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Principles of Business Finance Fin 510

Principles of Business Finance Fin 510. Dr. Lawrence P. Shao Marshall University Spring 2002. CHAPTER 4 The Financial Environment: Markets, Institutions, and Interest Rates. Financial markets Types of financial institutions Determinants of interest rates Yield curves. Define these markets.

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Principles of Business Finance Fin 510

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  1. Principles of Business FinanceFin 510 Dr. Lawrence P. Shao Marshall University Spring 2002

  2. CHAPTER 4The Financial Environment:Markets, Institutions,and Interest Rates • Financial markets • Types of financial institutions • Determinants of interest rates • Yield curves

  3. Define these markets • Financial assets • Money vs. capital • Primary vs. secondary • Spot vs. future

  4. Three Primary Ways Capital Is Transferred Between Savers and Borrowers • Direct transfer • Investment banking house • Financial intermediary

  5. Organized Exchanges vs.Over-the-Counter Market • Auction market vs. dealer market (exchanges vs. OTC) • NYSE vs. NASDAQ system • Differences are narrowing

  6. What do we call the price, or cost, of debt capital? The interest rate • What do we call the price, or cost, of equity capital? Required Dividend Capital return yield gain = + .

  7. What four factors affect the cost of money? • Production opportunities • Time preferences for consumption • Risk • Expected inflation

  8. = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. k* k kRF “Real” Versus “Nominal” Rates

  9. 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.

  10. Premiums Added to k* for Different 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

  11. What is the “term structure of interest rates”? What is a “yield curve”? • Term structure: the relationship between interest rates (or yields) and maturities. • A graph of the term structure is called the yield curve.

  12. Treasury Yield Curve Interest Rate (%) 1 yr 5.4% 5 yr 5.7% 10 yr 5.7% 30 yr 6.0% 15 Yield Curve (March 1998) 10 5 Years to Maturity 0 10 20 30

  13. What are the 2 main factors that explain the shape of the yield curve?

  14. 1. Expectations • Shape of the yield curve depends on the investors’ 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 or down.

  15. The Pure Expectations Hypothesis (PEH) • MRP = 0. • Long-term rates are an average of current and future short-term rates. • If PEH is correct, you can use the yield curve to back out expected future interest rates.

  16. An Example • Assume that 1-year securities yield 6% today, and the market expects that 1-year securities will yield 7% in 1 year, and that 1-year securities will yield 8% in 2 years. • If the PEH is correct, the 2-year rate today should be 6.5% = (6% + 7%)/2. • If the PEH is correct, the 3-year rate today should be 7% = (6% + 7% + 8%)/3.

  17. 2. Risk • 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).

  18. Example data: • Inflation for Year 1 is 5%. • Inflation for Year 2 is 6%. • Inflation for Year 3 and beyond is 8%. k* = 3% MRPt = 0.1%(t - 1).

  19. Yield Curve Construction Step 1:Find the average expected inflation rate over years 1 to n: n SINFLt t = 1 n IPn = .

  20. IP1 = 5%/1.0 = 5.00%. IP10 = [5 + 6 + 8(8)]/10 = 7.50%. 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).

  21. 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%.

  22. Step 3: Add the IPs and MRPs to k*: kRFt = k* + IPt + MRPt . kRF = Quoted market interest rate on treasury securities. Assume k* = 3%: kRF1 = 3.0% + 5.0% + 0.0% = 8.0%. kRF10 = 3.0% + 7.5% + 0.9% = 11.4%. kRF20 = 3.00% + 7.75% + 1.90% = 12.65%.

  23. Yield Curves Interest Rate (%) 15 BB-Rated 10 AAA-Rated Treasury yield curve 6.0% 5.7% 5 5.4% Years to maturity 0 0 1 5 10 15 20

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