U4-1 Chapters 5&6 Financial Environment and Interest Rates Capital allocation process Financial markets and institutions Stock market efficiency Determinants of interest rates Other factors influencing rates

U4-2 The Capital Allocation Process In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it. Suppliers of capital – individuals and institutions with “excess funds”. These groups are saving money and looking for a rate of return on their investment. Demanders or users of capital – individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

U4-3 How is capital transferred between savers and borrowers? Direct transfers Investment banking house Financial intermediaries

U4-4 What is a market? A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

U4-5 Types of financial markets Physical assets vs. Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Futures Public vs. Private

U4-6 The importance of financial markets Well-functioning financial markets facilitate the flow of capital from investors to the users of capital. Markets provide savers with returns on their money saved/invested, which provides them money in the future. Markets provide users of capital with the necessary funds to finance their investment projects. Well-functioning markets promote economic growth. Economies with well-developed markets perform better than economies with poorly-functioning markets.

U4-7 Types of financial institutions Commercial banks Investment banks Mutual savings banks Credit unions Pension funds Life insurance companies Mutual funds Hedge funds

U4-8 Physical location stock exchanges vs. Electronic dealer-based markets Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq Differences are narrowing

U4-9 Stock Market Transactions Apple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction? Since new shares of stock are being issued, this is a primary market transaction. What if instead an investor buys existing shares of Apple stock in the open market – is this a primary or secondary market transaction? Since no new shares are created, this is a secondary market transaction.

U4-10 Where can you find a stock quote, and what does one look like? Stock quotes can be found in a variety of print sources (Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).

U4-11 What is the Efficient Market Hypothesis (EMH)? Securities are normally in equilibrium and are “fairly priced.” Investors cannot “beat the market” except through good luck or better information. Levels of market efficiency Weak-form efficiency Semistrong-form efficiency Strong-form efficiency

U4-12 Weak-form efficiency Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but “technical analysis” is still used.

U4-13 Semistrong-form efficiency All publicly available information is reflected in stock prices, so it doesn’t pay to over analyze annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information.

U4-14 Strong-form efficiency All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

U4-15 Conclusions about market efficiency Empirical studies suggest the stock market is: Highly efficient in the weak form. Reasonably efficient in the semistrong form. Not efficient in the strong form. Insiders have made abnormal (and sometimes illegal) profits. Behavioral finance Incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations.

U4-16 Implications of market efficiency You hear in the news that a medical research company received FDA approval for one of its products. If the market is semi-strong efficient, can you expect to take advantage of this information by purchasing the stock? No – if the market is semi-strong efficient, this information will already have been incorporated into the company’s stock price. So, it’s probably too late …

U4-17 Implications of market efficiency A small investor has been reading about a “hot” IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this? Probably not. The long-run track record of hot IPOs is not that great, unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading.

U4-18 What four factors affect the level of interest rates? Production opportunities Time preferences for consumption Risk Expected inflation

U4-19 “Nominal” vs. “Real” rates r= represents any nominal rate r*= represents the “real” risk-free rate of interest. Like a T-bill rate, if there was no inflation. Typically ranges from 1% to 4% per year. r RF = represents the rate of interest on Treasury securities.

U4-20 Determinants of interest rates r = r* + IP + DRP + LP + MRP r =required return on a debt security r*=real risk-free rate of interest IP=inflation premium DRP=default risk premium LP=liquidity premium MRP=maturity risk premium

U4-21 Premiums added to r* for different types of debt IPMRPDRPLP S-T Treasury L-T Treasury S-T Corporate L-T Corporate

U4-22 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. The November 2005 Treasury yield curve is shown at the right.

U4-23 Constructing the yield curve: Inflation Step 1 – Find the average expected inflation rate over years 1 to N:

U4-24 Constructing the yield curve: Inflation Assume inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP 1 = 5% / 1 = 5.00% IP 10 = [5% + 6% + 8%(8)] / 10 = 7.50% IP 20 = [5% + 6% + 8%(18)] / 20 = 7.75% Must earn these IPs to break even vs. inflation; these IPs would permit you to earn r* (before taxes).

U4-25 Constructing the yield curve: Maturity Risk Step 2 – Find the appropriate maturity risk premium (MRP). For this example, the following equation will be used find a security’s appropriate maturity risk premium.

U4-26 Constructing the yield curve: Maturity Risk Using the given equation: MRP 1 = 0.1% x (1-1) = 0.0% MRP 10 = 0.1% x (10-1) = 0.9% MRP 20 = 0.1% x (20-1) = 1.9% Notice that since the equation is linear, the maturity risk premium is increasing as the time to maturity increases, as it should be.

U4-27 Add the IPs and MRPs to r* to find the appropriate nominal rates Step 3 – Adding the premiums to r*. r RF, t = r* + IP t + MRP t Assume r* = 3%, r RF, 1 = 3% + 5.0% + 0.0% = 8.0% r RF, 10 = 3% + 7.5% + 0.9% = 11.4% r RF, 20 = 3% % + 1.9% = 12.65%

U4-28 Hypothetical yield curve An upward sloping yield curve. Upward slope due to an increase in expected inflation and increasing maturity risk premium. Years to Maturity Real risk-free rate Interest Rate (%) Maturity risk premium Inflation premium

U4-29 What is the relationship between the Treasury yield curve and the yield curves for corporate issues? Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve. The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.

U4-30 Illustrating the relationship between corporate and Treasury yield curves Years to Maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury Yield Curve BB-Rated AAA-Rated

U4-31 Other factors that influence interest rate levels Federal reserve policy Federal budget surplus or deficit Level of business activity International factors

U4-32 Risks associated with investing overseas Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates. Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.