CHAPTER 2 & 6 The Financial Environment: Markets, Institutions, an Interest Rates

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

!hat is a market" A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

Financial Markets

hat is the role of financial markets in Finance! "ash flows to and from the Firm

#$"%&'T'$# ( #T)"*# A+D ,)+D# &$-&$#$+T'+. ),/'.AT')+# )F T0$ '##%$& T) -&)1'D$ T0$ -%&"0A#$& A+ $2-$"T$D &$T%&+ )+ T0$ '+1$#T3$+T

T#$es o% %inancial markets -hysical assets vs. Financial assets 4 5-hysical6 wheat7 real estate7 machinery8 3oney vs. "apital 4 53oney 3arket6 where funds are borrowed or loaned for less than one year8 Financial 3arket6 stocks and long term debt trade -rimary vs. #econdary PRIMAR& MAR'ET ( +$ '##%$# )F #$"%&'T'$# A&$ #)/D -%,/'"/Y F)& T0$ F'&#T T'3$

(EC)*+AR& MAR'ET( 3A&*$T 0$&$ #0A&$# )F #T)"*# A+D ,)+D# 0'"0 $&$ -&$1')%#/Y '##%$D T&AD$ -ublic vs. -rivate 5-ublic6 3arket in which standardized contracts are traded on an organized exchange8

0ow is capital transferred between savers and borrowers!

Direct transfers 'nvestment banking house Financial intermediaries

Types of financial intermediaries

"ommercial banks #avings and loan associations 3utual savings banks "redit unions -ension funds /ife insurance companies 3utual funds

-hysical location stock exchanges vs. $lectronic dealer(based markets Auction market vs. Dealer market 5$xchanges vs. )T"8 +Y#$ vs. +asda9 Organized Exchanges - Trading takes place in a location with face to face trading (auction market) New York Stock Exchange - NYSE (1792): Before 2006 the !"# was a nonprofit corporation with 1$66 seats% &n 2006 it 'ecame a pu'licl( traded compan( (ticker s(m'ol: !))% *em'ership seats are replaced '( annual trading licenses% Then in +pril ,- 200. !"#-#urone/t is formed- merging !"# with ma0or #uropean e/changes% 2100 stocks listed on !"# "pecialist - "pecialists are people on the trading floor of the e/change of the !"# who hold in2entories of particular stocks% + specialist3s 0o' is not onl( to match 'u(ers and sellers- 'ut also to keep an in2entor( for him or herself that can 'e used to shift the market during a period of illi4uidit( 1% Auctioneer 4 #hows best bids and offers7 becoming a market maker 2% Catalyst 4 *eeps track of the interests of different buyers and sellers and continually
updates them.

$% Agent 4 -laces electronically routed orders on behalf of clients. Floor brokers can leave
an order with a specialist7 freeing themselves up to take on other orders. #pecialists then take on the responsibilities of a broker.

,% Principal 4 Acts as the ma:or party to a transaction ( specialists are responsible for
keeping the market in e9uilibrium7 they are re9uired to execute all customer orders ahead of their own.

