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Chapter 2
The Financial Environment and the Level of Interest
Rates
Learning Objectives
1. Discuss the primary role of the financial system in the economy, and describe the two
basic ways in which fund transfers take place.
2. Discuss direct financing and the important role that investment banks play in this process.
3. Describe the primary and secondary markets, and explain why secondary markets are so
important to businesses.
4. Explain why money markets are important financial markets for large corporations.
5. Discuss the most important stock market exchanges and indexes.
6. Explain how financial institutions serve consumers and small businesses that are unable
to participate in the direct financial markets and describe how corporations use the
financial system.
7. Explain how the real rate of interest is determined in the economy, differentiate between
the real rate and the nominal rate of interest, and be able to compute the nominal rate of
interest.
I.
Chapter Outline
2.1
The Financial System
A.
The Financial System at Work

It is competitive.
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
Money is aggregated in small amounts and loaned in large amounts.

The people with investment opportunities are rarely the ones who have the
money to lend.

B.
Financial markets benefit consumers.
Moving Funds from Lenders to Borrowers


Budget positions

Balanced budget: income and expenditures are equal

Surplus budget: income exceeds expenditures

Deficit budget: expenditures exceed income
The primary concern of the financial system is funneling money from surplus
spending units (SSUs) to deficit spending units (DSUs).
2.2

Direct funds flow, or

Indirect funds flow (intermediation)
Direct Financing
Financial markets perform the important function of channeling funds from people who
have surplus funds (SSUs) to businesses (DSUs) that need money for capital projects.
A.
Direct Financial Markets—wholesale markets in which the minimum transaction
size is $1 million or more.

Investment Banks—firms that specialize in helping companies sell new debt
or equity issues in the public or private security markets.
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
Money Center Banks—large commercial banks located in major U.S.
financial centers that transact in both the national and international money
markets.

Underwriting—a basic investment banking service is to assist firms in the
sale of debt or equity in the primary market. To underwrite a new security
issue, the investment banker buys the entire issue at a guaranteed price
from the issuing firm and resells the securities to institutional investors
and the public.
2.3
Types of Financial Markets
A.
Primary Market—any financial market in which new security issues are sold for
the first time.
B.
Secondary Market—any financial market in which the owners of outstanding
securities can resell them to other investors.

Investors are willing to pay higher prices for securities in primary markets if
the securities have active secondary markets.

The ease with which a security can be sold and converted into cash is called
marketability.

The ability to convert an asset into cash quickly without loss of value is called
liquidity.
C.
Brokers versus Dealers

Brokers—market specialists who bring buyers and sellers together in
secondary markets.
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
They execute transactions for their clients and are compensated for
their services with a commission fee.

They bear no risk of ownership of the securities in the transactions;
their only service is that of a “matchmaker.”

Dealers—“make markets” for securities and do bear risk.

They make a market for a security by buying and selling from an
inventory of securities they own. The risk is that they will not be
able to sell a security for more than they paid for it.

Securities Exchanges

Organized Exchanges—provide a physical meeting place and
communication facilities for members to conduct business under a
specific set of rules and regulations. Only members can use the
exchange, and each exchange has a limited number of seats.


New York Stock Exchange (NYSE)

American Stock Exchange

Pacific Stock Exchange

Chicago Stock Exchange

Philadelphia Stock Exchange
Over-the-Counter (OTC) Markets—have no central trading location,
as the NYSE has. Instead, investors can execute OTC transactions by
visiting or telephoning an OTC dealer or by using a computer-based
electronic trading system linked to the OTC dealer.
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A.
Money Markets—a collection of markets with no formal organization or location,
each trading distinctly different financial instruments. Financial instruments sold
in money markets have very short maturities, usually overnight to 180 days, are
highly marketable in that they can be easily converted into cash, and are issued by
economic units of the highest credit standing.

Instruments include U.S. Treasury bills, negotiable CDs, and commercial
paper.
B.
Capital Markets—that segment of the marketplace where capital goods, such as
plant and equipment, are financed with equities or long-term debt.
C.
Public and Private Markets

Public markets are organized financial markets where the general public
buys and sells securities through their stockbroker.

