Chapter 8

Understanding Financial Markets and Institutions

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Chapter 8 Learning GoalsLG1: Differentiate between primary and secondary markets and between

money and capital markets

LG2: List the types of securities traded in money and capital markets

LG3: Identify different types of financial institutions and the services that each financial institution provides

LG4: Analyze specific factors that influence interest rates

LG5: Offer different theories that explain the shape of the term structure of interest rates

LG6: Demonstrate how forward interest rates derive from the term structure of interest rates

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Financial Markets

• Financial markets exist to manage the flow of funds from investors to borrowers

• Financial markets can be distinguished along two dimensions:– Primary versus secondary markets– Money versus capital markets

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Primary Markets

• Provide a forum in which corporations and governments raise funds by issuing new financial instruments (stocks and bonds)

• Because many companies and government entities can’t generate enough cash flow from internal sources to fund their needs, they must raise capital from external sources (households)

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• Financial institutions called investment banks arrange most primary market transactions for businesses– Morgan Stanley– Goldman Sachs– Lehman Brothers

• Investment banks provide a number of important services to businesses that need to raise capital– Advice– Pricing– Attracting investors

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• One of the best-known types of primary market transactions is an initial public offering (IPO)– Company’s shares are publicly traded for the

first time

• When a firm that is already public issues new securities it is called a seasoned offering– Example: Procter & Gamble issues $500

million worth of stock

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• Once a company’s bonds or shares of stock are issued in the primary market they trade among investors in the secondary market– NYSE

– AMEX

– NASDAQ

• Secondary markets provide a centralized marketplace where economic agents know they can buy or sell securities quickly and efficiently

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• Securities brokers such as Charles Schwab or other brokerage firms act as intermediaries in the secondary market

• Note: the firm that originally issued the bond or stock is not involved in secondary transactions– If you buy shares of IBM through your

broker, you are buying them from another investor. IBM has nothing to do with the transaction

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• Secondary markets offer benefits to both investors and issuers– Investors gain liquidity and diversification

benefits– Issuers gain information about the value

of their securities• Publicly-traded firms can observe what

investors think of their firm value and corporate decisions by tracking their stock price

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• Trading volume in the secondary market is huge– On August 16, 2007, trading volume on

the NYSE broke the all-time record at 5.8 billion shares

– In contrast, in the 1980s a 250 million share day was considered a high-volume day

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Money Markets versus Capital Markets

• Money markets feature debt securities with maturities of one year or less– Because of the shorter maturity,

fluctuations in secondary market prices are usually small

– Money market securities are less risky than long-term instruments

– Most money market securities trade over-the-counter

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• Corporations and governmental entities issue a variety of money market securities to obtain short-term funds– Treasury bills– Federal funds– Repurchase agreements– Commercial paper– Negotiable CDs– Banker’s acceptances

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• Stocks and long-term debt (with a maturity of greater than one year) trade in capital markets

• Capital market instruments are subject to wider price fluctuations than money market instruments

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• Capital market securities include:– U.S. Treasury notes and bonds– State and local government– U.S. government agency bonds– Mortgages and mortgage-backed

securities– Corporate bonds– Corporate stocks

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• Other Markets– Foreign Exchange Markets

• Events in other countries affect U.S. firms’ performance

• For example, in 2001 Argentina experienced an economic crisis that hurt U.S. stock prices. Coca Cola Co. attributed a 5 percent decline in operating profits to the unfavorable exchange rate movements between the dollar and Argentinian peso

• Foreign exchange markets trade currency for immediate delivery (spot) or for some future delivery

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• Firms that sell goods outside the U.S. receive cash flows that are subject to foreign exchange risk– Investors who deal in foreign-

denominated securities face the same risk– If the foreign currency depreciates in

value, the dollar value of the cash flows will fall

• If the foreign currency appreciates in value, the dollar value of the cash flows will rise

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• Derivative Markets– A derivative security is a financial security

linked to another, underlying security such as a stock or currency

• Futures contract• Option contract• Swap contract

– Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future

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– As the value of the underlying security changes, the value of the derivative security changes

– Derivative contracts involve a high degree of leverage

• The investor has to put up only a small amount of the value of the underlying commodity to control a large amount of the underlying commodity

– Derivative markets are the newest and potentially the riskiest financial security market

– Derivative are used both for hedging and speculating

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Financial Institutions

• Financial institutions include:– Banks– Thrifts– Insurance companies– Mutual funds

• These institutions act to channel funds from those with surplus funds to those with a shortage of funds

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• Without financial institutions, the flow of funds between suppliers of funds (households) and users of funds (corporations) would be low for several reasons:– Institutions efficiently monitor the users of funds– Institutions provide liquidity to suppliers of funds

• Even though many financial claims feature a long-term financial commitment, institutions provide a means for suppliers to withdraw their cash as needed

– Institutions can provide a means to lower the price risk and transactions costs compared to trading on secondary markets

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• Financial institutions act as financial intermediaries between fund suppliers and fund users. – Fund suppliers and users use financial

institutions because of their unique ability to reduce monitoring costs, liquidity costs, and price risk

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Interest Rates

• We often speak of the interest rate as if only one rate applies to all financial situations– In fact there are hundreds of different rates that

are appropriate for various situations within the U.S. economy

• The rates we actually observe in financial markets are called nominal interest rates, sometimes called the quoted rate

