difference between the T-bond interest rate and a corporate bond with same features)  LP = premium if asset cannot be converted to cash quickly and at close to the original cost (2 – 5%)  MRP = the interest rate risk associated with longer maturity periods (usually 1 – 2%)

17 Quoted Risk-Free Rate = k = k RF + DRP + LP + MRP k= Quoted or nominal rate k RF = Real risk-free rate plus a premium for expected inflation or k RF = k* + IP DRP= Default risk premium LP= Liquidity premium MRP= Maturity risk premium Determinants of Market Interest Rates

18 IP= Inflation premium DRP= Default risk premium LP= Liquidity premium MRP= Maturity risk premium Premiums Added to k* for Different Types of Debt  Short-Term (S-T) Treasury: only IP for S-T inflation  Long-Term (L-T) Treasury:  IP for L-T inflation plus MRP  Short-Term corporate: Short-Term IP, DRP, LP  Long-Term corporate: IP, DRP, MRP, LP

19 The Term Structure of Interest Rates  Term structure: the relationship between interest rates (or yields) and maturities  A graph of the term structure is called the yield curve.

20 U.S. Treasury Bond Interest Rates on Different Dates Interest Rate Term to March July July Maturity months 16.0% 6.1%0.9% 1 year years years years Short Term Intermediate Term Long Term Interest Rate (%) March 1980 July 2000 July 2003 Abnormal Flat = horizontal Normal

21 Three Explanations for the Shape of the Yield Curve  Liquidity Preference Theory  Expectations Theory  Market Segmentation Theory

22 Liquidity Preference Theory  Lenders prefer to make short-term loans  Less interest-rate risk  More liquid  Lenders lend short-term funds at lower rates  Says MRP > 0  Results in “normal” curve

23 Expectations Theory  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.  The yield curve can slope up OR down.

24 Calculating Interest Rates under Expectations Theory Step 1:Find the Inflation Premium, the average expected inflation rate over years 1 to N

25  Inflation for Year 1 is 5%.  Inflation for Year 2 is 6%.  Inflation for Year 3 and beyond is 8%.  k* = 3%  MRP t = 0.1% (t-1) IP 1 = 5%/ 1.0 = 5.00% IP 10 = [ (8)] / 10 = 7.5% 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). Example:

26 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% Calculating Interest Rates under Expectations Theory:

27 Calculating Interest Rates under Expectations Theory: 1-Yr: k RF1 = 3% + 5.0% + 0.0% = 8.0% 10-Yr: k RF10 = 3% + 7.5% + 0.9% = 11.4% 20-Yr: k RF20 = 3% % + 1.9% = 12.7% k RFt = k* + IP t + MRP t k RF = Quoted market interest rate on treasury securities. Assume k* = 3%. Step 3: Add the IPs and MRPs to k*:

28 Yield Curve Years to maturity Interest Rate (%) 8.0% 11.4% 12.7% Treasury yield curve

29 Market Segmentation Theory  Borrowers and lenders have preferred maturities  Slope of yield curve depends on supply and demand for funds in both the L-T and S-T markets  Curve could be flat, upward, or downward sloping

30 Other Factors that Influence Interest Rate Levels  Federal Reserve Policy  Controls money supply; impacts S-T interest rates  Federal Deficits  Larger federal deficits mean higher interest rates  Foreign Trade Balance  Larger trade deficits mean higher interest rates  Business Activity  Does the Federal Reserve need to stimulate activity?

31 Interest Rate Levels and Stock Prices  The higher the rate of interest, the lower a firm’s profits  Interest rates affect the level of economic activity... which affects corporate profits  If interest rates rise... Investors turn to the bond market, sell stock, and decrease stock prices  If interest rates decline... Investors turn to the stock market, sell bonds, and increase stock prices

32 For Next Class: Chapter 2 Homework problems Review Chapters 1 and 2 Prepare for Chapter 1-2 quiz Read Chapter 3