Lecture_2_FTM.ppt

Lecture 2 Financial Markets, Institutions, and Interest Rates

Finance for Technical Management - Lecture 2

The Capital Allocation ProcessIn 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.Finance for Technical Management - Lecture 2*


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.Finance for Technical Management - Lecture 2*


Types of financial marketsPhysical assets vs. Financial assetsMoney vs. CapitalPrimary vs. SecondarySpot vs. FuturesPublic vs. PrivateFinance for Technical Management - Lecture 2*


How is capital transferred between savers and borrowers?Direct transfersInvestment banking houseFinancial intermediariesFinance for Technical Management - Lecture 2*


Financial MarketsPrimary

Secondary

Finance for Technical Management - Lecture 2*


Financial MarketsFinance for Technical Management - Lecture 2*


Primary MarketsChannel funds toBorrowers Households as a group are net savers Businesses and government, as a group, tend to be net borrowers

SaversFinance for Technical Management - Lecture 2*


Primary Claims of A CorporationDebtMortgage bondsDebenture bondsCommercial paperLines of creditEquity offeringsCommon stockPreferred stockFinance for Technical Management - Lecture 2*


Offering Common Stock to the Public

IPO

Seasoned equity offeringFinance for Technical Management - Lecture 2*


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 companys 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 regulations and reporting requirements. Finance for Technical Management - Lecture 2*


Stock Market TransactionsApple 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? What if instead an investor buys existing shares of Apple stock in the open market is this a primary or secondary market transaction?Finance for Technical Management - Lecture 2*


Indirect Flow of Funds to BorrowersFinancial intermediaries include:commercial banksthrift institutionsinvestment companiespension fundsInsurance companiesfinance companies. Savers invest in secondary claims of financial intermediaries, which in turn invest in primary claims of borrowersFinance for Technical Management - Lecture 2*


Financial IntermediariesFinance for Technical Management - Lecture 2*


Potential Benefits of Financial IntermediariesDiversificationExpertiseLiquidityConvenienceRisk managementFinance for Technical Management - Lecture 2*


FINANCIAL MARKETS

Money marketsShort-term securities

Capital marketsLong-term securities



Market InstrumentsFinance for Technical Management - Lecture 2*


Benefits of Secondary MarketsLiquidity

Efficient pricing and information disclosure

Efficient allocation of capitalFinance for Technical Management - Lecture 2*


InterestInterest represents the return or compensation a lender demands before agreeing to loan money It is the charge for the privilege of borrowing money. Whenever people agree to lend money to others, they take risk as a number of factors might prevent them from taking all their money back. This risk requires a monetary compensation that is referred to as interest. Interest is normally expressed in percentage terms, called the interest rate. Thus if a person lends Rs.1,000 to another person, and the return he requires for doing so is Rs.100, we could say the interest rate charged is 10% (100/1000).



DETERMINANTS OF INTERESTThe prevailing rate of interest in any situation is called nominal rate of interest. For example in the above example the nominal interest rate is 10%. The following are the components of nominal interest rate. The nominal interest rate is composed of real interest rate plus a number of premiums.



Inflation PremiumReal Rate of Interest

Maturity Risk PremiumLiquidity Risk Premium

Default Risk Premium

Inflation Premium

Real Rate of Interest

Maturity Risk PremiumLiquidity Risk Premium

Default Risk Premium

Nominal Risk-Free+ Risk Premiums = Nominal Interest RateInterest RateDETERMINANTS OF INTERESTFinance for Technical Management - Lecture 2*


THE YIELD CURVEA yield curve is a graphical depiction of interest rates on securities that differ only in the time remaining until their maturity. It is a linethat plots and depicts theinterest rates, at aset point in time,of securities having equal credit quality but differing maturity dates.



THE SHAPE OF THE YIELD CURVE A normal yield curve is onein which longer maturitybonds have a higher yield compared to shorter-termbonds, due to the risks associated with time. It is sometimes referred to as "positive yield curve". An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economictransition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.



Normal Yield Curve

Inverted Yield Curve THE SHAPE OF THE YIELD CURVEYieldFlat Yield Curve MaturityYieldYieldMaturityMaturityFinance for Technical Management - Lecture 2*


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