Lecture 4

The Markets and Interest Rate

Types of Markets

1-1

Function of Financial Markets

1-2

1. Allows transfers of funds

from person or business
without investment
opportunities to one who has
them

2. Improves economic
efficiency

2-2

MARKETS FOR SECURITIES

1-3

Definition:
A security market is a place or medium where buying and
selling of securities takes place.
Most of the countries in the world have developed such
markets to facilitate security trading as it is considered to play
a significant role in the economy.
Security markets can be broadly classified in:

Primary markets, and

Secondary markets.

Another classification is:

Money markets, and

Capital markets

Market mechanisms make possible the transfer of funds from

surplus to deficit sectors, efficiently and at low cost.

MARKETS FOR SECURITIES1 - 4

Security Market
Equity Market

Primary Market

Secondary market

Debt Market
Government
Securities Market

Corporate Debt
Market

Money Market

Derivatives Market

Options Market

Future Markets

MARKETS FOR SECURITIES

1-5

Pakistan Stock Markets

Islamabad Stock Exchange (ISE)
Lahore Stock Exchange (LSE)

Karachi Stock Exchange (KSE):

A stock market was established in 1947.

Started with 5 companies with a paid-up capital of

Rs.37 million.

Currently Karachi Stock exchange is now owned

by 200 members.

1850 terminals exist at broker end.

651 companies are listed with KSE.

Trading through an electronic trading system

Market capitalization, as of June 30, 2009, US$

26.48 billion.

MARKETS FOR SECURITIES

1-6

Characteristics of Good Stock Markets

To determine the appropriate price, participants must have timely

and accurate information on the volume and prices of past
transactions and on all currently outstanding bids and offers.
Therefore, one attribute of a good market is timely and accurate
information.

Another prime requirement is liquidity, the ability to buy or sell an

asset quickly and at a known pricethat is, a price not substantially
different from the prices for prior transactions, assuming no new
information is available.

A component of liquidity is price continuity, which means that

prices do not change much from one transaction to the next unless
substantial new information becomes available.

A market with price continuity requires depth, which means that

numerous potential buyers and sellers must be willing to trade at
prices above and below the current market price.

Another factor contributing to a good market is the transaction cost.

Prices to adjust quickly to new information regarding supply or

demand, which means that prices reflect all available information
about the asset. This attribute is referred to as external efficiency or
informational efficiency.

MARKETS FOR SECURITIES

1-7

Key Terminologies:
Stock Exchanges: It is an institution where securities that have already been
issued are bought and sold. Presently there are three stock exchanges
in Pakistan. The oldest and most important one is Karachi Stock
Exchange.

Listed Securities: Securities that are listed on various stock exchanges and
hence eligible for being traded.
Depositories: A depository is an institution which dematerializes physical
certificates and effects transfer of ownership by electronic book
entries.
Brokers: Brokers are registered members of the stock exchanges through
whom investors transact.
Under-writers: An under-writer agrees to subscribe to a given number of
shares (or any other security) in the even the public subscription is
inadequate. The under-writer, in a essence, stands guarantee for public
subscription.

Bankers to an issue: The Bankers to an issue collect money on behalf of the

company from the applicants.
Venture Capital Funds: A Venture Capital Fund is a pool of capital which is
essentially invested in equity shares or equity-linked instruments of
unlisted companies.

1-8

MARKETS FOR SECURITIES

Primary Markets:

Securities available for the first time

are offered through the Primary
Markets. These are primarily arranges
additional funds for the coffers of the
issuer. Whereas in the secondary
markets just change in hands takes
place.

After going through the primary

markets the securities can be traded
in the secondary markets.

MARKETS FOR SECURITIES

Primary Markets:

1-9

MARKETS FOR SECURITIES

1 - 10

Secondary Markets:
The stock once sold to the investor can be traded in the
Secondary Markets.

Organized Exchanges are physical market- places where the

agents of buyers and sellers operate through the auction
process.
The transactions in the Secondary Markets can be divided into:

Organized Exchange
Over-the-counter (OTC)
The primary middleman is categorized as:
Broker: It acts as an agent
Dealer: It acts as principal dealer in transaction.

MARKETS FOR SECURITIES

1 - 11

Secondary Markets:
The over-the-counter (OTC) market includes
trading in all stocks not listed on one of the
exchanges.
The OTC market is not a formal organization
with membership requirements or a specific
list of stocks deemed eligible for trading.
In theory, any security can be traded on the
OTC market as long as a registered dealer is
willing to make a market in the security
(willing to buy and sell shares of the stock).

