The Financial Environment: Markets, Institutions, and Interest Rates

After reading this chapter, students should be able to:

List some of the many different types of financial markets, and identify several recent trends taking place in the financial markets.

Identify some of the most important money and capital market instruments, and list the characteristics of each.

Describe three ways in which the transfer of capital takes place.

Compare and contrast major financial institutions.

Distinguish between the two basic types of stock markets.

Explain how capital is allocated in a supply/demand framework, and list the fundamental factors that affect the cost of money.

Write out two equations for the nominal, or quoted, interest rate, and briefly discuss each component.

Define what is meant by the term structure of interest rates, and graph a yield curve for a given set of data.

Explain the two key factors that determine the shape of the yield curve.

Discuss country risk.

List four additional factors that influence the level of interest rates and the slope of the yield curve.

Briefly explain how interest rate levels affect business decisions.

The Financial Markets

Financial Market: An organized institutional structure or mechanism for creating and exchanging financial assets.

Money Markets: Markets for debt securities with maturities of one year or less. Treasury bills, repurchase agreements, banker’s acceptances, commercial paper, negotiable CD’s, money market funds and Eurodollar deposits.

Capital Markets: The markets for long-term debt (corporate, state, local and federal government) and corporate stock (common and

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preferred). U.S. Treasury notes and bonds, municipal bonds, mortgages, corporate bonds, preferred stock and common stock.

Primary Markets: The first buyer of a newly issued security buys that security in the primary market. All subsequent trading of those securities is done in the secondary market.

Secondary Markets: The market where securities are traded after they are initially offered in the primary market. Most trading is done in the secondary market. The New York Stock Exchange, as well as all other stock exchanges, the bond markets, etc., are secondary markets. Seasoned securities are traded in the secondary market.

Financial Institutions

An enterprise such as a bank whose primary business and function is to collect money from the public and invest it in financial assets such as stocks and bonds. Financial intermediaries are institutions that provide the market function of matching borrowers and lenders or traders, as well as create new financial products.

Investment banker: Financial intermediaries who perform a variety of services, including aiding in the sale of securities, facilitating mergers and other corporate reorganizations, acting as brokers to both individual and institutional clients, and trading for their own accounts.

The Stock Market

Also called the equity market, the market for trading equities.

Stock Exchanges: Formal organizations, approved and regulated by the Securities and Exchange Commission (S.E.C.), that are made up of members that use the facilities to exchange certain common stocks. The two major national stock exchanges are the New York Stock Exchange (N.Y.S.E.) and the American Stock Exchange (A.S.E. or A.M.E.X.). Five regional stock exchanges include the Midwest, Pacific, Philadelphia, Boston, and Cincinnati.

Over-the-Counter (OTC) Market: A decentralized market (as opposed to an exchange market) where geographically dispersed dealers are linked together by telephones and computer screens. The market is for securities not listed on a stock or bond exchange. The N.A.S.D.A.Q. market is an O.T.C. market for U.S. stocks.

National Association of Securities Dealers Automatic Quotation System (N.A.S.D.A.Q.): An electronic quotation system that provides price quotations to market participants about the more actively traded

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common stock issues in the O.T.C. market. About 4,000 common stock issues are included in the N.A.S.D.A.Q. system.

The Cost of Money

Quoted, or Nominal Rate of Interest (k): The price paid for borrowing money. It is expressed as a percentage rate over a period of time and reflects the rate of exchange of present consumption for future consumption.

Real Risk-Free Rate of Interest (k*): The rate of interest excluding the effect of expected inflation; that is, the rate that is earned in terms of constant-purchasing-power dollars (pure time value of money). Interest rate expressed in terms of real goods, i.e. nominal interest rate adjusted for expected inflation.

Risk-Free Rate (kRF): The rate earned on a riskless investment, typically the rate earned on the 90-day U.S. Treasury Bill (includes the premium for expected inflation).

Inflation Premium: Premium for expected inflation. Default Risk Premium: The risk that a borrower will default on a

loan. Liquidity Premium: Premium due to lack of liquidity (Liquidity is

measured by the speed with which the asset can be converted to cash without loss of principle).

Maturity Risk Premium: Reflects the degree of interest rate risk (Interest rate risk: The chance that a security's value will change due to a change in interest rates. For example, a bond's price drops as interest rates rise. Reinvestment rate risk: The risk that proceeds received in the future will have to be reinvested at a lower potential interest rate.).

Nominal Rate = k = kRF + DRP +LP + MRP

Note: kRF = k* + IP

Term Structure of Interest Rates

The relationship between interest rates on bonds of different maturities usually depicted in the form of a graph often called a yield curve (the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities).

The Yield Curve, the yields of U.S. Treasury bill, notes and bonds, can reveal a lot about markets. The absolute level of yields, as in "rates are low" or "rates are high" is relative. In 1981, 30 year Treasury bonds yielded over 14%, while short term bills were over 20%. In 1993, bills were around 3% with bonds at 5.75%. Not only

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were rates different at those two times, but so was the "shape" of the curve.

In 1981, short term rates were higher than long term (inverted). The "usual shape" is positive; that is, with short rates lower than long. Almost all recessions have been preceded by an inverted curve, and such a curve usually points to lower rates in the future. A steeply positive curve points to future higher rates.

Also, since Treasury securities are the safest available, unconditionally backed by the U.S. Treasury, other debt securities should yield more - they are by definition risky. Investors can judge whether they are getting sufficient "risk premium", in other words, enough incremental yield over Treasuries, by comparing the yield of any bond with that of Treasuries of similar maturity.

Yield Curve

Term Rate

6 months 5.1% 1 year 5.5 2 years 5.6 3 years 5.7 4 years 5.8 5 years 6.010 years 6.120 years 6.530 years 6.3

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