5 - 1
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
CHAPTER 5
The Financial Environment:
Markets,Institutions,
and Interest Rates
?Financial markets
?Types of financial institutions
?Determinants of interest rates
?Yield curves
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Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Define these markets
?Markets in general
?Markets for physical assets
?Markets for financial assets
?Money versus capital markets
?Primary versus secondary markets
?Spot versus future markets
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?Direct transfer
?Through an investment banking
house
?Through a financial intermediary
Three Primary Ways Capital Is
Transferred Between Savers and
Borrowers
5 - 4
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
The Top 5 Banking Companies
in the World,1999
Bank Name Country Total assets
Deutsche Bank AG Germany $735 billion
UBS Group Switzerland $687 billion
Citigroup United States $669 billion
Bank of America United States $618 billion
Bank of Tokyo Japan $580 billion
5 - 5
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Organized Exchanges versus
Over-the-Counter Market
?Auction markets versus dealer
markets (exchanges versus the
OTC market)
?NYSE versus Nasdaq system
?Differences are narrowing
?Nasdaq vs,true OTC
5 - 6
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?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= +,
5 - 7
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What four factors affect the cost
of money?
?Production opportunities
?Time preferences for consumption
?Risk
?Expected inflation
5 - 8
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Real versus Nominal Rates
k* = Real risk-free rate.
T-bond rate if no inflation;
1% to 4%.
= Any nominal rate.
= Rate on Treasury securities.
k
kRF
5 - 9
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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.
5 - 10
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Premiums Added to k* for Different
Types of Debt
?ST Treasury,only IP for ST inflation
?LT Treasury,IP for LT inflation,MRP
?ST corporate,ST IP,DRP,LP
?LT corporate,IP,DRP,MRP,LP
5 - 11
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
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.
5 - 12
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Treasury Yield Curve
0
5
10
15
10 20 30
Years to Maturity
Interest
Rate (%)
1 yr 6.3%
5 yr 6.7%
10 yr 6.5%
30 yr 6.2%
Yield Curve
(May 2000)
5 - 13
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Yield Curve Construction
Step 1,Find the average expected
inflation rate over years 1 to n:
n
??INFLt
t = 1
nIPn =,
5 - 14
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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
versus inflation; that is,these IPs
would permit you to earn k* (before
taxes).
5 - 15
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
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% = 12.65%.
5 - 17
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Hypothetical Treasury Yield Curve
0
5
10
15
1 10 20
Years to Maturity
Interest
Rate (%) 1 yr 8.0%10 yr 11.4%
20 yr 12.65%
Real risk-free rate
Inflation premium
Maturity risk premium
5 - 18
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What factors can explain the shape of
this yield curve?
?This constructed yield curve is
upward sloping.
?This is due to increasing expected
inflation and an increasing
maturity risk premium.
5 - 19
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
What kind of relationship exists
between the Treasury yield curve and
the yield curves for corporate issues?
?Corporate yield curves are higher than
that of the Treasury bond,However,
corporate yield curves are not neces-
sarily parallel to the Treasury curve.
?The spread between a corporate yield
curve and the Treasury curve widens
as the corporate bond rating
decreases.
5 - 20
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Hypothetical Treasury and
Corporate Yield Curves
0
5
10
15
0 1 5 10 15 20
Years to
maturity
Interest
Rate (%)
5.2% 5.9%
6.0% Treasuryyield curve
BB-Rated
AAA-Rated
5 - 21
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
How does the volume of corporate
bond issues compare to that of
Treasury securities?
Recently,the volume of investment grade corporate
bond issues has overtaken Treasury issues.
?95 ?96 ?97 ?98 ?99
600
450
300
150
Gross U.S,Treasury Issuance (in blue)
Investment Grade Corporate Bond
Issuance (in red)
Bi
llio
ns
of
do
lla
rs
5 - 22
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
The Pure Expectations Hypothesis
(PEH)
?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.
5 - 23
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?PEH assumes that 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.
5 - 24
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Observed Treasury Rates
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?
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
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0 1 2 5
6.0%
3 4
x%
6.2%
PEH tells us that one-year securities will
yield 6.4%,one year from now (x%).
6.2% =
12.4% = 6.0 + x%
6.4% = x%.
(6.0% + x%)
2
5 - 26
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0 1 2 5
6.2%
3 4
x%
6.5% [ 2(6.2%) + 3(x%) ]
5
PEH tells us that three-year securities
will yield 6.7%,two years from now (x%).
6.5% =
32.5% = 12.4% + 3(x%)
20.1% = 3(x%)
6.7% = x%.
5 - 27
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
?Some argue that the PEH isn?t 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
> 0).
Conclusions about PEH
5 - 28
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
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 country?s economic,
political,and social environment.
Exchange rate risk,If investment is
denominated in a currency other than
the dollar,the investment?s value will
depend on what happens to exchange
rate.
5 - 29
Copyright ? 2002 by Harcourt,Inc,All rights reserved.
Two Factors Lead to Exchange
Rate Fluctuations
? Changes in relative inflation will
lead to changes in exchange rates.
? An increase in country risk will
also cause that country?s currency
to fall.