The Financial System and Interest

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The Financial Systemand Interest

• Chapter 4

2

• Read Ch. 4
• Possible test questions in lab this week
• Interesting books on investing
• One Up On Wall Street How To Use What You
  Already Know To Make Money In The Market by Peter
  Lynch, John Rothchild
• Take On the Street What Wall Street and
  Corporate America Don't Want You to Know by
  Arthur Levitt

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Primary and Secondary Markets

• Purpose of a financial market is to facilitate
  the flow of funds from savers to production
  sector (investment in business projects)
• This occurs in the
• Primary market (market in which securities are
  initially sold)
• Investors trade securities between each other in
  the
• Secondary market

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Primary and Secondary Markets

• Corporations, even though they do not raise money
  in the secondary market, are interested in the
  stocks price in the secondary market
• Goal Max. Stock Price
• Influences how much money can be raised in future
  stock issues
• Senior managements compensation is usually tied
  to the stock price

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The Stock Market and Stock Exchanges

• Stock marketa network of exchanges and brokers
• Exchangea physical marketplace (NYSE, AMEX,
  regional exchanges)
• Brokerindividual whose job is to assist people
  in buying and selling securities
• Work for brokerage firms
• Members of stock exchange

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Exchanges

• New York Stock Exchange (NYSE)
• Trades securities for ?1,200 of largest,
  strongest companies in U.S.
• Handles about 85 of trading activity
• American Stock Exchange (AMEX)
• Handles slightly smaller, younger firms than NYSE
• Regional stock exchanges (Philadelphia, Chicago,
  San Francisco, etc.)
• Exchanges are linked electronically

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Exchanges

• The Market
• The stock market refers to the entire
  interconnected set of places, organizations and
  processes involved in trading stocks
• Regulation
• Securities are regulated under state and federal
  laws
• Securities Act of 1933
• Required companies to disclose certain
  information
• Securities Act of of 1934
• Set up Securities and Exchange Commission
• Securities law is primarily aimed at disclosure

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Private, Public, and Listed Companies, and the
NASDAQ Market

• Assume a business is successful and the owner
  decides to raise money for expansion by
  incorporating and selling stock to others
• Privately held companiescant sell securities to
  the general public (also, sale of securities is
  severely restricted by regulation)
• Publicly traded companieshave received approval
  of the SEC to offer securities to the general
  public
• Process of obtaining approval and registration is
  known as going public

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Private, Public, and Listed Companies, and the
NASDAQ Market

• Process of going public
• Use an investment banking firm (e.g., Goldman
  Sachs or Morgan Stanley), to determine
• If a market exists for shares of your company
• The likely price for your firms stock
• Develop a prospectusprovides detailed
  information about company
• Financial statements
• Key executives/background
• SEC reviews prospectus
• An unapproved prospectus is call a red herring

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Private, Public, and Listed Companies, and the
OTC Market

• The IPO
• Once prospectus is approved by SEC securities can
  be sold to public
• Initial sale is known as an IPO or initial public
  offering
• Market for IPOs is very volatile and risky
• Prices can rise (or fall) very dramatically
• Investment banks usually line up buyers prior to
  the actual sale of securities
• Buyers are usually institutional investors
• IPO occurs in primary market, but once securities
  are placed with investors, trading begins in the
  secondary market

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myths about IPOs

• The general perception is that IPOs are a
  fail-safe way to make money and that if one
  invests money in an IPO returns are guaranteed.
  This is the greatest myth about IPOs. Many IPOs
  will result in losses for the investors, the
  prices of the same will go down because of
  several reasons like a weak company, over
  pricing, weak management or simply because the
  price fell along with the general markets.
• http//www.19.5degs.com/element/19427.php

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The NASDAQ Market

• After a company goes public, its shares are
  usually traded in the over-the-counter (OTC)
  market
• Eventually a firm may wish to be listed on an
  exchange
• Loosely organized network of brokers
• The National Association of Securities Dealers
  Automated Quotation System (NASDAQ) is the
  markets computer system

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The NASDAQ Market

• The Nasdaq Stock Market is a computerized
  communication system that provides the bid and
  asked prices of more than 5,000 over-the-counter
  (OTC)stocks that have met the market's
  registration requirements.

