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					                                 Chapter 2
                       The Financial Environment and
                         the Level of Interest Rates
Learning Objectives

      1. Discuss the primary role of the financial system in the economy, and describe the two
         basic ways in which fund transfers take place.
      2. Discuss direct financing and the important role that investment banks play in this
      3. Describe the primary and secondary markets, and explain why secondary markets are
         so important to businesses.
      4. Explain why money markets are important financial markets for large corporations.
      5. Discuss the most important stock market exchanges and indexes.
      6. Explain how financial institutions serve consumers and s mall businesses that are unable
         to participate in the direct financial markets and describe how corporations use the
         financial system.
      7. Explain how the real rate of inte rest is determined in the economy, diffe rentiate
         between the real rate and the nominal rate of inte rest, and be able to compute the
         nominal rate of interest.
I.       Chapter Outline

2.1      The Financial System

         A.     The Financial System at Work

                   It is competitive.

                   Money is aggregated in small amounts and loaned in large amounts.

                   The people with investment opportunities are rarely the ones who have the money

                    to lend.

                   Financial markets benefit consumers.

      B.     Moving Funds from Lenders to Borrowers

                Budget positions

                    Balanced budget: income and expenditures are equal

                    Surplus budget: income exceeds expenditures

                    Deficit budget: expenditures exceed income

                The primary concern of the financial system is funneling money from surplus

                 spending units (SSUs) to deficit spending units (DSUs).

                    Direct funds flow, or

                    Indirect funds flow (intermediation)

2.2   Direct Financing

      Financial markets perform the important function of channeling funds from people who have

      surplus funds (SSUs) to businesses (DSUs) that need money for capital projects.

      A.    Direct Financial Markets—wholesale markets in which the minimum transaction

            size is $1 million or more.

               Investment Banks—firms that specialize in helping companies sell new debt or

                equity issues in the public or private security markets.

               Money Center Banks—large commercial banks located in major U.S. financial

                centers that transact in both the national and international money markets.

                   Underwriting—a basic investment banking service is to assist firms in the sale

                    of debt or equity in the primary market. To underwrite a new security issue,

                    the investment banker buys the entire issue at a guaranteed price from the

                    issuing firm and resells the securities to institutional investors and the public.

2.3   Types of Financial Markets

      A.    Primary Market—any financial market in which new security issues are sold for the

            first time.

      B.    Secondary Market—any financial market in which the owners of outstanding

            securities can resell them to other investors.

               Investors are willing to pay higher prices for securities in primary markets if the

                securities have active secondary markets.

               The ease with which a security can be sold and converted into cash is called


               The ability to convert an asset into cash quickly without loss of value is called


      C.    Brokers versus Dealers

               Brokers—market specialists who bring buyers and sellers together in secondary


                 They execute transactions for their clients and are compensated for their

                  services with a commission fee.

                 They bear no risk of ownership of the securities in the transactions; their

                  only service is that of a ―matchmaker.‖

        Dealers—―make markets‖ for securities and do bear risk.

                 They make a market for a security by buying and selling from an

                  inventory of securities they own. The risk is that they will not be able to

                  sell a security for more than they paid for it.

        Securities Exchanges

                 Organized Exchanges—provide a physical meeting place and

                  communication facilities for members to conduct business under a

                  specific set of rules and regulations. Only members can use the

                  exchange, and each exchange has a limited number of seats.

                           New York Stock Exchange (NYSE)

                           American Stock Exchange

                           Pacific Stock Exchange

                           Chicago Stock Exchange

                           Philadelphia Stock Exchange

                 Over-the-Counter (OTC) Markets—have no central trading location, as

                  the NYSE has. Instead, investors can execute OTC transactions by

                  visiting or telephoning an OTC dealer or by using a computer-based

                  electronic trading system linked to the OTC dealer.

A.   Money Markets—a collection of markets with no formal organization or location,

     each trading distinctly different financial instruments. Financial instruments sold in

     money markets have very short maturities, usually overnight to 180 days, are highly

     marketable in that they can be easily converted into cash, and are issued by economic

     units of the highest credit standing.

           Instruments include U.S. Treasury bills, negotiable CDs, and commercial


B.   Capital Markets—that segment of the marketplace where capital goods, such as plant

     and equipment, are financed with equities or long-term debt.

