Chapter 1

An Overview of Corporate Finance and

The Financial Environment
ANSWERS TO END-OF-CHATER !"EST#ONS
1-1 a. A proprietorship, or sole proprietorship, is a business owned by one individual. A
partnership exists when two or more persons associate to conduct a business. In
contrast, a corporation is a legal entity created by a state. The corporation is separate
and distinct from its owners and managers.
b. In a limited partnership, limited partners liabilities, investment returns and control
are limited, while general partners have unlimited liability and control. A limited
liability partnership !!"#, sometimes called a limited liability company !!$#,
combines the limited liability advantage of a corporation with the tax advantages of a
partnership. A professional corporation "$#, %nown in some states as a professional
association "A#, has most of the benefits of incorporation but the participants are not
relieved of professional malpractice# liability.
c. &toc%holder wealth maximi'ation is the appropriate goal for management decisions.
The ris% and timing associated with expected earnings per share and cash flows are
considered in order to maximi'e the price of the firms common stoc%.
d. A money mar%et is a financial mar%et for debt securities with maturities of less than
one year short-term#. The (ew )or% money mar%et is the worlds largest. $apital
mar%ets are the financial mar%ets for long-term debt and corporate stoc%s. The (ew
)or% &toc% *xchange is an example of a capital mar%et. "rimary mar%ets are the
mar%ets in which newly issued securities are sold for the first time. &econdary
mar%ets are where securities are resold after initial issue in the primary mar%et. The
(ew )or% &toc% *xchange is a secondary mar%et.
Answers and Solutions: 1- 1
e. In private mar%ets, transactions are wor%ed out directly between two parties and
structured in any manner that appeals to them. +an% loans and private placements of
debt with insurance companies are examples of private mar%et transactions. In public
mar%ets, standardi'ed contracts are traded on organi'ed exchanges. &ecurities that
are issued in public mar%ets, such as common stoc% and corporate bonds, are
ultimately held by a large number of individuals. "rivate mar%et securities are more
tailor-made but less li,uid, whereas public mar%et securities are more li,uid but
sub-ect to greater standardi'ation. .erivatives are claims whose value depends on
what happens to the value of some other asset. /utures and options are two important
types of derivatives, and their values depend on what happens to the prices of other
assets, say I+0 stoc%, 1apanese yen, or por% bellies. Therefore, the value of a
derivative security is derived from the value of an underlying real asset.
f. An investment ban%er is a middleman between businesses and savers. Investment
ban%ing houses assist in the design of corporate securities and then sell them to savers
investors# in the primary mar%ets. /inancial service corporations offer a wide range
of financial services such as bro%erage operations, insurance, and commercial
ban%ing. A financial intermediary buys securities with funds that it obtains by issuing
its own securities. An example is a common stoc% mutual fund that buys common
stoc%s with funds obtained by issuing shares in the mutual fund.
g. A mutual fund is a corporation that sells shares in the fund and uses the proceeds to
buy stoc%s, long-term bonds, or short-term debt instruments. The resulting dividends,
interest, and capital gains are distributed to the funds shareholders after the deduction
of operating expenses. .ifferent funds are designed to meet different ob-ectives.
0oney mar%et funds are mutual funds which invest in short-term debt instruments
and offer their shareholders chec% writing privileges2 thus, they are essentially
interest-bearing chec%ing accounts.
h. "hysical location exchanges, such as the (ew )or% &toc% *xchange, facilitate
communication between buyers and sellers of securities. *ach physical location
exchange is a physical entity at a particular location and is governed by an elected
board of governors. A computer3telephone networ%, such as (asda,, consists of all
the facilities that provide for security transactions not conducted at a physical location
exchange. These facilities are, basically, the communications networ% that lin%s the
buyers and sellers.
i. An open outcry auction is a method of matching buyers and sellers. In an auction, the
buyers and sellers are face-to-face, with each stating the prices and which they will
buy or sell. In a dealer mar%et, a dealer holds an inventory of the security and ma%es
a mar%et by offering to buy or sell. 4thers who wish to buy or sell can see the offers
made by the dealers, and can contact the dealer of their choice to arrange a
transaction. In an *$(, orders from potential buyers and sellers are automatically
matched, and the transaction is automatically completed.
Answers and Solutions: 1- $
-. "roduction opportunities are the returns available within an economy from investment
in productive assets. The higher the production opportunities, the more producers
would be willing to pay for re,uired capital. $onsumption time preferences refer to
the preferred pattern of consumption. $onsumers time preferences for consumption
establish how much consumption they are willing to defer, and hence save, at
different levels of interest.
%. The real ris%-free rate is that interest rate which e,uali'es the aggregate supply of,
and demand for, ris%less securities in an economy with 'ero inflation. The real ris%-
free rate could also be called the pure rate of interest since it is the rate of interest that
would exist on very short-term, default-free 5.&. Treasury securities if the expected
rate of inflation were 'ero. It has been estimated that this rate of interest, denoted by
r6, has fluctuated in recent years in the 5nited &tates in the range of 7 to 8 percent.
