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Chapter 4
The Financial Environment:
Markets, Institutions, and Interest Rates
ANSWERS TO END-OF-CHAPTER QUESTIONS
4-1
a. A money market is a financial market for debt securities with
maturities of less than one year (short-term).
The New York money
market is the world’s largest.
Capital markets are the financial
markets for long-term debt and corporate stocks. The New York Stock
Exchange is an example of a capital market.
b. Primary markets are the markets in which newly issued securities are
sold for the first time. Secondary markets are where securities are
resold after initial issue in the primary market. The New York Stock
Exchange is a secondary market.
c. In private markets, transactions are worked out directly between two
parties and structured in any manner that appeals to them. Bank loans
and private placements of debt with insurance companies are examples of
private market transactions. In public markets, standardized contracts
are traded on organized exchanges.
Securities that are issued in
public markets, such as common stock and corporate bonds, are
ultimately held by a large number of individuals.
Private market
securities are more tailor-made but less liquid, whereas public market
securities are more liquid but subject to greater standardization.
d. Derivatives are claims whose value depends on what happens to the value
of some other asset. Futures and options are two important types of
derivatives, and their values depend on what happens to the prices of
other assets, say IBM stock, Japanese yen, or pork bellies. Therefore,
the value of a derivative security is derived from the value of an
underlying real asset.
e. An investment banker is a middleman between businesses and savers.
Investment banking houses assist in the design of corporate securities
and then sell them to savers (investors) in the primary markets.
Financial service corporations offer a wide range of financial services
such as brokerage operations, insurance, and commercial banking.
f. A financial intermediary buys securities with funds that it obtains by
issuing its own securities. An example is a common stock mutual fund
that buys common stocks with funds obtained by issuing shares in the
mutual fund.
g. A mutual fund is a corporation that sells shares in the fund and uses
the proceeds to buy stocks, long-term bonds, or short-term debt
instruments. The resulting dividends, interest, and capital gains are
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Learning Objectives: 4 - 1
distributed to the fund’s shareholders after the deduction of operating
expenses. Different funds are designed to meet different objectives.
Money market funds are mutual funds which invest in short-term debt
instruments and offer their shareholders check writing privileges;
thus, they are essentially interest-bearing checking accounts.
h. Organized security exchanges, such as the New York Stock Exchange,
facilitate communication between buyers and sellers of securities.
Each organized exchange is a physical entity and is governed by an
elected board of governors. The over-the-counter market consists of
all the facilities that provide for security transactions not conducted
on the organized exchanges.
These facilities are, basically, the
relatively few dealers who hold inventories of over-the-counter
securities, the thousands of brokers who act as agents in bringing
these dealers together with investors, and the communications network
that links the dealers and agents.
I. Production opportunities are the returns available within an economy
from investment in productive assets.
The higher the production
opportunities, the more producers would be willing to pay for required
capital. Consumption time preferences refer to the preferred pattern
of consumption. Consumer’s time preferences for consumption establish
how much consumption they are willing to defer, and hence save, at
different levels of interest.
j. The real risk-free rate is that interest rate which equalizes the
aggregate supply of, and demand for, riskless securities in an economy
with zero inflation. The real risk-free rate could also be called the
pure rate of interest since it is the rate of interest that would exist
on very short-term, default-free U.S. Treasury securities if the
expected rate of inflation were zero. It has been estimated that this
rate of interest, denoted by k*, has fluctuated in recent years in the
United States in the range of 2 to 4 percent. The nominal risk-free
rate of interest, denoted by kRF, is the real risk-free rate plus a
premium for expected inflation. The short-term nominal risk-free rate
is usually approximated by the U.S. Treasury bill rate, while the longterm nominal risk-free rate is approximated by the rate on U.S.
Treasury bonds.
Note that while T-bonds are free of default and
liquidity risks, they are subject to risks due to changes in the
general level of interest rates.
k. The inflation premium is the premium added to the real risk-free rate
of interest to compensate for the expected loss of purchasing power.
The inflation premium is the average rate of inflation expected over
the life of the security.
l. Default risk is the risk that a borrower will not pay the interest
and/or principal on a loan as they become due. Thus, a default risk
premium (DRP) is added to the real risk-free rate to compensate
investors for bearing default risk.
Answers and Solutions: 4 - 2
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m. Liquidity refers to a firm’s cash and marketable securities position,
and to its ability to meet maturing obligations. A liquid asset is any
asset that can be quickly sold and converted to cash at its “fair”
value. Active markets provide liquidity. A liquidity premium is added
to the real risk-free rate of interest, in addition to other premiums,
if a security is not liquid.
n. Interest rate risk arises from the fact that bond prices decline when
interest rates rise. Under these circumstances, selling a bond prior
to maturity will result in a capital loss, and the longer the term to
maturity, the larger the loss. Thus, a maturity risk premium must be
added to the real risk-free rate of interest to compensate for interest
rate risk.
o. Reinvestment rate risk occurs when a short-term debt security must be
“rolled over.”
If interest rates have fallen, the reinvestment of
principal will be at a lower rate, with correspondingly lower interest
payments and ending value. Note that long-term debt securities also
have some reinvestment rate risk because their interest payments have
to be reinvested at prevailing rates.
p. The term structure of interest rates is the relationship between yield
to maturity and term to maturity for bonds of a single risk class. The
yield curve is the curve that results when yield to maturity is plotted
on the Y axis with term to maturity on the X axis.
q. When the yield curve slopes upward, it is said to be “normal,” because
it is like this most of the time. Conversely, a downward-sloping yield
curve is termed “abnormal” or “inverted.”
r. The expectations theory states that the slope of the yield curve
depends on expectations about future inflation rates and interest
rates. Thus, if the annual rate of inflation and future interest rates
are expected to increase, the yield curve will be upward sloping,
whereas the curve will be downward sloping if the annual rates are
expected to decrease.
s. The liquidity preference theory states that since investors generally
prefer to lend short-term and borrowers prefer to borrow long-term,
long-term rates will generally be higher than short-term rates.
Borrowers are willing to pay a premium for long-term debt because it
exposes them to less risk of having to repay the debt under adverse
conditions, and investors demand a higher return on long-term debt
because it exposes them to more interest rate risk.
t. A foreign trade deficit occurs when businesses and individuals in the
U.S. import more goods from foreign countries than are exported. Trade
deficits must be financed, and the main source of financing is debt.
