Financial Markets Four Fundamental Factors - PowerPoint

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					Financial Markets

   A market is a place where goods and
    services are exchanged.

   A financial market is a place where
    individuals and organizations who want
    to borrow funds are brought together
    with those having a surplus of funds.

We can classify markets

Based on:    Underlying asset
             Delivery date



   London Gold Market
       physical, spot
   New York Stock Exchange
      financial, spot, secondary, capital
   Sale of commercial paper by HP
      financial, money, primary

How is capital transferred between savers and

   Direct transfers
   Investment banking house
   Financial intermediaries

A firm’s selling its stock directly to
another firm/individual is an example of
direct transfer
Through Investment bankers

Investment banking firm helps a company in the
design and sale of securities. The investment
banker is also called the underwriter.

The agreement between the firm and
underwriter can be of two types:

   firm-commitment basis: underwriter bears all the risk
   best-efforts basis: underwriter does not buy the issue
    but acts as a selling agent

    Through Investment bankers

   In general, the lead investment banker puts
    together a purchase group and a selling group
   purchase group underwrites the offering
    (purchases securities from the issuing
   selling group contacts potential buyers and do
    the selling on a commission basis

Examples of Investment Banking Firms:
Merrill Lynch, Salomon Smith Barney
    Examples of financial intermediaries

    Commercial banks
    Pension funds
    Life insurance companies
    Mutual funds

Financial intermediaries get savings from individuals by
creating new financial products

For example, commercial banks open checking and
saving accounts, life insurance companies sell policies
and mutual funds sell new shares and are ready to buy
back outstanding shares.

financial intermediaries

Strengths of financial intermediaries

   Economies of scale in analyzing
    creditworthiness of potential borrowers

   Pooling risk

    Mutual funds
Mutual funds differ in their investment objectives, e.g.
 Pursue Aggressive growth
 Invest in Precious metals
 Invest in Global equity

    Turkish: type A minimum 25% investment in stocks, it may also
     include fixed income securities. Type B investment only in fixed
     income securities. Type B liquid funds limit maturity up to 90

Ranking of Mutual Funds (US):
 Lipper Ranking
 Morningstar Ranking
 Each fund is ranked within the universe of funds similar in
  investment objectives
Physical location stock exchanges vs. Electronic
dealer-based markets

Auction market vs. Dealer market (Exchanges vs. OTC)
Exchanges can have continuous trading, call auctions
or both

Mostly: Continuous-auction also contain opening call

How do they provide continuity: Limit Order Book

Liquidity:   conversion to cash
             quickly, with low cost, and
             for reasonable transaction sizes
Physical location stock exchanges vs. Electronic
dealer-based markets

Members have seats (e.g. NYSE ≈1400 members)
Only members can execute transactions

Over-the-counter (OTC) market
e.g. Nasdaq
Several dealers assigned to each stock

They quote bid/ask prices
Computerized system
Dealers hold inventory

Cost of Money

except social, strategic policies capital is allocated
through a price system

debt capital:         interest rate
equity capital:       dividend yield
                      capital gains

Four fundamental factors

Four fundamental factors
 Production opportunities
 Time preferences for consumption

 Risk
 Inflation

Different markets
 Interest rates differ due to differences in risk,
  but the rates are interrelated

Determinants of Market Interest Rates

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

k*:        real risk-free rate
IP:        Inflation Premium
DRP:       Default risk premium
LP:        Liquidity premium
MRP:       Maturity risk premium
Determinants of Market Interest Rates

   Inflation is expected future inflation, not the past rate

   Default: The borrower will not pay the interest or principal,
    probably because of financial distress

   Liquidity: being able to sell the security quickly at fair market

Determinants of Market Interest Rates
Government securities e.g. T-bonds have basically no DRP and
little LP. They are only subject to IP and MRP

   Maturity risk premium: Extra return offered by securities with
    longer time to maturity.

Bond prices are negatively related to interest rates. In other words,
as interest rate rises, bond price will fall.

Simple example

A security that has a single payoff of $110 in one year.

If the market price of this security is $100, what is the
promised return?
                                 $110  $100
                            r                10%

If the market price of this security is $90, what is the
promised return?
                                 $110  $90
                            r               22%

So a decrease in price increases return.

For example
Interest rate (promised return)=10% and bond price=$920 now
I own this bond but I have just decided to sell it (I need cash).
If interest rate rises to 12% (market prices similar securities so
that their promised return rises to 12%), price of the bond will fall.
So I and other bondholders will have a loss due to a fall in price
when interest rates rise. This is called as the interest risk.
When I sell the bond at the new (lower) price, the buyer will have
a promised return of 12%.
The amount and the timing of payments made by the issuer of the
bond to bondholders are fixed. The market price is the only bond
feature that can change. So to raise the promised return from 10%
to 12%, the price of the bond has to fall.

 interest rate risk

For a given holding period, the interest rate risk as measured by
the price change at the end of your holding period increases
with the time to maturity of the bond.
So other things being equal, a bond with 20 year time-to-
maturity will have larger MRP than that of a 10 year bond.

reinvestment rate risk

   We did ignore another type of risk, the
    reinvestment rate risk from the discussion
    above. Actually, MRP is the net effect of
    interest rate and reinvestment rate risks.