The nominal ris%-free rate of interest, denoted by r9/, is the real ris%-free rate plus a
premium for expected inflation. The short-term nominal ris%-free rate is usually
approximated by the 5.&. Treasury bill rate, while the long-term nominal ris%-free
rate is approximated by the rate on 5.&. Treasury bonds. (ote that while T-bonds are
free of default and li,uidity ris%s, they are sub-ect to ris%s due to changes in the
general level of interest rates.
l. The inflation premium is the premium added to the real ris%-free rate of interest to
compensate for the expected loss of purchasing power. The inflation premium is the
average rate of inflation expected over the life of the security. .efault ris% is the ris%
that a borrower will not pay the interest and3or principal on a loan as they become
due. Thus, a default ris% premium .9"# is added to the real ris%-free rate to
compensate investors for bearing default ris%. !i,uidity refers to a firms cash and
mar%etable securities position, and to its ability to meet maturing obligations. A
li,uid asset is any asset that can be ,uic%ly sold and converted to cash at its :fair;
value. Active mar%ets provide li,uidity. A li,uidity premium is added to the real
ris%-free rate of interest, in addition to other premiums, if a security is not li,uid.
m. Interest rate ris% arises from the fact that bond prices decline when interest rates rise.
5nder these circumstances, selling a bond prior to maturity will result in a capital
loss, and the longer the term to maturity, the larger the loss. Thus, a maturity ris%
premium must be added to the real ris%-free rate of interest to compensate for interest
rate ris%. 9einvestment rate ris% occurs when a short-term debt security must be
:rolled over.; If interest rates have fallen, the reinvestment of principal will be at a
lower rate, with correspondingly lower interest payments and ending value. (ote that
long-term debt securities also have some reinvestment rate ris% because their interest
payments have to be reinvested at prevailing rates.
Answers and Solutions: 1- %
n. The term structure of interest rates is the relationship between yield to maturity and
term to maturity for bonds of a single ris% class. The yield curve is the curve that
results when yield to maturity is plotted on the )-axis with term to maturity on the <-
axis.
o. =hen the yield curve slopes upward, it is said to be :normal,; because it is li%e this
most of the time. $onversely, a downward-sloping yield curve is termed :abnormal;
or :inverted.;
p. The expectations theory states that the slope of the yield curve depends on
expectations about future inflation rates and interest rates. Thus, if the annual rate of
inflation and future interest rates are expected to increase, the yield curve will be
upward sloping, whereas the curve will be downward sloping if the annual rates are
expected to decrease.
r. A foreign trade deficit occurs when businesses and individuals in the 5. &. import
more goods from foreign countries than are exported. Trade deficits must be
financed, and the main source of financing is debt. Therefore, as the trade deficit
increases, the debt financing increases, driving up interest rates. 5. &. interest rates
must be competitive with foreign interest rates2 if the /ederal 9eserve attempts to set
interest rates lower than foreign rates, foreigners will sell 5.&. bonds, decreasing
bond prices, resulting in higher 5. &. rates. Thus, if the trade deficit is large relative
to the si'e of the overall economy, it may hinder the /eds ability to combat a
recession by lowering interest rates.
1-7 &ole proprietorship, partnership, and corporation are the three principal forms of business
organi'ation. The advantages of the first two include the ease and low cost of formation.
The advantages of the corporation include limited liability, indefinite life, ease of
ownership transfer, and access to capital mar%ets.
The disadvantages of a sole proprietorship are 1# difficulty in obtaining large sums of
capital2 7# unlimited personal liability for business debts2 and ># limited life. The
disadvantages of a partnership are 1# unlimited liability, 7# limited life, ># difficulty of
transferring ownership, and 8# difficulty of raising large amounts of capital. The
disadvantages of a corporation are 1# double taxation of earnings and 7# re,uirements to
file state and federal reports for registration, which are expensive, complex and time-
consuming.
1-> The three primary determinants of a firms cash flows are? 1# sales revenues2 7#
operating expenses, such as raw materials costs and labor costs2 and ># the necessary
investments in operating capital, such as buildings, e,uipment, and inventory.
1-8 /inancial intermediaries are business organi'ations that receive funds in one form and
repac%age them for the use of those who need funds. Through financial intermediation,
resources are allocated more effectively, and the real output of the economy is thereby
Answers and Solutions: 1- &
increased.
1-@ &hort-term rates are more volatile because 1# the /ed operates mainly in the short-term
sector, hence /ederal 9eserve intervention has its ma-or effect here, and 7# long-term
rates reflect the average expected inflation rate over the next 7A to >A years, and this
average does not change as radically as year-to-year expectations.