Therefore, as the trade deficit increases, the debt financing
increases, driving up interest rates.
U.S. interest rates must be
competitive with foreign interest rates; if the Federal Reserve
attempts to set interest rates lower than foreign rates, foreigners
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Answers and Solutions: 4 - 3
will sell U.S. bonds, decreasing bond prices, resulting in higher U.S.
rates. Thus, if the trade deficit is large relative to the size of the
overall economy, it may hinder the Fed’s ability to combat a recession
by lowering interest rates.
4-2
Financial intermediaries are business organizations that receive funds in
one form and repackage them for the use of those who need funds. Through
financial intermediation, resources are allocated more effectively, and
the real output of the economy is thereby increased.
4-3
Regional mortgage rate differentials do exist, depending on supply/demand
conditions in the different regions. However, relatively high rates in
one region would attract capital from other regions, and the end result
would be a differential that was just sufficient to cover the costs of
effecting the transfer (perhaps ½ of one percentage point). Differentials
are more likely in the residential mortgage market than the business loan
market, and not at all likely for the large, nationwide firms, which will
do their borrowing in the lowest-cost money centers and thereby quickly
equalize rates for large corporate loans.
If Congress were to permit
nationwide branching, interest rates would become more competitive, making
it easier for small borrowers, and borrowers in rural areas, to obtain
lower cost loans.
4-4
It would be difficult for firms to raise capital.
Thus, capital
investment would slow down, unemployment would rise, the output of goods
and services would fall, and, in general, our standard of living would
decline.
4-5
The prices of goods and services must cover their costs. Costs include
labor, materials, and capital.
Capital costs to a borrower include a
return to the saver who supplied the capital, plus a mark-up (called a
"spread") for the financial intermediary which brings the saver and the
borrower together. The more efficient the financial system, the lower the
costs of intermediation, the lower the costs to the borrower, and, hence,
the lower the prices of goods and services to consumers.
4-6
Short-term rates are more volatile because (1) the Fed operates mainly in
the short-term sector, hence Federal Reserve intervention has its major
effect here, and (2) long-term rates reflect the average expected
inflation rate over the next 20 to 30 years, and this average does not
change as radically as year-to-year expectations.
4-7
Interest rates will fall as the recession takes hold because (1) business
borrowings will decrease and (2) the Fed will increase the money supply to
stimulate the economy. Thus, it would be better to borrow short-term now,
and then to convert to long-term when rates have reached a cyclical low.
Note, though, that this answer requires interest rate forecasting, which
is extremely difficult to do with better than 50 percent accuracy.
4-8
a. If transfers between the two markets are costly, interest rates would
be different in the two areas.
Area Y, with the relatively young
population, would have less in savings accumulation and stronger loan
Answers and Solutions: 4 - 4
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demand. Area O, with the relatively old population, would have more
savings accumulation and weaker loan demand as the members of the older
population have already purchased their houses and are less consumption
oriented. Thus, supply/demand equilibrium would be at a higher rate of
interest in Area Y.
b. Yes.
Nationwide branching, and so forth, would reduce the cost of
financial transfers between the areas. Thus, funds would flow from
Area O with excess relative supply to Area Y with excess relative
demand.
This flow would increase the interest rate in Area O and
decrease the interest rate in Y until the rates were roughly equal, the
difference being the transfer cost.
4-9
A significant increase in productivity would raise the rate of return on
producers' investment, thus causing the investment curve (see Figure 4-2
in the textbook) to shift to the right. This would increase the amount of
savings and investment in the economy, thus causing all interest rates to
rise.
4-10
a. The immediate effect on the yield curve would be to lower interest
rates in the short-term end of the market, since the Fed deals
primarily in that market segment. However, people would expect higher
future inflation, which would raise long-term rates. The result would
be a much steeper yield curve.
b. If the policy is maintained, the expanded money supply will result in
increased rates of inflation and increased inflationary expectations.
This will cause investors to increase the inflation premium on all debt
securities, and the entire yield curve would rise; that is, all rates
would be higher.
4-11
a. S&Ls would have a higher level of net income with a "normal" yield
curve.
In this situation their liabilities (deposits), which are
short-term, would have a lower cost than the returns being generated by
their assets (mortgages), which are long-term. Thus they would have a
positive "spread."
b. It depends on the situation.
A sharp increase in inflation would
increase interest rates along the entire yield curve. If the increase
were large, short-term interest rates might be boosted above the
long-term interest rates that prevailed prior to the inflation increase.
Then, since the bulk of the fixed-rate mortgages were
initiated when interest rates were lower, the deposits (liabilities) of
the S&Ls would cost more than the return being provided on the assets.
If this situation continued for any length of time, the equity
(reserves) of the S&Ls would be drained to the point that only a
"bailout" would prevent bankruptcy. This has indeed happened in the
United States.
Thus, in this situation the S&L industry would be
better off selling their mortgages to federal agencies and collecting
servicing fees rather than holding the mortgages they originated.
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Answers and Solutions: 4 - 5
4-12
Treasury bonds, along with all other bonds, are available to investors as
an alternative investment to common stocks. An increase in the return on
Treasury bonds would increase the appeal of these bonds relative to common
stocks, and some investors would sell their stocks to buy T-bonds. This
would cause stock prices, in general, to fall. Another way to view this
is that a relatively riskless investment (T-bonds) has increased its
return by 7 percentage points. The return demanded on riskier investments
(stocks) would also increase, thus driving down stock prices. The exact
relationship will be discussed in Chapters 5 (with respect to risk) and 8
and 9 (with respect to price).
Answers and Solutions: 4 - 6
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SOLUTIONS TO END-OF-CHAPTER PROBLEMS
4-1
k* = 3%; I1 = 2%; I2 = 4%; I3 = 4%; MRP = 0; kT-2 = ?; kT-3 = ?
k = k* + IP + DRP + LP + MRP.
Since these are Treasury securities, DRP = LP = 0.
kT-2 = k* + IP2
IP2 = (2% + 4%)/2 = 3%
kT-2 = 3% + 3% = 6%.
kT-3 = k* + IP3
IP3 = (2% + 4% + 4%)/3 = 3.33%
kT-3 = 3% + 3.33% = 6.33%.
