Download Chapter 7: The Financial System and Interest

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Slides Developed by:
Terry Fegarty
Seneca College
The Financial System
and Interest
Chapter 7 – Outline (1)
• The Financial System
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Raising and Spending Money in Business
Term
Financial Markets
Capital and Money Markets
Primary and Secondary Markets
Transfer of Funds from Investors to Businesses
Financial Intermediaries
• The Stock Market and Stock Exchanges
 Trading—The Role of Brokers
 Market Regulation
 Process of Going Public
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Chapter 7 – Outline (2)
• Interest
 The Relationship Between Interest and the Stock
Market
 Interest and the Economy
 Supply and Demand for Money
• The Components of an Interest Rate
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Different Kinds of Lending Risk
Putting the Pieces Together
Risk Free and Real Rates
The Risk-Free Rate
The Real Rate of Interest
Yield Curves—The Term Structure of Interest Rates
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The Financial System
• Producers/Borrowers
 Companies need to raise money to finance
business activities
• Savers/investors
 People need a place to deposit their savings
and to earn a return
• The financial system facilitates the flow of
savings from savers to borrowers
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The Financial System
• Financial markets connect producers’
need for money with investors’ available
savings
 Buyers and sellers of securities meet in
financial marketplace
• Companies issue shares or bonds to raise money
• Savers purchase these securities hoping to earn
return on their savings (investment)
• Return comes as interest from bonds or
dividends and price appreciation from shares
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Raising and Spending Money in
Business
• Businesses spend money on:
 Day-to-day operations (inventory, wages, etc.)
• Money for these operations comes from generating revenue
 Capital investments (new capital assets such as
new production line, expansion overseas, etc.)
• Money is raised for capital investments in the financial
marketplace
• Borrowed money is debt financing
• Money raised through the sale of shares is equity
financing
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Term
• Term—length of time between now and end (or
termination) of something
• Maturity matching
 Long-term projects (typically those lasting over 510 years) are usually financed with long-term funds
• Debt (bonds)
• Equity
 Short-term projects (typically those lasting less
than 1 year) are usually financed with short-term
funds
• Bank loans
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Financial Markets
• Vehicles through which financial securities
are bought, sold, and traded
• Financial markets may be classified as:
 Capital or money markets
 Primary or secondary markets
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Capital and Money Markets
• Capital Markets
 Market for shares and long-term debt
• Money Markets
 Market for short-term, high-quality debt
securities with maturities of 1-year or less
 Marketable securities such as commercial
paper, notes, bills
• Federal government issues Treasury bills
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Primary and Secondary
Markets
• Primary Market
 Issuers sell new securities to investors
• Secondary Market
 Investors sell existing securities to other
investors
 Most transactions occur in the secondary
market
 Corporations don’t raise money in the secondary
market
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Transfer of Funds From
Investors to Businesses
• Primary market transactions can occur
 Directly (issuing firm sells securities to investors
through an investment dealer)
• Helps companies market their securities
 Indirectly (issuing firm sells securities to an
institutional investor—such as a mutual fund
• Mutual fund buys securities and sells shares in the fund to
buyers)
• Mutual fund owns specific stocks/bonds
• Investor in mutual fund owner owns shares in the fund
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Transfer of Funds
From Investors to Businesses
Figure 7.2:
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Financial Intermediaries
• Institutional investors
 Mutual funds and similar financial
intermediaries
 Play major role in financial markets
• Own ¼ of all stocks but make over ¾ of all trades
 Examples include
• Mutual funds
• Pension funds
• Insurance companies
• Banks and trust companies
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The Stock Market and Stock
Exchanges
• Stock market—network of exchanges
and brokers
 Exchange—physical or electronic
marketplace (TSX, OTC, NYSE)
 Brokers—individuals who assist people in
buying and selling securities
• Work for brokerage firms
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The Stock Market and Stock
Exchanges
• Security Exchanges (Example: TSX)
 Financial marketplace with specific
requirements for listing and trading securities
 Often are associated with a market index
