5-1 CHAPTER 5 The Financial environment. Markets, Institutions and Interest Rates ■ Financial markets Types of financial institutions Determinants of interest rates ■ Yield curves Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 1 Copyright © 2002 by Harcourt, Inc. All rights reserved. CHAPTER 5 The Financial Environment: Markets, Institutions, and Interest Rates ◼Financial markets ◼Types of financial institutions ◼Determinants of interest rates ◼Yield curves
5-2 Define these markets ■ Markets in genera Markets for physical assets Markets for financial assets Money versus capital markets Primary versus secondary markets Spot versus future markets Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 2 Copyright © 2002 by Harcourt, Inc. All rights reserved. Define these markets ◼Markets in general ◼Markets for physical assets ◼Markets for financial assets ◼Money versus capital markets ◼Primary versus secondary markets ◼Spot versus future markets
5-3 Three Primary Ways Capital Is Transferred Between Savers and Borrowers ■ Direct transfer Through an investment banking house Through a financial intermediary Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 3 Copyright © 2002 by Harcourt, Inc. All rights reserved. ◼Direct transfer ◼Through an investment banking house ◼Through a financial intermediary Three Primary Ways Capital Is Transferred Between Savers and Borrowers
5-4 The Top 5 Banking Companies 园 in the world,1999 Bank Name Country Total assets Deutsche Bank AG Germany $735 billion UBS Group Switzerland $687 billion Citigroup United States $669 billion Bank of America United States $618 billion Bank of Tokyo Japan s580 billion Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 4 Copyright © 2002 by Harcourt, Inc. All rights reserved. The Top 5 Banking Companies in the World, 1999 Bank Name Country Total assets Deutsche Bank AG Germany $735 billion UBS Group Switzerland $687 billion Citigroup United States $669 billion Bank of America United States $618 billion Bank of Tokyo Japan $580 billion
5-5 Organized Exchanges versus Over-the-Counter Market Auction markets versus dealer markets(exchanges versus the OTC market) NYSE versus Nasdaq system Differences are narrowing ■ Nasdaq vs. true otc Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 5 Copyright © 2002 by Harcourt, Inc. All rights reserved. Organized Exchanges versus Over-the-Counter Market ◼Auction markets versus dealer markets (exchanges versus the OTC market) ◼NYSE versus Nasdaq system ◼Differences are narrowing ◼Nasdaq vs. true OTC
What do we call the price, or cost, of debt capital? The interest rate What do we call the price, or cost, of equity capita Required- Dividend Capital return yI ield gain Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 6 Copyright © 2002 by Harcourt, Inc. All rights reserved. ◼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 = +
5-7 What four factors affect the cost of money ? Production opportunities Time preferences for consumption I Risk ■ Expected inflation Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 7 Copyright © 2002 by Harcourt, Inc. All rights reserved. What four factors affect the cost of money? ◼Production opportunities ◼Time preferences for consumption ◼Risk ◼Expected inflation
5-8 Real versus nominal rates k* Real risk-free rate T-bond rate if no inflation 1%to4% k Any nominal rate kre Rate on Treasury securities Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 8 Copyright © 2002 by Harcourt, Inc. All rights reserved. Real versus Nominal Rates k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. k kRF
kEk+IP+ DRP LP MRP Here k Required rate of return on a debt security. k*= Real risk-free rate IP Inflation premium DRP E Default risk premium LP E Liquidity premium MRP= Maturity risk premium Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 9 Copyright © 2002 by Harcourt, Inc. All rights reserved. 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
5-10 Premiums added to k for different ypes of Debt ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: STIP DRP LP LT corporate: IP, DRP, MRP, LP Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 10 Copyright © 2002 by Harcourt, Inc. All rights reserved. Premiums Added to k* for Different Types of Debt ◼ST Treasury: only IP for ST inflation ◼LT Treasury: IP for LT inflation, MRP ◼ST corporate: ST IP, DRP, LP ◼LT corporate: IP, DRP, MRP, LP
