4-2

4-3

4

1.
2.
3.
4.
5.
6.

7. Term Structure of Interest Rates

8. Yield Curve
9. Yield Curve

10.
11.
12.
13.

4-4

 (What is a market?)

4-5

A market is a venue where goods and services

are exchanged. (
)
A financial market is a place where individuals and
organizations wanting to borrow funds are brought
together with those having a surplus of funds.
(
)

1.

Types of Market
1. Physical asset markets : (Tangible Real
asset markets)

Financial asset markets :

4-6

4-7

2. Spot markets : (on - the - spot)

Futures markets :

4-8

3. Money markets :
1
Capital markets :
1

4-9

4. Mortgage markets :


Consumer credit markets :

4 - 10

5. World, National, Reginal and Local

markets :


world markets

4 - 11

6. Primary markets () :

4 - 12

7. Secondary markets () :

4 - 13

(OTC)

( Primary Market )

( Secondary Market )

4 - 14

8. Initial public offering (IPO) market :

IPO

4 - 15

9. Private markets :
/

Public markets :

2.

4 - 16

How is capital transferred between savers and borrowers?

Direct transfers
Investment banking house

Financial intermediaries

4 - 17

Business

Securities (Stocks or Bonds)

Dollars

Savers

Business

Investment Bonds
Dollars Banking House Dollars

Savers

Business

Stocks

Business,
Securities

Dollars

Financial

Intermediary,s
Securities

Intermediary Dollars

Savers

4 - 18

S&L
Mutual Saving Banks
Credit Unions
Pension Funds

Mutual funds

...

4 - 20

3.
Organized Security Exchanges
Over - the - Counter Market : OTC

Physical location stock exchanges vs.

Electronic dealer - based markets

4 - 21

Auction market vs.

Dealer market
(Exchanges vs. OTC)
NYSE vs. Nasdaq
Differences are
narrowing
(Nasdaq = National Association of Securities Dealers Automated Quotation System )

4 - 22

4. (The Cost of Money)

The price, or cost, of debt capital is the interest rate.
( )
The price, or cost, of equity capital is the required
return. The required return investors expect is
composed of compensation in the form of dividends
and capital gains. (

)

4 - 23

Production opportunities
( )
Time preferences for
consumption (
)
Risk ( )
Expected inflation ( )

5.

4 - 24

Market A : Low - Risk Securities Market B : High - Risk Securities

Interest Rate , k
Interest Rate , k

kA = 10
8

S1

kB = 12

D1

D2

Dollars

S1

D1
0

Dollars

4 - 25

6.
k = k* + IP + DRP + LP + MRP

Nominal vs. Real rates

4 - 26

k = (represents any nominal

rate)
(required rate of return on a
debt security)
k* =
(realrisk - free rate of interest)

IP
kRF

4 - 27
= (inflation premium)
= k* + IP =

(rate of interest on treasury securities)

DRP =
(default risk premium)
LP =
(liquidity premium)
MRP =
(maturity risk premium)

4 - 28

kRF = k* + IP

Nominal (Quoted)

Risk - Free Rate - US. Treasury bill (T - bill)

of Interest
- Treasury bonds (T - bonds)
*

4 - 29

IP

DRP (Default Risk Premium)

DRP

4 - 30

LP (Liquidity Premium)

2 - 4 - 5 %

4 - 31

MRP (Maturity Risk Premium)

(interest rate risk)

4 - 32

Premiums added to k* for different types of debt

Types of debt

IP

S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

MRP DRP

LP

4 - 33

7. Term Structure of Interest Rates

Term structure
( )

[Term structure relationship between interest
rates (or yields) and maturities.]
Yield curve Term structure
[The yield curve is a graph of the term structure.]

