FinanceChapter 4The financial environment: markets, institutions, & interest rates

Financial environment

Financial environment Financial markets Financial institutions Tax & regulatory policies State of the economy

Types of financial markets

Physical asset vs. financial asset markets E.g., wheat vs. bonds

Spot markets – “on-the-spot” delivery Futures markets – agreement to buy/sell an

asset at some future date Money markets – loan/borrow funds < 1 year Capital markets – loan/borrow funds > 1 year Primary markets – selling new securities Secondary markets – securities trading by

investors after issuance by corporations

Types of financial markets

Initial public offering (IPO) market – where firms “go public” by offering shares to the public

Private markets – transaction between 2 parties

Public markets – standardized contracts are traded on organized exchanges

Major market instruments See Table 4-1, pages 120-121

U.S. Treasury bills U.S. Treasury notes & bonds Money market funds Consumer credit loans Mortgages Corporate bonds Leases Preferred stocks Common stocks

Derivatives

Any financial asset (contract) whose value is derived from the value of some other underlying asset

Uses: Speculate (anticipating an increased return) Hedge (reduce risk)

Transfers of capital

Direct transfers Transfers through investment banking houses Transfers through financial intermediaries

which create new securities Stock markets

Physical location (NYSE) Electronic (NASDAQ and over-the-counter

market) Capital is allocated through a price system

Lenders receive “rent” (interest) Investors receive dividends & capital gains

Cost of money

Fundamental factors affecting the cost of money:

1. Production opportunities – returns from investments in cash-generating assets

2. Time preferences for consumption – preference of consumers for current vs. future consumption (savings)

3. Risk of low or negative return4. Inflation – the amount prices increase over

time

Cost of money

Risk-free rate of interest, kRF

The real risk-free rate, k*, plus an inflation premium, IP kRF = k* + IP

The nominal (quoted) interest rate also includes default risk (DRP), liquidity (LP), & maturity risk (MRP) kRF = k* + IP + DRP + LP + MRP

Effecting the cost of money: The real rate and inflation change over time Central bank money supply management International currency flows

Cost of money

Effecting the cost of money: The real rate and inflation change over time Central bank money supply management &

International currency flows also lead to interest rate changes

Because interest rate levels are difficult to predict, sound financial policy calls for using a mix of short- and long-term debt