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CHAPTER 2:The Financial

Environment: Markets,
Institutions, and Interest Rates
Importance & Functions of Financial
Markets
Classification of Financial Markets
Financial Institutions
Determinants of Interest rates
Yield Curves


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Functions/Role of Financial
Markets
Bridging the gap between net borrowers and net savers. Net
borrowers or investors are the deficit sector. They demand loan. Net savers are
surplus sector. They supply loan. The two groups do not know each other,
financial market brings them together.
Providing the equilibrium interest rate. Net savers like to get more
interest and net borrowers like to pay less interest. Financial market provides
the equilibrium rate.
Separation principle: Financial institutions separate the pattern of current
consumption from the pattern of current income by means of intertemporal
consumption function. People in need of more current consumption than current
income borrow money. People who like to defer consumption lend money.
Facilitating liquidity: Financial markets provides liquidity of financial assets
by facilitating trading of these whenever required by investors.
Discovering market prices of financial assets: Through interaction
of demand and supply financial market sets of price of financial assets
at which these will be traded among investors.

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Types of Financial Markets
Debt vs. Equity Markets. Financial market deals with debt
instruments like bond, debenture, bank loan, mortgage,
commercial and consumer credit is known as debt market.
Equity market deals with equity securities like preferred stock
and common stock. Interest on debt is a compulsory payment
but dividend is not. Cost of debt is usually less than cost of
equity.
Money vs. Capital Markets. Money market deals with short
term financial instruments. Capital market deals long term
financial instruments like preferred stock and ordinary stock .
Primary vs. Secondary Markets. In the primary market, the
firm directly issues financial assets to the applicant. In the
secondary market, existing financial assets are traded among
investors.
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Types of Financial Markets
Public vs. Private Markets. Securities traded in the
public markets are traded among large number of
investors who do not know each other and cannot
devote time, effort and cost necessary to ensure the
validity of specialized transaction. In the private
market transactions, securities are traded among
investors who are generally familiar with each other.
Spot vs. Future Markets. In spot market transactions
are settled down at available price immediately,
whereas in future market transactions would be
executed at a some later date.
World, National, Regional and Local Markets.
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Financial Institutions and Intermediary
Commercial banks
Savings and loan associations
Credit unions
Pension funds
Life insurance companies
Mutual funds
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The cost of money
It means the extra rate of payment made by the
user to the supplier of fund for a specific time
period.
In case of debt capital, cost of money refers to
the interest rate.
In case of equity capital, cost of money is the
required return. This is the return expected by
the shareholders to leave the share price
unchanged.
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Factors Affecting Cost of Money
Production opportunities-return available within
an economy from investment in productive assets.
Time preference for consumption-the
preferences of consumers for current consumption
as opposed to saving for future consumption.
Risk-the chance that a financial asset will not earn
the return promised.
Inflation-the tendency of prices to increase over
time.
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Cost of Money (interest rate
level): Loanable Fund Theory

D (Investment)
S (Savings)
k
Quantity of Loanable Fund
Interest rate(%)
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Nominal vs. Real rates
k
RF
= k*+IP
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.
k
RF
= represents the rate of interest on
Treasury securities.
IP= Inflation premium
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Determinants of interest rates
k = k* + IRP + DRP + LRP + MRP
k = required return on a debt
security
k* = real risk-free rate of interest
IRP = expected inflation premium
DRP = default risk premium
LRP = liquidity premium
MRP = maturity risk premium
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Concepts of risk premium
Inflation Premium refers to the additional interest to
cover the loss due to inflation.
Default risk premium is the addition in the interest
rate to compensate the possibility that the borrower
may fail to pay interest and principal.
Liquidity risk premium is the addition to compensate
the possibility that the security may not be sold with
in a short notice.
Maturity risk premium covers the possibility of price
fluctuation of bond. The price depends on market
interest rate. Bonds of longer maturity assumes more
maturity risk premium.

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Risk-Return trade-off
k=k
RF
+ Risk Premium (RP)
E(R) = R
f
+ RP
RP=DRP+LP+MRP
Return
Risk
R
f
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Term Structure of Interest Rates &
Yield Curve: Relationship between interest
rate/yields and time period/maturities.
Normal
Abnormal
Flat
Maturity
k
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Why Do Yield Curves Differ?
(Theories of Yield Curves)
Liquidity Preference Theory: Lenders prefer to
make short term loan than long term loan. Yield
curve should be positive.
Expectations Theory: Yield curve depends on the
expectation about inflation. If inflation is expected
to rise in future, then yield curve should be
positive and vice-versa.
Market Segmentation Theory: The short term
market and the long term market are different
from one another. Yield curve should not have a
definite pattern.
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Other Factors That Influence
Interest Rate Levels:
Government reserve policy i.e. to control level of
money supply.
Government deficit i.e. to borrow or print new money for
meeting up the shortage drives up interest rate.
Foreign trade balance i.e. larger trade deficit, larger
borrowing that drives up interest rate and vice-versa.
Business activity/cycle i.e. in case of recession there is
higher inflation and higher interest rate.