The Financial Environment:
Markets, Institutions, and Interest Rates

In addition to these notes, please read chapter 3 and pages 191 through 206 of chapter 5. Problems 5-18 through 5-23 of chapter 5 are related to this topic.

Since this part of the course deals with different types of markets, let us start by defining what these markets are.

What are markets in general?

Markets are transactions where individuals or organizations exchange items. The exchange could be goods for goods, goods for service, or goods and services for money. Whenever you exchange something for another you have a market. Again a market is a transaction, not a physical location.

Now, let us look at the different types of markets:

Markets for physical assets（财产，有利条件）:

These are markets where tangible（有形的） assets, things you can touch are exchanged for money.

Markets for financial assets:

These are markets where financial assets sold and bought. Financial assets are intangible. Examples of financial assets include stocks （股票，存货）and bonds（债券）. By buying a financial asset you become an owner of a company or a lender to one. Buying a stock makes you one of the owners of a corporations and buying a bond makes you one of the lenders.

Money versus capital markets:

Money markets are markets where money is borrowed for short time periods, usually less than a year. Here the loans are used mainly to manage cash in a corporation. If a firm has excess cash, it will lend it to a firm who need cash for a short time period. Money markets are known for their low risk participants. The loans in the money market are low risk, low interest, and short-term.

Capital markets are long-term financial markets. Here companies raise funds that they will utilize（利用） either permanently（永久的，长期的） or for long time periods. If a company issues(发行) stock, then the funds become permanent. If the firm issues bonds, the funds will be repaid at a later date. Financial instruments in this market have varying risk levels.

Primary versus secondary markets:

Primary markets are markets where financial instruments are sold for the first time. For example if a company issues new stock or bonds then the total number of outstanding stocks or bonds increases.

Secondary markets are markets where existing financial instruments are traded. Secondary market transactions do not change the number of outstanding instruments and usually do not involve the company that issued the instruments in the first place.

Spot versus future markets:

Spot markets are transactions that take place at the present time.

Future markets are transaction where the details of the sale, including price and delivery date, are agreed upon at the present time, but the actual exchange takes place at a later date.

Function of the financial institutions（体系） in the financial markets:
Financial institutions act as intermediaries（中间机构，中间商） between the lenders and the borrowers. It would very difficult for an individual who wants to save money to find a company that wants to borrow money and arrange the transaction. This is how banks and other financial institutions come into the picture. We deposit money in a bank and the bank lends it to a company.

The Price of Money:

Question. What do we call the price, or cost, of debt capital（借入资产）?

Answer. The interest rate（利率）. The term used to describe borrowing money is purchasing（采购，购买） funds although the money has to be paid pack. The interest paid represents the purchase price. Actually, the transaction looks more like renting than buying.

Question. What do we call the price, or cost, of equity capital（权益资本）?

Answer. Required return. This is the return the stockholders, the owners of the company, want. It is the sum of the dividend yield and the capital gain. The dividend yield is next year’s expected dividends divided by the current price and the capital gain is the change in the stock price.

Required return = Dividend yield + Capital gain where: Dividend yield = Next year’s expected dividend / Current stock price

The Determinants of Interest Rates:

k = k* + IP + DRP + LP + MRP.

Here:

k = Required rate of return on a debt security. This is the interest rate you are quoted. It represents the change in the nominal size of money.

k* = Real risk-free rate. This represents the change in the purchasing power of money. Historically, the real interest rate has averaged around 3%.

IP = Inflation premium. This is to compensate the lender for the expected future inflation.

DRP = Default risk premium. This works as an insurance premium incase the borrower defaults and does not pay back the loan. The size of the premium depends on the credit of the borrower.

LP = Liquidity premium. This premium is charged to compensate the lender for reduced liquidity of the loan. In some cases the lender may sell the loan to another lender. If the loan is difficult to sell, a premium is charged.

MRP = Maturity risk premium. This premium is added to compensate the lender incase the interest rates drop during the period the loan is outstanding and he/she may have to reinvest the money at a lower interest rate after the loan matures.

