Tài chính doanh nghiệp - Chapter 4: The financial environment: markets, institutions, and interest rates

CHAPTER 4The Financial Environment: Markets, Institutions, and Interest RatesFinancial marketsTypes of financial institutionsDeterminants of interest ratesYield curvesWhat 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.Types of financial marketsPhysical assets vs. Financial assetsMoney vs. CapitalPrimary vs. SecondarySpot vs. FuturesPublic vs. PrivateHow is capital transferred between savers and borrowers?Direct transfersInvestment banking houseFinancial intermediariesTypes of financial intermediariesCommercial banksSavings and loan associationsMutual savings banksCredit unionsPension fundsLife insurance companiesMutual fundsPhysical location stock exchanges vs. Electronic dealer-based marketsAuction market vs. Dealer market (Exchanges vs. OTC)NYSE vs. NasdaqDifferences are narrowingThe cost of moneyThe price, or cost, of debt capital is the interest rate.The price, or cost, of equity capital is the required return. The required return investors expect is composed of compensation in the form of dividends and capital gains.What four factors affect the cost of money?Production opportunitiesTime preferences for consumptionRiskExpected inflation“Nominal” vs. “Real” ratesk = represents any nominal ratek* = represents the “real” risk-free rate of interest. Like a T-bill rate, if there was no inflation. Typically ranges from 1% to 4% per year.kRF = represents the rate of interest on Treasury securities.Determinants of interest ratesk = k* + IP + DRP + LP + MRPk = required return on a debt securityk* = real risk-free rate of interestIP = inflation premiumDRP = default risk premiumLP = liquidity premiumMRP = maturity risk premiumPremiums added to k* for different types of debtIPMRPDRPLPS-T TreasuryL-T TreasuryS-T CorporateL-T CorporateYield curve and the term structure of interest ratesTerm structure – relationship between interest rates (or yields) and maturities.The yield curve is a graph of the term structure.A Treasury yield curve from October 2002 can be viewed at the right.Constructing the yield curve: InflationStep 1 – Find the average expected inflation rate over years 1 to n:Constructing the yield curve:InflationSuppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP1 = 5% / 1 = 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).Constructing the yield curve: InflationStep 2 – Find the appropriate maturity risk premium (MRP). For this example, the following equation will be used find a security’s appropriate maturity risk premium.Constructing the yield curve: Maturity RiskUsing the given equation: MRP1 = 0.1% x (1-1) = 0.0% MRP10 = 0.1% x (10-1) = 0.9% MRP20 = 0.1% x (20-1) = 1.9%Notice that since the equation is linear, the maturity risk premium is increasing in the time to maturity, as it should be.Add the IPs and MRPs to k* to find the appropriate nominal ratesStep 3 – Adding the premiums to k*.kRF, t = k* + IPt + MRPtAssume k* = 3%,kRF, 1 = 3% + 5.0% + 0.0% = 8.0%kRF, 10 = 3% + 7.5% + 0.9% = 11.4%kRF, 20 = 3% + 7.75% + 1.9% = 12.65%Hypothetical yield curveAn upward sloping yield curve.Upward slope due to an increase in expected inflation and increasing maturity risk premium.Years to MaturityReal risk-free rate0510151 10 20InterestRate (%)Maturity risk premiumInflation premiumWhat is the relationship between the Treasury yield curve and the yield curves for corporate issues?Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve.The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.Illustrating the relationship between corporate and Treasury yield curves051015015101520Years toMaturityInterest Rate (%)5.2%5.9%6.0%TreasuryYield CurveBB-RatedAAA-RatedPure Expectations HypothesisThe PEH contends that the shape of the yield curve depends on investor’s 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, down, or even bow.Assumptions of the PEHAssumes that the maturity risk premium for Treasury securities is zero.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.An example:Observed Treasury rates and the PEH Maturity Yield 1 year 6.0% 2 years 6.2% 3 years 6.4% 4 years 6.5% 5 years 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?One-year forward rate 6.2% = (6.0% + x%) / 2 12.4% = 6.0% + x% 6.4% = x%PEH says that one-year securities will yield 6.4%, one year from now.Three-year security, two years from now 6.5% = [2(6.2%) + 3(x%) / 5 32.5% = 12.4% + 3(x%) 6.7% = x%PEH says that one-year securities will yield 6.7%, one year from now.Conclusions about PEHSome would argue that the MRP ≠ 0, and hence the PEH is incorrect.Most evidence supports the general view 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).Other factors that influence interest rate levelsFederal reserve policyFederal budget surplus or deficitLevel of business activityInternational factorsRisks associated with investing overseasExchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates.Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.Factors that cause exchange rates to fluctuateChanges in relative inflationChanges in country risk