CHAPTER 4

The Financial Environment:

Markets, Institutions, and Interest
Rates

 Financial markets
 Types of financial
institutions
 Determinants of interest
rates 4-1
What is a market?
 A market is a venue 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.

4-2
Types of financial markets
 Physical assets vs. Financial assets
 Money vs. Capital
 Primary vs. Secondary
 Spot vs. Futures
 Public vs. Private

4-3
How is capital transferred
between savers and borrowers?
 Direct transfers
 Investment
banking house
 Financial
intermediaries

4-4
Types of financial
intermediaries
 Commercial banks
 Savings and loan associations
 Mutual savings banks
 Credit unions
 Pension funds
 Life insurance companies
 Mutual funds
4-5
Physical location stock
exchanges vs. Electronic
dealer-based markets
 Auction market
vs. Dealer market
(Exchanges vs.
OTC)
 NYSE vs. Nasdaq
 Differences are
narrowing

4-6
The cost of money
 The price, or cost, of debt capital
is the interest rate.
 The price, or cost, of equity
capital is the required return.
The required return investors
expect is composed of
compensation in the form of
dividends and capital gains.
4-7
What four factors affect the
cost of money?
 Production
opportunities
 Time preferences
for consumption
 Risk
 Expected inflation

4-8
“Nominal” vs. “Real” rates
k = represents any nominal rate

k* = represents the “real” risk-

free rate of interest. Like a T-
bill rate, if there was no
inflation. Typically ranges from
1% to 4% per year.

kRF = represents the rate of

interest on Treasury securities.
4-9
Determinants of interest
rates
k = k* + IP + DRP + LP + MRP

k = required return on a debt security

k* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP= maturity risk premium
4-10
Premiums added to k* for
different types of debt

IP MR DRP LP
S-T Treasury  P

L-T Treasury  

S-T   
Corporate
L-T    
Corporate
4-11
 Yield curve and the term
structure of interest rates
 Term structure –
relationship
between interest
rates (or yields)
and maturities.
 The yield curve is a
graph of the term
structure.
 A Treasury yield
curve from October
2002 can be
viewed at the right. 4-12
 Hypothetical yield curve
Interest  An upward
Rate (%)
sloping yield
15 Maturity risk premium
curve.
 Upward slope due
10 Inflation premium
to an increase in
expected inflation
5 and increasing
Real risk-free rate maturity risk
0
premium.
Years to
1 10 20 Maturity
4-13
What is the relationship between
the Treasury yield curve and the
yield curves for corporate issues?
 Corporate yield curves are higher
than that of Treasury securities,
though not necessarily parallel to
the Treasury curve.
 The spread between corporate and
Treasury yield curves widens as
the corporate bond rating
decreases.
4-14
 Illustrating the relationship
between corporate and Treasury
yield curves
Interest
Rate (%)
15

BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%

Years to
0 Maturity
0 1 5 10 15 20
4-15
Other factors that influence
interest rate levels
 Federal reserve policy
 Federal budget surplus or deficit
 Level of business activity
 International factors

4-16
Risks associated with investing
overseas
 Exchange rate risk – If an
investment is denominated
in a currency other than
U.S. dollars, the
investment’s value will
depend on what happens to
exchange rates.
 Country risk – Arises from
investing or doing business
in a particular country and
depends on the country’s
economic, political, and
social environment. 4-17
Factors that cause exchange
rates to fluctuate
 Changes in
relative
inflation
 Changes in
country risk

4-18