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Copyright 2002 by Harcourt, Inc. All rights reserved.

CHAPTER 5The Financial Environment:Markets, Institutions,

and Interest Rates

Financial markets

Types of financial institutions

Determinants of interest rates

Yield curves

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Define these markets

Markets in general

Markets forphysical assetsMarkets forfinancial assets

Money versus capital markets

Primary versus secondary markets

Spot versus future markets

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Direct transfer

Through an investment banking

houseThrough a financial intermediary

Three Primary Ways Capital Is

Transferred Between Savers andBorrowers

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The Top 5 Banking Companies

in the World, 1999

$580 billionJapanBank of Tokyo

$618 billionUnited StatesBank of America

$669 billionUnited StatesCitigroup

$687 billionSwitzerlandUBS Group$735 billionGermanyDeutsche Bank AG

Total assetsCountryBank Name

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What do we call the price, or cost,ofdebt capital?

The interest rate

What do we call the price, or cost,ofequity capital?

Required Dividend Capitalreturn yield gain

= + .

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What four factors affect the cost

of money?

Production opportunitiesTime preferences for consumption

Risk

Expected inflation

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Real versus Nominal Rates

k* = Real risk-free rate.

T-bond rate if no inflation;1% to 4%.

= Any nominal rate.

= Rate on Treasury securities.

k

kRF

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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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Premiums Added to k* for Different

Types of Debt

ST Treasury: only IP for ST inflation

LT Treasury: IP for LT inflation, MRP

ST corporate: ST IP, DRP, LPLT corporate: IP, DRP, MRP, LP

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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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Treasury Yield Curve

0

5

10

15

10 20 30

Years to Maturity

Interest

Rate (%)1 yr 6.3%

5 yr 6.7%

10 yr 6.5%

30 yr 6.2%Yield Curve

(May 2000)

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Yield Curve Construction

Step 1: Find the average expected

inflation rate over years 1 to n:n

INFLt t = 1

nIPn = .

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IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.5%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.

Must earn these IPs to break evenversus inflation; that is, these IPswould permit you to earn k* (beforetaxes).

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Step 2: Find MRP based on thisequation:

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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Step 3: Add the IPs and MRPs to k*:

kRFt = k* + IPt + MRPt .

kRF = Quoted market interestrate on treasury securities.

Assume k* = 3%:

kRF1 = 3% + 5% + 0.0% = 8.0%.

kRF10 = 3% + 7.5% + 0.9% = 11.4%.

kRF20 = 3% + 7.75% + 1.9% = 12.65%.

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Hypothetical Treasury Yield Curve

0

5

10

15

1 10 20

Years to Maturity

Interest

Rate (%)1 yr 8.0%

10 yr 11.4%

20 yr 12.65%

Real risk-free rate

Inflation premium

Maturity risk premium

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What factors can explain the shape of

this yield curve?

This constructed yield curve isupward sloping.

This is due to increasing expectedinflation and an increasing

maturity risk premium.

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What kind of relationship existsbetween the Treasury yield curve andthe yield curves for corporate issues?

Corporate yield curves are higher thanthat of the Treasury bond. However,corporate yield curves are not neces-sarily parallel to the Treasury curve.

The spread between a corporate yieldcurve and the Treasury curve widensas the corporate bond ratingdecreases.

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Hypothetical Treasury and

Corporate Yield Curves

0

5

10

15

0 1 5 10 15 20

Years to

maturity

InterestRate (%)

5.2% 5.9%

6.0%Treasury

yield curve

BB-Rated

AAA-Rated

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How does the volume of corporatebond issues compare to that of

Treasury securities?

Recently, the volume of investment grade corporatebond issues has overtaken Treasury issues.

95 96 97 98 99

600

450

300

150

Gross U.S. Treasury Issuance (in blue)

Investment Grade Corporate Bond

Issuance (in red)

Billionsofdo

llars

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The Pure Expectations Hypothesis

(PEH)

Shape of the yield curve depends

on the investors expectationsabout future interest rates.

If interest rates are expected to

increase, L-T rates will be higherthan S-T rates and vice versa.Thus, the yield curve can slope upor down.

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PEH assumes that MRP = 0.

Long-term rates are an average ofcurrent and future short-term rates.

If PEH is correct, you can use theyield curve to back out expectedfuture interest rates.

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Observed Treasury Rates

If PEH holds, what does the market expectwill be the interest rate on one-yearsecurities, one year from now? Three-yearsecurities, two years from now?

6.5%5 years6.5%4 years6.4%3 years

6.2%2 years6.0%1 yearYieldMaturity

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0 1 2 5

6.0%

3 4

x%

6.2%

PEH tells us that one-year securities willyield 6.4%, one year from now (x%).

6.2% =

12.4% = 6.0 + x%

6.4% = x%.

(6.0% + x%)2

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0 1 2 5

6.2%

3 4

x%

6.5%[ 2(6.2%) + 3(x%) ]

5

PEH tells us that three-year securitieswill yield 6.7%, two years from now (x%).

6.5% =32.5% = 12.4% + 3(x%)

20.1% = 3(x%)

6.7% = x%.

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Some argue that the PEH isnt correct,because securities of differentmaturities have different risk.

General view (supported by mostevidence) is that lenders prefer S-Tsecurities, and view L-T securities as

riskier.Thus, investors demand a MRP to get

them to hold L-T securities (i.e., MRP> 0).

Conclusions about PEH

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What various types of risks arise

when investing overseas?

Country risk: Arises from investing ordoing business in a particular country.

It depends on the countrys economic,political, and social environment.

Exchange rate risk: If investment is

denominated in a currency other thanthe dollar, the investments value willdepend on what happens to exchangerate.

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Two Factors Lead to Exchange

Rate Fluctuations

Changes in relative inflation willlead to changes in exchange rates.

An increase in country risk will

also cause that countrys currencyto fall.

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