1-B a. If transfers between the two mar%ets were costly, interest rates would be different in
the two areas. Area ), with the relatively young population, would have less in
savings accumulation and stronger loan demand. Area 4, with the relatively old
population, would have more savings accumulation and wea%er loan demand as the
members of the older population have already purchased their houses, and are less
consumption oriented. Thus, supply3demand e,uilibrium would be at a higher rate of
interest in Area ).
b. )es. (ationwide branching, and so forth, would reduce the cost of financial transfers
between the areas. Thus, funds would flow from Area 4 with excess relative supply
to Area ) with excess relative demand. This flow would increase the interest rate in
Area 4 and decrease the interest rate in ) until the rates were roughly e,ual, the
difference being the transfer cost.
1-C a. The immediate effect on the yield curve would be to lower interest rates in the short-
term end of the mar%et, since the /ed deals primarily in that mar%et segment.
Dowever, people would expect higher future inflation, which would raise long-term
rates. The result would be a much steeper yield curve.
b. If the policy is maintained, the expanded money supply will result in increased rates
of inflation and increased inflationary expectations. This will cause investors to
increase the inflation premium on all debt securities, and the entire yield curve would
rise2 that is, all rates would be higher.
Answers and Solutions: 1- '
SO("T#ONS TO END-OF-CHATER RO)(E*S
1-1 r6 E >F2 I1 E 7F2 I7 E 8F2 I> E 8F2 09" E A2 rT-7 E G2 rT-> E G
r E r6 H I" H .9" H !" H 09".
&ince these are Treasury securities, .9" E !" E A.
rT-7 E r6 H I"7
I"7 E 7F H 8F#37 E >F
rT-7 E >F H >F E BF.
rT-> E r6 H I">
I"> E 7F H 8F H 8F#3> E >.>>F
rT-> E >F H >.>>F E B.>>F.
1-7 rT-1A E BF2 r$-1A E IF2 !" E A.@F2 .9" E G
r E r6 H I" H .9" H !" H 09".
rT-1A E BF E r6 H I" H 09"2 .9" E !" E A.
r$-1A E IF E r6 H I" H .9" H A.@F H 09".
+ecause both bonds are 1A-year bonds the inflation premium and maturity ris% premium
on both bonds are e,ual. The only difference between them is the li,uidity and default
ris% premiums.
r$-1A E IF E r6 H I" H 09" H A.@F H .9". +ut we %now from above that r6 H I" H 09"
E BF2 therefore,
r$-1A E IF E BF H A.@F H .9"
1.@F E .9".
1-> r6 E >F2 I" E >F2 rT-7 E B.7F2 09"7 E G
rT-7 E %6 H I" H 09" E B.7F
rT-7 E >F H >F H 09" E B.7F
09" E A.7F.
Answers and Solutions: 1- +
1-8 r E r6 H I" H 09" H .9" H !".
r6 E A.A>.
I" E JA.A> H A.A8 H @#A.A>@#K3C E A.A>@.
09" E A.AAA@B# E A.AA>.
.9" E A.
!" E A.
r E A.A> H A.A>@ H A.AA> E A.ABI E B.IF.
1-@ /irst, note that we will use the e,uation rt E >F H I"t H 09"t. =e have the data needed
to find the I"s?
I"@ E
@
8F H 8F H 8F H @F H IF
E
5
25%
E @F.
I"7 E
2
5% + 8%
E B.@F.
(ow we can substitute into the e,uation?
r7 E >F H B.@F H 09"7 E 1AF. r@ E >F H @F H 09"@ E 1AF.
(ow we can solve for the 09"s, and find the difference?
09"@ E 1AF - IF E 7F. 09"7 E 1AF - L.@F E A.@F.
.ifference E 7F - A.@F# E 1.@F.
1-B +asic relevant e,uations?
rt E r6 H I"t H .9"t H 09"t H !"t.
+ut here I" is the only premium, so rt E r6 H I"t.
I"t E Avg. inflation E I1 H I7 H ...#3(.
=e %now that I1 E I"1 E >F and r6 E 7F. Therefore,
r1 E 7F H >F E @F. r> E r1 H 7F E @F H 7F E CF. +ut,
r> E r6 H I"> E 7F H I"> E CF, so
I"> E CF - 7F E @F.
Answers and Solutions: 1- ,
=e also %now that It E $onstant after t E 1.
=e can set up this table?
r6 I Avg. I E I"t r E r6 H I"t
1 7 > >F31 E >F @F
7 7 I >F H I#37 E I"7
> 7 I >F H I H I#3> E I"> r> E CF, so I"> E CF - 7F E @F.
Avg. I E I"> E >F H 7I#3> E @F
7I E 17F
I E BF.