4-2
kT-10 = 6%; kC-10 = 8%; LP = 0.5%; DRP = ?
k = k* + IP + DRP + LP + MRP.
kT-10 = 6% = k* + IP + MRP; DRP = LP = 0.
kC-10 = 8% = k* + IP + DRP + 0.5% + MRP.
Because both bonds are 10-year bonds the inflation premium and maturity
risk premium on both bonds are equal. The only difference between them is
the liquidity and default risk premiums.
kC-10 = 8% = k* + IP + MRP + 0.5% + DRP.
IP + MRP = 6%; therefore,
But we know from above that k* +
kC-10 = 8% = 6% + 0.5% + DRP
1.5% = DRP.
4-3
4-4
kT-1,
1
= 5%; kT-1,
kT-2
Install Equation Editor and double= click here to view equation.
= 5.5%.
2
= 6%; kT-2 = ?
k* = 3%; IP = 3%; kT-2 = 6.2%; MRP2 = ?
kT-2 = k* + IP + MRP = 6.2%
kT-2 = 3% + 3% + MRP = 6.2%
MRP = 0.2%.
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Answers and Solutions: 4 - 7
4-5
Let x equal the yield on 1-year securities 1 year from now:
(5.6% + x)/2 = 6%
5.6% + x = 12%
x = 6.4%.
4-6
Let x equal the yield on 2-year securities 4 years from now:
7.5% = [(4)(7%) + 2x]/6
0.45 = 0.28 + 2x
x = 0.085 or 8.5%.
4-7
k
k*
IP
MRP
DRP
LP
=
=
=
=
=
=
k* + IP + MRP + DRP + LP.
0.03.
[0.03 + 0.04 + (5)(0.035)]/7 = 0.035.
0.0005(6) = 0.003.
0.
0.
k = 0.03 + 0.035 + 0.003 = 0.068 = 6.8%.
4-8
a. k1 = 3%, and
Install Equation Editor and doublek2 = click here to view equation.
= 4.5%,
Solving for k1 in Year 2, we obtain
k1 in Year 2 = (4.5%  2) - 3% = 6%.
b. For riskless bonds under the expectations theory, the interest rate for
a bond of any maturity is kn = k* + average inflation over n years. If
k* = 1%, we can solve for IPn:
Year 1: k1 = 1% + I1 = 3%;
I1 = expected inflation = 3% - 1% = 2%.
Year 2: k1 = 1% + I2 = 6%;
I2 = expected inflation = 6% - 1% = 5%.
Note also that the average inflation rate is (2% + 5%)/2 = 3.5%,
which, when added to k* = 1%, produces the yield on a 2-year bond,
4.5%. Therefore, all of our results are consistent.
Alternative solution:
2 first:
Solve for the inflation rates in Year 1 and Year
kRF = k* + IP
Answers and Solutions: 4 - 8
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Year 1:
3% = 1% + IP1; IP1 = 2%, thus I1 = 2%.
Year 2:
4.5% = 1% + IP2; IP2 = 3.5%.
IP2 = (I1 + I2)/2
3.5% = (2% + I2)/2
I2 = 5%.
Then solve for the yield on the one-year bond in the second year:
Year 2:
4-9
k1 = 1% + 5% = 6%.
k* = 2%; MRP = 0%.
k1 = 5%; k2 = 7%.
Install Equation Editor and doublek2 = click here to view equation.
,
Install Equation Editor and double7% = click here to view equation.
,
9% = k1 in Year 2.
k1 in Year 2 = k* + I2,
9% = 2% + I2
7% = I2.
The average interest rate during the 2-year period differs from the 1-year
interest rate expected for Year 2 because of the inflation rate reflected
in the two interest rates. The inflation rate reflected in the interest
rate on any security is the average rate of inflation expected over the
security's life.
4-10
First, note that we will use the equation kt = 3% + IPt + MRPt.
the data needed to find the IPs:
We have
Install Equation Editor and doubleInstall Equation Editor and doubleclick
here
to
view
equation.
IP5 =
= click here to view equation.
= 5%.
Install Equation Editor and doubleIP2 = click here to view equation.
= 6.5%.
Now we can substitute into the equation:
k2 = 3% + 6.5% + MRP2 = 10%.
k5 = 3% + 5% + MRP5 = 10%.
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Answers and Solutions: 4 - 9
Now we can solve for the MRPs, and find the difference:
MRP5 = 10% - 8% = 2%.
MRP2 = 10% - 9.5% = 0.5%.
Difference = (2% - 0.5%) = 1.5%.
4-11
Basic relevant equations:
kt = k* + IPt + DRPt + MRPt + LPt.
But here IP is the only premium, so kt = k* + IPt.
IPt = Avg. inflation = (I1 + I2 + )/N.
We know that I1 = IP1 = 3% and k* = 2%.
k1 = 2% + 3% = 5%.
Therefore,
k3 = k1 + 2% = 5% + 2% = 7%.
But,
k3 = k* + IP3 = 2% + IP3 = 7%, so
IP3 = 7% - 2% = 5%.
We also know that It = Constant after t = 1.
We can set up this table:
1
2
3
k*
___
I
___
Avg. I = IPt
____________________
2
2
2
3
I
I
3%/1 = 3%
(3% + I)/2 = IP2
(3% + I + I)/3 = IP3
k = k* + IPt
____________________________
5%
k3 = 7%, so IP3 = 7%-2% = 5%.
Avg. I = IP3 = (3% + 2I)/3 = 5%
2I = 12%
I = 6%.
4-12
a.
Years to
Maturity
________
1
2
3
4
5
10
20
Real
Risk-Free
Rate (k*)
_________
2%
2
2
2
2
2
2
Answers and Solutions: 4 - 10
IP**
______
7.00%
6.00
5.00
4.50
4.20
3.60
3.30
MRP
____
0.2%
0.4
0.6
0.8
1.0
1.0
1.0
kT = k* + IP + MRP
__________________
9.20%
8.40
7.60
7.30
7.20
6.60
6.30
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**The computation of the inflation premium is as follows:
Year
1
2
3
4
5
10
20
Expected
Inflation
7%
5
3
3
3
3
3
Average
Expected Inflation
7.00%
6.00
5.00
4.50
4.20
3.60
3.30
For example, the calculation for 3 years is as follows:
Install Equation Editor and doubleclick here to view equation.
