Chapter 2 Financial Markets & Institution

CHAPTER 2

Financial Markets and Institutions

„ The Capital Allocation Process „ Financial markets

„ Financial institutions

„ Stock Markets and Returns

„ Determinants of interest rates

The Capital Allocation Process

„ In a well-functioning economy, capital flows

efficiently from those who supply capital to those who demand it.

„ Suppliers of capital – individuals and institutions with

“excess funds”. These groups are saving money and looking for a rate of return on their investment.

„ Demanders or users of capital – individuals and

institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

How is capital transferred between

savers and borrowers?

„ Direct transfers „ Investment

banking house

„ Financial

„ Direct transfer (e.g., corporation issues

commercial paper to insurance company)

„ Through an investment banking house (e.g.,

IPO, seasoned equity offering, or debt placement)

„ Through a financial intermediary (e.g.,

individual deposits money in bank, bank makes commercial loan to a company)

What are three ways that capital

is transferred between savers

Cash

Cash

Securities

Securities

„ Direct Transfer of Funds

saver firm

Transferring Capital

Funds

Funds

„ Indirect Transfer using Investment Banker Securities Securities Funds Funds Securities Securities saver investment banker firm

Transferring Capital

Transferring Capital

Investment Banking

Investment Banking

How do investment bankers

help firms issue securities?

Advising the firm.

Underwriting the issue.

Distributing the issue.

Funds

Funds

„ Indirect Transfer using a Financial Intermediary Intermediary Intermediary Securities Securities Funds Funds Firm Firm Securities Securities financial intermediary firm saver

Transferring Capital

Transferring Capital

What 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 markets

„ Physical assets vs. Financial assets „ Money vs. Capital

„ Primary vs. Secondary „ Spot vs. Futures

Physical assets vs. Financial assets

tangible or real asset markets, such as real estates, autos, computers and

machinery.

„ Financial asset markets deal with

stocks, bonds, and other claims on assets are traded in the financial markets.

Money vs. Capital

„ Money markets: The financial markets in

which funds are borrowed or loaned for short period.

„ Commercial paper, Treasury bill.

„ Capital markets are the markets for

long-term debt and corporate stocks.

„ The New York Stock Exchange is an example of a capital market.

Primary vs. Secondary

„ Primary markets are markets in which

corporations raise capital by issuing new securities

„ Secondary markets are markets in

which securities and other financial

assets are traded among investors after they have been issued by corporations.

Spot vs. Futures

„ Spot markets are markets in which

assets are bought or sold for “on-the-spot” delivery

„ Futures markets are markets in which

participants agree today to buy or sell an asset at some future date.

Private vs. Public

„ Private markets, where transactions

are worked out directly between two parties

„ Public markets, where standardized

contracts are traded on organized exchanges.

The importance of financial

markets

„ Well-functioning financial markets facilitate the flow

of capital from investors to the users of capital.

„ Markets provide savers with returns on their money

saved/invested, which provides them money in the future.

„ Markets provide users of capital with the necessary funds

to finance their investment projects.

„ Well-functioning markets promote economic

growth.

„ Economies with well-developed markets perform

better than economies with poorly-functioning markets.

What are derivatives? How can they be used to reduce or increase risk?

„ A derivative security’s value is “derived” from the

price of another security (e.g., options and futures).

„ Can be used to “hedge” or reduce risk. For

example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens.

„ Also, speculators can use derivatives to bet on the

direction of future stock prices, interest rates,

exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess

Financial Intermediary

„ An organization that raises money from

investors and provides financing for individuals, corporations, or other organizations.

„ Commercial banks

„ Savings & Loans, mutual savings

banks, and credit unions

„ Life insurance companies „ Pension funds

„ Mutual funds

Financial Intermediaries

Financial Intermediaries

Pension fund

„ Investment plan set up by an employer

to provide for employees’ retirement.

„ Designed for long-run investment.

„ Provide professional management &

diversification.

„ Tax advantage: contributions are

tax-deductible, & investment returns inside the plan are not taxed until cash is

Pension funds

„ The EPF is a scheme which provides

retirement benefits for members through management of their savings in an efficient and reliable manner.

„ The EPF also provides a convenient

framework for employers to meet their statutory and moral obligations to their employees.

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Mutual Fund

„ Corporations that pool investor funds to

purchase financial instruments and thus reduce risks through diversification.

„ Achieve economies of scale in analyzing

securities, managing portfolios, and buying and selling securities.

