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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