We will return to this discussion after we
cover the Time Value of Money concept.


Bond Rating Agencies:
Moody’s and S&P
Attributes associated with
   better ratings
  Lower financial leverage
  Larger firm size
 Larger and steadier profits

  Larger cash flows
  Lack of subordination to
   other debt issues

Term Structure of Interest Rates

   The relationship between short term
    and long term interest rates is known
    as term structure of interest rates
   Yield curve: graph showing the
    relationship between bond yields and

     Yield Curve

     e.g. Yield Curve for Government securities (DRP=LP=0)
                                              TTM     rate/year
 Interest                                     1 yr     8.0%
   Rate                                       10 yr   11.4%
                                              20 yr   12.7%
              Maturity risk premium
                                                              Yield Curve can be
10                 Inflation premium
                                                              Upward sloping,
                                                              Downward sloping, or

                   Real risk-free rate
                                         Years to Maturity
     1        10                     20

     Forward rates

Consider the following two investment alternatives for an investor who has a two-year
investment horizon.

Alternative 1:      Buy a two-year zero-coupon instrument. (rate=s2)
Alternative 2:      Buy a one-year zero-coupon instrument (rate=s1) and when it
                    matures in one year, buy another one-year instrument.

Assume    s1 8.000%           Given the price of zero-coupon bond, you can
          s2 8.995%           find the interest rate from the following formula
Note that:
In a world of certainty (future interest rates are known) both of these strategies must
yield identical final payoffs. Otherwise, no one holds either the two-year bond or the one
year bond

Forward rates
The interest rate that would need to prevail in the second year to make the short
and long-term investments equally attractive, ignoring risk is called the forward

                   approximately (s1+f1,2)/2=s2
              or exactly (1+s1)(1+f1,2)=(1+s2)2
       when you know s1 and s2, you can calculate f1,2
         f1,2=9.99% approximately or 10% exactly

Forward rates
Now consider the case of uncertainty where future interest rates are uncertain.
Assume that E(s12)=10% same as the forward rate

P1-year=$1000/1.08=$925.93 P2-year= $1000/(1.08*1.1)=$841.75

So 2-year security is priced using E(s12). Note that this is consistent with the
s2=8.995%, $1000/(1.08995)2=$841.75

Forward rates
Consider a short-term investor who wishes to invest for one year

Under Alternative 2:the return is a riskless 8%
Under Alternative 1:the return is risky. If s12 turns out 10% as expected, the return
will be 8% since the bond price will be $1000/1.1=$909.09 in one year and
$841.75*(1.08)=$909.09. If s12 turns out different than 10%, the return will not be

Why should this investor buy the risky 2-year bond when its expected return is 8%,
no better than that of the risk-free one-year bond.

This requires the 2-year bond to sell at a price lower than the $841.75

Forward rates
Suppose all investors have short-term horizons and therefore are willing to hold
the 2-year bond only if its price falls to $819.
At this price, this year’s expected return on this bond is 11% ($909.09/$819=1.11).
This means a premium of 3% compared to the risk-free one-year bond.

In this environment, the forward rate f12 no longer equals E(s12). s2 now equals
10.5%((1000/819)1/2=1.105) and f12=13%.

   Investors require a premium to hold the two-year bond and be willing to hold
    the bond if E(s12) is less than f12.
   E(s12) < f12 means: since 2s2=s1+f1,2 then 2s2>s1+E(s1,2)

The change in s2 by 1.5% (10.5%-8.995%) denotes a positive MRP. It is the risk
premium given for holding long term bond.

Forward rates
We can also imagine a scenario in which long-term bonds can be perceived by
investors to be safer than short-term bonds.

Suppose all investors have long-term horizons (2-year). In this case, investing in
two-year bond is riskless and investing in one-year bond has reinvestment rate risk.
This would cause E(s12) to be more than f12.

In this case, we will have a negative MRP.

    Term Structure Theories

try to explain the shape of yield curve
e.g. Pure Expectations Hypothesis

   The PEH argues that the shape of the yield curve
    depends on investor’s expectations about future
    short term interest rates.

   If short term interest rates are expected to increase,
    long-term rates will be higher than current short-term
    rates, and vice-versa. Thus, the yield curve can slope
    up, down, or even bow.

Assumptions of the PEH

   Assumes that the maturity risk premium for Treasury
    securities is zero.

   It states that f1,2 =E(s12). This implies that long-term
    rates are an average of current and expected future
    short-term rates. e.g. s2=[s1+E(s1,2)]/2

   If PEH is correct, you can use the yield curve to
    “back out” expected future interest rates.