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Interest

• Interest rates typically refer to the rate
  charged on a debt instrument
• There are MANY interest rates, including the
  prime rate, the federal funds rate, etc.
• Interest rates tend to move in tandem

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The Relationship Between Interest and the Stock
Market

• The stock market reacts to changes in interest
  rates (even though interest rates are related to
  the bond market)
• Stocks (equity) and bonds (debt) compete for
  investors dollars
• Stocks offer higher returns but have more risk
• If you could earn 10 by investing in a bond of
  IBM, what return would you want to invest in
  IBMs stock?
• ANS. More than 10 because the stock is more risky

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The Relationship Between Interest and the Stock
Market

• If interest rates were to rise to 12 on IBMs
  bonds, what would happen to your required rate of
  return on IBMs stock?
• Your required return on IBMs stock would rise
  and therefore, the value of IBMs stock would
  drop in the market
• Interest rates and security prices move in
  opposite directions
• Good reason for us to have an interest in
  interest rates

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Interest and the Economy

• Would you be more likely to buy a house/car when
  interest rates are high or low?
• Interest rates have a significant effect on the
  economy
• Lower interest rates stimulate business and
  economic activity
• Businesses and individuals use credit a great
  deal
• Interest rates represent the cost of borrowing
  money (credit)

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This is a copy of a later slide (33) Putting the
Pieces Together

• The factors that make up an interest rate, k, can
  be expanded to include the particular types of
  risk
• K KPure Interest Rate Inflation Default
  Risk Premium Liquidity Risk Premium Maturity
  Risk Premium
• k kpr INFL DR LR MR
• K is known as the nominal or quoted interest rate

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The Components of an Interest Rate

• Interest rates include base rates and risk
  premiums
• Interest rate will be represented by the letter k
• k base rate risk premiums

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The Components of an Interest Rate

• Components of the Base Rate
• The base rate is pure interest plus expected
  inflation
• The rate at which people lend money when no risk
  is involved
• Pure interest rate is AKA earning power of money
• An unobservable rate that would exist in the real
  world if there were no inflation and no risk
• Generally considered to be between 2 and 4

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The Components of an Interest Rate

• The Inflation Adjustment
• Inflation refers to a general increase in prices
• Refers to the fact that, if prices rise, 100 at
  the beginning of the year will not buy as much at
  the end of the year
• If you lent someone 100 at the beginning of the
  year, you need to be compensated for what you
  expect inflation to be during the year
• Interest rates include estimates of average
  annual inflation over loan periods

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Risk Premiums

• Risk in loans refers to the chance that the
  lender will not receive the full amount of
  principal and interest payments agreed upon
• Some loans are more risky than others
• Lenders demand a risk premium of extra interest
  for making risky loans

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Different Kinds of Lending Risk

• Bond lending losses can be associated with
  fluctuations in the prices of bonds as well as
  with the failure of borrowers to repay the loans
• Default Risk
• The chance the borrower won't pay principal or
  interest
• Losses can be the entire amount or anywhere in
  between
• Investors demand a default risk premium which
  depends on the investor's perception of the
  creditworthiness of the borrower
• Perception is based on the firm's financial
  condition and credit record

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Different Kinds of Lending Risk

• Default Risk (continued)
• Premiums range from 0 to 6 or 8
• Once a company's default risk becomes too high,
  they will be unable to borrow at any interest
  rate
• Default doesn't actually have to occur for
  problems to exist
• If investors realize that a firm is having
  difficulty making interest payments (although it
  is still making them) the bond's price will
  probably fall
• A time dimension is involved in the risk of
  default
• The longer the time period involved with the debt
  instrument the more likely that the firm will
  face financial difficulty

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Different Kinds of Lending Risk

