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CHAPTER 4

The Financial Environment:Markets, Institutions, and InterestRates

Financial markets

Types of financialinstitutions

Determinants of interest

rates

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What is a market? A market is a venue where goods

and services are exchanged.

A financial market is a place whereindividuals and organizationswanting to borrow funds are

brought together with those havinga surplus of funds.

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Types of financial markets Physical assets vs. Financial assets

Money vs. Capital

Primary vs. Secondary

Spot vs. Futures

Public vs. Private

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How is capital transferred

between savers and borrowers? Direct transfers

Investment

banking house Financial

intermediaries

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Types of financial

intermediaries Commercial banks

Savings and loan associations

Mutual savings banks

Credit unions

Pension funds Life insurance companies

Mutual funds

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Physical location stockexchanges vs. Electronic

dealer-based markets Auction market

vs. Dealer market

(Exchanges vs.OTC)

NYSE vs. Nasdaq

Differences arenarrowing

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The cost of moneyThe price, or cost, of debt capital

is the interest rate.

The price, or cost, of equitycapital is the required return.

The required return investors

expect is composed ofcompensation in the form ofdividends and capital gains.

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What four factors affect the

cost of money? Production

opportunities

Time preferencesfor consumption

Risk

Expected inflation

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Nominal vs. Real ratesk = represents any nominal rate

k* = represents the real risk-free rate of interest. Like a T-bill rate, if there was noinflation. Typically ranges from1% to 4% per year.

kRF = represents the rate of

interest on Treasury securities.

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Determinants of interest

ratesk = k* + IP + DRP + LP + MRP

k = required return on a debt security

k* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premiumLP = liquidity premium

MRP= maturity risk premium

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Premiums added to k* for

different types of debt

L-TCorporate

S-TCorporate

L-T Treasury

S-T Treasury

LPDRPMR

P

IP

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Yield curve and the term

structure of interest rates Term structure

relationshipbetween interestrates (or yields)and maturities.

The yield curve is agraph of the term

structure. A Treasury yield

curve from October2002 can be

viewed at the right.

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Hypothetical yield curve An upward

sloping yield

curve. Upward slope due

to an increase inexpected inflation

and increasingmaturity riskpremium.Years to

Maturity

Real risk-free rate

0

5

10

15

1 10 20

Interest

Rate (%)

Maturity risk premium

Inflation premium

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What is the relationship betweenthe Treasury yield curve and the

yield curves for corporate issues? Corporate yield curves are higher

than that of Treasury securities,

though not necessarily parallel tothe Treasury curve.

The spread between corporate and

Treasury yield curves widens asthe corporate bond ratingdecreases.

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Illustrating the relationshipbetween corporate and Treasury

yield curves

0

5

10

15

0 1 5 10 15 20

Years toMaturity

InterestRate (%)

5.2% 5.9%6.0%

Treasury

Yield Curve

BB-Rated

AAA-Rated

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Other factors that influence

interest rate levels Federal reserve policy

Federal budget surplus or deficit

Level of business activity

International factors

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Risks associated with investing

overseas Exchange rate risk If an

investment is denominatedin a currency other than

U.S. dollars, theinvestments value willdepend on what happens toexchange rates.

Country risk Arises frominvesting or doing businessin a particular country anddepends on the countryseconomic, political, andsocial environment.

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Factors that cause exchange

rates to fluctuate Changes in

relative

inflation Changes in

country risk