MARKETS FOR SECURITIES

1 - 12

Secondary Markets:

Every market lists certain stocks for trading.

KSE has a list of 651 companies.

These companies have to follow certain rules

and regulations and pay annual fees for
maintaining their name in the registered list.

The initial listing requirements are:

Number of shareholders

Minimum demonstrated earnings

Asset size

Number of shares outstanding

MARKETS FOR SECURITIES

1 - 13

Secondary Markets:
A person is eligible for registration as a broker, in the
Karachi Stock Exchange if s/he:

is a member of the stock exchange;

is not less than twenty one years of age;

is a citizen of Pakistan;

has at least passed graduation or equivalent examination

from an institution recognized by the Government;

Provided that the SECP may relax the educational

qualification in suitable cases on merit having regard to the
applicants experience;

has not been adjudicated as insolvent or has suspended

payment or has compounded with his creditors;

has experience of not less than five years in the business of

buying selling or dealing in securities

1 - 14

INTRODUCTION TO THE SECURITY ANALYSIS

The measures of risk for an investment are:
Variance of rates of return
Standard deviation of rates of return
Coefficient of variation of rates of return (standard
deviation/means)
Covariance of returns with the market portfolio (beta)
The sources of risk are:
Business risk
Financial risk
Liquidity risk

Exchange rate risk

Country risk

1 - 15
What 4 factors affect the cost of money
(Interest Rates)?

1. Production opportunities

2. Time preferences for

consumption - the higher value on
current (future) consumption, the
higher (lower) the interest rate
3. Risk - higher (lower) risk, higher
(lower) interest rate
4. Expected inflation - higher
expected inflation, higher interest
rates

1 - 16

Nominal vs. Real rates

r

= Represents any nominal rate

r* = 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.

rRF = Represents the rate of interest on

default risk-free Treasury
securities.

1 - 17

Determinants of interest rates

r = r* + IP + DRP + LP + MRP
r

required return on a debt security

r*

real risk-free rate of interest

IP

inflation premium (e)

DRP =

default risk premium

LP =

liquidity premium (illiquidity)

MRP=

maturity risk premium (time)

1 - 18

Premiums added to r* for

different types of debt
IP
S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

MRP DRP

LP

1 - 19

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.

Yield
(%)
6
5
4
3
2
1
0
0.25

0.5

10

Maturity (years)

30

1 - 20

Illustrating the relationship between

corporate and Treasury yield curves
Interest
Rate (%)
15

BB-Rated
10

AAA-Rated

Treasury
6.0% Yield Curve

5.9%

5.2%

Years to
Maturity

0
0

10

15

20

1 - 21

Pure Expectations Hypothesis

The PEH contends that the shape of
the yield curve depends on investors
expectations about future interest
rates.
If interest rates are expected to
increase, L-T rates will be higher than
S-T rates, and vice-versa. Thus, the
yield curve can slope up, down, or
even bow.

1 - 22

Assumptions of the PEH

Assumes that the maturity risk

premium for Treasury securities is
zero.
Long-term rates are an average of
current and future short-term rates.
If PEH is correct, you can use the
yield curve to back out expected
future interest rates.

1 - 23

An example:
Observed Treasury rates and the
PEH
Maturity
1 year
2 years
3 years
4 years
5 years

Yield
6.0%
6.2%
6.4%
6.5%
6.5%

If PEH holds, what does the market

expect will be the interest rate on oneyear securities, one year from now?
Three-year securities, two years from
now?

1 - 24

One-year forward rate (x%)

6.0%
0

x%
1

2
6.2%

(1.062)2
1.12784/1.060
6.4004%

= (1.060) (1+x)
= (1+x)
=x

PEH says that one-year securities will yield

6.4004%, one year from now.
Notice, if an arithmetic average is used, the
answer is still very close. Solve: 6.2% = (6.0% +
x)/2, and the result will be 6.4%.

1 - 25

Three-year security, two years

from now
6.2%
0

x%
2

6.5%

(1.065)5 = (1.062)2 (1+x)3

1.37009/1.12784 = (1+x)3
6.7005% = x

PEH says that three-year securities will yield

6.7005%, two years from now.

1 - 26

Other factors that influence

interest rate levels
Federal Reserve monetary policy
Expansionary or Contractionary?

