CDA COLLEGE BUS235: PRINCIPLES OF FINANCIAL ANALYSIS Lecture 2 Lecture 2 Lecturer: Kleanthis Zisimos

Lecture Topic List Financial Markets Financial Markets Financial Institutes Financial Institutes Cost of money Cost of money Interest Rates levels Interest Rates levels

Financial Markets Companies, individuals and governments often need to raise capital for achieving their goals. Companies, individuals and governments often need to raise capital for achieving their goals. On the other hand some other companies, individuals or governments have available funds to invest. On the other hand some other companies, individuals or governments have available funds to invest. Financial markets bring together the above two groups in order to do business with each other. Financial markets bring together the above two groups in order to do business with each other. According to the type of transactions we have different financial market which we shall see in the next slide According to the type of transactions we have different financial market which we shall see in the next slide

Major Types of Markets Physical asset markets are those for such products as wheat, autos, real estate, computers and machinery. Physical asset markets are those for such products as wheat, autos, real estate, computers and machinery. Financial asset markets deal with stocks, bonds, notes, mortgages and other claims or real assets Financial asset markets deal with stocks, bonds, notes, mortgages and other claims or real assets Spot markets and future markets are terms that refer to whether the assets are being bought or sold for “on the spot” delivery or for delivery at some future date, such as six months or a year into the future. Spot markets and future markets are terms that refer to whether the assets are being bought or sold for “on the spot” delivery or for delivery at some future date, such as six months or a year into the future. Money markets are the markets for debt securities with maturities of less than one year. Money markets are the markets for debt securities with maturities of less than one year.

Major types of Markets Capital markets are the markets for long term debt and corporate stocks Capital markets are the markets for long term debt and corporate stocks Mortgage markets deal with loans on residential, commercial, and industrial real estate, and on farmland. Mortgage markets deal with loans on residential, commercial, and industrial real estate, and on farmland. Credit markets involve loans on autos and appliances, as well as loans for education, vacations, and so on. Credit markets involve loans on autos and appliances, as well as loans for education, vacations, and so on. Primary markets are the markets in which corporations raise new capital. Primary markets are the markets in which corporations raise new capital. Secondary markets are markets in which existing securities are traded among investors. Secondary markets are markets in which existing securities are traded among investors.

Financial Institutions Transfer of capital between savers and those who need capital take place either directly to one another or through financial institutes. Transfer of capital between savers and those who need capital take place either directly to one another or through financial institutes. We have two types of Financial institutes. We have two types of Financial institutes. 1. Investments Banks. They buy stocks from a company and sell the same stocks to savers. This is a primary market transaction 2. Financial Intermediaries. They obtain funds from savers and issue their own securities in exchange.

Financial Intermediaries Commercial banks which are the main financial intermediaries Commercial banks which are the main financial intermediaries Credit unions are cooperate associations whose members have a common bond and lend only to their members like employees of the same firm. Credit unions are cooperate associations whose members have a common bond and lend only to their members like employees of the same firm. Pensions funds are retirement plans funded by corporations or government agencies for their workers Pensions funds are retirement plans funded by corporations or government agencies for their workers Life insurance companies take savings in the form of annual premiums, then invest theses funds in stock, bonds, real estate, and mortgages and finally make payments to the beneficiaries of the insured parties. Life insurance companies take savings in the form of annual premiums, then invest theses funds in stock, bonds, real estate, and mortgages and finally make payments to the beneficiaries of the insured parties. Mutual funds are corporations which accept money from savers and then use these funds to buy stocks or bonds issued by businesses or government units. Mutual funds are corporations which accept money from savers and then use these funds to buy stocks or bonds issued by businesses or government units.

The Stock Exchanges 1. Organized security exchanges are tangible physical entities. Each of the larger ones occupies its own building, has specifically designated members, and has an elected governing body – its board of governors. Members are said to have “seat” on the exchange, although everybody stands up. 2. Over the counter market. is defined to include all facilities that are needed to conduct security transactions not conducted on the organized exchanges. These facilities consist of: The relatively few dealers who hold inventories of over-the-counter securities and who are said to “make a market” in these securities. The relatively few dealers who hold inventories of over-the-counter securities and who are said to “make a market” in these securities. The thousands of brokers who act as agents in bringing these dealers together with investors. The thousands of brokers who act as agents in bringing these dealers together with investors. The computers, terminals, and electronic networks that provide a communications link between dealers and brokers. The computers, terminals, and electronic networks that provide a communications link between dealers and brokers.

