2-1

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Chapter 2

The FinancialEnvironment:

MarketsInstitutionsInterest Ratesand Taxes

Copyright © 2000 by Harcourt, Inc.

All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887-6777

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The Financial Markets

Money and capital markets Primary and secondary markets Debt and equity markets Mortgage and consumer credit markets World, national, regional, and local markets Spot and future markets

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Three Primary Ways CapitalIs Transferred Between Savers and Borrowers:

Direct transfer

Investment banking house

Financial intermediary

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Financial Institutions

Commercial banks Savings and loan associations Credit unions Pension funds Life insurance companies Mutual funds

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The Stock Market

Organized Security Exchanges• NYSE, AMEX, and regional Actual physical locations

Over-the-Counter Market• Network of brokers and dealers• Auction market

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The Cost of Money

Production opportunities Time preferences for consumption Risk Expected inflation

Four factors that affect the cost of moneyFour factors that affect the cost of money

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What do we call the price, or cost, of

debt capital?

The Interest RateThe Interest Rate

What do we call the price, or cost, of

equity capital?

Return on Equity = Dividends + Capital GainsReturn on Equity = Dividends + Capital Gains

The Cost of Money

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Interest Rate Levels

kA = 10

kB = 12

8

0 Dollars Dollars

%Interest Rate, kA

Market A: Low-Risk SecuritiesInterest Rate, kB

Market B:High-Risk Securities

%

0

Interest Rates as a Function of Supply and Demand

S1

D1

D1

D2

S1

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= real risk-free rate.T-Bond rate if no inflation;1% to 4%.

k*

= any nominal rate.k

= Rate on T-securities.kRF

“Real” versus “Nominal” Rates

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k = Quoted or nominal rate

k* = Real risk-free rate (“k-star”)

IP = Inflation premium

DRP = Default risk premium

LP = Liquidity premium

MRP = Maturity risk premium

The Determinants of Market Interest Rates

Quoted Interest Rate = k = k* + IP + DRP + LP + MRP

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k = Quoted or nominal rate

kRF = Real risk-free rate plus a premium for expected inflation or k* + IP

DRP = Default risk premium

LP = Liquidity premium

MRP = Maturity risk premium

The Determinants of Market Interest Rates

Quoted Risk-Free Rate = k = kRF + DRP + LP + MRP

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Premiums Added to k* forDifferent 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

IP = Inflation premiumDRP = Default risk premiumLP = Liquidity premiumMRP = Maturity risk premium

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The Term Structure of Interest Rates

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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U.S. Treasury Bond Interest Rates on Different Dates

16

14

12

10

8

6

4

2

0

Interest Rate (%)

1 5 10 20Short Term Intermediate Term Long Term

Term to Interest RateMaturity Mar 1980 Mar 19996 months 15.0% 4.6%1 year 14.0 4.95 years 13.5 5.210 years 12.8 5.520 years 12.5 5.9

Yield Curve for March 1980(Current rate of inflation: 12%

Yield Curve for March 1999(Current rate of inflation: 2%

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Three Explanations for the Shape of the Yield Curve

Term Structure Theories

Expectations Theory

Liquidity Preference Theory

Market Segmentation Theory

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Expectations Theory

Shape of curve depends on investors’ expectations about future inflation rates.

If inflation is expected to increase, S-T rates will be low, L-T rates high, and vice versa. Thus, the yield curve can slope up or down.

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Calculating Interest Rates under Expectations Theory:

Step 1: Find the average expected inflation rate over years 1 to N:

IP

INFLt = 1

N

N n =

t

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Example data: Inflation for Yr 1 is 5%. Inflation for Yr 2 is 6%. Inflation for Yr 3 and beyond is 8%.

k* = 3%

MRPt = 0.1% (t-1)

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 even vs. inflation;these IPs would permit you to earn k* (before taxes).

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Calculating Interest Rates under Expectations Theory:

Step 2: Find MRP based on this equation: 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 interest rate on treasury securities.

Assume k* = 3%.

1-Yr: kRF1 = 3% + 5.0% + 0.0% = 8.0%10-Yr: kRF10 = 3% + 7.5% + 0.9% = 11.4%20-Yr: kRF20 = 3% + 7.75% + 1.9% = 12.7%

Calculating Interest Rates under Expectations Theory:

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Yield CurveYield Curve

0

5

10

15

0 1 5 10 15 20

Years tomaturity

Interest Rate (%)

8.0%

11.4%12.7%

Treasuryyield curve

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Lenders prefer S-T securities because they are less risky.

Thus, S-T rates should be low, and the yield curve should be upward sloping.

Liquidity Preference Theory

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Borrowers and lenders have preferred maturities.

Slope of yield curve depends on supply and demand for funds in both the L-T and S-T markets (curve could be flat, upward, or downward sloping).

Market Segmentation Theory

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Other Factors that Influence Interest Rate Levels

Federal Reserve Policy – Controls the supply of money

Federal Deficits– Larger federal deficit means higher

interest rates Foreign Trade Balance

– Larger trade deficit means higher interest rates

Business Activity

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Interest Rate Levels and Stock Prices

The higher the rate of interest, the lower a firm’s profits

Interest rates affect the level of economic activity, and economic activity affects corporate profits

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Real risk-free rate - is that rate of interest which would exist on default-free securities in the absence of inflation (k*)

Nominal risk-free rate - is equal to the real risk free rate plus an inflation premium which is equal to the average rate of expected inflation over the life of the investment (kRF)

Default Risk Premium- is a premium based on the probability that the issuer will default on the loan, and it is measured by the difference between the interest rate on a U.S. Treasury Bond and a corporate bond of equal maturity and marketability (liquidity)

Liquidity Premium is a premium added to the rate of interest on securities that are not liquid

A liquid asset is one that can be sold at a "fair" price, on short notice

Maturity Risk Premium - is a premium which reflects interest rate risk...

Interest rate risk is the risk of capital loss due to changing interest rates

Longer term securities have more interest rate risk than otherwise comparable shorter term securities

Definitions

2-27Interest Rate Calculation

Step 1 Find the average expected inflation rate over years 1-N

 

N=1 IP = 5.0%

N=5 IP = (5+6+8+8+8)/5 = 7.0%

N=10 IP = (5+6+8+8+8+...+8)/10 = 7.5%

N=20 IP = (5+6+8+8+8+...+8)/20 = 7.75%

Step 2 Find the maturity risk premium for each maturity

 

N=1 MRP = 0.0%

N=5 MRP = .1*4 = .4%

N=10 MRP = .1*9 = .9%

N=20 MRP = .1*19 = 1.9%

Step 3 Sum the IPs and the MRPs, and add to k* (real risk free rate)

 

N=1 kRF = 3% + 5% +0% = 8.0%

N=5 kRF = 3% + 7.0% + .4% = 10.4%

N=10 kRF = 3% + 7.5% + .9% = 11.4%

N=20 kRF = 3% + 7.75% + 1.9% = 12.65%