Federal budget surplus or deficit, Dc

Level of business activity, Dc
International factors, Trade Deficit,
Dc

1 - 27

Risks associated with investing

overseas
Exchange rate risk If an
investment is denominated in
a currency other than U.S.
dollars, the investments
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 countrys
economic, political, and
social environment.

1 - 28

Risk and Rate of Return

All Financial Assets Produce CFs

Risk of Asset Depends on Risk of CFs

Stand-alone Risk of Assets CFs

Portfolio Risk of CFs

Diversifiable and Market Risk

Risk & return: CAPM / SML

1 - 29

Investment returns
The rate of return on an investment can be
calculated as follows:
(Amount received Amount invested)

Return =

________________________
Amount invested

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%.

1 - 30

What is investment risk?

Two types of investment risk
Stand-alone risk
Portfolio risk

Investment risk is related to the probability

of earning a low or negative actual return.
The greater the chance of lower than
expected or negative returns, the riskier the
investment.
Risk = Dispersion of Returns around mean,
or expected mean: variance or standard
deviation

1 - 31

Expected Return
The future is uncertain.

Investors do not know with certainty whether the

economy will be growing rapidly or be in
recession.
Investors do not know what rate of return their
investments will yield.
Therefore, they base their decisions on their
expectations concerning the future.

The expected rate of return on a stock represents

the mean of a probability distribution of possible
future returns on the stock.
31

Expected Return

1 - 32

The table below provides a probability distribution for the returns

on stocks A and B
State

Probability

Return On

Return On

Stock A

Stock B

20%

5%

50%

30%

10%

30%

30%

15%

10%

20%

20%

-10%

The state represents the state of the economy one period in the
future i.e. state 1 could represent a recession and state 2 a growth
economy.

The probability reflects how likely it is that the state will occur. The
sum of the probabilities must equal 100%.
The last two columns present the returns or outcomes for stocks
A and B that will occur in each of the four states. 32

1 - 33

Expected Return
Given a probability distribution of returns, the
expected return can be calculated using the
following equation:
N

E[R] = S (piRi)
i=1

Where:
E[R] = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.
33

1 - 34

Expected Return
In this example, the expected return for stock A
would be calculated as follows:
E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%

Now you try calculating the expected return for

stock B!

34

Expected Return

1 - 35

Did you get 20%? If so, you are correct.

If not, here is how to get the correct answer:
E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%

So we see that Stock B offers a higher

expected return than Stock A.
However, that is only part of the story; we
35
haven't considered risk.

1 - 36

Measures of Risk
Risk reflects the chance that the actual return on
an investment may be different than the expected
return.
One way to measure risk is to calculate the
variance and standard deviation of the
distribution of returns.
We will once again use a probability distribution
in our calculations.

The distribution used earlier is provided again for

ease of use.
36

1 - 37

Measures of Risk
Probability Distribution:
State

Probability

Return On

Return On

Stock A

Stock B

20%

5%

50%

30%

10%

30%

30%

15%

10%

20%

20%

-10%

E[R]A = 12.5%
E[R]B = 20%

37

1 - 38

Measures of Risk
Given an asset's expected return, its variance can
be calculated using the following equation:
N

Var(R) = s2 = S pi(Ri E[R])2

i=1

Where:
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i
E[R] = the expected return on the stock
38

1 - 39

Measures of Risk
The standard deviation is calculated as the
positive square root of the variance:
SD(R) = s =

s2 = (s2)1/2 = (s2)0.5

39

1 - 40

Measures of Risk
The variance and standard deviation for stock A is
calculated as follows:
s2A = .2(.05 -.125)2 + .3(.1 -.125)2 + .3(.15 -.125)2 + .2(.2 -.125)2 = .002625

sA = (.002625)0.5 = .0512 = 5.12%

Now you try the variance and standard deviation for stock
B!

If you got .042 and 20.49% you are correct.

40

1 - 41

Measures of Risk
If you didnt get the correct answer, here is how to get it:
s2B = .2(.50 -.20)2 + .3(.30 -.20)2 + .3(.10 -.20)2 + .2(-.10 - .20)2 = .042

sB = (.042)0.5 = .2049 = 20.49%

Although Stock B offers a higher expected return than
Stock A, it also is riskier since its variance and standard
deviation are greater than Stock A's.
This, however, is still only part of the picture because
most investors choose to hold securities as part of a
41
diversified portfolio.

