4 - 1 Copyright © 1999 by The Dryden PressAll rights reserved. CHAPTER 4 The Financial Environment: Markets, Institutions, and Interest Rates Financial markets Types of financial institutions Determinants of interest rates Yield curves

4 - 2 Copyright © 1999 by The Dryden PressAll rights reserved. Define these markets Markets in general Markets for physical assets Markets for financial assets Money versus capital markets Primary versus secondary markets Spot versus future markets

4 - 3 Copyright © 1999 by The Dryden PressAll rights reserved. Direct transfer Through an investment banking house Through a financial intermediary Three Primary Ways Capital Is Transferred Between Savers and Borrowers

4 - 4 Copyright © 1999 by The Dryden PressAll rights reserved. Organized Exchanges versus Over-the-Counter Market Auction markets versus dealer markets (exchanges versus the OTC market) NYSE versus NASDAQ system Differences are narrowing

4 - 5 Copyright © 1999 by The Dryden PressAll 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 = +.

4 - 6 Copyright © 1999 by The Dryden PressAll rights reserved. What four factors affect the cost of money? Production opportunities Time preferences for consumption Risk Expected inflation

4 - 7 Copyright © 1999 by The Dryden PressAll 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

4 - 8 Copyright © 1999 by The Dryden PressAll 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.

4 - 9 Copyright © 1999 by The Dryden PressAll rights reserved. Premiums Added to k* for Different Types of Debt ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: ST IP, DRP, LP LT corporate: IP, DRP, MRP, LP

Copyright © 1999 by The Dryden PressAll 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 © 1999 by The Dryden PressAll rights reserved. Two Factors Lead to Exchange Rate Fluctuations Changes in relative inflation will lead to changes in exchange rates. An increase in country risk will also cause that country’s currency to fall.

Copyright © 1999 by The Dryden PressAll 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 © 1999 by The Dryden PressAll rights reserved. T-Bond Yield Curve Years to Maturity Interest Rate (%) 1 yr=5.5% 5 yr=5.9% 10 yr=6.1% 30 yr=6.4% Yield Curve (October 1997)

Copyright © 1999 by The Dryden PressAll rights reserved. Yield Curves Years to maturity Interest Rate (%) 5.5% 6.1% 6.4% BB-Rated AAA-Rated Treasury yield curve

Copyright © 1999 by The Dryden PressAll rights reserved. What are the two main factors that explain the shape of the yield curve? Inflation expectations Risk

Copyright © 1999 by The Dryden PressAll rights reserved. Expectations Theory Shape of the yield curve depends on the investors’ expectations about future interest rates. If interest rates are expected to increase, long-term rates will be higher than short-term rates, and vice versa. Thus, the yield curve can slope up or down.

Copyright © 1999 by The Dryden PressAll rights reserved. The Pure Expectations Hypothesis (PEH) MRP = 0. Long-term rates are an average of current and expected future short- term rates. If PEH is correct, you can use the yield curve to back out expected future interest rates.

Copyright © 1999 by The Dryden PressAll rights reserved. Assume that 1-year securities yield 6% today, and the market expects that 1- year securities will yield 7% in 1 year, and that 1-year securities will yield 8% in 2 years. If the PEH is correct, the 2-year rate today should be (6% + 7%)/2 = 6.5%. If the PEH is correct, the 3-year rate today should be (6% + 7% + 8%)/3 = 7%. Example

Copyright © 1999 by The Dryden PressAll 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 short- term securities because they view long-term securities as riskier. Thus, investors demand a MRP to buy long-term securities (i.e., MRP > 0). Risk

Copyright © 1999 by The Dryden PressAll rights reserved. Inflation for Yr 1 is 5%. Inflation for Yr 2 is 6%. Inflation for Yr 3 and beyond is 8%. k* = 3%. MRP t = 0.1%(t - 1). Combining Risk and Expectations (More…)

Copyright © 1999 by The Dryden PressAll rights reserved. n  INFL t t = 1 Yield Curve Construction Step 1:Find the average expected inflation rate over years 1 to n: IP n = n

Copyright © 1999 by The Dryden PressAll rights reserved. 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 versus inflation; that is, these IPs would permit you to earn k* (before taxes).

Copyright © 1999 by The Dryden PressAll 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 © 1999 by The Dryden PressAll 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% + 5% + 0.0% = 8.0%. k RF10 = 3% + 7.5% + 0.9% = 11.4%. k RF20 = 3% % + 1.9% = 12.7%.