Private markets involve direct transactions between two parties.
Transactions in private markets are called private placements.
D.
Futures and Options Markets—are often called derivative securities because
they derive their value from some underlying asset.

Futures Contracts—contracts for future delivery of securities, foreign
currencies, interest rates, or commodities.

Options Contracts—call for one party (the option writer) to perform a
specific act if called upon to do so by the option buyer or owner.
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2.4
The Stock Market
A. The New York Stock Exchange
a. Founded in 1792, the NYSE is the oldest, largest, and best known traditional
securities exchange in the United States.
B. NASDAQ
a. NASDAQ is the world’s largest electronic stock market, listing nearly four
thousand companies. It was created in 1971 by the National Assoc. of Securities
Dealers
C. Stock Market Indexes
a. These are used to measure the performance of the stock market – whether stock
prices on average are moving up or down. A wide variety of general and
specialized indexes is available.

Stock Market Indexes—used to measure the performance of the stock
market—whether stock prices on average are moving up or down.

Dow Jones Industrial Average—consists of 30 companies that represent about
20 percent of the market value of all U.S. stocks.

Standard and Poor’s 500 Index—is regarded as the best index for measuring
the performance of the largest companies in the U.S. economy. It represents
about 80 percent of the total market capitalization of all stocks on the NYSE.

NASDAQ Composite Index—consists of all of the common stocks listed on
the National Association of Securities Dealers Automatic Quotation System
(hence NASDAQ) of over 5,000 firms.
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2.5
Financial Institutions and Indirect Financing
A.
Indirect Financing—when a financial intermediary such as a commercial bank or
insurance company stands between the SSU and the DSU.
B.
Financial Institutions and Their Services
a. Commercial Banks—are the most prominent and largest financial intermediaries
in the economy and offer the widest range of financial services to businesses.

The major sources of funds for commercial banks are consumers:
checking accounts, savings accounts, and a variety of time deposits. The
banks accumulate these funds and make a variety of loans to consumers,
businesses, and governments.

They also do a significant amount of equipment lease financing.
b. Life Insurance Companies—obtain funds by selling life insurance policies that
protect individuals against the loss of income from a family member’s premature
death.

Provide funding to public corporations through the purchase of stocks and
bonds in the direct credit markets and to closely held corporations through
direct placement financing.
c. Casualty Insurance Companies—sell protection against loss of property from
fire, theft, accidents, negligence, and other predictable causes.
d. Pension Funds—provide retirement programs for businesses as part of their
employee benefit programs. They obtain money from employee and employer
contributions during the employee’s working years, and they provide monthly
payments upon retirement.
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e. Investment Funds—sell shares to investors and use the funds to purchase a wide
range of direct and indirect financial instruments.
f. Business Finance Companies—sell short-terms IOUs, called commercial paper,
to investors in the direct credit markets, where these funds are used to make a
variety of short- and intermediate-term loans and leases to small and large
businesses.
2.6
The Determinants of Interest Rate Levels
A. The Real Rate of Interest—a long-term interest rate determined in the absence of
inflation.

The determinants of the real rate are a firm’s return on investment as well as
the time preference for consumption.
B. Money, Inflation, and Purchasing Power

The value of money is its purchasing power.

There is an inverse relationship between changes in price level and the value
of money.
C. Inflation and Loan Contracts—the real rate of interest ignores inflation.

Lenders must incorporate anticipated inflation into lending contracts;
otherwise they may lose purchasing power when the loan is repaid.
D. Inflation Premiums—lenders can incorporate protection against changes in buying
power due to inflation in a loan contract.

Nominal Rate = Real Rate of interest + Expected Changes in Commodity
Prices

Realized rate of return = Nominal Rate – Actual Rate of Inflation
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E. The Fisher Equation and Inflation

How do we write a loan contract that provides protection against loss of
purchasing power due to inflation?

To incorporate “inflation expectations” into a loan contract we need to adjust
the real rate of interest by amount of inflation expected during the contract
period
o The mathematical formula for this is called the Fisher Equation
F. Cyclical and Long-Term Trends in Interest Rates

Interest rates tend to follow the business cycle—during periods of
economic expansion, interest rates tend to rise; during a recession, the
opposite tends to occur.

Inflationary expectations have a major impact on interest rates.
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