1 - 42

Comments on standard
deviation as a measure of risk
Standard deviation (i) measures
total, or stand-alone, risk.
The larger i is, the lower the
probability that actual returns will
be closer to expected returns.
Larger i is associated with a wider
probability distribution of returns.

1 - 43

Coefficient of Variation (CV)

A standardized measure of dispersion
about the expected value, that shows the
risk per unit of return.

Standard deviation s
CV =
=
Expected return
r

Portfolio Risk and Return

1 - 44

Most investors do not hold stocks in isolation.

Instead, they choose to hold a portfolio of several
stocks.
When this is the case, a portion of an individual
stock's risk can be eliminated, i.e., diversified
away.

From our previous calculations, we know that:

the expected return on Stock A is 12.5%
the expected return on Stock B is 20%
the variance on Stock A is .00263
the variance on Stock B is .04200
the standard deviation on Stock A is 5.12%
44
the standard deviation on Stock B is 20.49%

1 - 45

Investor attitude towards risk

Risk aversion assumes investors
dislike risk and require higher rates of
return to encourage them to hold
riskier securities.

Risk premium the difference between

the return on a risky asset and a
riskless asset, which serves as
compensation for investors to hold
riskier securities.

Portfolio Risk and Return

1 - 46

Most investors do not hold stocks in isolation.

Instead, they choose to hold a portfolio of several
stocks.
When this is the case, a portion of an individual
stock's risk can be eliminated, i.e., diversified
away.

From our previous calculations, we know that:

the expected return on Stock A is 12.5%
the expected return on Stock B is 20%
the variance on Stock A is .00263
the variance on Stock B is .04200
the standard deviation on Stock A is 5.12%
46
the standard deviation on Stock B is 20.49%

1 - 47

Returns distribution for two perfectly

positively correlated stocks ( = 1.0)
Stock M

Stock M

Portfolio MM

25

25

25

15

15

15

-10

-10

-10

1 - 48

Breaking down sources of risk

Stand-alone risk = Market risk + Diversifiable
risk
Market risk portion of a securitys standalone risk that cannot be eliminated through
diversification. Measured by beta.
Diversifiable risk portion of a securitys
stand-alone risk that can be eliminated
through proper diversification.

1 - 49

INVESTMENT RETURN

Diversification and the Correlation

Coefficient
SECURITY E

TIME

SECURITY F

TIME

Combination
E and F

TIME

Combining securities that are not perfectly,

positively correlated reduces risk.

1 - 50

Total Risk = Systematic Risk +

Unsystematic Risk
Total Risk = Systematic Risk +
Unsystematic Risk

Systematic Risk is the variability of return

on stocks or portfolios associated with
changes in return on the market as a whole.
Unsystematic Risk is the variability of return
on stocks or portfolios not explained by
general market movements. It is avoidable
through diversification.

1 - 51

STD DEV OF PORTFOLIO RETURN

Total Risk = Systematic Risk +

Unsystematic Risk
Factors such as changes in nations
economy, tax reform by the Congress,
or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

1 - 52

STD DEV OF PORTFOLIO RETURN

Total Risk = Systematic Risk +

Unsystematic Risk
Factors unique to a particular company
or industry. For example, the death of a
key executive or loss of a governmental
defense contract.
Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

1 - 53

CAPM and SML

CAPM is a model that describes the
relationship between risk and expected
(required) return; in this model, a securitys
expected (required) return is the risk-free rate
plus a premium based on the systematic risk of
the security.

The Capital Asset Pricing Model1 - 54

Assumptions

CAPM is based on the following assumptions:

1. All investors have identical expectations about
expected returns, standard deviations, and correlation
coefficients for all securities.
2. All investors have the same one-period investment
time horizon.
3. All investors can borrow or lend money at the riskfree rate of return (RF).
4. There are no transaction costs.
5. There are no personal income taxes so that investors
are indifferent between capital gains an dividends.
6. There are many investors, and no single investor can
affect the price of a stock through his or her buying
and selling decisions. Therefore, investors are pricetakers.
7. Capital markets are in equilibrium. 9 - 54

1 - 55

Capital Asset Pricing Model

(CAPM)
Model linking risk and required returns.
CAPM suggests that there is a Security
Market Line (SML) that states that a stocks
required return equals the risk-free return
plus a risk premium that reflects the stocks
risk after diversification.
ri = rRF + (rM rRF) bi
Primary conclusion: The relevant riskiness of
a stock is its contribution to the riskiness of
a well-diversified portfolio.

