Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
The Financial
Environment
Markets
Institutions
Interest Rates
2005 Thomson/South-Western
Financial Institutions
Funds are transferred between those who have
funds and those who need funds by three
Direct transfers
processes:
No intermediaries
Often part of private market transactions
Financial intermediaries
Banks or mutual funds
Savers invest in one type of product (e.g., CDs or savings
accounts)
Bank then creates loans, mortgages, etc. to sell to borrowers
Financial Intermediaries
1993 Glass-Steagall Act
Prohibited commercial banks from I-banking activities
Tried to prohibit conflict of interest situations
Result: Morgan Bank
JP Morgan Chase & Company = commercial bank
Morgan Stanley = investment bank
Financial Intermediaries
The Gramm-Leach-Bliley Act blurred the
distinctions:
Commercial banks
Savings and loan associations
Credit unions
Pension funds
Life insurance companies
Mutual funds
Stock Markets
Old classification
Organized Security Exchanges
NYSE, AMEX, and regional
New classification
Physical stock exchanges
NYSE, AMEX
Physical Stock
Exchanges
A physical, material entity
A building
Designated members
A board of governors
Auction markets
Sell orders and buy orders come together
Organized Investment
Networks
For securities not traded on physical stock
exchanges
An intangible trading system
A network of brokers and dealers (NASD)
Dealers make the market
The bid price = what the dealer will pay to buy
The ask price = what the dealer will take to sell
Spread = the dealers profit
Risk
How likely is it that this investment wont pan
out?
Expected inflation
How much will prices increase over time?
10
11
S1
kB = 12
kA = 10
8
D1
D1
D2
Dollars
12
Dollars
kRF
13
The Determinants of
Market Interest Rates
k=
k*
IP
DRP
LP
MRP
14
The Determinants of
Market Interest Rates
QuotedInterestRate=k
k=Riskfreeinterestrate+riskpremium
k=kRF+RP
k=kRF+[DRP+LP+MRP]
k=[k*+IP]+[DRP+LP+MRP]
15
The Determinants of
Market Interest Rates
NominalInterestRate=k=[k*+IP]+[DRP+LP+MRP]
IP = average rate of inflation expected in future
DRP = risk that a borrower will default on a loan (difference
between the T-bond interest rate and a corporate bond with
same features)
LP = premium if asset cannot be converted to cash quickly
and at close to the original cost (2 5%)
MRP = the interest rate risk associated with longer maturity
periods (usually 1 2%)
16
Determinants of
Market Interest Rates
Quoted Risk-Free Rate = k = kRF + DRP + LP +
MRP
k
= Quoted or nominal rate
kRF = Real risk-free rate plus a
premium for expected inflation
or kRF = k* + IP
DRP= Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
17
19
Flat=horizontal
Interest Rate
(%)16
Interest Rate
Term to
MarchMarch
July
1980
Maturity 1980
2000
12
3 months 16.0%
6.1%
1 year
14.0
6.1
10
5 years
13.5
6.2
10 years
12.8
6.1
8
July
2000
20 years
12.3
6.2
14
July
2003
0.9%
1.0
2.3
3.3
4.3
July 2003
Normal
10
20
Long Term
20
21
Liquidity Preference
Theory
Lenders prefer to make short-term loans
Less interest-rate risk
More liquid
22
Expectations Theory
Shape of curve depends on investors
expectations about future inflation rates.
If inflation is expected to increase, S-T
rates will be low, L-T rates high, and vice
versa.
The yield curve can slope up OR down.
23
24
Example:
Inflation for Year 1 is 5%.
Inflation for Year 2 is 6%.
Inflation for Year 3 and beyond is 8%.
k* = 3%
MRPt = 0.1% (t-1)
IP1
IP10
IP20
= 0.1% x 0
= 0.0%
MRP10
= 0.1% x 9
= 0.9%
MRP20
= 0.1% x 19
= 1.9%
26
+ 0.0% = 8.0%
+ 0.9% = 11.4%
+
1.9% = 12.7%
27
Yield Curve
Interest
Rate (%)
15
Treasury
12.7% yield curve
11.4%
10
8.0%
5
0
0
10
15
20
Years to
maturity
28
Market Segmentation
Theory
Borrowers and lenders have preferred
maturities
Slope of yield curve depends on supply
and demand for funds in both the L-T
and S-T markets
Curve could be flat, upward, or
downward sloping
29
Federal Deficits
Larger federal deficits mean higher interest rates
Business Activity
Does the Federal Reserve need to stimulate activity?
30
31
32