Thus, the yield curve would be as follows:
b. The interest rate on the Exxon bonds has the same components as the
Treasury securities, except that the Exxon bonds have default risk, so
a default risk premium must be included. Therefore,
kExxon = k* + IP + MRP + DRP.
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Answers and Solutions: 4 - 11
For a strong company such as Exxon, the default risk premium is
virtually zero for short-term bonds.
However, as time to maturity
increases, the probability of default, although still small, is sufficient to warrant a default premium. Thus, the yield risk curve for the
Exxon bonds will rise above the yield curve for the Treasury
securities. In the graph, the default risk premium was assumed to be
1.0 percentage point on the 20-year Exxon bonds. The return should
equal 6.3% + 1% = 7.3%.
c. LILCO bonds would have significantly more default risk than either
Treasury securities or Exxon bonds, and the risk of default would
increase over time due to possible financial deterioration. In this
example, the default risk premium was assumed to be 1.0 percentage
point on the 1-year LILCO bonds and 2.0 percentage points on the 20year bonds. The 20-year return should equal 6.3% + 2% = 8.3%.
4-13
6
1
2
3
4
5
10
20
Term
months
year
years
years
years
years
years
years
30 years
4-14
Rate
5.5%
5.6
5.8
5.9
6.0
6.0
6.3
6.5
6.4
a. The average rate of inflation for the 5-year period is calculated as:
Answers and Solutions: 4 - 12
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Average
inflation = (0.13 + 0.09 + 0.07 + 0.06 + 0.06)/5 = 8.20%.
rate
b. k = k* + IPAvg. = 2% + 8.2% = 10.20%.
c. Here is the general situation:
Year
1
2
3
5
.
.
.
10
20
1-Year
Expected
Inflation
13%
9
7
6
.
.
.
6
6
Arithmetic
Average
Expected
Inflation
13.0%
11.0
9.7
8.2
.
.
.
7.1
6.6
k*
2%
2
2
2
.
.
.
2
2
Maturity
Risk
Premium
0.1%
0.2
0.3
0.5
.
.
.
1.0
2.0
Estimated
Interest
Rates
15.1%
13.2
12.0
10.7
.
.
.
10.1
10.6
d. The "normal" yield curve is upward sloping because, in "normal" times,
inflation is not expected to trend either up or down, so IP is the same
for debt of all maturities, but the MRP increases with years, so the
yield curve slopes up. During a recession, the yield curve typically
slopes up especially steeply, because inflation and consequently
short-term interest rates are currently low, yet people expect
inflation and interest rates to rise as the economy comes out of the
recession.
e. If inflation rates are expected to be constant, then the expectations
theory holds that the yield curve should be horizontal. However, in
this event it is likely that maturity risk premiums would be applied to
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Answers and Solutions: 4 - 13
long-term bonds because of the greater risks of holding long-term
rather than short-term bonds:
If maturity risk premiums were added to the yield curve in Part e
above, then the yield curve would be more nearly normal; that is, the
long-term end of the curve would be raised. (The yield curve shown in
this answer is upward sloping; the yield curve shown in Part c is downward
sloping.)
Answers and Solutions: 4 - 14
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MINI CASE
ASSUME THAT YOU RECENTLY GRADUATED WITH A DEGREE IN FINANCE AND HAVE JUST
REPORTED TO WORK AS AN INVESTMENT ADVISOR AT THE BROKERAGE FIRM OF BALIK AND
KIEFER INC.
YOUR FIRST ASSIGNMENT IS TO EXPLAIN THE NATURE OF THE U.S.
FINANCIAL MARKETS TO MICHELLE DELLATORRE, A PROFESSIONAL TENNIS PLAYER WHO HAS
JUST COME TO THE UNITED STATES FROM CHILE.
DELLATORRE IS A HIGHLY RANKED
TENNIS PLAYER WHO EXPECTS TO INVEST SUBSTANTIAL AMOUNTS OF MONEY THROUGH BALIK
AND KIEFER.
SHE IS ALSO VERY BRIGHT, AND, THEREFORE, SHE WOULD LIKE TO
UNDERSTAND IN GENERAL TERMS WHAT WILL HAPPEN TO HER MONEY.
YOUR BOSS HAS
DEVELOPED THE FOLLOWING SET OF QUESTIONS WHICH YOU MUST ASK AND ANSWER TO
EXPLAIN THE U.S. FINANCIAL SYSTEM TO DELLATORRE.
A.
WHAT IS A MARKET?
HOW ARE PHYSICAL ASSET MARKETS DIFFERENTIATED FROM
FINANCIAL MARKETS?
ANSWER:
A MARKET IS ONE IN WHICH ASSETS ARE BOUGHT AND SOLD.
THERE ARE MANY
DIFFERENT TYPES OF FINANCIAL MARKETS, EACH ONE DEALING WITH A DIFFERENT
TYPE OF FINANCIAL ASSET, SERVING A DIFFERENT SET OF CUSTOMERS, OR
OPERATING IN A DIFFERENT PART OF THE COUNTRY.
FINANCIAL MARKETS DIFFER
FROM PHYSICAL ASSET MARKETS IN THAT REAL, OR TANGIBLE, ASSETS SUCH AS
MACHINERY, REAL ESTATE, AND AGRICULTURAL PRODUCTS ARE TRADED IN THE
PHYSICAL ASSET MARKETS, BUT FINANCIAL SECURITIES REPRESENTING CLAIMS ON
ASSETS ARE TRADED IN THE FINANCIAL MARKETS.
B.
ANSWER:
DIFFERENTIATE BETWEEN MONEY MARKETS AND CAPITAL MARKETS.
MONEY MARKETS ARE THE MARKETS IN WHICH DEBT SECURITIES WITH MATURITIES
OF LESS THAN ONE YEAR ARE TRADED.
MAJOR MONEY MARKET CENTERS.
