The Financial Environment Markets, Institutions, and Interest Rates.pptVIP

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The Financial Environment Markets, Institutions, and Interest Rates.ppt

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The Financial Environment Markets, Institutions, and Interest Rates

CHAPTER 5The Financial Environment:Markets, Institutions,and Interest Rates Financial markets Types of financial institutions Determinants of interest rates Yield curves Define These Markets Markets in general Physical assets Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Future Three Primary Ways Capital Is Transferred Between Savers and Borrowers Direct transfer Investment banking house Financial intermediary The Top 5 Banking Companiesin the World, 1999 Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq system Differences are narrowing 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? What four factors affect the cost of money? Production opportunities Time preferences for consumption Risk Expected inflation 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. Premiums Added to k* for Different Types of Debt S-T Treasury: only IP for S-T inflation L-T Treasury: IP for L-T inflation, MRP S-T corporate: S-T IP, DRP, LP L-T corporate: IP, DRP, MRP, LP 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. Yield Curve Construction Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. IP1 = 5%/1.0 = 5.00%. IP10 = [5 + 6 + 8(8)]/10 = 7.50%. IP20 = [5 + 6 + 8(18)]/20 = 7.75%. Step 2: Find MRP Based on This Equation: What factors can explain the shape of this yield curve? This constructed yield curve is upward sloping. This