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Principles of Business

Finance

Fin 510

Dr. Lawrence P. Shao

Marshall University

Spring 2002

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CHAPTER 4The Financial Environment:

Markets, Institutions,

and Interest Rates

Financial markets

Types of financial institutions

Determinants of interest rates

Yield curves

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Define these markets

Financial assets

Money vs. capitalPrimary vs. secondary

Spot vs. future

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Direct transfer

Investment banking house

Financial intermediary

Three Primary Ways Capital Is

Transferred Between Savers andBorrowers

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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 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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Treasury Yield Curve

0

5

10

15

10 20 30

Years to Maturity

Interest

Rate (%)1 yr 5.4%

5 yr 5.7%

10 yr 5.7%

30 yr 6.0%Yield Curve

(March 1998)

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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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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 Year 1 is 5%.

Inflation for Year 2 is 6%.

Inflation for Year 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 = 7.50%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.

Must earn these IPs to break even vs.

inflation; these IPs would permit you toearn 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 = 3.0% + 5.0% + 0.0% = 8.0%.kRF10 = 3.0% + 7.5% + 0.9% = 11.4%.

kRF20 = 3.00% + 7.75% + 1.90% = 12.65%.

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Yield Curves

0

5

10

15

0 1 5 10 15 20

Years to

maturity

Interest

Rate (%)

5.4%5.7%

6.0%

BB-Rated

AAA-Rated

Treasury

yield curve