NEW YORK, LONDON, AND TOKYO ARE
LONGER-TERM SECURITIES, INCLUDING STOCKS
AND BONDS, ARE TRADED IN THE CAPITAL MARKETS.
THE NEW YORK STOCK
EXCHANGE IS AN EXAMPLE OF A CAPITAL MARKET, WHILE THE NEW YORK
COMMERCIAL PAPER AND TREASURY BILL MARKETS ARE MONEY MARKETS.
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Mini Case: 4 - 15
C.
DIFFERENTIATE BETWEEN A PRIMARY MARKET AND A SECONDARY MARKET.
IF
APPLE COMPUTER DECIDED TO ISSUE ADDITIONAL COMMON STOCK AND DELLATORRE
PURCHASED 100 SHARES OF THIS STOCK FROM MERRILL LYNCH, THE UNDERWRITER, WOULD
THIS TRANSACTION BE A PRIMARY MARKET TRANSACTION OR A SECONDARY MARKET
TRANSACTION?
WOULD IT MAKE A DIFFERENCE IF DELLATORRE PURCHASED PREVIOUSLY
OUTSTANDING APPLE STOCK IN THE OVER-THE-COUNTER MARKET?
ANSWER:
A PRIMARY MARKET IS ONE IN WHICH COMPANIES RAISE CAPITAL BY SELLING
NEWLY ISSUED SECURITIES, WHEREAS PREVIOUSLY OUTSTANDING SECURITIES ARE
TRADED
AMONG
INVESTORS
IN
THE
SECONDARY
MARKETS.
IF
DELLATORRE
PURCHASED NEWLY ISSUED APPLE STOCK, THIS WOULD CONSTITUTE A PRIMARY
MARKET TRANSACTION, WITH MERRILL LYNCH ACTING AS AN INVESTMENT BANKER
IN THE TRANSACTION.
IF DELLATORRE PURCHASED "USED" STOCK, THEN THE
TRANSACTION WOULD BE IN THE SECONDARY MARKET.
D.
DESCRIBE THE THREE PRIMARY WAYS IN WHICH CAPITAL IS TRANSFERRED
BETWEEN SAVERS AND BORROWERS.
ANSWER:
TRANSFERS OF CAPITAL CAN BE MADE (1) BY DIRECT TRANSFER OF MONEY AND
SECURITIES, (2) THROUGH AN INVESTMENT BANKING HOUSE, OR (3) THROUGH A
FINANCIAL INTERMEDIARY.
IN A DIRECT TRANSFER, A BUSINESS SELLS ITS
STOCKS OR BONDS DIRECTLY TO INVESTORS (SAVERS), WITHOUT GOING THROUGH
ANY TYPE OF INSTITUTION.
THE BUSINESS BORROWER RECEIVES DOLLARS FROM
THE SAVERS, AND THE SAVERS RECEIVE SECURITIES (BONDS OR STOCK) IN
RETURN.
IF THE TRANSFER IS MADE THROUGH AN INVESTMENT BANKING HOUSE, THE
INVESTMENT
BANK
SERVES
AS
A
MIDDLEMAN.
THE
BUSINESS
SELLS
ITS
SECURITIES TO THE INVESTMENT BANK, WHICH IN TURN SELLS THEM TO THE
SAVERS.
ALTHOUGH
THE
SECURITIES
ARE
SOLD
TWICE,
THE
TWO
SALES
CONSTITUTE ONE COMPLETE TRANSACTION IN THE PRIMARY MARKET.
IF THE TRANSFER IS MADE THROUGH A FINANCIAL INTERMEDIARY, SAVERS
INVEST
FUNDS
WITH
THE
SECURITIES IN EXCHANGE.
INTERMEDIARY,
WHICH
THEN
ISSUES
ITS
OWN
BANKS ARE ONE TYPE OF INTERMEDIARY, RECEIVING
DOLLARS FROM MANY SMALL SAVERS AND THEN LENDING THESE DOLLARS TO
BORROWERS TO PURCHASE HOMES, AUTOMOBILES, VACATIONS, AND SO ON, AND
Mini Case: 4 - 16
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ALSO
TO
BUSINESSES
AND
GOVERNMENT
UNITS.
THE
SAVERS
RECEIVE
A
CERTIFICATE OF DEPOSIT OR SOME OTHER INSTRUMENT IN EXCHANGE FOR THE
FUNDS DEPOSITED WITH THE BANK.
MUTUAL FUNDS, INSURANCE COMPANIES, AND
PENSION FUNDS ARE OTHER TYPES OF INTERMEDIARIES.
E.
SECURITIES CAN BE TRADED ON ORGANIZED EXCHANGES OR IN THE OVER-
THE-COUNTER MARKET.
DEFINE EACH OF THESE MARKETS, AND DESCRIBE HOW STOCKS ARE
TRADED IN EACH OF THEM.
ANSWER:
THE
ORGANIZED
SECURITY
EXCHANGES
ARE
FORMAL
ORGANIZATIONS
HAVING
TANGIBLE, PHYSICAL LOCATIONS AND TRADING IN DESIGNATED SECURITIES.
THERE ARE EXCHANGES FOR STOCKS, BONDS, COMMODITIES, FUTURES, AND
OPTIONS.
TWO WELL-KNOWN EXCHANGES IN THE UNITED STATES ARE THE NEW
YORK STOCK EXCHANGE AND THE AMERICAN STOCK EXCHANGE.
THE ORGANIZED
EXCHANGES ARE CONDUCTED AS AUCTION MARKETS WITH SECURITIES GOING TO THE
HIGHEST BIDDER.
BUYERS AND SELLERS PLACE ORDERS WITH THEIR BROKERS WHO
THEN EXECUTE THOSE ORDERS BY MATCHING BUYERS AND SELLERS, ALTHOUGH
SPECIALISTS ASSIST IN PROVIDING CONTINUITY TO THE MARKETS.
THE OVER-THE-COUNTER MARKET IS MADE UP OF HUNDREDS OF BROKERS AND
DEALERS
AROUND
THE
COUNTRY
TELEPHONES AND COMPUTERS.
WHO
ARE
CONNECTED
ELECTRONICALLY
BY
THE OVER-THE-COUNTER MARKET FACILITATES
TRADING OF SECURITIES THAT ARE NOT LISTED WITH AN ORGANIZED EXCHANGE.