1-C a. 9eal
)ears to 9is%-/ree
0aturity 9ate r6# I"66 09" rT E r6 H I" H 09"
1 7F C.AAF A.7F L.7AF
7 7 B.AA A.8 I.8A
> 7 @.AA A.B C.BA
Answers and Solutions: 1- -
8 7 8.@A A.I C.>A
@ 7 8.7A 1.A C.7A
1A 7 >.BA 1.A B.BA
7A 7 >.>A 1.A B.>A
66The computation of the inflation premium is as follows?
*xpected Average
)ear Inflation *xpected Inflation
1 CF C.AAF
7 @ B.AA
> > @.AA
8 > 8.@A
@ > 8.7A
1A > >.BA
7A > >.>A
/or example, the calculation for > years is as follows?
@.AAF. E
>
>F H @F H CF
Thus, the yield curve would be as follows?
Answers and Solutions: 1- .
b. The interest rate on the *xxon bonds has the same components as the Treasury
securities, except that the *xxon bonds have default ris%, so a default ris% premium
must be included. Therefore,
r*xxon E r6 H I" H 09" H .9".
/or a strong company such as *xxon, the default ris% premium is virtually 'ero for
short-term bonds. Dowever, as time to maturity increases, the probability of default,
although still small, is sufficient to warrant a default premium. Thus, the yield ris%
curve for the *xxon bonds will rise above the yield curve for the Treasury securities.
In the graph, the default ris% premium was assumed to be 1.A percentage point on the
7A-year *xxon bonds. The return should e,ual B.>F H 1F E C.>F.
c. !I!$4 bonds would have significantly more default ris% than either Treasury
securities or *xxon bonds, and the ris% of default would increase over time due to
possible financial deterioration. In this example, the default ris% premium was
assumed to be 1.A percentage point on the 1-year !I!$4 bonds and 7.A percentage
points on the 7A-year bonds. The 7A-year return should e,ual B.>F H 7F E I.>F.
Answers and Solutions: 1- 1/
(%)
11.0
10.5
10.0
9.5
9.0
8.5
8.0
7.5
7.0
0 2 4 6 8 10 12 14 16 18 20
Interest Rate
6.5
LILCO
Exxon
T-bons
!ears to "at#r$t%
SO("T#ON TO SREADSHEET RO)(E*
1-I The detailed solution for the spreadsheet problem is available both on the instructors
resource $.-940 in the file Solution for FM11 Ch 01 P08 Build a Model.xls# and on
the instructors side of the textboo%s web site, http0112ri3ham45wcolle3e4com.
Answers and Solutions: 1- 11
*#N# CASE
A556me that 7o6 recentl7 3rad6ated with a de3ree in finance and have 865t reported to
wor9 a5 an inve5tment advi5or at the 2ro9era3e firm of )ali9 and :iefer #nc4 One of the
firm;5 client5 i5 *ichelle Dellatorre< a profe55ional tenni5 pla7er who ha5 865t come to the
"nited State5 from Chile4 Dellatorre i5 a hi3hl7 ran9ed tenni5 pla7er who wo6ld li9e to
5tart a compan7 to prod6ce and mar9et apparel that 5he de5i3n54 She al5o e=pect5 to inve5t
5625tantial amo6nt5 of mone7 thro63h )ali9 and :iefer4 Dellatorre i5 al5o ver7 2ri3ht<
and< therefore< 5he wo6ld li9e to 6nder5tand< in 3eneral term5< what will happen to her
mone74 >o6r 2o55 ha5 developed the followin3 5et of ?6e5tion5 which 7o6 m65t a59 and
an5wer to e=plain the "4S4 financial 575tem to Dellatorre4
a4 Wh7 i5 corporate finance important to all mana3er5@
An5wer0 $orporate finance provides the s%ills managers need to? 1# identify and select the
corporate strategies and individual pro-ects that add value to their firm2 and 7#
forecast the funding re,uirements of their company, and devise strategies for
ac,uiring those funds.
24 De5cri2e the or3aniAational form5 a compan7 mi3ht have a5 it evolve5 from a 5tart-6p
to a ma8or corporation4 (i5t the advanta3e5 and di5advanta3e5 of each form4
An5wer0 The three main forms of business organi'ation are 1# sole proprietorships, 7#
partnerships, and ># corporations. In addition, several hybrid forms are gaining
popularity. These hybrid forms are the limited partnership, the limited liability
partnership, the professional corporation, and the s corporation.
The proprietorship has three important advantages? 1# it is easily and
inexpensively formed, 7# it is sub-ect to few government regulations, and ># the
business pays no corporate income taxes. The proprietorship also has three important
limitations? 1# it is difficult for a proprietorship to obtain large sums of capital2 7#
the proprietor has unlimited personal liability for the businesss debts, and ># the life
of a business organi'ed as a proprietorship is limited to the life of the individual who
created it.