         C.     Public and Private Markets

                       Public markets are organized financial markets where the general public buys

                        and sells securities through their stockbroker.

                       Private markets involve direct transactions between two parties. Transactions

                        in private markets are called private placements.

         D.     Futures and Options Markets—are often called derivative securities because they

                derive their value from some underlying asset.

                       Futures Contracts—contracts for future delivery of securities, foreign

                        currencies, interest rates, or commodities.

                       Options Contracts—call for one party (the option writer) to perform a specific

                        act if called upon to do so by the option buyer or owner.

2.4      The Stock Market

      A. The New York Stock Exchange
            a. Founded in 1792, the NYSE is the oldest, largest, and best known traditional
                securities exchange in the United States.
      B. NASDAQ
           a. NASDAQ is the world’s largest electronic stock market, listing nearly four thousand
                companies. It was created in 1971 by the National Assoc. of Securities Dealers

      C. Stock Market Indexes
            a. These are used to measure the performance of the stock market – whether stock prices
                on average are moving up or down. A wide variety of general and specialized indexes
                is available.
                   Stock Market Indexes—used to measure the performance of the stock market—

                    whether stock prices on average are moving up or down.

                 Dow Jones Industrial Average—consists of 30 companies that represent about 20

                  percent of the market value of all U.S. stocks.


                 Standard and Poor’s 500 Index—is regarded as the best index for measuring the

                  performance of the largest companies in the U.S. economy. It represents about 80

                  percent of the total market capitalization of all stocks on the NYSE.


                 NASDAQ Composite Index—consists of all of the common stocks listed on the

                  National Association of Securities Dealers Automatic Quotation System (hence

                  NASDAQ) of over 5,000 firms.


2.5   Financial Institutions and Indirect Financing

      A.      Indirect Financing—when a financial intermediary such as a commercial bank or

              insurance company stands between the SSU and the DSU.

      B.      Financial Institutions and Their Services

           a. Commercial Banks—are the most prominent and largest financial intermediaries in

              the economy and offer the widest range of financial services to businesses.

                      The major sources of funds for commercial banks are consumers: checking

                       accounts, savings accounts, and a variety of time deposits. The banks

              accumulate these funds and make a variety of loans to consumers, businesses,

              and governments.

             They also do a significant amount of equipment lease financing.

b. Life Insurance Companies—obtain funds by selling life insurance policies that

     protect individuals against the loss of income from a family member’s premature


             Provide funding to public corporations through the purchase of stocks and

              bonds in the direct credit markets and to closely held corporations through

              direct placement financing.

c. Casualty Insurance Companies—sell protection against loss of property from fire,

     theft, accidents, negligence, and other predictable causes.

d. Pension Funds—provide retirement programs for businesses as part of their

     employee benefit programs. They obtain money from employee and employer

     contributions during the employee’s working years, and they provide monthly

     payments upon retirement.

e. Investment Funds—sell shares to investors and use the funds to purchase a wide

     range of direct and indirect financial instruments.

f.   Business Finance Companies—sell short-terms IOUs, called commercial paper, to

     investors in the direct credit markets, where these funds are used to make a variety of

     short- and intermediate-term loans and leases to small and large businesses.

2.6   The Determinants of Interest Rate Levels

      A. The Real Rate of Interest—a long-term interest rate determined in the absence of


                The determinants of the real rate are a firm’s return on investment as well as the

                 time preference for consumption.

B. Money, Inflation, and Purchasing Power

          The value of money is its purchasing power.

          There is an inverse relationship between changes in price level and the value of


C. Inflation and Loan Contracts—the real rate of interest ignores inflation.

          Lenders must incorporate anticipated inflation into lending contracts; otherwise

           they may lose purchasing power when the loan is repaid.

D. Inflation Premiums—lenders can incorporate protection against changes in buying

   power due to inflation in a loan contract.

          Nominal Rate = Real Rate of interest + Expected Changes in Commodity Prices

          Realized rate of return = Nominal Rate – Actual Rate of Inflation

E. The Fisher Equation and Inflation

          How do we write a loan contract that provides protection against loss o f

           purchasing power due to inflation?