• Because changes in interest rates have a profound impact on the value of security prices, financial managers and investors closely monitor these rates

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• Factors that influence interest rates for individual securities– Inflation– The “real” interest rate– Default risk– Liquidity risk– Special provisions regarding use of funds– Term to maturity

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• Inflation– Inflation is the percentage increase of a

standardized basket of goods or services over a given period of time

– Actual or Expected inflation rate• The higher the level of actual or expected

inflation, the higher the interest rate• Investors want to at least maintain their

purchasing power

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• Real Interest Rates– The rate that a security would pay if no

inflation were expected over its holding period– Measures society’s relative time preference

for consuming today rather than in the future

• Fisher Effect– Nominal interest rates must compensate

investors for:• Inflation-related reduction in purchasing power• Forgoing present consumption (real rate)

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• The Fisher Effect can be written as:

• The last term will generally be very small for small values of Expected (IP) and RIR, so we often use an approximate formula for the Fisher Effect:

i = Expected (IP) + RIR

RIR] x (IP) [Expected RIR (IP) Expected i

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• Example: The one-year Treasury bill rates in 2007 averaged 4.93 percent and inflation for the year was 1.80 percent. Calculate the real interest rate for 2007 according to the Fisher Effect.

RIR = i – Expected (IP)

= 4.93% - 1.80%

= 3.13%

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• Default or Credit Risk– Default risk it the risk that a security issuer may

fail to make its promised interest and principal payments to its bondholders

– The higher the default risk, the higher the interest rate demanded by investors to compensate them for the risk

– U.S. Treasury securities are considered to be free of default risk

– The difference between a quoted interest rate on a security j and a similar Treasury security is

called a default risk premium

DRPj = ijt - iTt

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• Liquidity Risk– If an asset is highly liquid, the holder can convert it into

cash at its fair market value on short notice– If a security is illiquid, investors add a liquidity risk

premium to the interest rate on the security– A different type of liquidity risk premium may exist if

investors dislike long-term securities because their prices react more to changes in interest rates

• In this case, a liquidity risk premium may be added to long-term securities because of its greater exposure to price risk

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• Special Provisions or Covenants– Some securities have special features

attached to them that affect their interest rate relative to a similar security without the provisions

– Examples include• Taxability (e.g. municipal bonds)• Convertibility (into stock at a preset price)• Callability

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• Term to Maturity– The relationship between interest rates

and maturity is called the term structure of interest rates, or the yield curve

• Assumes all other characteristics, such as default risk, liquidity risk, are identical

– In general, the longer the term to maturity the higher the required interest rate

• Maturity premium

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Figure 8.11A

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Figure 8.11B

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Figure 8.11C

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Putting it Together

• Putting together the factors that affect interest rates in different markets, we can use the following general equation for the fair interest rate:

ij* = f(IP, RIR, DRPj, LRPj, SCPj, MPj)

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Term Structure Theories

• The three major theories to explain the shape of the yield curve are:– The unbiased expectation theory– The liquidity premium theory– The market segmentation theory

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• Unbiased Expectations Theory– According to this theory, at any given point in

time the yield curve reflects the market’s current expectations of future short-term rates

– Intuition:• If an investor has a 4-year investment horizon

they could – A) buy a 4-year bond and earn the current (spot) annual

yield on a 4-year bond each year for four years– B) buy four successive 1-year bonds (of which they

know only the current one-year spot rate, but they have expectations of the rates in years 2,3, and 4.)

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• According to the unbiased expectation theory, the return from holding a 4-year bond to maturity should equal the expected return for investing in four successive 1-year bonds.– If not, then an arbitrage opportunity exists

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– According to the unbiased expectations theory, an upwardly sloping yield curve indicates that future one-year rates will be higher than they are currently

– The theory states that current long-term interest rates are geometric averages of current and expected future short-term interest rates

– [insert equation 8-7]

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• Liquidity Premium Theory– This theory builds on the unbiased

expectations theory– It states that investors will hold long-term

maturities only if these securities are offered at a premium to compensate for future uncertainty in the security’s value

• Investors must be offered a liquidity premium to buy longer-term securities that carry higher capital loss risk

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– The liquidity premium theory state that long-term interest rates are geometric averages of current and expected short-term rates (just like the unbiased expectations theory) plus liquidity risk premiums that increase with the security’s maturity

Equation 8-8

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• Market Segmentation Theory– This theory states that investors have specific maturity

preferences, and to encourage buyers to hold securities with maturities other than their most preferred maturity requires a higher interest rate (i.e. a maturity premium)

• Investors don’t consider securities with different maturities to be perfect substitutes

– Examples: banks may prefer short-term securities to match their short-term deposit liabilities, whereas insurance companies may prefer long-term bonds to match their long-term liabilities

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Forecasting Interest Rates

• Changes in interest rate affect the value of financial securities, so investors and firms have an incentive to try to predict interest rates

• Using the unbiased expectations hypothesis, we can discern the market’s forecast for expected short-term rates, called forward rates– A forward rate is an implied rate on a short-

term security

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– To find an implied forward rate on a one-year security in the future we can re-write the unbiased expectations formula

Equation 8-11

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