The ma-or advantage of a partnership is its low cost and ease of formation. The
disadvantages are similar to those associated with proprietorships? 1# unlimited
liability, 7# limited life of the organi'ation, ># difficulty of transferring ownership,
and 8# difficulty of raising large amounts of capital. The tax treatment of a
partnership is similar to that for proprietorships, which is often an advantage.
Mini Case: 1 - 1$
The corporate form of business has three ma-or advantages? 1# unlimited life, 7#
easy transferability of ownership interest, and ># limited liability. =hile the
corporate form offers significant advantages over proprietorships and partnerships, it
does have two primary disadvantages? 1# corporate earnings may be sub-ect to
double taxation and 7# setting up a corporation and filing the many re,uired state and
federal reports is more complex and time-consuming than for a proprietorship or a
partnership.
In a limited partnership, the limited partners are liable only for the amount of their
investment in the partnership2 however, the limited partners typically have no control.
The limited liability partnership form of organi'ation combines the limited liability
advantage of a corporation with the tax advantages of a partnership. "rofessional
corporations provide most of the benefits of incorporation but do not relieve the
participants of professional liability. & corporations are similar in many ways to
limited liability partnerships, but !!"& fre,uently offer more flexibility and benefits
to their owners.
c4 How do corporation5 B3o p62licC and contin6e to 3row@ What are a3enc7
pro2lem5@
An5wer0 A company goes public when it sells stoc% to the public in an initial public as the firm
grows, it might issue additional stoc% or debt. An agency problem occurs when the
managers of the firm act in their own self interests and not in the interests of the
shareholders.
d4 What 5ho6ld 2e the primar7 o28ective of mana3er5@
An5wer0 The corporations primary goal is stoc%holder wealth maximi'ation, which translates
to maximi'ing the price of the firms common stoc%.
d4 14 Do firm5 have an7 re5pon5i2ilitie5 to 5ociet7 at lar3e@
An5wer0 /irms have an ethical responsibility to provide a safe wor%ing environment, to avoid
polluting the air or water, and to produce safe products. Dowever, the most
significant cost-increasing actions will have to be put on a mandatory rather than a
voluntary basis to ensure that the burden falls uniformly on all businesses.
Mini Case: 1- 1%
d4 $4 #5 5toc9 price ma=imiAation 3ood or 2ad for 5ociet7@
An5wer0 The same actions that maximi'e stoc% prices also benefit society. &toc% price
maximi'ation re,uires efficient, low-cost operations that produce high-,uality goods
and services at the lowest possible cost. &toc% price maximi'ation re,uires the
development of products and services that consumers want and need, so the profit
motive leads to new technology, to new products, and to new -obs. Also, stoc% price
maximi'ation necessitates efficient and courteous service, ade,uate stoc%s of
merchandise, and well-located business establishments--factors that are all necessary
to ma%e sales, which are necessary for profits.
d4 %4 Sho6ld firm5 2ehave ethicall7@
An5wer0 )es. 9esults of a recent study indicate that the executives of most ma-or firms in the
5nited &tates believe that firms do try to maintain high ethical standards in all of their
business dealings. /urthermore, most executives believe that there is a positive
correlation between ethics and long-run profitability. $onflicts often arise between
profits and ethics. $ompanies must deal with these conflicts on a regular basis, and a
failure to handle the situation properly can lead to huge product liability suits and
even to ban%ruptcy. There is no room for unethical behavior in the business world.
e4 What three a5pect5 of ca5h flow5 affect the val6e of an7 inve5tment@
An5wer0 1# amount of expected cash flows2 7# timing of the cash flow stream2 and >#
ris%iness of the cash flows.
f4 What are free ca5h flow5@ What are the three determinant5 of free ca5h flow5@
An5wer0 free cash flows are the cash flows available for distribution to all investors
stoc%holders and creditors# after paying expenses including taxes# and ma%ing the
necessary investments to support growth. Three factors determine cash flows? 1#
current level and growth rates of sales2 7# operating expenses2 and ># capital
expenses.
34 What i5 the wei3hted avera3e co5t of capital@ What affect5 it@
An5wer0 The weighted average cost of capital =A$$# is the average rate of return re,uired
by all of the companys investors stoc%holders and creditors#. It is affected by the
firms capital structure, interest rates, the firms ris%, and the mar%ets overall attitude
toward ris%.
Mini Case: 1 - 1&
h4 How do free ca5h flow5 and the wei3hted avera3e co5t of capital interact to
determine a firm;5 val6e@
An5wer0 A firms value is the sum of all future expected free cash flows, converted into todays
dollars.

+
+
+
+
+
=
# =A$$ 1
/$/
. . . .