The Yield Curve:
The yield curve is a graphical representation of the relationship between the maturity of a loan and the interest rate charged on that loan. Here are some examples:

This is known as the upward or normal yield curve. The interest rates increase as the maturity or life of the loan increases. That is, if you borrow for five years you end up paying a higher interest rate than borrowing for a shorter period such as two years. Also note that the corporate bonds pay higher interest rate than government bonds due to increased risk. However, the difference in interest increases as the life or maturity of the bond increases. That is why the two curves are not parallel.

This is known as the inverted yield curve because the interest on a longer maturity loans is less that on shorter maturity ones.

[pic]
The last curve is known as the flat curve. Interest rates do not change with maturity.

Construction of the yield curve:
Suppose that the expected inflation for the next three years is 3% for next year, 4% for the following year, and 5% for the third year. Then the inflation premium for each of the following years is determined as follows:

IP at any point = the sum of the expected inflation for the years leading up to that point divided by the number of years.

In mathematical notation: [pic] In this equation INFLt is the expected inflation at a future time t and n is the number of years till time t.

|Year |Expected inflation for that year |IP for that year |
|1 |3% |3%/1 = 3% |
|2 |4% |(3% + 4%)/2 = 3.5% |
|2 |5% |(3% + 4% + 5%)/3 = 4% |

MRP is calculated using the equation: MRPt = 0.1% (t-1)
|Year |t-1 |MRP |
|1 |1-1 = 0 |0.1% * 0 = 0 |
|2 |2-1 = 1 |0.1% * 1 = 0.1% |
|3 |3-2 = 2 |0.1% * 2 = 0.2% |

k* is assumed to equal 3% and lets assume that LP is 1% then:

|Loan maturity in years |Interest rate, k = k* + IP + DRP + LP + MRP. |
|1 |3 + 3 + 2 + 1 + 0 = 9% |
|2 |3 + 3.5 + 2 + 1 + 0.1 = 9.6% |
|3 |3 + 4 + 2 + 1 + 0.2 = 10.2% |

[pic]

Theories that explain the shape of the yield curve.

There are three prevailing theories that attempt to explain the yield curve:
1) The Pure Expectations Hypothesis (PEH)
2) The Liquidity Preference Theory
3) The Market Segmentation Theory

The first of these theories, PEH, is explained in your text and blow. The other two theories are not covered in the text book.

The Pure Expectations Hypothesis (PEH):

The shape of the yield curve depends on the investors’ expectations about future short-term risk-free interest rates. Therefore, investors determine the interest rate on a loan by averaging the expected interest rate for the period leading up to the maturity of the loan. In addition, PEH assumes that MRP = 0.

The Liquidity Preference Theory:
This theory assumes that borrowers prefer long-term loan to avoid income risk. Income risk is defined as reduced income in the future if interest rates increase the company has to roll over the loan at a higher interest rate. Therefore, the firm’s income is reduced due to increased expenses.

However, lenders prefer to lend short-term to avoid capital risk. Capital risk is defined as the decrease in the market value of the loan or bond if interest rates go up. This problem is not an issue if the loans have short lives.

This situation, according to the theory, causes the borrowers to offer increased interest for long-term loans to convince the lenders to lend long term.

The Market Segmentation Theory:
According to this theory, the market is divided into segments. Some borrowers and lenders prefer short-term loans, some medium-term, and some long-term. In each maturity, the interest rates are determined by the supply and demand for that maturity.

PEH is theoretically the strongest of the three but it still does not escape criticism. Here are some conclusions about PEH*:

Some argue that the PEH isn’t correct, because securities of different maturities have different risk.

General view (supported by most evidence) is that lenders prefer S-T securities, and view L-T securities as riskier.

Thus, investors demand a MRP to get them to hold L-T securities (i.e., MRP > 0).

What various types of risks arise when investing overseas?

Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment.

Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate.

Two Factors Lead to Exchange Rate Fluctuations:

Changes in relative inflation will lead to changes in exchange rates.

An increase in country risk will also cause that country’s currency to fall.

*The notes after this point are taken from the book publisher’s power point presentation for chapter 3 in the text book.