THIS MARKET CONSISTS OF (1) THE DEALERS WHO HOLD INVENTORIES OF
OVER-THE-COUNTER SECURITIES, (2) THE BROKERS WHO ACT AS AGENTS IN
BRINGING
TOGETHER
TERMINALS,
AND
DEALERS
ELECTRONIC
AND
INVESTORS,
NETWORKS
BETWEEN DEALERS AND BROKERS.
THAT
AND
(3)
FACILITATE
THE
COMPUTERS,
COMMUNICATIONS
DEALERS CONTINUOUSLY POST A PRICE AT
WHICH THEY ARE WILLING TO BUY THE STOCK (THE BID PRICE) AND A PRICE AT
WHICH THEY ARE WILLING TO SELL THE STOCK (THE ASKED PRICE).
THE ASKED
PRICE IS ALWAYS HIGHER THAN THE BID PRICE, AND THE DIFFERENCE (OR
"SPREAD") REPRESENTS THE DEALER'S PROFIT.
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Mini Case: 4 - 17
F.
WHAT DO WE CALL THE PRICE THAT A BORROWER MUST PAY FOR DEBT
CAPITAL?
WHAT IS THE PRICE OF EQUITY CAPITAL?
WHAT ARE THE FOUR MOST
FUNDAMENTAL FACTORS THAT AFFECT THE COST OF MONEY, OR THE GENERAL LEVEL OF
INTEREST RATES, IN THE ECONOMY?
ANSWER:
THE INTEREST RATE IS THE PRICE PAID FOR BORROWED CAPITAL, WHILE THE
RETURN ON EQUITY CAPITAL COMES IN THE FORM OF DIVIDENDS PLUS CAPITAL
GAINS.
THE RETURN THAT INVESTORS REQUIRE ON CAPITAL DEPENDS ON (1)
PRODUCTION OPPORTUNITIES, (2) TIME PREFERENCES FOR CONSUMPTION, (3)
RISK, AND (4) INFLATION.
PRODUCTION OPPORTUNITIES REFER TO THE RETURNS THAT ARE AVAILABLE
FROM INVESTMENT IN PRODUCTIVE ASSETS:
THE MORE PRODUCTIVE A PRODUCER
FIRM BELIEVES ITS ASSETS WILL BE, THE MORE IT WILL BE WILLING TO PAY
FOR THE CAPITAL NECESSARY TO ACQUIRE THOSE ASSETS.
TIME PREFERENCE FOR CONSUMPTION REFERS TO CONSUMERS' PREFERENCES FOR
CURRENT CONSUMPTION VERSUS SAVINGS FOR FUTURE CONSUMPTION:
CONSUMERS
WITH LOW PREFERENCES FOR CURRENT CONSUMPTION WILL BE WILLING TO LEND AT
A
LOWER
RATE
THAN
CONSUMERS
WITH
A
HIGH
PREFERENCE
FOR
CURRENT
CONSUMPTION.
INFLATION REFERS TO THE TENDENCY OF PRICES TO RISE, AND THE HIGHER
THE EXPECTED RATE OF INFLATION, THE LARGER THE REQUIRED RATE OF RETURN.
RISK, IN A MONEY AND CAPITAL MARKET CONTEXT, REFERS TO THE CHANCE
THAT A LOAN WILL NOT BE REPAID AS PROMISED--THE HIGHER THE PERCEIVED
DEFAULT RISK, THE HIGHER THE REQUIRED RATE OF RETURN.
RISK IS ALSO LINKED TO THE MATURITY AND LIQUIDITY OF A SECURITY.
THE LONGER THE MATURITY AND THE LESS LIQUID (MARKETABLE) THE SECURITY,
THE HIGHER THE REQUIRED RATE OF RETURN, OTHER THINGS CONSTANT.
THE PRECEDING DISCUSSION RELATED TO THE GENERAL LEVEL OF MONEY
COSTS, BUT THE LEVEL OF INTEREST RATES WILL ALSO BE INFLUENCED BY SUCH
THINGS AS FED POLICY, FISCAL AND FOREIGN TRADE DEFICITS, AND THE LEVEL
OF ECONOMIC ACTIVITY.
ALSO, INDIVIDUAL SECURITIES WILL HAVE HIGHER
YIELDS THAN THE RISK-FREE RATE BECAUSE OF THE ADDITION OF VARIOUS
PREMIUMS AS DISCUSSED BELOW.
Mini Case: 4 - 18
The Dryden Press items and derived items copyright © 1999 by The Dryden Press
G.
WHAT IS THE REAL RISK-FREE RATE OF INTEREST (k*) AND THE NOMINAL
RISK-FREE RATE (kRF)?
ANSWER:
HOW ARE THESE TWO RATES MEASURED?
KEEP THESE EQUATIONS IN MIND AS WE DISCUSS INTEREST RATES.
WE WILL
DEFINE THE TERMS AS WE GO ALONG:
k = k* + IP + DRP + LP + MRP.
kRF = k* + IP.
THE
REAL
RISK-FREE
RATE,
k*,
IS
THE
RATE
THAT
WOULD
EXIST
ON
DEFAULT-FREE SECURITIES IN THE ABSENCE OF INFLATION.
THE NOMINAL RISK-FREE RATE, kRF, IS EQUAL TO THE REAL RISK-FREE RATE
PLUS AN INFLATION PREMIUM WHICH IS EQUAL TO THE AVERAGE RATE OF
INFLATION EXPECTED OVER THE LIFE OF THE SECURITY.
THERE IS NO TRULY RISKLESS SECURITY, BUT THE CLOSEST THING IS A
SHORT-TERM U.S. TREASURY BILL (T-BILL), WHICH IS FREE OF MOST RISKS.
THE REAL RISK-FREE RATE, k*, IS ESTIMATED BY SUBTRACTING THE EXPECTED
RATE OF INFLATION FROM THE RATE ON SHORT-TERM TREASURY SECURITIES.
IT
IS GENERALLY ASSUMED THAT k* IS IN THE RANGE OF 1 TO 4 PERCENTAGE
POINTS.
RATE.