# =A$$ 1
/$/
# =A$$ 1
/$/
Malue
7
7
1
1
i4 What are financial a55et5@ De5cri2e 5ome financial in5tr6ment54
An5wer0 /inancial assets are pieces of paper with contractual obligations. &ome short-term
i.e., they mature in less than a year# are instruments with low default ris% are u.s.
treasury bills, ban%ers acceptances, commercial paper, negotiable $.s, and
eurodollar deposits. $ommercial loans which have maturities up to seven years#
have rates that are usually tied to the prime rate i.e., the rate that 5.&. ban%s charge
to their best customers# or !I+49 the !ondon Interban% 4ffered 9ate, which is the
rate that ban%s in the 5.N. charge one another. 5.&. treasury notes and bonds have
maturities from two to thirty years2 they are free of default ris%. 0ortgages have
maturities up to thirty years. 0unicipal bonds have maturities of up to thirty years2
their interest is exempt from most taxes. $orporate bonds have maturities up to forty
years. 0unicipal and corporate bonds are sub-ect to default ris%. &ome preferred
stoc%s have no maturity date, some do have a specific maturity date. $ommon stoc%
has no maturity date, and is ris%ier than preferred stoc%.
84 Who are the provider5 D5aver5E and 65er5 D2orrower5E of capital@ How i5 capital
tran5ferred 2etween 5aver5 and 2orrower5@
An5wer0 Douseholds are net savers. (on-financial corporations are net borrowers.
Oovernments are net borrowers, although the 5.&. government is a net saver when it
runs a surplus. (on-financial corporations i.e., financial intermediaries# are slightly
net borrowers, but they are almost brea%even. $apital is transferred through? 1#
direct transfer e.g., corporation issues commercial paper to insurance company#2 7#
an investment ban%ing house e.g., I"4, seasoned e,uity offering, or debt placement#2
># a financial intermediary e.g., individual deposits money in ban%, ban% ma%es
commercial loan to a company#.
Mini Case: 1- 1'
94 (i5t 5ome financial intermediarie54
An5wer0 $ommercial ban%s, savings P loans, mutual savings ban%s, and credit unions, life
insurance companies, mutual funds, and pension funds are financial intermediaries.
l4 What are 5ome different t7pe5 of mar9et5@
An5wer0 A mar%et is a method of exchanging one asset usually cash# for another asset. &ome
types of mar%ets are? physical assets vs. financial assets2 spot versus future mar%ets2
money versus capital mar%ets2 primary versus secondary mar%ets.
m4 How are 5econdar7 mar9et5 or3aniAed@
An5wer0 They are categori'ed by :location; physical location exchanges or
computer3telephone networ%s# and by the way that orders from buyers and sellers are
matched open outcry auctions, dealers i.e., mar%et ma%ers#, and electronic
communications networ%s *$(&#.
m4 14 (i5t 5ome ph75ical location mar9et5 and 5ome comp6ter1telephone networ954
An5wer0 "hysical location exchanges include the ()&*, A0*<, $+4T, and To%yo stoc%
exchange. $omputer3telephone networ%s include (asda,, government bond mar%ets,
and foreign exchange mar%ets.
m4 $4 E=plain the difference5 2etween open o6tcr7 a6ction5< dealer mar9et5< and
electronic comm6nication5 networ95 DECNSE4
An5wer0 The ()&* and A0*< are the two largest auction mar%ets for stoc%s ()&* is a
modified auction, with a :specialist;#. "articipants have a seat on the exchange, meet
face-to-face, and place orders for themselves or for their clients2 e.g., $+4T. &ome
orders are mar%et orders, which are executed at the current mar%et price, some are
limit orders, which specify that the trade should occur only at a certain price within a
certain time period or the trade does not occur at all#. In dealer mar%ets, :dealers;
%eep an inventory of the stoc% or other financial asset# and place bid and as%
:advertisements,; which are prices at which they are willing to buy and sell. A
computeri'ed ,uotation system %eeps trac% of bid and as% prices, but does not
automatically match buyers and sellers. &ome examples of dealer mar%ets are the
(asda, national mar%et, the (asda, small cap mar%et, the !ondon &*AQ, and the
Oerman (euer mar%et. *$(& are computeri'ed systems that match orders from
buyers and sellers and automatically execute the trades. &ome examples are Instinet
Mini Case: 1 - 1+
5&, stoc%s#, *urex &wiss-Oerman, futures contracts#, sets !ondon, stoc%s#. In the
old days, securities were %ept in a safe behind the counter, and passed :over the
counter; when they were sold. (ow the 4T$ mar%et is the e,uivalent of a computer
bulletin board, which allows potential buyers and sellers to post an offer. Dowever,
the 4T$ has no dealers and very poor li,uidity.
n4 What do we call the price that a 2orrower m65t pa7 for de2t capital@ What i5 the
price of e?6it7 capital@ What are the fo6r mo5t f6ndamental factor5 that affect
the co5t of mone7< or the 3eneral level of intere5t rate5< in the econom7@
An5wer0 The interest rate is the price paid for borrowed capital, while the return on e,uity
capital comes in the form of dividends plus capital gains. The return that investors
re,uire on capital depends on 1# production opportunities, 7# time preferences for
consumption, ># ris%, and 8# inflation.
