1. A market is a place where goods and services are exchanged.
Financial Markets
A market is a place where goods and services are exchanged.
A financial market is a place where individuals and organizations who want to borrow funds are brought together with those having a surplus of funds.

2. We can classify markets
Based on: Underlying asset
Delivery date
Maturity
Players
Physical/Financial/Derivatives
Spot/Futures
Money/Capital
Primary/Secondary
Private/Public

3. London Gold Market physical, spot New York Stock Exchange
Examples
London Gold Market physical, spot
New York Stock Exchange
financial, spot, secondary, capital
Sale of commercial paper by HP
financial, money, primary

4. How is capital transferred between savers and borrowers?
Direct transfers
Investment banking house
Financial intermediaries
A firm’s selling its stock directly to
another firm/individual is an example of
direct transfer

5. Through Investment bankers
Investment banking firm helps a company in the
design and sale of securities. The investment
banker is also called the underwriter.
The agreement between the firm and
underwriter can be of two types:
firm-commitment basis: underwriter bears all the risk
best-efforts basis: underwriter does not buy the issue but acts as a selling agent

6. Through Investment bankers
In general, the lead investment banker puts together a purchase group and a selling group
purchase group underwrites the offering (purchases securities from the issuing corporation)
selling group contacts potential buyers and do the selling on a commission basis
Examples of Investment Banking Firms:
Merrill Lynch, Salomon Smith Barney

7. Examples of financial intermediaries
Commercial banks
Pension funds
Life insurance companies
Mutual funds
Financial intermediaries get savings from individuals by
creating new financial products
For example, commercial banks open checking and
saving accounts, life insurance companies sell policies
and mutual funds sell new shares and are ready to buy
back outstanding shares.

8. financial intermediaries
Strengths of financial intermediaries
Economies of scale in analyzing creditworthiness of potential borrowers
Pooling risk

9. Mutual funds Mutual funds differ in their investment objectives, e.g.
Pursue Aggressive growth
Invest in Precious metals
Invest in Global equity
Turkish: type A minimum 25% investment in stocks, it may also include fixed income securities. Type B investment only in fixed income securities. Type B liquid funds limit maturity up to 90 days.
Ranking of Mutual Funds (US):
Lipper Ranking
Morningstar Ranking
Each fund is ranked within the universe of funds similar in investment objectives

10. Physical location stock exchanges vs. Electronic dealer-based markets
Auction market vs. Dealer market (Exchanges vs. OTC)
Exchanges can have continuous trading, call auctions
or both
Mostly: Continuous-auction also contain opening call
How do they provide continuity: Limit Order Book
Liquidity: conversion to cash
quickly, with low cost, and
for reasonable transaction sizes

11. Physical location stock exchanges vs. Electronic dealer-based markets
Members have seats (e.g. NYSE ≈1400 members)
Only members can execute transactions
Over-the-counter (OTC) market
e.g. Nasdaq
Several dealers assigned to each stock
They quote bid/ask prices
Computerized system
Dealers hold inventory

12. Cost of Money
except social, strategic policies capital is allocated
through a price system
debt capital: interest rate
equity capital: dividend yield
capital gains

13. Four fundamental factors
Production opportunities
Time preferences for consumption
Risk
Inflation
Different markets
Interest rates differ due to differences in risk, but the rates are interrelated

14. Determinants of Market Interest Rates
rate = k* + IP + DRP + LP + MRP
k*: real risk-free rate
IP: Inflation Premium
DRP: Default risk premium
LP: Liquidity premium
MRP: Maturity risk premium

15. Determinants of Market Interest Rates
Inflation is expected future inflation, not the past rate
Default: The borrower will not pay the interest or principal, probably because of financial distress
Liquidity: being able to sell the security quickly at fair market value

16. Determinants of Market Interest Rates
Government securities e.g. T-bonds have basically no DRP and
little LP. They are only subject to IP and MRP
Maturity risk premium: Extra return offered by securities with longer time to maturity.
Bond prices are negatively related to interest rates. In other words,
as interest rate rises, bond price will fall.

17. Simple example
A security that has a single payoff of $110 in one year.
If the market price of this security is $100, what is the
promised return?
If the market price of this security is $90, what is the
So a decrease in price increases return.

18. For example
Interest rate (promised return)=10% and bond price=$920 now
I own this bond but I have just decided to sell it (I need cash).
If interest rate rises to 12% (market prices similar securities so
that their promised return rises to 12%), price of the bond will fall.
So I and other bondholders will have a loss due to a fall in price
when interest rates rise. This is called as the interest risk.
When I sell the bond at the new (lower) price, the buyer will have
a promised return of 12%.
The amount and the timing of payments made by the issuer of the
bond to bondholders are fixed. The market price is the only bond
feature that can change. So to raise the promised return from 10%
to 12%, the price of the bond has to fall.

19. interest rate risk
For a given holding period, the interest rate risk as measured by the price change at the end of your holding period increases with the time to maturity of the bond.
So other things being equal, a bond with 20 year time-to-maturity will have larger MRP than that of a 10 year bond.