(i.e. TSX, Dow Jones, S&P 500, NASDAQ)
• Over-the-counter (OTC) Market
 Public stock issues not traded on stock
exchange
 Dealers act as market makers
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Trading—The Role of Brokers
• What brokers do…
 Investor will open an account with a broker
and place trades via telephone or online
 On TSX, buy and sell orders are matched
electronically by exchange’s computerized
system
 Specialists make markets in designated
securities
 Confirmation of trade is forwarded to local
broker and investor
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Market Regulation
• 10 provinces and three territories
regulate own securities markets
 Ontario Securities Commission—the most
influential because it has the most investors
and companies within its jurisdiction
• Securities law is primarily aimed at
disclosure and prevention of unfair
trading practices
 For example, unfair use of insider
information
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Process of Going Public (1)
• Assume a business is successful and the owner
decides to raise money for expansion selling
shares to others
 Privately (closely) held companies—sale of
securities severely restricted by regulation
 Publicly traded (public) companies—have
received approval of the Securities Commission to
offer securities to general public
• Process of obtaining approval and registration is known as
‘going public’
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Process of Going Public (2)
• The Prospectus
 Use investment dealer to determine
• If a market exists for shares of company
• The likely issue price for shares
 Develop prospectus—provides detailed
information about company
• Financial statements
• Key executives/background
 Provincial Securities Commission reviews
prospectus
• Prospectus not yet approved is called preliminary
or a red herring
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Process of Going Public (3)
• The IPO
 Once prospectus approved by SC, securities can be
sold to public
• Initial sale is known as initial public offering (IPO)
• Market for IPOs very volatile and risky
• Prices can rise (or fall) very dramatically
 Investment dealers usually line up buyers prior to
actual sale of securities
• Buyers are usually institutional investors (bought deal)
 IPO occurs in primary market
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Process of Going Public (4)
• The OTC Market
 After company goes public, its shares are
usually traded in over-the-counter (OTC)
market
 Nation-wide computerized network of brokers
dealing in shares of small companies
• In U.S., The National Association of Securities
Dealers Automated Quotation System (NASDAQ)
 OTC trades are secondary market
transactions
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Process of Going Public (5)
• Stock Exchange Listing
 Eventually firm may wish to be listed on a
stock exchange (ex; TSX)
 Easier to sell future share issues
 Must meet exchange’ requirements for size
and length of time in business
 Becomes listed company
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Stock Market
Quotation for CIBC, Tuesday,
June 22, 2004
Figure 7.5:
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Interest
• Interest rates—the return on a debt
instrument (for example, a bond)
 Issuer of bond (borrower) pays interest to
investor (lender)
 There are many interest rates, including the
prime rate, the bank rate, etc.
• Interest rates tend to move in tandem
 Debt instruments are loans with a specified
term (maturity date)
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The Relationship Between
Interest and the Stock Market
• The stock market reacts to changes in interest
rates
• Shares (equity) and bonds (debt) compete for
investor’s dollars
 Shares offer higher returns but have more risk
• If interest rates go up, bonds become more
attractive
• The required return on shares would rise and
therefore the price of shares would drop in the
market
 Interest rates and share prices move in opposite
directions
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Interest and the Economy
• Would you be more likely to buy a
house/car when interest rates are high or
low?
• Interest rates have significant effect on
the economy
 Interest rates represent the cost of borrowing
money (credit)
 Lower interest rates stimulate business and
economic activity
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Supply and Demand for Money
• Interest rates set by supply and demand
in debt markets
• Supply—funds from those willing to lend
money
 Lenders (investors) buy debt securities
such as bills, notes and bonds
 Supply of borrowed funds depends on their
willingness to invest their savings
• Affected by changes in the economy
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Supply and Demand for Money
• Demand—people, companies and
governments desiring to borrow money
 Borrowers sell bonds, etc.
• Demand for borrowed funds depends on
 Opportunities available to use these funds
 Attitudes of people and businesses about
using credit
• If people feel good about the economy they will
go on vacation, buy houses and cars, etc.