"roduction opportunities refer to the returns that are available from investment in
productive assets? the more productive a producer firm believes its assets will be, the
more it will be willing to pay for the capital necessary to ac,uire those assets.
Time preference for consumption refers to consumers preferences for current
consumption versus savings for future consumption? consumers with low preferences
for current consumption will be willing to lend at a lower rate than consumers with a
high preference for current consumption.
Inflation refers to the tendency of prices to rise, and the higher the expected rate
of inflation, the larger the re,uired rate of return.
9is%, in a money and capital mar%et context, refers to the chance that a loan will
not be repaid as promised--the higher the perceived default ris%, the higher the
re,uired rate of return.
9is% is also lin%ed to the maturity and li,uidity of a security. The longer the
maturity and the less li,uid mar%etable# the security, the higher the re,uired rate of
return, other things constant.
The preceding discussion related to the general level of money costs, but the level
of interest rates will also be influenced by such things as fed policy, fiscal and foreign
trade deficits, and the level of economic activity. Also, individual securities will have
higher yields than the ris%-free rate because of the addition of various premiums as
discussed below.
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o4 What i5 the real ri59-free rate of intere5t DrFE and the nominal ri59-free rate
DrRFE@ How are the5e two rate5 mea56red@
An5wer0 Neep these e,uations in mind as we discuss interest rates. =e will define the terms as
we go along?
r E r6 H I" H .9" H !" H 09".
r9/ E r6 H I".
The real ris%-free rate, r6, is the rate that would exist on default-free securities in the
absence of inflation.
The nominal ris%-free rate, rrf, is e,ual to the real ris%-free rate plus an inflation
premium which is e,ual to the average rate of inflation expected over the life of the
security.
There is no truly ris%less security, but the closest thing is a short-term 5. &.
Treasury bill t-bill#, which is free of most ris%s. The real ris%-free rate, r6, is
estimated by subtracting the expected rate of inflation from the rate on short-term
treasury securities. It is generally assumed that r6 is in the range of 1 to 8 percentage
points. The t-bond rate is used as a proxy for the long-term ris%-free rate. Dowever,
we %now that all long-term bonds contain interest rate ris%, so the t-bond rate is not
really ris%less. It is, however, free of default ris%.
p4 Define the term5 inflation premi6m D#E< defa6lt ri59 premi6m DDRE< li?6idit7
premi6m D(E< and mat6rit7 ri59 premi6m D*RE4 Which of the5e premi6m5 i5
incl6ded when determinin3 the intere5t rate on D1E 5hort-term "4S4 trea56r7
5ec6ritie5< D$E lon3-term "4S4 trea56r7 5ec6ritie5< D%E 5hort-term corporate
5ec6ritie5< and D&E lon3-term corporate 5ec6ritie5@ E=plain how the premi6m5
wo6ld var7 over time and amon3 the different 5ec6ritie5 li5ted a2ove4
An5wer0 The inflation premium I"# is a premium added to the real ris%-free rate of interest to
compensate for expected inflation.
The default ris% premium .9"# is a premium based on the probability that the
issuer will default on the loan, and it is measured by the difference between the
interest rate on a 5.&. treasury bond and a corporate bond of e,ual maturity and
mar%etability.
A li,uid asset is one that can be sold at a predictable price on short notice2 a
li,uidity premium is added to the rate of interest on securities that are not li,uid.
The maturity ris% premium 09"# is a premium which reflects interest rate ris%2
longer-term securities have more interest rate ris% the ris% of capital loss due to rising
interest rates# than do shorter-term securities, and the 09" is added to reflect this
ris%.
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1. &hort-term treasury securities include only an inflation premium.
7. !ong-term treasury securities contain an inflation premium plus a maturity ris%
premium. (ote that the inflation premium added to long-term securities will
differ from that for short-term securities unless the rate of inflation is expected to
remain constant.
>. The rate on short-term corporate securities is e,ual to the real ris%-free rate plus
premiums for inflation, default ris%, and li,uidity. The si'e of the default and
li,uidity premiums will vary depending on the financial strength of the issuing
corporation and its degree of li,uidity, with larger corporations generally having
greater li,uidity because of more active trading.
8. The rate for long-term corporate securities also includes a premium for maturity
ris%. Thus, long-term corporate securities generally carry the highest yields of
these four types of securities.
?4 What i5 the term 5tr6ct6re of intere5t rate5@ What i5 a 7ield c6rve@
An5wer? The term structure of interest rates is the relationship between interest rates, or
yields, and maturities of securities. =hen this relationship is graphed, the resulting
curve is called a yield curve.
