Fin 3234
Transcript of Fin 3234
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Principles of Business
Finance
Fin 510
Dr. Lawrence P. Shao
Marshall University
Spring 2002
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CHAPTER 4The Financial Environment:
Markets, Institutions,
and Interest Rates
Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves
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Define these markets
Financial assets
Money vs. capitalPrimary vs. secondary
Spot vs. future
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Direct transfer
Investment banking house
Financial intermediary
Three Primary Ways Capital Is
Transferred Between Savers andBorrowers
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Organized Exchanges vs.
Over-the-Counter Market
Auction market vs. dealermarket (exchanges vs. OTC)
NYSE vs. NASDAQ system
Differences are narrowing
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What do we call the price, or cost,ofdebt capital?
The interest rate
What do we call the price, or cost,ofequity capital?
Required Dividend Capitalreturn yield gain
= + .
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What four factors affect the cost of
money?
Production opportunities
Time preferences for consumption
Risk
Expected inflation
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Real Versus Nominal Rates
k* = Real risk-free rate.T-bond rate if no inflation;1% to 4%.
= Any nominal rate.
= Rate on Treasury securities.
k
kRF
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k = k* + IP + DRP + LP + MRP.
Here:
k = Required rate of return on a
debt security.k* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.LP = Liquidity premium.
MRP = Maturity risk premium.
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Premiums Added to k* for Different
Types of Debt
S-T Treasury: only IP for S-T inflation
L-T Treasury: IP for L-T inflation, MRP
S-T corporate: S-T IP, DRP, LP
L-T corporate: IP, DRP, MRP, LP
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What is the term structure of interest
rates? What is a yield curve?
Term structure: the relationshipbetween interest rates (or yields)and maturities.
A graph of the term structure iscalled the yield curve.
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Treasury Yield Curve
0
5
10
15
10 20 30
Years to Maturity
Interest
Rate (%)1 yr 5.4%
5 yr 5.7%
10 yr 5.7%
30 yr 6.0%Yield Curve
(March 1998)
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What are the 2 main factors that
explain the shape of the yield curve?
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1. Expectations
Shape of the yield curve dependson the investors expectations
about future interest rates.
If interest rates are expected toincrease, L-T rates will be higher
than S-T rates and vice versa.Thus, the yield curve can slope upor down.
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Assume that 1-year securities yield 6%today, and the market expects that 1-
year securities will yield 7% in 1 year,and that 1-year securities will yield 8%in 2 years.
If the PEH is correct, the 2-year ratetoday should be 6.5% = (6% + 7%)/2.
If the PEH is correct, the 3-year ratetoday should be 7% = (6% + 7% + 8%)/3.
An Example
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Some argue that the PEH isnt correct,because securities of differentmaturities have different risk.
General view (supported by mostevidence) is that lenders prefer S-Tsecurities, and view L-T securities as
riskier.Thus, investors demand a MRP to get
them to hold L-T securities (i.e., MRP> 0).
2. Risk
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Example data:
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).
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Yield Curve Construction
Step 1:Find the average expected
inflation rate over years 1 to n:n
SINFLtt = 1
nIPn = .
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IP1 = 5%/1.0 = 5.00%.
IP10 = [5 + 6 + 8(8)]/10 = 7.50%.
IP20 = [5 + 6 + 8(18)]/20 = 7.75%.
Must earn these IPs to break even vs.
inflation; these IPs would permit you toearn k* (before taxes).
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Step 2: Find MRP based on thisequation:
MRPt = 0.1%(t - 1).
MRP1 = 0.1% x 0 = 0.0%.
MRP10= 0.1% x 9 = 0.9%.
MRP20= 0.1% x 19 = 1.9%.
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Step 3: Add the IPs and MRPs to k*:
kRFt = k* + IPt + MRPt .
kRF = Quoted market interestrate on treasury securities.
Assume k* = 3%:
kRF1 = 3.0% + 5.0% + 0.0% = 8.0%.kRF10 = 3.0% + 7.5% + 0.9% = 11.4%.
kRF20 = 3.00% + 7.75% + 1.90% = 12.65%.
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Yield Curves
0
5
10
15
0 1 5 10 15 20
Years to
maturity
Interest
Rate (%)
5.4%5.7%
6.0%
BB-Rated
AAA-Rated
Treasury
yield curve