20. reinvestment rate risk
We did ignore another type of risk, the reinvestment rate risk from the discussion above. Actually, MRP is the net effect of interest rate and reinvestment rate risks.
We will return to this discussion after we
cover the Time Value of Money concept.

21. Ratings Bond Rating Agencies: Moody’s and S&P
Attributes associated with better ratings
Lower financial leverage
Larger firm size
Larger and steadier profits
Larger cash flows
Lack of subordination to other debt issues

22. Term Structure of Interest Rates
The relationship between short term and long term interest rates is known as term structure of interest rates
Yield curve: graph showing the relationship between bond yields and maturities

23. e.g. Yield Curve for Government securities (DRP=LP=0)5 10 15 1 20
Years to Maturity
TTM rate/year
1 yr %
10 yr %
20 yr %
Real risk-free rate
Inflation premium
Maturity risk premium
Interest
Rate
Yield Curve can be Upward sloping, Downward sloping, or
Flat

24. Forward rates
Consider the following two investment alternatives for an investor who has a two-year
investment horizon.
Alternative 1: Buy a two-year zero-coupon instrument. (rate=s2)
Alternative 2: Buy a one-year zero-coupon instrument (rate=s1) and when it matures in one year, buy another one-year instrument.
Assume s %
s %
Note that:
In a world of certainty (future interest rates are known) both of these strategies must
yield identical final payoffs. Otherwise, no one holds either the two-year bond or the one
year bond
Given the price of zero-coupon bond, you can find the interest rate from the following formula
Pk=$1000/(1+sk)k

25. Forward rates approximately (s1+f1,2)/2=s2
The interest rate that would need to prevail in the second year to make the short
and long-term investments equally attractive, ignoring risk is called the forward
rate.
approximately (s1+f1,2)/2=s2
or exactly (1+s1)(1+f1,2)=(1+s2)2
when you know s1 and s2, you can calculate f1,2
f1,2=9.99% approximately or 10% exactly

26. Forward rates
Now consider the case of uncertainty where future interest rates are uncertain.
Assume that E(s12)=10% same as the forward rate
P1-year=$1000/1.08=$ P2-year= $1000/(1.08*1.1)=$841.75
So 2-year security is priced using E(s12). Note that this is consistent with the
s2=8.995%, $1000/( )2=$841.75

27. Forward rates
Consider a short-term investor who wishes to invest for one year
Under Alternative 2:the return is a riskless 8%
Under Alternative 1:the return is risky. If s12 turns out 10% as expected, the return
will be 8% since the bond price will be $1000/1.1=$ in one year and
$841.75*(1.08)=$ If s12 turns out different than 10%, the return will not be
8%.
Why should this investor buy the risky 2-year bond when its expected return is 8%,
no better than that of the risk-free one-year bond.
This requires the 2-year bond to sell at a price lower than the $841.75

28. Forward rates
Suppose all investors have short-term horizons and therefore are willing to hold
the 2-year bond only if its price falls to $819.
At this price, this year’s expected return on this bond is 11% ($909.09/$819=1.11).
This means a premium of 3% compared to the risk-free one-year bond.
In this environment, the forward rate f12 no longer equals E(s12). s2 now equals
10.5%((1000/819)1/2=1.105) and f12=13%.
Investors require a premium to hold the two-year bond and be willing to hold the bond if E(s12) is less than f12.
E(s12) < f12 means: since 2s2=s1+f1,2 then 2s2>s1+E(s1,2)
The change in s2 by 1.5% (10.5%-8.995%) denotes a positive MRP. It is the risk
premium given for holding long term bond.

29. Forward rates
We can also imagine a scenario in which long-term bonds can be perceived by
investors to be safer than short-term bonds.
Suppose all investors have long-term horizons (2-year). In this case, investing in
two-year bond is riskless and investing in one-year bond has reinvestment rate risk.
This would cause E(s12) to be more than f12.
In this case, we will have a negative MRP.

30. Term Structure Theories
try to explain the shape of yield curve
e.g. Pure Expectations Hypothesis
The PEH argues that the shape of the yield curve depends on investor’s expectations about future short term interest rates.
If short term interest rates are expected to increase, long-term rates will be higher than current short-term rates, and vice-versa. Thus, the yield curve can slope up, down, or even bow.

31. Assumptions of the PEH
Assumes that the maturity risk premium for Treasury securities is zero.
It states that f1,2 =E(s12). This implies that long-term rates are an average of current and expected future short-term rates. e.g. s2=[s1+E(s1,2)]/2
If PEH is correct, you can use the yield curve to “back out” expected future interest rates.