The Cost of Money Capital in a free economy is allocated through the price system. The interest rate is the price paid to borrow debt capital, whereas in the case of equity capital, investors expect to receive dividends and capital gains. Capital in a free economy is allocated through the price system. The interest rate is the price paid to borrow debt capital, whereas in the case of equity capital, investors expect to receive dividends and capital gains. The four most fundamental factors affecting the cost of money are: 1) production opportunities, 2) time preferences for consumption, 3)risk and 4) inflation. The four most fundamental factors affecting the cost of money are: 1) production opportunities, 2) time preferences for consumption, 3)risk and 4) inflation.

The Determinants of Market Interest Rates Interest Rate =k = k*+IP+DRP+LP+MRP K* = The real risk free rate of interest is defined as the interest rate that would exist on a riskless security if no inflation were expected. K* = The real risk free rate of interest is defined as the interest rate that would exist on a riskless security if no inflation were expected. IP = Inflation Premium is the average expected inflation rate over the line of the security IP = Inflation Premium is the average expected inflation rate over the line of the security

The Determinants of Market Interest Rates DRP = Default Risk Premium reflects the possibility that the borrower will not to pay the interest or the principal, on a security at the stated time and amount DRP = Default Risk Premium reflects the possibility that the borrower will not to pay the interest or the principal, on a security at the stated time and amount LP = Liquidity Premium generally is defined as the ability to convert an asset to cash at a “fair market value”. LP = Liquidity Premium generally is defined as the ability to convert an asset to cash at a “fair market value”. MRP = Maturity Risk Premium reflects the extra risk taken for long term security. MRP = Maturity Risk Premium reflects the extra risk taken for long term security.

Moody's credit rating for Default risk

The Term Structure of Interest Rates The term structure of interest rates is the relationship between long term rates and short term rates. Sometimes short term rates are lower and sometimes higher than long term rates. Why this is happening? Several theories have been proposed to explain this relationship and the three major ones are the following: The term structure of interest rates is the relationship between long term rates and short term rates. Sometimes short term rates are lower and sometimes higher than long term rates. Why this is happening? Several theories have been proposed to explain this relationship and the three major ones are the following: Market Segmentation Theory Market Segmentation Theory The Liquidity Preference Theory The Liquidity Preference Theory The expectations theory The expectations theory

Market Segmentation theory Market Segmentation Theory states that each lender and each borrower has a preferred maturity. Market Segmentation Theory states that each lender and each borrower has a preferred maturity. The thrust of the market segmentation theory is that the slope of the yield curve depends on supply / demand conditions in the long – term and short – term markets. According to this theory, the yield curve could at any given time be either flat, upward sloping, or downward sloping. An upward sloping yield curve would occur when there was a large supply of short –term funds relative to demand, but a shortage of long – term funds. The thrust of the market segmentation theory is that the slope of the yield curve depends on supply / demand conditions in the long – term and short – term markets. According to this theory, the yield curve could at any given time be either flat, upward sloping, or downward sloping. An upward sloping yield curve would occur when there was a large supply of short –term funds relative to demand, but a shortage of long – term funds.

Liquidity Preference Theory The Liquidity Preference Theory states that long – term bonds normally yield more than short – term bonds for two reasons: The Liquidity Preference Theory states that long – term bonds normally yield more than short – term bonds for two reasons: 1. Investors generally prefer to hold short –term securities, because such securities are more liquid in the sense that they can converted to cash with little danger of loss of principal. Investors will, therefore, generally accept lower yields on short term securities. 2. Borrowers, on the other hand, generally prefer long – term debt, because short – term debt exposes them to the risk of having to repay the debt under adverse conditions. Borrowers are willing to pay a higher rate, for long –term funds than for short- term funds, and this also leads to relatively low short term rates.

Expectation Theory The expectations theory states that the yield curve depends on expectations about future inflation rates. The expectations theory states that the yield curve depends on expectations about future inflation rates. Specifically, kt, the nominal interest rate on a U.S. Treasury bond that matures in t years, is found as follows under the expectations theory: Specifically, kt, the nominal interest rate on a U.S. Treasury bond that matures in t years, is found as follows under the expectations theory: Kt = k* + IPt Kt = k* + IPt K* is the real risk – free interest rate IPt is an inflation premium which is equal to the average expected rate of inflation over the t years until the bond matures.

Interest Rate Levels and Stock Prices Interest rates have two effects on corporate profits: (1) The higher the rate of interest, the lower a firm’s profit. (2) Interest rates affect the level of economic activity, and economic activity affects corporate profits. Interest rates obviously affect stock prices because of their profits, but, perhaps even more important, they have an affect due to competition in the market between stocks and bonds. If interest rates rise sharply investors can get higher returns from the stock market to the bond market. Stock sales in response to rising interest rates depress stock prices