• Businesses will borrow for expansion and new
projects
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Supply and Demand for Money
• The price—the interest rate
 Borrowers will borrow more when interest
rates low
 Lenders will lend more (buy more bonds)
when interest rates high
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The Components of an Interest
Rate
• Interest rates include base rates and risk
premiums
• Interest rate = k
 k = base rate + risk premium
• Base Rate
 Pure interest rate
 Inflation adjustment
• Premium for Lender’s risk
 Default risk
 Liquidity risk
 Maturity risk
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The Components of an Interest
Rate
• The Base Rate
 Base rate is pure interest plus expected
inflation
• Rate at which people lend money when no risk is
involved
 Pure interest rate is rent paid to lenders
for the use of their money
• An abstract rate that would exist in a perfect
economy with no inflation or risk
• Generally considered to be between 2% and 4%
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The Components of an Interest
Rate
• The Inflation Adjustment
 Inflation—general increase in prices
• Money loses some of its value
 If you loaned someone $100 at the beginning
of the year, you need to be compensated for
what you expect inflation to be during the
year
 Lender must charge interest rate higher than
inflation rate
• Interest rates include estimates of average annual
inflation over loan periods
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The Components of an Interest
Rate
• Risk Premiums
 Some loans are more risky than others
 Lenders demand a risk premium of extra
interest for making risky loans
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Different Kinds of Lending Risk
• Default Risk
 The chance the borrower won't pay principal
or interest, or will repay late
• Losses can be portion of or entire amount
 Lenders demand a default risk premium
which depends on lender’s perception of
creditworthiness of the borrower
• Perception is based on the borrower’s financial
condition and credit record
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Different Kinds of Lending Risk
• Liquidity Risk
 Bond lending losses can be associated with
fluctuations in prices of bonds
 Associated with being unable to sell the bond of
little known issuer
 Sellers may have to reduce their prices to encourage
investors to buy the illiquid securities
 Liquidity risk premium is extra interest demanded
by lenders as compensation for bearing liquidity risk
 Very short-term securities (ex; commercial paper)
usually bear little liquidity risk
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Different Kinds of Lending Risk
• Maturity Risk
 Bond prices and interest rates move in opposite
directions
 If interest rates increase after an investor purchases
a bond, its price will decline
• The investor will take a loss if he or she sells before maturity
 Long-term bond prices change more with interest
rate swings than short-term bond prices
• Gives rise to maturity risk
 Investors demand a maturity risk premium
• Ranges from 0% for short-term securities to 2% or more for
long-term issues
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Putting the Pieces Together
• The Interest Rate Model
 k = kPure Interest Rate + Inflation + Default Risk
Premium + Liquidity Risk Premium +
Maturity Risk Premium
 k—the nominal or quoted interest rate
 Model explains interest rate needs of
investors
 However, rates set by supply and demand
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Risk-Free and Real Rates
• Federal Government Securities
 Federal government issues many short-term
securities
• Treasury bills and short-term bonds
• Treasury bills have terms from 90 days to a year
• ST bonds have terms from 1 to 10 years
 No default risk associated with federal government
debt
• Can print money to pay off its debt
 No liquidity risk for federal government debt
• Always an active market
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The Risk-Free Rate
• The risk-free rate is approximately the
yield on short-term Treasury bills
 Includes the pure rate and an allowance for
inflation
• Same as the base rate discussed earlier
• Viewed as current minimum interest
rate
 No investment that does have risk can offer a
lower rate
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The Real Rate of Interest
• The real interest rate is current interest
rate less inflation adjustment
• Tells investors whether or not they are
getting ahead
 If you earn a real rate of 8% on investment and
inflation is 10%, you are losing purchasing power on
investment
• The Real Risk-Free Rate
 Implies that both the inflation adjustment and the
risk premium are zero
 = the pure interest rate
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Yield Curves—The Term
Structure of Interest Rates
• Interest rates generally vary with term of debt
 The relationship is known as the term structure of
interest rates
 The yield curve is a graph of interest rates
compared to terms for similar loans
• Most of the time short-term rates are lower
than long-term rates (normal yield curve)
 At times opposite is true
• Known as an inverted yield curve
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Figure 7.6:
Yield Curves
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Yield Curves—The Term
Structure of Interest Rates
• Theories to explain the term structure of
interest rates
 Expectations theory
• Today's rates rise or fall with term as future rates are
expected to rise or fall
 Liquidity preference theory
• Lenders prefer shorter term loans and must receive higher
interest rates to make longer loans
 Market segmentation theory
• Loan terms define independent segments of the debt market
which set separate rates
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