THE T-BOND RATE IS USED AS A PROXY FOR THE LONG-TERM RISK-FREE
HOWEVER, WE KNOW THAT ALL LONG-TERM BONDS CONTAIN INTEREST RATE
RISK, SO THE T-BOND RATE IS NOT REALLY RISKLESS.
IT IS, HOWEVER, FREE
OF DEFAULT RISK.
H.
DEFINE THE TERMS INFLATION PREMIUM (IP), DEFAULT RISK PREMIUM
(DRP), LIQUIDITY PREMIUM (LP), AND MATURITY RISK PREMIUM (MRP).
WHICH OF
THESE PREMIUMS IS INCLUDED WHEN DETERMINING THE INTEREST RATE ON (1) SHORTTERM U.S. TREASURY SECURITIES, (2) LONG-TERM U.S. TREASURY SECURITIES, (3)
SHORT-TERM CORPORATE SECURITIES, AND (4) LONG-TERM CORPORATE SECURITIES?
EXPLAIN HOW THE PREMIUMS WOULD VARY OVER TIME AND AMONG THE DIFFERENT
SECURITIES LISTED ABOVE.
ANSWER:
THE INFLATION PREMIUM (IP) IS A PREMIUM ADDED TO THE REAL RISK-FREE
RATE OF INTEREST TO COMPENSATE FOR EXPECTED INFLATION.
THE DEFAULT RISK PREMIUM (DRP) IS A PREMIUM BASED ON THE PROBABILITY
THAT THE ISSUER WILL DEFAULT ON THE LOAN, AND IT IS MEASURED BY THE
DIFFERENCE BETWEEN THE INTEREST RATE ON A U.S. TREASURY BOND AND A
CORPORATE BOND OF EQUAL MATURITY AND MARKETABILITY.
The Dryden Press items and derived items copyright © 1999 by The Dryden Press
Mini Case: 4 - 19
A LIQUID ASSET IS ONE THAT CAN BE SOLD AT A PREDICTABLE PRICE ON
SHORT NOTICE; A LIQUIDITY PREMIUM IS ADDED TO THE RATE OF INTEREST ON
SECURITIES THAT ARE NOT LIQUID.
THE MATURITY RISK PREMIUM (MRP) IS A PREMIUM WHICH REFLECTS INTEREST
RATE RISK; LONGER-TERM SECURITIES HAVE MORE INTEREST RATE RISK (THE
RISK OF CAPITAL LOSS DUE TO RISING INTEREST RATES) THAN DO SHORTER-TERM
SECURITIES, AND THE MRP IS ADDED TO REFLECT THIS RISK.
1. SHORT-TERM TREASURY SECURITIES INCLUDE ONLY AN INFLATION PREMIUM.
2. LONG-TERM TREASURY SECURITIES CONTAIN AN INFLATION PREMIUM PLUS A
MATURITY RISK PREMIUM.
NOTE THAT THE INFLATION PREMIUM ADDED TO
LONG-TERM SECURITIES WILL DIFFER FROM THAT FOR SHORT-TERM SECURITIES
UNLESS THE RATE OF INFLATION IS EXPECTED TO REMAIN CONSTANT.
3. THE RATE ON SHORT-TERM CORPORATE SECURITIES IS EQUAL TO THE REAL
RISK-FREE RATE PLUS PREMIUMS FOR INFLATION, DEFAULT RISK, AND
LIQUIDITY.
THE SIZE OF THE DEFAULT AND LIQUIDITY PREMIUMS WILL VARY
DEPENDING ON THE FINANCIAL STRENGTH OF THE ISSUING CORPORATION AND
ITS DEGREE OF LIQUIDITY, WITH LARGER CORPORATIONS GENERALLY HAVING
GREATER LIQUIDITY BECAUSE OF MORE ACTIVE TRADING.
4. THE RATE FOR LONG-TERM CORPORATE SECURITIES ALSO INCLUDES A PREMIUM
FOR MATURITY RISK.
THUS, LONG-TERM CORPORATE SECURITIES GENERALLY
CARRY THE HIGHEST YIELDS OF THESE FOUR TYPES OF SECURITIES.
I.
DELLATORRE IS ALSO INTERESTED IN INVESTING IN COUNTRIES OTHER THAN
THE UNITED STATES.
DESCRIBE THE VARIOUS TYPES OF RISKS THAT ARISE WHEN
INVESTING OVERSEAS.
ANSWER:
FIRST, DELLATORRE SHOULD CONSIDER COUNTRY RISK, WHICH REFERS TO THE
RISK THAT ARISES FROM INVESTING OR DOING BUSINESS IN A PARTICULAR
COUNTRY.
THIS RISK DEPENDS ON THE COUNTRY’S ECONOMIC, POLITICAL, AND
SOCIAL ENVIRONMENT.
COUNTRY RISK ALSO INCLUDES THE RISK THAT PROPERTY
WILL BE EXPROPRIATED WITHOUT ADEQUATE COMPENSATION, AS WELL AS NEW HOST
COUNTRY
Mini Case: 4 - 20
STIPULATIONS
ABOUT
LOCAL
PRODUCTION,
SOURCING
OR
HIRING
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PRACTICES, AND DAMAGE OR DESTRUCTION OF FACILITIES DUE TO INTERNAL
STRIFE.
SECOND, DELLATORRE SHOULD CONSIDER EXCHANGE RATE RISK.
DELLATORRE
NEEDS TO KEEP IN MIND WHEN INVESTING OVERSEAS THAT MORE OFTEN THAN NOT
THE SECURITY WILL BE DENOMINATED IN A CURRENCY OTHER THAN THE DOLLAR,
WHICH MEANS THAT THE VALUE OF YOUR INVESTMENT WILL DEPEND ON WHAT
HAPPENS TO EXCHANGE RATES. TWO FACTORS CAN LEAD TO EXCHANGE RATE
FLUCTUATIONS.
EXCHANGE RATES.
CHANGE IN RELATIVE INFLATION WILL LEAD TO CHANGES IN
ALSO, AN INCREASE IN COUNTRY RISK WILL ALSO CAUSE THE
COUNTRY’S CURRENCY TO FALL.
CONSEQUENTLY, INFLATION RISK, COUNTRY
RISK, AND EXCHANGE RATE RISK ARE ALL INTERRELATED.
J.
CURVE?