4 - 34

Yield Curve
1. Normal Yield Curve == > Upward Sloping
2. Invested Yield Curve
Abnormal Yield Curve
3. Humped Yield Curve

== > Downward
Sloping

4 - 35
Yield Curve U.S.Treasury Bond
Interest Rate ( % )
16
14
Downward sloping .. 1980
12
10
8
Humped ..2000
6
Upward sloping ..2002
4
2
0 1 5
10
Years to Maturity

4 - 36
Treasury Yield Curve
Interest
Rate (%)
15
10

1 yr
5 yr
10 yr
30 yr

2.0%
4.5%
5.2%
5.7%

Yield Curve
(April 2002)

Years to Maturity

0
10

20

30

4 - 37

A Treasury yield curve from October 2002

4 - 38

8. Yield Curve

kT = kt* + IPt + MRPt

kCt = kt* + IPt + MRPt + DRPt + LPt

 Yield Curve
(Hypothetical Yield Curve)
Interest
Rate (%)
15

10

An upward sloping yield

curve. (yield curve
)
Upward slope due to an
increase in expected inflation
and increasing maturity risk
premium. (

Years to
MRP)

Maturity risk premium

Inflation premium

5
Real risk-free rate

0
1

10

4 - 39

20

Maturity

4 - 40
Treasury Yield Curve
Interest
Rate (%)
9

Maturity risk premium

Inflation premium

1 yr

3.00%

10 yr

4.00%

30 yr

4.67%

Real risk-free rate

Years to Maturity

0
1

15

30

4 - 41
Treasury Yield Curve
Interest
Rate (%)
9

Maturity risk premium

6
Inflation premium

Real risk-free rate

Years to Maturity

0
1

15

30

4 - 42
Treasury yield curve Corporate yield curve

Corporate yield curves are higher than that of Treasury

securities, though not necessarily parallel to the Treasury
curve. (Corporate yield curves Treasury securities
Treasury yield curve)
The spread between corporate and Treasury yield
curves widens as the corporate bond rating decreases.
( Corporate
Treasury yield curves )

4 - 43

Illustrating the relationship between corporate

and treasury yield curves
Interest
Rate (%)
15

BB-Rated
10

AAA-Rated

6.0%

5.9%

5.2%

Treasury
Yield Curve

Years to

Maturity
0

10

15

20

4 - 44

9. Yield Curve
Pure Expectations Hypothesis

The PEH contends that the shape of the yield curve depends
on investors expectations about future interest rates.
(PEH - yield curve
)
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. (

yield curve )

4 - 45

PEH (Assumptions of the PEH)

Assumes that the maturity risk premium for Treasury securities

is zero. ( MRP Treasury securities )
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. ( PEH
yield curve )

4 - 46

Yield Curve

Pure Expectations Theory :

 : Observed Treasury rates and the PEH

Maturity
1 year
2 years
3 years
4 years
5 years

4 - 47

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 one - year securities, one year from now?
Three-year securities, two years from now?

One-year forward rate

PEH says that one - year 6.2% = (6.0% + x%) / 2

securities will yield 6.4%, 12.4% = 6.0% + x%
one year from now.
6.4% = x%

4 - 48

4 - 49

Three - year security, two years from now

PEH says that one - year 6.5% = [2(6.2%) + 3(x%)]/ 5

securities will yield 6.7%, 32.5% = 12.4% + 3(x%)
one year from now.

6.7% = x%

 PEH (Conclusions about PEH)

Some would argue that the MRP 0, and hence the PEH
is incorrect. ( MRP 0
PEH )
Most evidence supports the general view that lenders
prefer S-T securities, and view L-T securities as riskier.
(
)

Thus, investors demand a MRP to get them to hold L-T

securities (i.e., MRP > 0). [ MRP
(i.e., MRP > 0) ]

4 - 50

4 - 57

10.

2

1. Exchange Rate Risk

2. Country Risk

4 - 58

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.

4 - 59

Changes in relative
inflation (
)
Changes in country risk
(
)

4 - 60

11.

IP, DRP, LP, MRP

Federal reserve policy ()
Federal budget surplus or deficit
()
Level of business activity ()
International factors ( )

12.

4 - 61

4 - 62

13.
1 30

1. 1
5.2 %
2. 30 6 %
2
1

4 - 63

1.

2.

4 - 64

k = (Required rate of return)

= (Discount rate)
= (Cost of capital)
= (Interest rate)
k =
(Realized rate of return)
^k =
(Expected rate of return)

k* =
Real risk - free rate of interest
kRF =
= k* + IP
kd = (Cost of debt)
kS =
(Cost of retained earning)

4 - 65

4 - 66

ke =
(Cost of new common stock)
kP =
(Cost of preferred stock)
kj =

k = k* + IP + DRP + LP + MRP