Lecture%20Two:%20Financial%20Markets

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Lecture Two Financial Markets

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

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Saving/Investing or Borrowing/Lending
Process Aggregate Economic Sectors
Government Sector Regulates and supervises where
Congress has granted authority (Political
Process). Also it participates in the activities
of the 3 sectors below.
Household Sector Saves/lends or invests in
financial assets
Business Sector Borrows/invests in real assets or
productive assets
Financial Sector Collects savings from small
units in the amounts, maturities, etc. , needed
by the business sector. Also provides market
liquidity to stimulate savings/investing/hedging
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Fundamental Functions of The Financial Sector
1. Transfer savings to investors distribution or
allocation of financial resources. 2. Provide
medium of exchange Money supply by commercial
banks. 3. Provides liquidity by providing
markets that are large, active, stable,
resilient. It must therefore accommodate
position takers, i.e... speculators. 4.
Maintains healthy environment for hedging
activity so that risk takers and risk avoiders
can partake in the market so that the volume of
real investment can be at a maximum.
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Define these markets

• Markets in general
• Physical assets
• Financial assets
• Money vs. capital
• Primary vs. secondary
• Spot vs. future

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Real Asset Market
Financial Market
Capital Market
Money Market
Securities
Mortgage
Consumer Credit
Commercial Paper
Euro
exchanges
brokers
Inv. Bkrs.
Com. Bks.
Indiv. Invest.
COs.
COs.
Fin. CO.
Ins. CO.
S L
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Three Primary Ways Capital Is Transferred Between
Savers and Borrowers

• Direct transfer
• Investment banking house
• Financial intermediary

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Financial Institutions

• Investment Banks
• Commercial Banks
• Savings and Loans Associations
• Mutual Savings Banks
• Credit Unions
• Life Insurance COs.
• Mutual Funds
• Money
• Bond
• Stocks
• Derivatives
• Pension Funds (generally administered by
  commercial banks or life insurance companies)

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Balance sheet of Commercial Bank v. a
Manufacturing CO.
Manufacturing Firm
Commercial Bank
Govt. Sec. Loans --------------- Fixed
Assets
DD TD ---------- NW
Cash AR Inv. ----------- Fixed Assets
Short Term Debt ------------------ Long Term
Debt -------------------- NW Equity
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Balance sheet of Insurance Company v. a
Manufacturing CO.
Manufacturing Firm
Insurance Company
Stocks Bonds Mortgages ------------- Fixed
Assets
Premiums Other Debt ---------- NW
Cash AR Inv. ----------- Fixed Assets
Short Term Debt ------------------ Long Term
Debt -------------------- NW Equity
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Organized Exchanges vs.Over-the-Counter Market

• Auction market vs. dealer market (exchanges vs.
  OTC)
• NYSE vs. NASDAQ system
• Differences are narrowing

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• 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
.
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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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Real Versus Nominal Rates
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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.

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Premiums Added to k for Different Types of Debt

• S-T Treasury only IP for S-T inflation
• L-T Treasury IP for L-T inflation, MRP
• S-T corporate S-T IP, DRP, LP
• L-T corporate IP, DRP, MRP, LP

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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 countrys economic, political, and social
  environment.
• Exchange rate risk If investment is denominated
  in a currency other than the dollar, the
  investments value will depend on what happens to
  exchange rate.

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Two Factors Lead to Exchange Rate Fluctuations

• 1. Changes in relative inflation will lead to
  changes in exchange rates.
• 2. An increase in country risk will also cause
  that countrys currency to fall.

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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.

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T-Bond Yield Curve
Interest Rate ()
1 yr 5.7 5 yr 6.5 10 yr 6.7 30 yr 6.9
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Yield Curve (March 1997)
10
5
Years to Maturity
0
10
20
30
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What are the 2 main factors that explain the
shape of the yield curve?
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1. Expectations

• Shape of the yield curve depends on the
  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 or
  down.

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The Pure Expectations Hypothesis (PEH)

• MRP 0.
• 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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An Example

• 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 6.5 (6 7)/2.
• If the PEH is correct, the 3-year rate today
  should be 7 (6 7 8)/3.

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2. Risk

• Some argue that the PEH isnt correct, because
  securities of different maturities have different
  risk.
• General view (supported by most evidence) is 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 gt 0).

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Example data

• Inflation for Yr 1 is 5.
• Inflation for Yr 2 is 6.
• Inflation for Yr 3 and beyond is 8.
• k 3
• MRPt 0.1(t - 1).

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Yield Curve Construction
Step 1 Find the average expected inflation
rate over years 1 to n n S INFLt
t 1 n
IPn .
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• IP1 5/1.0 5.00.
• IP10 5 6 8(8)/10 7.5.
• IP20 5 6 8(18)/20 7.75.
• Must earn these IPs to break even vs. inflation
  these IPs would permit you to earn k (before
  taxes).

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Step 2 Find MRP based on this equation
MRPt 0.1(t - 1).
MRP1 0.1 x 0 0.0. MRP10 0.1 x 9
0.9. MRP20 0.1 x 19 1.9.
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Step 3 Add the IPs and MRPs to k
kRFt k IPt MRPt .
kRF Quoted market interest rate on treasury
securities.
Assume k 3
kRF1 3 5 0.0 8.0. kRF10 3
7.5 0.9 11.4. kRF20 3 7.75 1.9
12.7.
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Yield Curves
Interest Rate ()
15
BB-Rated
10
AAA-Rated
Treasury yield curve
6.8
6.7
5.7
5
Years to maturity
0
0
1
5
10
15
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