WHAT IS THE TERM STRUCTURE OF INTEREST RATES?
WHAT IS A YIELD
AT ANY GIVEN TIME, HOW WOULD THE YIELD CURVE FACING AN AAA-RATED
COMPANY COMPARE WITH THE YIELD CURVE FOR U.S. TREASURY SECURITIES?
AT ANY
GIVEN TIME, HOW WOULD THE YIELD CURVE FACING A BB-RATED COMPANY COMPARE WITH
THE YIELD CURVE FOR U.S. TREASURY SECURITIES?
DRAW A GRAPH TO ILLUSTRATE YOUR
ANSWER.
ANSWER:
THE TERM STRUCTURE OF INTEREST RATES IS THE RELATIONSHIP BETWEEN
INTEREST RATES, OR YIELDS, AND MATURITIES OF SECURITIES.
WHEN THIS
RELATIONSHIP IS GRAPHED, THE RESULTING CURVE IS CALLED A YIELD CURVE.
(SKETCH OUT A YIELD CURVE ON THE BOARD.)
THE YIELD CURVE NORMALLY
SLOPES UPWARD, INDICATING THAT SHORT-TERM INTEREST RATES ARE LOWER THAN
LONG-TERM INTEREST RATES.
YIELD CURVES CAN BE DRAWN FOR GOVERNMENT
SECURITIES OR FOR THE SECURITIES OF ANY CORPORATION, BUT CORPORATE
YIELD CURVES WILL ALWAYS LIE ABOVE GOVERNMENT YIELD CURVES, AND THE
RISKIER THE CORPORATION, THE HIGHER ITS YIELD CURVE.
The Dryden Press items and derived items copyright © 1999 by The Dryden Press
Mini Case: 4 - 21
Yield Curves
Interest
Rate (%)
15
10
6.8%
6.7%
5.7%
5
0
0
K.
5
10
15
20
Years to
maturity
TWO MAIN THEORIES HAVE BEEN ADVANCED TO EXPLAIN THE SHAPE OF THE
YIELD CURVE:
THEORY.
1
BB-Rated
AAA-Rated
Treasury
yield curve
(1) THE EXPECTATIONS THEORY AND (2) THE LIQUIDITY PREFERENCE
BRIEFLY DESCRIBE EACH OF THESE THEORIES.
DO ECONOMISTS REGARD ONE AS
BEING "TRUE"?
ANSWER:
THE
EXPECTATIONS
THEORY
STATES
THAT
THE
YIELD
CURVE
INVESTORS' EXPECTATIONS ABOUT FUTURE INTEREST RATES:
DEPENDS
ON
IF INFLATION IS
EXPECTED TO INCREASE, THE YIELD CURVE WILL BE UPWARD-SLOPING.
THE LIQUIDITY PREFERENCE THEORY STATES THAT SINCE (1) INVESTORS
GENERALLY PREFER TO LEND SHORT-TERM AND (2) BORROWERS PREFER TO BORROW
LONG-TERM, LONG-TERM RATES WILL GENERALLY BE HIGHER THAN SHORT-TERM
RATES.
BORROWERS ARE WILLING TO PAY A PREMIUM FOR LONG-TERM DEBT
BECAUSE IT EXPOSES THEM TO LESS RISK OF HAVING TO REPAY THE DEBT UNDER
ADVERSE CONDITIONS, AND INVESTORS DEMAND A HIGHER RETURN ON LONG-TERM
DEBT BECAUSE IT EXPOSES THEM TO MORE INTEREST RATE RISK.
BOTH THEORIES HAVE MERIT, AND EACH OF THESE FACTORS CONTRIBUTES TO
THE SHAPE OF THE YIELD CURVE.
Mini Case: 4 - 22
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L.
SUPPOSE MOST INVESTORS EXPECT THE INFLATION RATE TO BE 5 PERCENT
NEXT YEAR, 6 PERCENT THE FOLLOWING YEAR, AND 8 PERCENT THEREAFTER.
RISK-FREE RATE IS 3 PERCENT.
THE REAL
THE MATURITY RISK PREMIUM IS ZERO FOR BONDS THAT
MATURE IN 1 YEAR OR LESS, 0.1 PERCENT FOR 2-YEAR BONDS, AND THEN THE MRP
INCREASES BY 0.1 PERCENT PER YEAR THEREAFTER FOR 20 YEARS, AFTER WHICH IT IS
STABLE.
BONDS?
WHAT IS THE INTEREST RATE ON 1-YEAR, 10-YEAR, AND 20-YEAR TREASURY
DRAW A YIELD CURVE WITH THESE DATA.
IS YOUR YIELD CURVE CONSISTENT
WITH THE EXPECTATIONS THEORY OR WITH THE LIQUIDITY PREFERENCE THEORY?
ANSWER:
STEP 1:
FIND THE AVERAGE EXPECTED INFLATION RATE OVER YEARS 1 TO 20:
YR
1: IP = 5.0%.
YR 10: IP = (5 + 6 + 8 + 8 + 8 + ... + 8)/10 = 7.5%.
YR 20: IP = (5 + 6 + 8 + 8 + ... + 8)/20 = 7.75%.
STEP 2:
FIND THE MATURITY PREMIUM IN EACH YEAR:
YR
STEP 3:
1:
MRP = 0.0%.
YR 10:
MRP = 0.1  9
YR 20:
MRP = 0.1  19 = 1.9%.
= 0.9%.
SUM THE IPs AND MRPs, AND ADD k* = 3%:
YR
1:
kRF = 3% + 5.0% + 0.0% = 8.0%.
YR 10:
kRF = 3% + 7.5% + 0.9% = 11.4%.
YR 20:
kRF = 3% + 7.75% + 1.9% = 12.65%.
THE YIELD CURVE IS BASED DIRECTLY ON:
LIQUIDITY PREFERENCES.
(1) EXPECTATIONS AND (2)
IT CONTAINS A MATURITY RISK PREMIUM, WHICH IS
THE ESSENCE OF THE LIQUIDITY PREFERENCE THEORY, AND (2) IT REFLECTS
INFLATION, WHICH IS THE ESSENCE OF THE EXPECTATIONS THEORY.
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Mini Case: 4 - 23
Mini Case: 4 - 24
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