• Liquidity Risk
• Associated with being unable to sell the bond of
  an little known issuer
• Debt of small firms are particularly hard to
  market
• Said to be illiquid
• Sellers must reduce their prices to encourage
  investors to buy the illiquid securities
• Liquidity risk premium is the extra interest
  demanded by lenders as compensation for bearing
  liquidity risk
• Very short-term securities usually bear little
  liquidity risk

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Different Kinds of Lending Risk

• Maturity Risk
• Bond prices and interest rates move in opposite
  directions
• Long-term bond prices change more with interest
  rate swings than short-term bond prices
• Gives rise to maturity risk
• Investors demand a maturity risk premium
• Ranges from 0 to 2 or more for long-term issues

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Putting the Pieces Together

• The factors that make up an interest rate, k, can
  be expanded to include the particular types of
  risk
• K KPure Interest Rate Inflation Default
  Risk Premium Liquidity Risk Premium Maturity
  Risk Premium
• k kpr INFL DR LR MR
• K is known as the nominal or quoted interest rate
• Setting Interest Rates
• Interest rates are set by the forces of supply
  and demand
• Thus the interest rate model above is only an
  economic model of reality
• Represents an explanation of what generally has
  to be behind the interest rate needs of investors

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Federal Government Securities, Risk Free and Real
Rates

• Federal Government Securities
• Cities, states and federal governments issue
  long-term bonds
• Federal treasury also issues short-term
  securities
• Known as Treasury securities
• Treasury bills have terms from 90 days to a year
• Treasury notes have terms from 1 to 10 years
• No default risk associated with federal
  government debt
• Can print money to pay off all of its debt
• No liquidity risk for federal government debt
• Always an active market

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The Risk-Free Rate

• The risk-free rate is approximately the yield on
  short-term Treasury bills
• Includes the pure rate and an allowance for
  inflation
• Same as the base rate discussed earlier
• Viewed as a conceptual floor for the structure of
  interest rates
• Denoted as kRF

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The Real Rate of Interest

• Real refers to values that have the effects of
  inflation removed
• Tells investors by how much they are getting
  ahead
• If you earn a real rate of 8 on an investment
  and inflation turns out to be 10, you are losing
  purchasing power on your investment
• There are periods in time when the real rate of
  interest has been negative
• Because we don't really know what the rate of
  inflation will be at the point in time when
  nominal rates are set
• The Real Risk-Free Rate
• Implies that both the inflation adjustment and
  the risk premium is zero

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Yield CurvesThe Term Structure of Interest Rates

• The relationship between interest rates and the
  term of debt is known as the term structure of
  interest rates
• The yield curve is a graphical representation of
  the term structure of interest rates
• Most of the time short-term rates are lower than
  long-term rates
• However at times the opposite is true
• Known as an inverted yield curve

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Figure 4.10 Yield Curves
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Yield CurvesThe Term Structure of Interest Rates

• Theories have developed attempting to explain the
  term structure of interest rates
• Expectations theory
• Today's rates rise or fall with term as future
  rates are expected to rise or fall
• Liquidity preference theory
• Investors prefer shorter term securities and must
  be induced to make longer loans
• Market segmentation theory
• Loan terms define independent segments of the
  debt market which set separate rates

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• 27. You have been assigned to estimate the
  interest rates that your company may have to pay
  when borrowing money in the near future. The
  following information is available.
• a. Calculate the inflation adjustment (INFL) for
  a 5-year loan.
• b. Calculate the appropriate interest rate for a
  5-year loan.
• kPR 2
• MR .1 for a 1 year loan increasing by .1 for
  each additional year

k kpr INFL DR LR MR
35

• LR .05 for a 1 year loan increasing by .05
  for each additional year
• DR 0 for a 1 year loan, .2 for a 2-year loan,
  increasing.1 for each additional year
• Expected Inflation Rates
• Year 1 7
• Year 2 5
• Year 3 and thereafter 3
•  a. INFL (7 5 3 3 3)/5 4.2

k kpr INFL DR LR MR
b. k 2 4.2 .5 .25 .5 7.45