Financial Markets and Interest Rates

1. Financial Markets and Interest Rates Chapter 2 2/02/09

2. Learning Objectives • Operation of U.S. financial system. • Financial securities. • Function of financial intermediaries. • Financial markets. • Securities traded in the money and capital markets. • Interest rates. How they are determined; factors that influence them; impact on financial markets

3. The Financial System • The purpose of the financial system is to bring together individuals, businesses, and government entities (economic units) that generate and spend funds. (Haves and have not’s) • Surplus economic units have funds left over after spending all they need to. Examples? • Deficit economic units need to acquire additional funds to sustain their operations. Examples?

4. Surplus/Deficit Units • Surplus units include: Households Corporate business Foreign Investors • Deficit units include: Corporate Business US Government State and Local Government College students 

5. The Financial System • To enable funds (money) to move through the financial system, funds are exchanged for securities. • Securities are documents that represent the right to receive money in the future • Examples are bonds, shares of stock, CDs, notes and accounts receivable, etc.

6. Financial Intermediaries • Financial intermediaries (See below) often help to facilitate this process. I. E., matching buyers and sellers of securities Investment bankers facilitate sale of corporate securities to the general public Brokers facilitate transactions between investors Dealers buy and sell securities for their own good

7. Financial Markets • Classified according to the characteristics of participants and securities involved. • The primary market is where economic units sell new securities to raise needed funds. Could be an Initial Public Offering (IPO) or issue of new shares of an existing publicly traded company. Link to Bloomberg about Financial markets

8. Financial Markets Funds Primary Market Securities

9. Financial Markets • The secondary market is where investors trade previously issued securities with each other. For example, when you want to buy or sell shares of stock Link to the NYSE Link to the NASDAQ

10. Financial Markets Funds Secondary Market Securities

11. Financial Markets Intermediaries such as mutual funds, banks and insurance companies help to facilitate the flow of funds in the financial marketplace. $$ Securities Securities $$

12. Market Efficiency • Market efficiency refers to the ease, speed, and cost of trading securities. (Axiom 6) • The market for the securities of large companies is generally efficient: Trades can be executed in a matter of seconds and commissions are very low. • By contrast, the real estate market is not generally efficient: It can take months to sell a house and the commission is 6% of the price.

13. Market Efficiency Why is market efficiency important? • The more efficient the market, the easier it is to transfer idle funds to those parties that need the funds. • If funds remain idle, this results in lower growth for the economy and higher unemployment and lower profits. • Investors can adjust their portfolios easily and at low cost as their needs and preferences change.

14. Financial Markets • Money Market • Trade short term (1 year or less) debt instruments (e.g. T-Bills, Commercial Paper, Corp CD’s, Gov’t Agencies, etc.) • Capital Market • Trades long term securities (Bonds, Stocks) • NYSE, AMEX, over-the-counter (NASDAQ and other OTC)

15. Securities in the Financial Market • Money Market Securities (short term) • Highly liquid, low risk • Treasury Bills (T-Bills) • Certificates of Deposit (CDs) • Commercial Paper • Eurodollars • Banker’s Acceptances • T-Bills: are short-term securities issued by the Federal government. • After initial sale, they have an active secondary market. • They are bought at a discount and at maturity the investor receives the full face value. • Essentially no risk, so very low return

16. Securities in the Financial Market • Money Market Securities (short term) • Highly liquid, low risk • Treasury Bills (T-Bills) • Certificates of Deposit (CDs) • Commercial Paper (Corp IOU’s) • Banker’s Acceptances (guarantee) (LOC)

17. Securities in the Financial Market • Capital Market Securities – more than one year • Bonds • Bonds:are “IOUs” issued by the borrower and sold to investors. • The issuer promises to repay the face amount on the maturity date and to pay interest each year in the amount of the coupon rate times the face value ($1,000). This is fixed for life of Bond Bond values can vary depending on the market rate of interest, so the rate of return on the bond can differ widely from the coupon rate.

18. Securities in the Financial Market • BondsTreasury Bonds Municipal Bonds Corporate Bonds Capital Market Securities (long term) • Treasury Bonds: are issued by the federal government. Treasury Notes 1 to 10 years; Treasury Bonds 10 to 30 years • Municipal Bonds: are issued by state and local governments. Usually free of federal taxes • Corporate Bonds: are issued by corporations. More risky than Government or Municipal bonds, higher yield; bonds are rated for risk

19. Securities in the Financial Market • Stock Capital Market Securities • Companies can also raise funds by selling shares of stock • Advantages: No guaranteed payments (like interest) and no specified payback period – maturity date (like bonds) • Two types: Common Stock and Preferred

20. Securities in the Financial Market • StockCommon Stock Capital Market Securities • Common stockholders:Individually, own a portion of the company and can vote on major company decisions. • They receive a return on their investment in the form of dividends and/or appreciation in the value of the stock.

