Financial Environment: Markets , Institutes and Interest Rates | FINC 3511, Study notes of Corporate Finance

Download Financial Environment: Markets , Institutes and Interest Rates | FINC 3511 and more Study notes Corporate Finance in PDF only on Docsity! 1 Chapters 5 and 6 The Financial Environment: Markets, Institutions, and Interest Rates Financial markets Types of financial institutions Determinants of interest rates Yield curves 2 What is a market? A market is a “place” 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. 3 Financial Markets Financial markets bring together people and organizations wanting to borrow money with those having surplus funds. There are many different financial markets in a developed economy, each dealing with a different type of instrument, serving a different set of customers, or operating in a different part of the country. 4 Markets Physical assets vs. Financial assets Physical asset markets (also called "tangible" or "real" asset markets) are the markets for such products as wheat, autos, real estate, computers, and machinery. Financial asset markets deal with stocks, bonds, notes, mortgages, and other claims on real assets. 9 Markets Public vs. Private Private markets are the markets where transactions are worked out directly between two parties. Public markets are the markets where standardized contracts are traded on organized exchanges. 10 Direct transfer Investment banking house Financial intermediary Three Primary Ways Capital Is Transferred Between Savers and Borrowers 11 Direct transfer Direct transfers of money and securities occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution. Business Saver Securities Dollars 12 Financial Intermediary Transfers through financial intermediaries occur when a bank or mutual fund obtains funds from savers, issues its own securities in exchange, and then uses these funds to purchase other securities. Intermediaries literally create new forms of capital. The existence of intermediaries greatly increases the efficiency of money and capital markets. Business SaversIntermediary Bus secs Int secs $$ $$ 13 Types of Financial Intermediaries Commercial banks Savings and loan associations Mutual savings banks Credit unions Pension funds Life insurance companies Mutual funds 14 Investment Bankers Transfers through an investment banking house occur when a brokerage firm, such as Merrill Lynch, serves as a middleman and facilitates the issuance of securities. These middlemen help corporations design securities that will be attractive to investors, buy these securities from the corporations, and then resell them to savers in the primary markets. Business SaversInvestment Banker secs secs $$ $$$ 19 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. 20 Yield Curve The term structure of interest rates describes the relationship between long- and short-term interest rates. The yield curve is the graph of interest rates for similar risk securities for different maturities. 21 Hypothetical Treasury Yield Curve 0 5 10 15 1 10 20 Years to Maturity Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% Real risk-free rate Maturity risk premium Inflation premium 22 What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues? Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not neces- sarily parallel to the Treasury curve. The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases. 23 Hypothetical Treasury and Corporate Yield Curves 0 5 10 15 0 1 5 10 15 20 Years to Maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury Yield Curve BB-Rated AAA-Rated 24 Pure Expectations Hypothesis The PEH contends that the shape of the yield curve depends on investor’s expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates, and vice-versa. Thus, the yield curve can slope up, down, or even bow.