Chapter 2 (Pinches) “Financial Systems, Interest Rates



Chapter 2 (Pinches) “Financial Systems, Interest Rates...”

Financial Markets: Money market - for ST (1 year or less) debts

Capital Market - LT assets: government bonds + private bonds + stocks

Preferred Stock - dividends paid before Common stock but claims on income come after debt.

Common Stock – receives dividends after Preferred stock

Primary - originally issued stocks + bonds.

Secondary - transferred between individuals + institutions - original issues not involved.

Security Exchange or Stock Markets - brings together buyers + sellers in secondary markets. E.g. -NYSE

-Tokyo, London

Importance of Role of Central Bank (e.g. Fed) to influence direction of ( of interest rates via tools of MP.

Tools of MP (Monetary Policy):

• Required reserve ratio (RRr) ↑ RRr => ↓Ms

• Open mkt. Operations (OMO): purchase by CB =>↑ Ms

Govt. int. rate policy (= discount rate = Fed. Funds rate): ↑r = ↓ Ms

CBs can affect, but not determine level on interest rates. If they could, then why have they determined that int.rates are at / or near historical lows? This reflects lack of sufficient profitability on RAs in macroeconomic sense.

According to neo-classical thinking, r determined by HK (human capital), physical k, tech ∆, innovation.

Creation of new RAs / Innovations is driving force of economic growth.

Quantity theory of Money: % ∆ P = % ∆ M – inflation is always a monetary phenomenon (Friedman).

▪ ( International economic integration ( importance of ER’s + (ER in affecting values of international assets.

Interest + Principal

Real interest rate = r = i - ( (3a)

i = nominal interest rate (risk-free)

( = expected inflation

r determined by S (from savers) + D (from investors) of loanable funds (LF).

r* = equilibrium r

(D or (S ( ( r*

(D or (S ( ( r*

(3a) ( i = r + ( (3b)

▪ If r is relatively constant ( ( ( ( (i (Fisher effect)

▪ Since inflation ( suppliers of funds are paid back in money with lower PP

▪ (3b) ( Nominal risk-free return (= kRF) = real interest rate + inflation premium

▪ Risk-free rate of return (i) is proxied by return on US Short-term (ST) T-bills

▪ PLT = P of LT bonds; PST = P of ST bonds

▪ If interest rates ( ( ( PLT + ( PST (interest rate r), but ( PLT > ( PST ( LT bonds require a maturity premium (mp) to compensate for (‘d risk due to ( interest rates ( interest rates on LT bonds > those on ST bonds.

Yield to Maturity (YTM) – k when bonds are held to maturity

Term structure - relationship between YTM + length to maturity

Yield curves (for a firm’s security) include the maturity premium.

YC1 ( (( YC2 ( (( (slope determined by ()

YC3 > YC1 ( greater risk associated with this firm

Since (r ( (PB (LT) > (PB (ST) ( preference will be to hold ST bonds due to smaller K loss

( To induce individuals to hold LT bonds – which are more desirable from firm’s point of view (to ( uncertainty) – a premium must be attached to LT bonds.

Risk Premium (RP) - bond issuer may not be able to pay principal + interest ( default premium

( Bond ratings: AAA – best ( C or less for default

( ( Quality of bond ( ( rating ( lower is i

T-bill yields represent risk free rate ( yield on corporate bond of same maturity - yield on T-bill = default premium (dp)

Liquidity – ability of an asset to be converted into cash (money is the most liquid asset)

Liquidity Premium (lp) - additional return required to compensate investors for investing in less liquid securities.

e.g. a small company stock may be more difficult to sell than a large, well-known company.

Issue-specific Premium (isp) - stocks vs. bonds – risk of no return to stock vs. bond

- due to problems unique to firm

( Risk Premium (RP) = mp + dp + lp + isp (RP is over + above risk free rate kRF)

( Required rate of return (k) - minimum return necessary to attract a firm or investor to make an investment.

k = kRF + RP

k represents minimum return expected by investors + the cost incurred by the firm.

- Negative slope YC ( LT debt cheaper than ST debt

- Interest rates ( in Recession.

- Equity more expensive means of financing for firm: since RP is higher + dividends are not tax deductible

Ps = stock P, determined by i, CF + r

( Ps = P (CF, i, r)

(CF ( ( Ps; (i ( ( Ps (( positive correlation between Ps + PB) or (i ( ( Ps due to a substitution effect (SE) in portfolios ( definition of Portfolio Balance (PB)

- PB ( (i ( (PV of CF’s ( (D for stocks ( (Ps

Yet (i also ( (CF ( ( Ps ( net effect depends on conditions in financial markets + economy.

Say in a recession low i ( low profits ( ↓CF (↓Ps

(r ( (k ( ( costs to firm for financing

A ( US T-bills

B ( LT government bonds

C ( LT corporate bonds

D ( Preferred stock

E ( Common stock

F ( Small Company stock

Variability of k (s in movement from A ( F ( ( variability of k ( (r

-----------------------

r

S

r*

D

LF

%

Yield (%)

YC3

YC1

YC2

M

M

F

k

E

D

C

B

A

R

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