The specialists at the !"# are emplo(ed '( se2en firms% 5ompanies listed on certain e/changes will inter2iew emplo(ees of the specialist firms- seeking out suita'le people to represent them ('( holding in2entories of the companies3 stocks)% 6ere are the se2en !"# specialist firms: Bear 7agner "pecialist 885%- 9leet "pecialist- &nc%- 8aBranche : 5o%- 885%-- ;erformance "pecialist <roup- 885%- "pear- 8eeds : =ellogg "pecialists 885%-"&< "pecialists- &nc%->an der *oolen "pecialists ?"+- 885% 9loor 'roker @ (commission 'rokers) e/ecute customer orders (working for 'rokerage houses) A00 floor 'rokers at !"#- use electronic trading s(stem ("uperBCT) to place orders through specialist &ndependent 'rokers @ donDt work for 'rokerage house 'ut place trades for customers of 'rokerage firms% 5ollect fee for ser2ice Super ot s!ste" # orders trans"itted direct$! to specia$ists # especia$$! S"a$$ orders N%S %& # Nationa$ %ssociation o' Securit! ea$ers %uto"ated &uotation s!ste" CT5 *arket @ C2er the 5ounter market @ when securities market is characteriEed '( dea$ers ("arket "akers) who 'u( and sell securities for their in2entories @ +"B+F is an CT5 market +"B+F @ 5omposed of two separate markets @ +"B+F ational *arket @ lists ,000 securities (larger companies) +"B+F 5apital *arket @ for smaller companies lists 1000 companies #5 @ #lectric 5ommunication etwork @ late 1GG0s in2estors trade directl( with each other through order 'ook @ 'u( sell order are placed in #5 and then transmitted to +"B+F and displa(ed (fourth market) - &nstinet- &sland- Trade'ook (trade stocks and currencies) ()*+ ,arket - Trading of e/change listed stocks occur off e/change through independent securities firms -O.+() ,arket @ &nstinet- Trade'ook @ in2estors trade among themsel2es% Big for after hours trading

Orders ,arket Order - +n order to 'u( or sell a stated 4uantit( of a securit( at the current market price% /i"it Order - +n order to 'u( or sell a securit( at a specific price or 'etter% + 'u( limit order is placed 'elow the market price% + sell limit order is place a'o2e the market price% +dditional limit order instructions: Ba(-orderH <ood Til 5ancelled Stop Order - +n order to 'u( or sell at the current market price once the stock has traded at- or through- the specified stop price% + sell stop or stop loss order is used to protect a profit or limit a loss in the e2ent of a decline the securit(3s market price% The cost o% mone# The price7 or cost7 of debt capital is the interest rate. The price7 or cost7 of e9uity capital is the re9uired return. The re9uired return investors expect is composed of compensation in the form of dividends and capital gains.

hat four factors affect the cost of money! ;+ominal< vs. ;&eal< rates r = represents any nominal rate r> r&F = represents the ;real< risk(free rate of interest. /ike a T(bill rate7 if there was no inflation. Typically ranges from ?@ to A@ per year. = represents the rate of interest on Treasury securities. Determinants of interest rates r = r> B '- B D&- B /- B 3&r r> 'D&/3&= = = = = = re9uired return on a debt security real risk(free rate of interest inflation premium default risk premium li9uidity premium maturity risk premium

-remiums added to k> for different types of debt &iel curve an the term structure o% interest rates ,

Term structure 4 relationship between interest rates 5or yields8 and maturities. The yield curve is a graph of the term structure.

#tep ? 4 Find the average expected inflation rate over years ? to n6

"onstructing the yield curve6 'nflation #uppose7 that inflation is expected to be C@ next year7 D@ the following year7 and E@ thereafter. '-? = C@ F ? = C.GG@ '-?G= HC@ B D@ B E@5E8I F ?G = J.CG@ '-KG= HC@ B D@ B E@5?E8I F KG = J.JC@ 3ust earn these '-s to break even vs. inflationL these '-s would permit you to earn r> 5before taxes8.

"onstructing the yield curve6 'nflation #tep K 4 Find the appropriate maturity risk premium 53&-8. For this example7 the following e9uation will be used find a securityMs appropriate maturity risk premium. "onstructing the yield curve6 3aturity &isk %sing the given e9uation6 3&-? = G.?@ x 5?(?8 = G.G@ 3&-?G = G.?@ x 5?G(?8 = G.N@ 3&-KG = G.?@ x 5KG(?8 = ?.N@ +otice that since the e9uation is linear7 the maturity risk premium is increasing in the time to maturity7 as it should be.

