Chapter 2:

FINANCIAL MARKETS AND INTEREST RATES

__Principles of Finance__
LEARNING OBJECTIVES

•Operation of financial system.

•Financial markets

•Financial securities.

•Securities traded in the money and capital markets

•Interest rates
2.1. OPERATION OF FINANCIAL SYSTEM

• Financial system is comprised of markets, intermediaries, service firms

and other institutions used to carry out the financial decisions of households,
business firms, and governments.
­ The financial markets facilitate the trading of financial assets between market participants.

­ The financial assets are instruments that facilitate transactions in real assets or constitute
the subject of a transaction between market participants.

­ The financial intermediaries facilitate the financial transactions of market participants.

FINANCIAL SYSTEM

•The purpose of the financial system is to bring together individuals,

businesses, and government entities (economic units) that generate and spend
funds.
• Surplus economic units have funds left over after spending all they wish to spend.

• Deficit economic units need to acquire additional funds to sustain their operations.

•To enable funds to move through the financial system, funds are exchanged for
securities.
•Securities are documents that represent the right to receive funds in the future.
•Financial intermediaries discussed in Chapter 3 often help to facilitate this
process.
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2.2. FINANCIAL MARKETS

• Classified according to the characteristics of participants and securities

involved.

• The primary market is where deficit economic units sell new securities.

• The secondary market is where investors trade previously issued securities

with each other.
FINANCIAL MARKETS

• Intermediaries such as commercial banks and insurance companies help to

facilitate the flow of funds in the financial marketplace.
MARKET EFFICIENCY

• Market efficiency refers to the ease, speed, and cost of trading securities.
üThe market for the securities of large companies is generally efficient: Trades can be
executed in a matter of seconds and commissions are very low.

üThe real estate market is not generally efficient: It can take months to sell a house and
the commission is 67% of the price.
WHY IS MARKET EFFICIENCY IMPORTANT?

•The more efficient the market, the easier it is to transfer idle funds to those
parties that need the funds.

• If funds remain idle, this results in lower growth for the economy and higher
unemployment.

• Investors can adjust their portfolios easily and at low cost as their needs and
preferences change.
FINANCIAL MARKETS
• Money Market vs. Capital Market
• Money Market
­ Trade short term (1 year or less) debt instruments (e.g. T Bills, Commercial Paper)

­ Major money centers in Tokyo, London and New York

• Capital Market
­ Trades long term securities (Bonds, Stocks)

­ NYSE, ASE, over the counter (Nasdaq and other OTC)

• Derivative Market
• Trade derivative securities

• Derivative is a financial instrument whose value is derived from the value of an underlying asset.
2.3. SECURITIES IN THE FINANCIAL MARKET
Money Market Securities Capital Market Securities Derivative Securities

• Treasury Bills (T-Bills) Ø Bonds • Forwards

• Certificates of Deposit • Treasury Bonds • Futures

• Municipal Bonds
• Commercial Paper • Options
• Corporate Bonds
• Eurodollars • Swaps

Ø Stocks
• Banker’s Acceptances
• Common Stock
• Repurchase Agreement
• Preferred Stock
MONEY MARKET SECURITIES
1. Treasury Bills

•short term securities issued by the Government

• after initial sale they have an active secondary market

• they are bought at a discount and at maturity the investor receives the full
face value

• Maturities: typically 4, 13, 26 and 52 weeks

• Interest: No coupon, sold at a discount from the par amount

• Principal: Multiples of $100

MONEY MARKET SECURITIES
2. Negotiable Certificates of Deposit (NCDs)

ü Interest bearing securities issued by financial institutions

ü They have maturities of one year or less

ü Maturities: Typically 30-180 days, sometimes up to several years

ü Interest: Single coupon at maturity

MONEY MARKET SECURITIES
3. Commercial Papers

• unsecured debt instruments issued by corporations with good credit

ratings

• most buyers are large institutions

•Maturities: typically less than 30 days, up to 270 days also common

•Interest: No coupon, sold on discount basis

•Principal: Typically $250,000 or more

MONEY MARKET SECURITIES
4. Eurodollars

• dollar denominated deposits located in non-US banks

• buyers and sellers are large institutions

MONEY MARKET SECURITIES
5. Banker’s Acceptances

• debt securities that have been guaranteed by a bank

• used to facilitate international transactions

• Maturities: Typically range from 30 days to 180 days

• Interest: No coupon, but sold at a discount on the secondary market

MONEY MARKET SECURITIES
6. Repurchase Agreement

• Investor sells a security and agrees to buy it back on a fixed date for a
fixed price à Short-term secured borrowing