Pure Expectations Hypothesis

Long-term rates are an average of current and expected
future short-term rates. For example:

To confirm

definition of f12 s2=(s1+f12)/2  f12=2 s2-s1
definition of f23 s3=(2s2+f23)/3  f23=3 s3-2s2

Plug into the first expression
s3=(s1+2 s2-s1+3 s3-2s2)/3= s3

PEH says s3=(s1+E(s12)+E(s23))/3 since E(s12)=f12 and E(s23)=f23

Pure Expectations Hypothesis

Also note that:

definition of f12 2 s2=(s1+f12)  f12=2 s2-s1
definition of f23 3s3=(2s2+f23)  f23=3 s3-2s2
definition of f13 3 s3=(s1+2f13)  2f13=3 s3-s1

Then f13=(f12+f23)/2

An example: Observed Treasury rates and the PEH

       Maturity       Yield
       1 year         6.0%
       2 years        6.2%
       3 years        6.4%
       4 years        6.5%
       5 years        6.5%
Upward sloping yield curve
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

      6.2%      = (6.0% + x%) / 2
      12.4%     = 6.0% + x%
           6.4% = x%

PEH says that one-year securities will yield
6.4%, one year from now.
Three-year security, two years from now

6.5%       = [2(6.2%) + 3(x%)] / 5
  32.5% = 12.4% + 3(x%)
  6.7%     = x%
PEH says that three-year securities will
  yield 6.7%, two years from now.
Calculating all the forward rates
    In the calculation above we relied on the expression E(s25)=f25
    Equivalently, we can use the fact that long term rate is
    arithmetic average of short term rates
        s1 6.0%

        s2 6.2% f12        6.4% =2s2-s1
        s3 6.4% f23        6.8% =3s3-2s2
        s4 6.5% f34        6.8% =4s4-3s3
        s5 6.5% f45        6.5% =5s5-4s4
three-year securities two years from now
Conclusions about PEH

   Some would argue that the MRP ≠ 0, and
    hence the PEH is incorrect.
   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).

Conclusions about PEH
recall that s2=(s1+f12)/2
If MRP≠0 and PEH is not correct
Recall definitions of s1 and s2
s2=k*+IP2+MRP2           and s1=k*+IP1   assuming MRP1=0

E(s12)=k*+IP12    so IP2=(IP1+IP12)/2
since    f12= 2s2 - s1     then
f12= E(s12)+2MRP2

Conclusions about PEH

f12= E(s12)+2MRP2

If yield curve is upward sloping i.e. s2>s1, then since 2s2=s1+f12
it must be f12>s1

   If PEH is correct, then since f12= E(s12) it must be E(s12) >s1

   If MRP≠0 and PEH is not correct, then we get
    So it is not necessarily true that E(s12) >s1, i.e. it can be that
    E(s12) <s1 but E(s12)+2MRP2>s1


Assume that the real risk free rate is 3% and that
inflation is expected to be 8% in year 1, 5% in year 2,
and 4% thereafter.

Assume that all treasury bonds are free of default risk.
If 2-year and 5-year treasury bonds both yield 10%,
what is the difference in maturity risk premiums on the
two bonds?


Assuming that real risk free rate and MRP stay constant over time

MRP5 = 10% - 8% = 2%.
MRP2 = 10% - 9.5% = 0.5%.
MRP5- MRP2 = (2% - 0.5%) = 1.5%.

    Exact solution

Exact solution :


(1+3%+8%+MRP2) (1+3%+5%+MRP2)=(1+10%)2



4-6 The real risk free rate is 3 percent. Inflation is expected to be 3
     percent this year, 4 percent next year, and then 3.5 percent
     thereafter. The maturity risk premium is estimated to be
     0.0005*(t-1), where t= number of years to maturity. What is
     the nominal interest rate on 7-year Treasury note?
MRP1= 0.0005*(1-1)=0, MRP2= 0.0005*(2-1)=0.05%
MRP7= 0.0005*(7-1)=0.3%


4-12    The 5-year bonds on Cartwright Enterprises are yielding
        7.75% per year. Treasury bonds with the same maturity
        are yielding 5.2 percent per year. The real risk free rate
        has not changed in recent years and is 2.3 percent. The
        average inflation premium is 2.5 percent, and the maturity
        risk premium takes the form: MRP=0.1%(t-1), where t=
        number of years to maturity. If the liquidity premium is 1
        percent, what is the default risk premium on Cartwright’s
        corporate bonds?
MRP5= 0.1%(5-1)=0.4%
Treasury bonds: k*+IP5+ MRP5 =2.3%+2.5%+0.4%=5.2%
Cartwright’s corporate bonds k*+IP5+ MRP5 +LP+DRP
LP+DRP=7.75%-5.2%=2.55% so DRP=1.55%


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