Mini Case: 1- 1.
r4 S6ppo5e mo5t inve5tor5 e=pect the inflation rate to 2e ' percent ne=t 7ear< +
percent the followin3 7ear< and - percent thereafter4 The real ri59-free rate i5 %
percent4 The mat6rit7 ri59 premi6m i5 Aero for 5ec6ritie5 that mat6re in 1 7ear
or le55< /41 percent for $-7ear 5ec6ritie5< and then the *R increa5e5 27 /41
percent per 7ear thereafter for $/ 7ear5< after which it i5 5ta2le4 What i5 the
intere5t rate on 1-7ear< 1/-7ear< and $/-7ear trea56r7 5ec6ritie5@ Draw a 7ield
c6rve with the5e data4 What factor5 can e=plain wh7 thi5 con5tr6cted 7ield
c6rve i5 6pward 5lopin3@
An5wer0 &tep 1? find the average expected inflation rate over years 1 to 7A?
)r 1? I" E @.AF.
)r 1A? I" E @ H B H I H I H I H ... H I#31A E C.@F.
)r 7A? I" E @ H B H I H I H ... H I#37A E C.C@F.
&tep 7? find the maturity premium in each year?
)r 1? 09" E A.AF.
)r 1A? 09" E A.1 L E A.LF.
)r 7A? 09" E A.1 1L E 1.LF.
&tep >? sum the I"& and 09"&, and add r6 E >F?
)r 1? r9/ E >F H @.AF H A.AF E I.AF.
)r 1A? r9/ E >F H C.@F H A.LF E 11.8F.
)r 7A? r9/ E >F H C.C@F H 1.LF E 17.B@F.
The shape of the yield curve depends primarily on two factors?
1# expectations about future inflation and 7# the relative ris%iness of securities with
different maturities.
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The constructed yield curve is upward sloping. This is due to increasing expected
inflation and an increasing maturity ris% premium.
54 At an7 3iven time< how wo6ld the 7ield c6rve facin3 an AAA-rated compan7
compare with the 7ield c6rve for "4 S4 Trea56r7 5ec6ritie5@ At an7 3iven time<
how wo6ld the 7ield c6rve facin3 a ))-rated compan7 compare with the 7ield
c6rve for "4 S4 Trea56r7 5ec6ritie5@ Draw a 3raph to ill65trate 7o6r an5wer4
An5wer0 The yield curve normally slopes upward, indicating that short-term interest rates are
lower than long-term interest rates. )ield curves can be drawn for government
securities or for the securities of any corporation, but corporate yield curves will
always lie above government yield curves, and the ris%ier the corporation, the higher
its yield curve. The spread between a corporate yield curve and the treasury curve
widens as the corporate bond rating decreases.
Mini Case: 1- $1
1&
12
11
10
9
8
!ears to 'at#r$t%
0 1 5 10 15 20
Interest
rate (%)
t4 What i5 the p6re e=pectation5 theor7@ What doe5 the p6re e=pectation5 theor7
impl7 a2o6t the term 5tr6ct6re of intere5t rate5@
An5wer0 The pure expectations theory assumes that investors establish bond prices and interest
rates strictly on the basis of expectations for interest rates. This means that they are
indifferent with respect to maturity in the sense that they do not view long-term bonds
as being ris%ier than short-term bonds. If this were true, then the maturity ris%
premium would be 'ero, and long-term interest rates would simply be a weighted
average of current and expected future short-term interest rates. If the pure
expectations theory is correct, you can use the yield curve to :bac% out; expected
future interest rates.
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4 - 20
Copyright 2002 by Harcourt, Inc. All rights reserved.
Hypothetical Treasury and
Corporate Yield Curves
0
5
0
5
0 5 0 5 20
Years to
!aturity
Interest
"ate #$%
5.2$
5.&$
'.0$
Treasury
yield curve
(()"ated
AAA)"ated
64 Finall7< Dellatorre i5 al5o intere5ted in inve5tin3 in co6ntrie5 other than the
"nited State54 De5cri2e the vario65 t7pe5 of ri595 that ari5e when inve5tin3
over5ea54
An5wer0 /irst, .ellatorre should consider country ris%, which refers to the ris% that arises from
investing or doing business in a particular country. This ris% depends on the countrys
economic, political, and social environment. $ountry ris% also includes the ris% that
property will be expropriated without ade,uate compensation, as well as new host
country stipulations about local production, sourcing or hiring practices, and damage
or destruction of facilities due to internal strife.
&econd, .ellatorre should consider exchange rate ris%. .ellatorre needs to %eep
in mind when investing overseas that more often than not the security will be
denominated in a currency other than the dollar, which means that the value of the
investment will depend on what happens to exchange rates. Two factors can lead to
exchange rate fluctuations. $hanges in relative inflation will lead to changes in
exchange rates. Also, an increase in country ris% will also cause the countrys
currency to fall. $onse,uently, inflation ris%, country ris%, and exchange rate ris% are
all interrelated.
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