TOPIC 2 The Financial Environment: Markets, Institutions, and Interest Rates

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TOPIC 2The Financial Environment Markets,
Institutions, and Interest Rates

• Financial markets
• Types of financial institutions
• Determinants of interest rates
• Yield curves

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THE MIRACLE OF FINANCING
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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.

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Types of financial markets

• Physical assets vs. Financial assets
• Money vs. Capital
• Primary vs. Secondary
• Spot vs. Futures
• Public vs. Private

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How is capital transferred between savers and
borrowers?

• Direct transfers
• Investment banking house
• Financial intermediaries

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Types of financial intermediaries

• Commercial banks
• Savings and loan associations
• Mutual savings banks
• Credit unions
• Pension funds
• Life insurance companies
• Mutual funds

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Physical location stock exchanges vs. Electronic
dealer-based markets

• Auction market vs. Dealer market (Exchanges vs.
  OTC)
• NYSE vs. Nasdaq
• Differences are narrowing

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GOING PUBLIC

• Makes it easier to raise equity capital
• in the future.
• Increases the liquidity of holders stock.
• Establishes a market value for the stock.
• Can cause some control problems

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• REASONS FOR GOING PUBLIC
• FINANCE GROWTH
• FINANCE ACQUISITIONS
• EMPLOYEE STOCK OPTIONS
• PERSONAL DIVERSIFICATION
• PERSONALITY CONFLICTS
• ESTATE TAXES
• MAKE OWNERS RICH!

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COST TO RAISE EXTERNAL CAPITAL

• AMOUNT COMMON STOCK DEBT
• 2-10 13 4
• 20-40 6 2
• 80-100 5 2
• 500 3 1

IPOs
lt 10 18 gt 500 6
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SERVICES OF AN INVESTMENT BANKER

• ADVICE
• RISK BEARING
• SELLING

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TYPES OF COMMON STOCK OFFERINGS

• SECURITIES LEGISLATION
• PUBLIC OFFERING
• PRIVATE PLACEMENT
• RIGHTS OFFERING

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PRIVATE PLACEMENT
DEFINITION ADVANTAGES TO ISSUER 1. SPEED
2. CHEAPER 3. MORE FLEXIBLE
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RIGHTS OFFERING
DEFINITION BRIEF DESCRIPTION Announcement
Date Record Date Expiration
Date EVALUATION Is this good for
stockholders? Is this good for the company?
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VENTURE CAPITAL

• A PROFESSIONALLY MANAGED POOL OF MONEY RAISED FOR
  THE SOLE PURPOSE OF MAKING ACTIVELY MANAGED
  DIRECT EQUITY INVESTMENTS IN FAST GROWING PRIVATE
  COMPANIES.

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SPECIALIZE IN START-UP OR EARLY STAGE COMPANIES
COMPENSATION OF VC FIRMS 50 OR MORE ON
START-UPS 20-30 ON LATER STAGE DEALS
THEY OFTEN SUPPLY MORE THAN CAPITAL MANAGEMENT
EXPERTISE BUSINESS PLANS
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ANGEL CAPITALISTS INSTITUTIONAL VENTURE CAPITAL
FUNDS

• SBICs
• SUBSIDIARIES OF FINANCIAL
• INSTITUTIONS
• SUBSIDIARIES OF NON-FINANCIAL
• COMPANIES
• VENTURE CAPITAL LIMITED
• PARTNERSHIPS

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The cost of money

• The price, or cost, of debt capital is the
  interest rate.
• The price, or cost, of equity capital is the
  required return. The required return investors
  expect is composed of compensation in the form of
  dividends and capital gains.

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What four factors affect the cost of money?

• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation

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Nominal vs. Real rates

• k represents any nominal rate
• k 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.
• kRF represents the rate of interest on
  short-term Treasury securities.

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Determinants of interest rates

• k k IP DRP LP MRP
• k required return on a debt security
• k real risk-free rate of interest
• IP inflation premium
• DRP default risk premium
• LP liquidity premium
• MRP maturity risk premium

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Real Rate of Interest The nominal rate minus
the rate of inflation. Inflation Premium The
(annual) rate of inflation expected over the
life of the security. Default Premium The
difference between the yield on

corporate bonds and government
bonds. Maturity Premium The difference
between the yields on very
short-term T-bills and longer-term bonds.
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Premiums added to k for different types of debt
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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.
• A Treasury yield curve from October 2002 can be
  viewed at the right.

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TYPICAL SHAPE OF THE YIELD CURVE
The yield curve usually slopes upward from left
to right, indicating that long-term rates
normally are higher than short-term rates.
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Hypothetical yield curve

• An upward sloping yield curve.
• Upward slope due to an increase in expected
  inflation and increasing maturity risk premium.

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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.

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Illustrating the relationship between corporate
and Treasury yield curves
Interest Rate ()
15
10
Treasury Yield Curve
6.0
5.9
5
5.2
Years to Maturity
0
0
1
5
10
15
20
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Pure Expectations Hypothesis

• The PEH contends that the shape of the yield
  curve depends on investors expectations about
  future interest rates.
• If interest rates are expected to increase, L-T
  rates will be higher than S-T rates, and
  vice-versa. Thus, the yield curve can slope up,
  down, or even bow.

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Assumptions of the PEH

• Assumes that the maturity risk premium for
  Treasury securities is zero.
• Long-term rates are an average of current and
  future short-term rates.
• If PEH is correct, you can use the yield curve to
  back out expected future interest rates.

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EXAMPLE OF EXPECTATIONS THEORY ASSUME k 3
AND EXPECTED INFLATION EACH YEAR IS 10, 8, 6,
AND 4
EXP. INFLATION YIELD OR YEAR k (1
YR.) RETURN 1 3 10
?? 2 3 8
?? 3 3 6 ??
4 3 4
??
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EXPECTED AVERAGE YIELD OR YEAR
k INFLATION RETURN 1 3
10 13 2 3
9 12 3 3 8 11
4 3 7 10
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QUESTIONS 1. WHAT IS THE YIELD OR RETURN
RIGHT NOW ON A 1 YEAR SECURITY? 2 YEAR
SECURITY?, 3 YEAR, ETC? 2. WHAT IS THE YIELD
ON A 1 YEAR SECURITY 1 YEAR FROM NOW?
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• QUESTIONS REGARDING INTEREST RATES
• 1. WHICH IS MORE VOLATILE, SHORT-TERM
• OR LONG-TERM INTEREST RATES? WHY?
• WHICH IS MORE VOLATILE, SHORT-TERM
• BOND PRICES OR LONG-TERM BOND PRICES?
• 3. HOW PREDICTABLE ARE INTEREST RATES?

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Other factors that influence interest rate levels

• Federal reserve policy
• Federal budget surplus or deficit
• Level of business activity
• International factors