21. Securities in the Financial Market • StockCommon StockPreferred Stock Capital Market Securities • Preferred stockholdersdo not generally have voting rights, but have priority in receiving dividends and are paid dividends at a pre-set rate. Often they get paid dividends in arrears (later) if dividends are not paid for a while.

22. Interest Rates Nominal (Prevailing) Interest Rates, Determined by: • Real Rate of Interest • Expected Inflation • Maturity Risk • Default Risk • Liquidity Risk Link to Financial Web

23. Interest Rates Real Rate of Interest • Compensates for the lender’s lost opportunity to consume. • The minimum rate I’m willing to accept in this market (over and above inflation) that convinces me to invest rather than spend my money. • The real rate of interest, by definition, would be risk free . • In this market, risk free can drive the real rate of interest to zero.

24. Interest Rates • Expected Inflation (Axiom 1) • Inflation erodes the purchasing power of money. • Example: If you loan someone $1,000 and they pay it back one year later with 10% interest, you will have $1,100. But if prices have increased by 5%, then something that would have cost $1,000 at the outset of the loan will now cost $1,000(1.05) = $1,050.

25. Nominal Risk-Free Rate • The real rate of interest, plus • The inflation risk premium • Example: The T-Bill Current Yield: 2.125% So, if inflation rate is 1.80%, then Real Rate of return is 2.125 – 1.80 or .325%

26. Interest Rates – other risks • Maturity Risk • If interest rates rise, lenders may find that their loans are earning rates that are lower than what they could get on new loans. • The risk of this occurring is higher for longer maturity loans. • Lenders will demand a premium to cover this risk depending on if they think long term rates will go up or down. • 10 years Treasury Note yielding 2.84% (0.7% premium over T-Bill rate)

27. Interest Rates – Other risks Default Risk • For most securities, there is some risk that the borrower will not repay the interest and/or principal on time, or at all. • The greater the chance of default, the greater the interest rate the investor demands and the issuer must pay. (risk/return trade-off) • Example: Junk bonds have a high risk of default and requires a high default risk premium. Current yield 12.20%

28. Interest Rates • Liquidity Risk Premium • Investments that are easy to sell without losing value are more liquid. • Illiquid securities have a higher interest rate premium to compensate the lender for the inconvenience of not being able to sell the bond easily. • Mortgage backed securities became illiquid! Cause of market collapse!

29. Determination of Rates k = the nominal, or observed rate on security k* = real rate of interest IRP = Inflation Risk Premium MP = Maturity Premium (for Bonds) DRP = Default Risk Premium (Corps) LP = Liquidity Premium k = k* + IRP + MP + DRP + LP

30. Determination of Interest Rate • If the Real Rate of return is 0.325% and Inflation is 1.80%, then the risk free rate would be 2.125%, i.e. a T-Bill • Add a Maturity risk premium of, say 0.72% and you would have a Government long-term security rate of 2.84% • Add a Default risk premium 3.74% and you would have a Corporate Bond rate of 6.58% • Add an additional 5.62 to for junk bond risk and you would have a rate of 12.20% • If the bond is not liquid, you might add another few 10ths of a % premium for liquidity.

31. Interest Rates • Term Structure • Relationship between long and short term interest rates. Which direction rates are expected to go in the future. • Yield curves follow • Compare to current yield curve

32. 8.00% 7.50% 7.00% 6.50% 6.00% 5.50% 5.00% 4.50% 4.00% 3.50% 3 6 1 2 3 5 7 10 20 mos. yr. maturities Treasury Yield Curve Jan 10, 2000

33. 8.00% 7.50% 7.00% 6.50% 6.00% 5.50% 5.00% March 22,1995 4.50% 4.00% 3.50% 3 6 1 2 3 5 7 10 20 mos. yr. maturities Treasury Yield Curve Jan 10, 2000

34. YIELD COMPARISONS 2/04/089/05/081/30/09 T-Bill 1.753.25 0.0 Treasury10 yr 3.60 3.65 2.84 CorporateDJ 5.28 5.91 6.58 High-yield Corporate 8.92 9.94 12.20 Term Structure of Interest Rates