Add the '-s and 3&-s to k> to find the appropriate nominal rates #tep O 4 Adding the premiums to k>. r&F7 t = r> B '-t B 3&-t Assume r> = O@7 r&F7 ? = O@ B C.G@ B G.G@ = E.G@ r&F7 ?G = O@ B J.C@ B G.N@ = ??.A@ r&F7 KG = O@ B J.JC@ B ?.N@ = ?K.DC@
10 ,aturit! risk

The real risk-free rate% is $ percent- and inflation is e/pected to 'e $ percent for the ne/t 2 (ears% + 2-(ear Treasur( securit( (ields 6%2 percent% 7hat is the maturit(

pre"iu"

risk premium for the 2-(ear securit(I

0ypothetical yield curve An upward sloping yield curve. %pward slope due to an increase in expected inflation and increasing maturity risk premium. hat is the relationship between the Treasury yield curve and the yield curves for corporate issues! "orporate yield curves are higher than that of Treasury securities7 though not necessarily parallel to the Treasury curve. The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.

'llustrating the relationship between corporate and Treasury yield curves -ure $xpectations 0ypothesis The -$0 contends that the shape of the yield curve depends on investorMs expectations about future interest rates. 'f interest rates are expected to increase7 /(T rates will be higher than #(T rates7 and vice(versa. Thus7 the yield curve can slope up7 down7 or even bow.

Assumptions of the -$0 Assumes that the maturity risk premium for Treasury securities is zero. /ong(term rates are an average of current and future short(term rates. 'f -$0 is correct7 you can use the yield curve to ;back out< expected future interest rates. +2erage annual rate J r J K(1 L r1) (1 L r2)%%( 1 L rn)M1Nn - 1 <eometric a2erage of indi2idual one (ear rates
2%
Expected rate o' interest

Cne-(ear Treasur( securities (ield A percent% The market anticipates that 1 (ear from now- l-(ear Treasur( securities will (ield 6 percent% &f the pure e/pectations theor( is correct- what should 'e the (ield toda( for 2-(ear Treasur( securitiesI

10 Expected rate

&nterest rates on ,-(ear Treasur( securities are currentl( . percent- while interest rates on 6-(ear Treasur( securities are currentl( .%A percent% &f the pure e/pectations

o' interest

theor( is correct- what does the market 'elie2e that 2-(ear securities will 'e (ielding , (ears from nowI

20 Expected rate o' interest

"uppose the annual (ield on a 2-(ear Treasur( 'ond is ,%A percent- while that on a 1-(ear 'ond is $ percent% rO is 1 percent- and the maturit( risk premium is Eero% a% ?sing the e/pectations theor(- forecast the interest rate on a 1-(ear 'ond during the second (ear% (6int: ?nder the e/pectations theor(- the (ield on a 2-(ear 'ond is e4ual to the a2erage (ield on 1-(ear 'onds in !ears 1 and 2%) '% 7hat is the e/pected inflation rate in !ear 1I !ear 2I

An example6 )bserved Treasury rates and the -$0 3aturity Yield ? year D.G@ K years D.K@ O years D.A@ average annual rates A years D.C@ C years D.C@ 'f -$0 holds7 what does the market expect will be the interest rate on one(year securities7 one year from now! Three(year securities7 two years from now!

)ne(year forward rate .GDK = H5?.GD85? B x8I?FK ( ? 5?.GDK8KF?.GD = 5? B x8 x = D.A@ -$0 says that one(year securities will yield D.A@7 one year from now. Three(year security7 two years from now "onclusions about -$0

#ome would argue that the 3&- P G7 and hence the -$0 is incorrect. 3ost evidence supports the general view that lenders prefer #(T .

securities7 and view /(T securities as riskier. Thus7 investors demand a 3&- to get them to hold /(T securities 5i.e.7 3&- Q G8. )ther factors that influence interest rate levels

Federal reserve policy Federal budget surplus or deficit /evel of business activity 'nternational factors

&isks associated with investing overseas Factors that cause exchange rates to fluctuate "hanges in relative inflation "hanges in country risk