32. Pure Expectations Hypothesis
Long-term rates are an average of current and expected
future short-term rates. For example:
s3=(s1+f12+f23)/3
To confirm
definition of f12 s2=(s1+f12)/2  f12=2 s2-s1
definition of f23 s3=(2s2+f23)/3  f23=3 s3-2s2
Plug into the first expression
s3=(s1+2 s2-s1+3 s3-2s2)/3= s3
PEH says s3=(s1+E(s12)+E(s23))/3 since E(s12)=f12 and E(s23)=f23

33. Pure Expectations Hypothesis
Also note that:
definition of f s2=(s1+f12)  f12=2 s2-s1
definition of f s3=(2s2+f23)  f23=3 s3-2s2
definition of f s3=(s1+2f13)  2f13=3 s3-s1
Then f13=(f12+f23)/2

34. An example: Observed Treasury rates and the PEH
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
Upward sloping yield curve
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?

35. PEH says that one-year securities will yield 6.4%, one year from now.
One-year forward rate
6.2% = (6.0% + x%) / 2
12.4% = 6.0% + x%
6.4% = x%
PEH says that one-year securities will yield 6.4%, one year from now.

36. Three-year security, two years from now
6.5% = [2(6.2%) + 3(x%)] / 5
32.5% = 12.4% + 3(x%)
6.7% = x%
PEH says that three-year securities will yield 6.7%, two years from now.

37. Calculating all the forward rates
In the calculation above we relied on the expression E(s25)=f25
Equivalently, we can use the fact that long term rate is arithmetic average of short term rates s1
6.0% s2
6.2%
f12
6.4%
=2s2-s1 s3
f23
6.8%
=3s3-2s2 s4
6.5%
f34
=4s4-3s3 s5
f45
=5s5-4s4
three-year securities two years from now
E(s25)=[E(s23)+E(s34)+E(s45)]/3=[6.8%+6.8%+6.5%]/3
=6.7%

38. Conclusions about PEH
Some would argue that the MRP ≠ 0, and hence the PEH is incorrect.
Most evidence supports the general view 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).

39. Conclusions about PEH recall that s2=(s1+f12)/2
If MRP≠0 and PEH is not correct
Recall definitions of s1 and s2
s2=k*+IP2+MRP and s1=k*+IP1 assuming MRP1=0
E(s12)=k*+IP so IP2=(IP1+IP12)/2
s2=k*+(E(s12)-k*+s1-k*)/2+MRP2
since f12= 2s2 - s then
f12= E(s12)+2MRP2

40. Conclusions about PEH f12= E(s12)+2MRP2
If yield curve is upward sloping i.e. s2>s1, then since 2s2=s1+f12
it must be f12>s1
If PEH is correct, then since f12= E(s12) it must be E(s12) >s1
If MRP≠0 and PEH is not correct, then we get
E(s12)+2MRP2>s1
So it is not necessarily true that E(s12) >s1, i.e. it can be that
E(s12) <s1 but E(s12)+2MRP2>s1

41. Example
Assume that the real risk free rate is 3% and that
inflation is expected to be 8% in year 1, 5% in year 2,
and 4% thereafter.
Assume that all treasury bonds are free of default risk.
If 2-year and 5-year treasury bonds both yield 10%,
what is the difference in maturity risk premiums on the
two bonds?

42. Example
Assuming that real risk free rate and MRP stay constant over time
MRP5 = 10% - 8% = 2%.
MRP2 = 10% - 9.5% = 0.5%.
MRP5- MRP2 = (2% - 0.5%) = 1.5%.

43. Exact solution
Exact solution :
(1+3%+8%+MRP5)(1+3%+5%+MRP5)(1+3%+4%+MRP5)
(1+3%+4%+MRP5)(1+3%+4%+MRP5)=(1+10%)5
MRP5=2.011%
(1+3%+8%+MRP2) (1+3%+5%+MRP2)=(1+10%)2
MRP2=0.51%

44. Example
4-6 The real risk free rate is 3 percent. Inflation is expected to be 3 percent this year, 4 percent next year, and then 3.5 percent thereafter. The maturity risk premium is estimated to be *(t-1), where t= number of years to maturity. What is the nominal interest rate on 7-year Treasury note?
MRP1= *(1-1)=0, MRP2= *(2-1)=0.05%
MRP7= *(7-1)=0.3%
IP7=(3%+4%+5*3.5%)/7=24.5%/7=3.5%
S7=k*+IP7+MRP7=3%+3.5%+0.3%=6.8%

45. Example
4-12 The 5-year bonds on Cartwright Enterprises are yielding 7.75% per year. Treasury bonds with the same maturity are yielding 5.2 percent per year. The real risk free rate has not changed in recent years and is 2.3 percent. The average inflation premium is 2.5 percent, and the maturity risk premium takes the form: MRP=0.1%(t-1), where t= number of years to maturity. If the liquidity premium is 1 percent, what is the default risk premium on Cartwright’s corporate bonds?
MRP5= 0.1%(5-1)=0.4%
Treasury bonds: k*+IP5+ MRP5 =2.3%+2.5%+0.4%=5.2%
Cartwright’s corporate bonds k*+IP5+ MRP5 +LP+DRP
LP+DRP=7.75%-5.2%=2.55% so DRP=1.55%