02_FinancialMarketsA

7/27/2019 02_FinancialMarketsA

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4 - 1

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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4 - 3Fundamental 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 arelarge, active, stable, resilient. It must therefore

accommodate position takers, i.e... speculators.

4. Maintains healthy environment for hedgingactivity 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. capitalPrimary vs. secondary

Spot vs. future


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4 - 5Financial

Market

Real Asset

Market

Capital

MarketMoney

Market

Securities Mortgage Consumer

CreditCommercial

PaperEuro $

e

x

c

ha

n

g

es

b

r

o

k

e

r

s

Inv.

Bkr

s.

Ins.

CO.

S & L

Com.Bks.Fin.

CO.

COs. COs.Indiv.

Invest.


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Direct transfer

Investment banking house

Financial intermediary

Three Primary Ways Capital Is

Transferred Between Savers andBorrowers


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4 - 7Financial 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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4 - 8Balance sheet of Commercial Bank v. a Manufacturing CO.

Commercial Bank

Govt. Sec.

Loans

---------------

Fixed Assets

DD

TD

----------

NW

Manufacturing Firm

CashAR

Inv.

-----------

Fixed

Assets

Short Term Debt------------------

Long Term Debt

--------------------

NW = Equity


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4 - 9Balance sheet of Insurance Company v. a Manufacturing CO.

Insurance Company

Stocks

Bonds

Mortgages

-------------

Fixed Assets

Premiums

Other Debt

----------

NW

CashAR

Inv.

-----------Fixed

Assets

Short Term Debt------------------

Long Term Debt

--------------------NW = Equity

Manufacturing Firm


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Organized Exchanges vs.

Over-the-Counter Market

Auction market vs. dealermarket (exchanges vs. OTC)

NYSE vs. NASDAQ system

Differences are narrowing


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What do we call the price, or cost,ofdebt capital?

The interest rate

What do we call the price, or cost,ofequity capital?

Required Dividend Capitalreturn 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

k* = Real risk-free rate.T-bond rate if no inflation;1% to 4%.

= Any nominal rate.

= Rate on Treasury securities.

k

kRF


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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 r isk: Arises from investing ordoing 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 thedollar, the investments value will dependon what happens to exchange rate.


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Two Factors Lead to Exchange Rate

Fluctuations

1. Changes in relative inflation willlead to changes in exchange rates.

2. An increase in country risk will

also cause that countrys currencyto fall.


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What is the term structure of interest

rates? What is a yield curve?

Term structure: the relationshipbetween interest rates (or yields)and maturities.

A graph of the term structure iscalled the yield curve.


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T-Bond Yield Curve

0

5

10

15

10 20 30

Years to Maturity

Interest

Rate (%)1 yr 5.7%

5 yr 6.5%

10 yr 6.7%

30 yr 6.9%Yield Curve

(March 1997)


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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 dependson the investors expectations

about future interest rates.

If interest rates are expected toincrease, L-T rates will be higher

than S-T rates and vice versa.Thus, the yield curve can slope upor down.


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The Pure Expectations Hypothesis

(PEH)

MRP = 0.

Long-term rates are an average ofcurrent and future short-term rates.

If PEH is correct, you can use theyield curve to back out expectedfuture interest rates.


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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 ratetoday should be 6.5% = (6% + 7%)/2.

If the PEH is correct, the 3-year ratetoday should be 7% = (6% + 7% + 8%)/3.

An Example


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Some argue that the PEH isnt correct,because securities of differentmaturities have different risk.

General view (supported by mostevidence) is that lenders prefer S-Tsecurities, and view L-T securities as

riskier.Thus, investors demand a MRP to get

them to hold L-T securities (i.e., MRP> 0).

2. Risk


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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

SINFLtt = 1 nIPn = .


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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 youto earn k* (before taxes).


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Step 2: Find MRP based on thisequation:

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 interestrate 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

0

5

10

15

0 1 5 10 15 20

Years to

maturity

Interest

Rate (%)

5.7%6.7% 6.8%

BB-Rated

AAA-Rated

Treasury

yield curve

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02_FinancialMarketsA