1 - 56

Beta

Measures a stocks market risk, and

shows a stocks volatility relative to
the market.
Indicates how risky a stock is if the
stock is held in a well-diversified
portfolio.

1 - 57

Comments on beta
If beta = 1.0, the security is just as risky as
the average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to
1.5.
Beta = Y/X or Ki /Km

1 - 58

Can the beta of a security be

negative?
Yes, if the correlation between Stock i
and the market is negative (i.e., i,m < 0).

If the correlation is negative, the

regression line would slope
downward, and the beta would be
negative.
However, a negative beta is highly
unlikely.

1 - 59

Calculating betas
Well-diversified investors are primarily
concerned with how a stock is expected
to move relative to the market in the
future.
Without a crystal ball to predict the future,
analysts are forced to rely on historical
data. A typical approach to estimate beta
is to run a regression of the securitys
past returns against the past returns of
the market.
The slope of the regression line is defined
as the beta coefficient for the security.

Characteristic Lines
Different Betas
EXCESS RETURN
ON STOCK

1 - 60

and

Beta > 1
(aggressive)
Beta = 1

Each characteristic
line has a
different slope.

Beta < 1
(defensive)

EXCESS RETURN
ON MARKET PORTFOLIO

1 - 61

Calculating beta
Regression line
Portfolio beta

1 - 62

Illustrating the calculation of

beta
_
ri
20

15

10

Year
1
2
3

rM
15%
-5
12

ri
18%
-10
16

-5

0
-5
-10

10

15

20

Regression line:
^
^
ri = -2.59 + 1.44 rM

_
rM

1 - 63

The Security Market Line (SML):

Calculating required rates of
return
SML: ri = rRF + (rM rRF) bi
ri = rRF + (RPM) bi
Assume the yield curve is flat and that
rRF = 5.5% and RPM = 5.0%.
The market (or equity) risk premium is
RPM = (kM kRF )= 10.5% 5.5% = 5%.

1 - 64

What is the market risk

premium?
Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
Its size depends on the perceived risk
of the stock market and investors
degree of risk aversion.
Varies from year to year, but most
estimates suggest that it ranges
between 4% and 8% per year.

1 - 65

Calculating required rates of

return
rHT

= 5.5% + (5.0%)(1.32)
= 5.5% + 6.6%

rM

= 12.10%

= 5.5% + (5.0%)(1.00)

= 10.50%

rUSR = 5.5% + (5.0%)(0.88)

= 9.90%

rT-bill = 5.5% + (5.0%)(0.00)

= 5.50%

rColl = 5.5% + (5.0%)(-0.87)

= 1.15%

1 - 66

Expected vs. Required returns

^

r
HT
Market
USR
T - bills
Coll.

12.4% 12.1%
10.5
9.8
5.5
1.0

10.5
9.9
5.5
1.2

Undervalued (r r)
^

Fairly val ued (r = r)

^

Overvalued (r r)
^

Fairly val ued (r = r)

^

Overvalued (r r)

An example:
Equally-weighted two-stock portfolio

1 - 67

Create a portfolio with 50% invested in HT

and 50% invested in Collections.
The beta of a portfolio is the weighted
average of each of the stocks betas.
bP = wHT bHT + wColl bColl
bP = 0.5 (1.32) + 0.5 (-0.87)

bP = 0.225

1 - 68

Factors that change the SML

What if investors raise inflation
expectations by 3%, what would happen to
the SML?

ri (%)

D I = 3%

SML2
SML1

13.5
10.5

8.5
5.5
Risk, bi
0

0.5

1.0

1.5

1 - 69

Factors that change the SML

What if investors risk aversion
increased, causing the market risk
premium to increase by 3%, what would
ri (%)happen to the SML?
SML2
D RP = 3%
M

SML1

13.5
10.5
5.5

Risk, bi
0

0.5

1.0

1.5

1 - 70

Verifying the CAPM empirically

The CAPM has not been verified

completely.
Statistical tests have problems that
make verification almost impossible.
Some argue that there are additional
risk factors, other than the market
risk premium, that must be
considered.

1 - 71

More thoughts on the CAPM

Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate
of ri.

ri = rRF + (rM rRF) bi + ???

CAPM/SML concepts are based upon
expectations, but betas are calculated
using historical data. A companys
historical data may not reflect investors
expectations about future riskiness.