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5-1
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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5-2
The Role of the Financial System
Two general categories:
 Those with excess cash (“savers”)
• Normally households, but can be others
 Those with needs for cash (“borrowers”)
• Normally companies & governments, but
can be others
 The financial system includes a series of
institutions that:
 aggregate funds
 find counterparties for various transactions
 In general, connect savers w/ borrowers
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5-3
Define These Markets
Markets in general
Physical assets
Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Future
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5-4
Money Vs. Capital Markets
 Money Markets
 Short term (< 1 yr.)
 Debt
 Low Risk, Low
Return
 Instruments
 Treasury Bills
 Capital Markets everything else
 Various maturities
 Debt or Equity
 Various risks, returns
 Instruments
 Stocks
 Bonds
 Commercial Paper
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5-5
Primary vs. Secondary Markets
 Primary
 Secondary
 New instruments
 “Used”
instruments
New Bonds
Initial Stocks
(IPOs, SEOs)
 Cash Flow goes
from investor to
company
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Existing Bonds
Existing Stocks
 Cash flow goes
from investor to
investor.
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5-6
Three Primary Ways Capital Is
Transferred Between Savers and
Borrowers
Direct transfer
Investment banking house
Financial intermediary
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5-7
What’s an Investment Banker and what
do they do???
Not really investors or bankers, per
se
They consult and assist with primary
market transactions - what they do:
 Advise companies on issuances
 File with S.E.C.
 Establish pricing & distribution
 Make lots of money (Great job, but VERY high
pressure!)
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5-8
Financial Intermediaries
 Play the largest role in the economy
 Include:
Commercial banks
Credit unions
Life insurance companies
Pension funds
Mutual funds
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5-9
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
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$580 billion
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5 - 10
Physical Location Stock Exchanges
vs. Electronic Dealer-Based Markets
Auction market vs. Dealer
market (Exchanges vs. OTC)
NYSE vs. Nasdaq system
Differences are narrowing
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5 - 11
Costs of Financing
 Companies need money to operate, but
this financing always comes at a cost
 For bonds (i.e., debt):
Primary cost = stated interest rate
Add’l cost = loss of flexibility
• Must disgorge cash on a regular basis
• Many inhibitive bond covenants regarding
levels of various financial ratios that must
be maintained
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5 - 12
Costs of Financing (cont.)
 For stocks (i.e., equity):
 No explicit payments required
 So, greater flexibility for company
 BUT – investors expect co. to perform and the
value of their shares, or they will sell off
 And Stocks are riskier than bonds
 need to earn more for S/H than for B/H to
keep them happy
 How much more? To be discussed later …
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5 - 13
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
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5 - 14
Cost of Debt
 We will have more to say about the cost of
equity later (a lot more, in fact)
 but first, more about interest rates
 Interest rates = one of the most important
measures and determinants of financial
activity
 Interest rate = “rent on borrowed money”
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5 - 15
What four factors affect the cost of
money?
Production opportunities
Time preferences for consumption
Risk
Expected inflation
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5 - 16
Additional Factors
 Federal Reserve policy
At least in short term
 Federal government deficits
 International factors
E.g., Japanese purchases of U.S. debt
 Business activity
Interest rates as economy heats up
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5 - 17
“Real” Versus “Nominal” Rates
k*
= Real risk-free rate.
T-bond rate if no inflation;
1% to 4%.
k
= Any nominal rate.
kRF
= Rate on Treasury securities.
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5 - 18
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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5 - 19
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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5 - 20
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.
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5 - 21
Treasury Yield Curve
Interest
Rate (%)
15
1 yr
5 yr
10 yr
30 yr
5.2%
5.8%
5.9%
6.0%
Yield Curve
(August 1999)
10
5
Years to Maturity
0
10
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20
30
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5 - 22
Normal/Abnormal Yield Curve
 Most frequent:
“normal” or upward sloping curve.
 Current:
relatively flat
 More unique:
downward sloping (1981-1983)
also seen last year
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5 - 23
Yield Curve Construction
Step 1:Find the average expected
inflation rate over Years 1 to n:
n
 INFL
IPn =
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t 1
n
t
.
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5 - 24
Suppose, that inflation is expected to
be 5% next year, 6% the following year,
and 8% thereafter.
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 to
earn k* (before taxes).
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5 - 25
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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5 - 26
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 = 3.0% + 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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5 - 27
Hypothetical Treasury Yield Curve
Interest
Rate (%)
15
Maturity risk premium
10
Inflation premium
1 yr
10 yr
20 yr
8.0%
11.4%
12.65%
5
Real risk-free rate
Years to Maturity
0
1
10
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5 - 28
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.
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5 - 29
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 necessarily parallel to the Treasury curve.
The spread between a corporate yield
curve and the Treasury curve widens
as the corporate bond rating
decreases.
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5 - 30
Hypothetical Treasury and
Corporate Yield Curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
5
Treasury
6.0%
yield curve
5.9%
5.2%
0
0
1
5
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10
15
20
Years to
maturity
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5 - 31
Billions of dollars
How does the volume of corporate
bond issues compare to that of
Treasury securities?
Gross U.S. Treasury Issuance (in blue)
Investment Grade Corporate Bond
Issuance (in red)
600
450
300
150
‘95
‘96
‘97
‘98
‘99
Recently, the volume of investment grade corporate
bond issues has overtaken Treasury issues.
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5 - 32
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.
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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.
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5 - 34
Observed Treasury Rates
Maturity
1 year
2 years
3 years
4 years
5 years
Yield
6.0%
6.2%
6.4%
6.5%
6.5%
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?
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5 - 35
x%
6.0%
0
1
6.2%
2
3
4
5
(6.0% + x%)
6.2% =
2
12.4% = 6.0 + x%
6.4% = x%.
PEH tells us that one-year securities will
yield 6.4%, one year from now (x%).
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5 - 36
6.2%
0
1
x%
2
3
4
5
6.5%
[ 2(6.2%) + 3(x%) ]
6.5% =
5
32.5% = 12.4% + 3(x%)
20.1% = 3(x%)
6.7% = x%.
PEH tells us that three-year securities
will yield 6.7%, two years from now (x%).
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5 - 37
Conclusions about PEH
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).
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5 - 38
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.
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5 - 39
Two Factors Lead to Exchange Rate
Fluctuations
1. Changes in relative inflation will
lead to changes in exchange rates.
2. An increase in country risk will
also cause that country’s currency
to fall.
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