                 To incorporate ―inflation expectations‖ into a loan contract we need to adjust the

                  real rate of interest by amount of inflation expected during the contract period

                      o The mathematical formula for this is called the Fishe r Equation

                          i = r + ∆Pe + r∆Pe


                                i = nominal (or market) rate of interest
                                r = real rate of interest
                                ∆Pe = expected annualized price-level change (inflation)
                                r∆Pe = adjustment of the interest rate for expected price-level change

Example: What was the nominal rate of return of your CD over the past year if the average rate of
inflation during the same period was 2.50% and the real rate of interest equaled 2.00%?

              i = nominal rate =

                                                                         1 i
                     To convert a nominal rate into a real rate: r            1
                                                                       1  Pe

              r = real rate =

       F. Cyclical and Long-Term Trends in Interest Rates

                         Interest rates tend to follow the business cycle—during periods of

                          economic expansion, interest rates tend to rise; during a recession, the

                          opposite tends to occur.

                         Inflationary expectations have a major impact on interest rates.

   Chapter 2 Sample Questions

   Multiple Choice
   Identify the choice that best completes the statement or answers the question.

1. If inflation is anticipated to be 4.87 percent during the next year, while the real rate of interest for a
   one-year loan is 4.07 percent, then what should the nominal rate of interest be for a risk- free one-
   year loan?
   a. 9.96 percent
   b. 9.14 percent
   c. 8.41 percent
   d. 7.77 percent

2. If inflation is anticipated to be 3.91 percent during the next year, while the real rate of interest for a
   one-year loan is 2.42 percent, then what should the nominal rate of interest be for a risk- free one-
   year loan?
   a. 5.26 percent
   b. 6.42 percent
   c. 5.39 percent
   d. 5.65 percent

3. If inflation is anticipated to be 3.63 percent during the next year, while the real rate of interest for a
   one-year loan is 2.61 percent, then what should the nominal rate of interest be for a risk- free one-
   year loan?
   a. 6.84 percent
   b. 5.95 percent
   c. 6.33 percent
   d. 4.75 percent

4. If inflation is anticipated to be 3.58 percent during the next year, while the real rate of interest for a
   one-year loan is 5.96 percent, then what should the nominal rate of interest be for a risk- free one-
   year loan?
   a. 8.00 percent
   b. 9.75 percent
   c. 9.26 percent
   d. 9.95 percent

5. If inflation is anticipated to be 4.13 percent during the next year, while the real rate of interest for a
   one-year loan is 2.85 percent, then what should the nominal rate of interest be for a risk- free one-
   year loan?
   a. 7.17 percent
   b. 8.17 percent
   c. 5.89 percent
   d. 7.10 percent

   Chapter 2 Sample Questions
   Ans wer Section


1. ANS: B
   Nominal rate = Real rate + Inflation + (Real rate x Inflation)
   Nominal rate = 0.0407 + 0.0487 + (0.0407 x 0.0487)
   Nominal rate = 0.0894 + 0.001982 = 0.091382 = 9.1382%

   PTS: 1               MSC: JDK

2. ANS: B
   Nominal rate = Real rate + Inflation + (Real rate x Inflation)
   Nominal rate = 0.0242 + 0.0391 + (0.0242 x 0.0391)
   Nominal rate = 0.0633 + 0.000946 = 0.064246 = 6.4246%

   PTS: 1               MSC: JDK

3. ANS: C
   Nominal rate = Real rate + Inflation + (Real rate x Inflation)
   Nominal rate = 0.0261 + 0.0363 + (0.0261 x 0.0363)
   Nominal rate = 0.0624 + 0.000947 = 0.063347 = 6.3347%

   PTS: 1               MSC: JDK

4. ANS: B
   Nominal rate = Real rate + Inflation + (Real rate x Inflation)
   Nominal rate = 0.0596 + 0.0358 + (0.0596 x 0.0358)
   Nominal rate = 0.0954 + 0.002134 = 0.097534 = 9.7534%

   PTS: 1               MSC: JDK

5. ANS: D
   Nominal rate = Real rate + Inflation + (Real rate x Inflation)
   Nominal rate = 0.0285 + 0.0413 + (0.0285 x 0.0413)
   Nominal rate = 0.0698 + 0.001177 = 0.070977 = 7.0977%

   PTS: 1          MSC: JDK


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