• Maturities: overnight up to 90 days

• Interest: implicit in a difference between…

­ Current price of security

­ And agreed repurchase price

CAPITAL MARKET SECURITIES
1. Bonds

•“IOUs” issued by the borrower and sold to investors

•The issuer promises to repay the face amount on the maturity date and to pay
interest each year in the amount of the coupon rate times the face value
ØTreasury Bonds
­ are issued by the federal gov’t.
ØMunicipal Bonds
­ are issued by state and local gov’ts.
ØCorporate Bonds
­ are issued by corporations.
CAPITAL MARKET SECURITIES

2. Stocks

•Companies can also raise funds by selling shares of stock

•Stockholders are not guaranteed any return on their investment

Ø Common Stockholders
• Own a portion of the company and can vote on major decisions
• They receive a return on their investment in the form of dividends and capital gains

Ø Preferred Stockholders
• Do not generally have voting rights, but have priority in receiving dividends
• Are paid dividends at a pre-set rate, usually stated as a percentage of face or par value
2.4. INTEREST RATES

• Determination of interest rates

• Term structure of interest rates

DETERMINATION OF INTEREST RATES

• Real Rate of Interest

• Expected Inflation

• Default Risk

• Maturity Risk

• Illiquidity Risk
REAL RATE OF RETURN

• Compensates for the lender’s lost opportunity to consume.

EXPECTED INFLATION

• Inflation erodes the purchasing power of money.

– Example: If you loan someone $1,000 and they pay it back one year later
with 10% interest, you will have $1,100. But if prices have increased by 5%,
then something that would have cost $1,000 at the outset of the loan will now
cost $1,000(1.05) = $1,050
NOMINAL RISK FREE RATE
•The real rate of interest PLUS the expected inflation combine to indicate
the risk-free rate

•This is considered “risk-free” because we have not included any

premiums for the uncertainties associated with borrowing and lending
DEFAULT RISK
• For most securities, there is some risk that the borrower will not repay
the interest and/or principal on time, or at all.

• The greater the chance of default, the greater the interest rate the
investor demands and the issuer must pay
MATURITY RISK

• If interest rates rise, lenders may find that their loans are earning rates
that are lower than what they could get on new loans.

• The risk of this occurring is higher for longer maturity loans.

• Lenders will adjust the premium

• They charge for this risk depending on whether they believe rates will go
up or down
ILLIQUIDITY RISK

• Investments that are easy to sell without losing value are more liquid.

• Illiquid securities have a higher interest rate to compensate the lender

for the inconvenience of being “stuck”.
DETERMINATION OF INTEREST RATES
k = k* + IRP + DRP + MP + ILP

k = the nominal, or observed rate on security

k* = real rate of interest

IRP = Inflation Risk Premium

DRP = Default Risk Premium

MP = Maturity Premium

ILP = Illiquidity Premium

TERM STRUCTURE OF INTEREST RATES

• Relationship between long and short term interest rates

• Yield curve
YIELD CURVE
YIELD CURVE

Source: US Treasury Department

QUICK QUIZ
1. To minimize risk, why don’t most firms simply finance their growth from
the profits they earn?

2. What market would a firm most probably go to if it needed cash for 90

days? If it needed cash for 10 years?

3. If your company’s stock were not listed on the New York Stock
Exchange, how could investors purchase the shares?

4. What alternatives does Microsoft, a very large and secure firm, have for
obtaining $3 million for 60 days?
QUICK QUIZ
5. Assume Treasury security yields for today are as follows:
­ One-year T-notes, 5.75%
­ Two-year T-notes, 5.5%
­ Three-year T-notes, 5.25%
­ Five-year T-notes, 5.0%
­ Ten-year T-notes, 4.75%
­ Twenty-year, T-bonds 4%
­ Thirty-year, T-bonds 3.25%
Draw a yield curve based on these data.