„ Different funds are designed to meet the

Question

„ As an investor has two options:

1. Buy bonds and stocks directly.

2. Invest money in a mutual fund or a pension fund.

„ What are the advantages of the second

Physical location stock exchanges

vs. Electronic dealer-based markets

„ Auction market vs. Dealer market (Exchanges vs. OTC) „ NYSE vs. Nasdaq „ Differences are narrowing

Stock Market Transactions

„ Apple Computer decides to issue additional stock

with the assistance of its investment banker. An investor purchases some of the newly issued

shares. Is this a primary market transaction or a secondary market transaction?

„ Since new shares of stock are being issued, this is a

primary market transaction.

„ What if instead an investor buys existing shares of

Apple stock in the open market – is this a primary or secondary market transaction?

„ Since no new shares are created, this is a secondary

What is an IPO?

„ An initial public offering (IPO) is where a

company issues stock in the public market for the first time.

„ “Going public” enables a company’s owners

to raise capital from a wide variety of

outside investors. Once issued, the stock trades in the secondary market.

„ Public companies are subject to additional

Historical stock market performance,

S&P 500 (1968-2004)

Where can you find a stock quote,

and what does one look like?

„ Stock quotes can be found in a variety of print sources (Wall

Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).

Interest Rates

Interest Rate

Interest Rate

Determinants

Determinants

„ What do we call the price, or cost, of

debt capital?

The interest rate

„ What do we call the price, or cost, of

equity capital?

Required Dividend Capital return yield gain= + .

What four factors affect the

level of interest rates?

„ Production

opportunities

„ Time preferences for

consumption

„ Risk

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What four factors affect the level

of interest rates?

1. Production opportunities

„ The returns available within an economy from investment

in productive (cash-generating) assets.

2. Time preferences for consumption

„ The preferences of consumers for current consumption as

opposed to saving for future consumption.

3. Risk

„ The chance that an investment will provide a low or

negative return.

4. Expected Inflation

„ The higher the expected rate of inflation, the larger the

“Nominal”

vs. “Real”

rates

r = represents any nominal rate

r* = 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. r_RF = represents the rate of interest on

Determinants of interest rates

r = r* + IP + DRP + LP + MRP r = required return on a debt security r* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premium

LP = liquidity premium

Premiums added to r* for

different types of debt

IP MRP DRP LP

S-T Treasury 9

L-T Treasury 9 9

S-T Corporate 9 9 9

Yield curve and the term

structure of interest rates

„ Term structure –

relationship between interest rates (or

yields) and maturities.

„ The yield curve is a

graph of the term structure.

„ The November 2005

Treasury yield curve

is shown at the right. 0

1 2 3 4 5 6 0.25 0.5 2 5 10 30 Maturity (years) Yield (%)

Constructing the yield curve:

Inflation

„ Step 1 – Find the average expected inflation

rate over years 1 to N:

N INFL IP N 1 t t N

∑

Constructing the yield curve:

Inflation

Assume 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.

Constructing the yield curve:

Maturity Risk

„ Step 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.

)

1

-t

(

0.1%

MRP

=

Constructing the yield curve:

Maturity Risk

Using 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 as the time to maturity increases, as it should be.

Add the IPs

and MRPs

to r* to find

the appropriate nominal rates

Step 3 – Adding the premiums to r*. r_{RF, t} = r* + IP_t + MRP_t

Assume r* = 3%,

r_{RF, 1} = 3% + 5.0% + 0.0% = 8.0% r_{RF, 10} = 3% + 7.5% + 0.9% = 11.4%

Hypothetical yield curve

„ An upward sloping

yield curve.

„ Upward slope due

to an increase in expected inflation and increasing maturity risk premium. Years to Maturity

Real risk-free rate

0 5 10 15 1 10 20 Interest Rate (%)

Maturity risk premium

What 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 curves

0 5 10 15 0 1 5 10 15 20 Years to Maturity Interest Rate (%) 5.2% 5.9%

6.0% Treasury_{Yield Curve}

BB-Rated

Pure Expectations Hypothesis

„ The 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 PEH

„ Assumes 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

(1.062)2 _{= (1.060) (1+x)}

1.12784/1.060 = (1+x) 6.4004% = x

„ PEH says that one-year securities will yield 6.4004%,

one year from now.

„ Notice, if an arithmetic average is used, the answer is

still very close. Solve: 6.2% = (6.0% + x)/2, and the result will be 6.4%.

0 1 2 6.0% x%

Three-year security, two years

from now

(1.065)5 _{= (1.062)}2 _(1+x)3

1.37009/1.12784= (1+x)3

6.7005% = x

„ PEH says that three-year securities will yield

6.7005%, two years from now.

0 1 2 3 4 5 6.2% x%

Conclusions about PEH

„ Some 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 premium to

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