ISBN: 0-03-028931-9
Chapter 5 The Financial Environment: Markets, Institutions, and Interest Rates
In this chapter, we discussed the nature of financial markets, the types of institutions that operate in these markets, how interest rates are determined, and some of the ways in which interest rates affect business decisions. In later chapters we will use this information to help value different investments, and to better understand corporate financing and investing decisions. The key concepts covered are listed below.
There are many different types of financial markets. Each market serves a different region or deals with a different type of security.
Physical asset markets, also called tangible or real asset markets, are those for such products as wheat, autos, and real estate.
Financial asset markets deal with stocks, bonds, notes, mortgages, and other claims on real assets.
Spot markets and futures markets are terms that refer to whether the assets are being bought or sold for "on-the-spot" delivery or for delivery at some future date.
Money markets are the markets for debt securities with maturities of less than one year.
Mortgage markets deal with loans on residential, commercial, and industrial real estate, and on farmland.
Capital markets are the markets for long-term debt and corporate stocks.
Primary markets are the markets in which corporations raise new capital.
Secondary markets are markets in which existing, already outstanding, securities are traded among investors.
The initial public offering market is a subset of the primary market, and provides a venue by which firms may offer shares of common stock to the public for the first time.
The private markets are venues where transactions are worked out directly between two parties. Public markets offer a place where standardized contracts are traded on organized exchanges.
A derivative is a security whose value is derived from the price of some other "underlying" asset.
Transfers of capital between borrowers and savers take place (1) by direct transfers of money and securities; (2) by transfers through investment bank houses, which act as middlemen; and (3) by transfers through financial intermediaries, which create new securities.
An investment banking house is an organization that underwrites and distributes new investment securities and helps businesses obtain financing.
Among the major classes of intermediaries are commercial banks, savings and loan associations, mutual savings backs, credit unions, pension funds, life insurance companies, and mutual funds.
One result of ongoing regulatory changes has been a blurring of the distinctions between the different financial institutions. The trend in the United States has been toward financial service corporations that offer a wide range of financial services, including investment banking, brokerage operations, insurance, and commercial banking.
The stock market is an especially important market because this is where stock prices (which are used to "grade" managers' performances) are established.
There are two basic types of stock markets-the formal exchanges (primarily the NYSE and Nasdaq markets) and the over-the-counter market.
Capital is allocated through the price system-a price must be paid to "rent" money. Lenders charge interest on funds they lend, while equity investors receive dividends and capital gains in return for letting firms use their money. The interest charged is called the cost of capital, or the cost of money.
Four fundamental factors affect the cost of money: (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.
The risk-free rate of interest, krf, is defined as the real risk-free rate, k*, plus the inflation premium (IP), hence krf = k* + IP.
The nominal (or quoted) interest rate on a debt security, k is composed of the real risk-free rate, k*, plus premiums that reflect inflation (IP), default risk (DRP), liquidity (LP), and maturity risk (MRP):
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k=k*+IP+DRP+LP+MRP
The default risk premium reflects the risk that a borrower will default on a loan, by failing to make a payment on interest or principal.
The liquidity premium is a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash quickly and close to fair market value.
The maturity risk premium serves as compensation to investors willing to hold long-term securities, and increases as the maturity of the security increases.
Reinvestment rate risk is the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested.
If the real risk-free rate of interest and the various premiums were constant over time, interest rates would be stable. However, both the real rate and the premiums- especially the premium for expected inflation-do change over time, causing market interest rates to change. Also, Federal Reserve interaction to increase or decrease the money supply, as well as international currency flows, lead to fluctuating interest rates.
The relationship between the yields of securities and the securities' maturities is known as the term structure of interest rates, and the yield curve is a graph of this relationship.
The shape of the yield curve depends on two key factors: (1) expectations about future inflation and (2) perceptions about the relative riskiness of securities with different maturities.
The yield curve is normally upward sloping-this is called a normal yield curve. However, the curve can slope downward (an inverted or abnormal yield curve) if the inflation rate is expected to decline. In some cases, the yield curve may be humped, as medium-term securities offer higher yields than both short-term and long-term securities (as was the case throughout the year 2000).
A number of theories have been proposed to explain the shape of the yield curve at any point in time. These theories include the expectations theory and liquidity preference theory.
Because interest rate levels are difficult, if not impossible to predict, sound financial policy calls for using a mix of short- and long-term debt, and also for positioning the firm to survive in any future interest rate environment.
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