The Financial Markets and Interest Rates

1
The Financial Markets and Interest Rates
Chapter 2
2
Chapter Objectives

• Internal and external sources of funds
• Mix of corporate securities sold
• Why financial markets exist
• U.S. financial market system
• Regulations

• Rates of Return and Interest rate determination
• Term structure of Interest rates

3
Federal Funds Rate

• Short-term market rate of interest
• Serves as a sensitivity indicator of the
  direction of future changes in interest rates

4
Objectives of the Fed

• Maximum sustainable employment
• Price stability

5
Recent Interest Rate Cycles
6
Nonfinancial Corporate Business Sources of Funds,
1981-2000

• Changes in market conditions influence the way
  corporate funds are raised
• Example High interest costs discourage the use
  of debt.

7
Corporate Securities Offered for Cash

• Nonfinancial Corporations- 3yr. Cash Weighted
  Average, 2001-2003
• Total Volume(M)
• 1,288,515

SourceStatistical Supplement to the Federal
Reserve Bulletin, Table 1.46, October 2004, A29.
8
Debt/Equity Mix

• U.S. tax system favors debt as means of raising
  capital
• --Interest Expense is tax deductible
• --Dividends paid are not tax deductible
• Double taxation of dividends

9
What are Financial Markets?

• Financial markets are institutions and procedures
  that facilitate transactions in all types of
  financial claimsfacilitate the transfer of
  savings from economic units with a surplus (like
  households) to economic units with a deficit
  (like firms).
• See Development of a Financial System Stages p.38

10
Why do Financial Markets Exist?

• Exist to facilitate the efficient flow of savings
  from the surplus sectors to deficit sectors
• It acts like a vehicle through which the forces
  of supply and demand for a financial assets (like
  stocks, bonds, or mortgages) are brought
  together.
• Rate of capital formation will not be as high if
  financial markets did not exist.
• Overall wealth of an economy would be less over
  the long run

11
Real and Financial Assets

• Real AssetsTangible assets such as houses,
  equipment and inventories
• Financial AssetsClaims for future payment on
  other economic unitscommon and preferred stocks
• In this book we will concentrate our attention to
  these assets

12
The Financing Process
Source Flow of Funds Accounts, First Quarter
2000, Flow if Funds Section, Statistical Release
Z.1 (Washington, D.C. Board of Governors of the
Federal Reserve System, June 9,2000).
13
Movement of Funds Through the Economy

• Direct Transfer of Funds
• Invest in a company directly
• Financial claims of businesses direct
  securities
• Indirect Transfer of Funds using an Investment
  Banker/Brokers
• Brokers help to channel the direct securities by
  buying them and then selling them at a higher
  price
• Indirect Transfer of Funds Using the Financial
  Intermediary (Banks, Mutual Funds)
• Issue their own financial claims indirect
  securities
• Uses the proceeds to purchase direct securities

14
Ways to Transfer Financial Capital in the Economy
15
Methods to Raise External Capital

• When a corporation needs to raise external
  capital, funds can be obtained by a
• Public Offering -where individuals and
  institutional investors have the opportunity to
  purchase securities
• or
• Private Placement - where securities are sold to
  a limited number of investors

16
Primary and Secondary Markets

• Primary Markets Securities are offered for the
  first time to investors (e.g. a new issue of
  stock). This increases the total stock of
  financial assets outstanding in the economy.
• Secondary Markets Transactions in currently
  outstanding securities. Include all transactions
  after the initial purchase. Sales do not affect
  the total stock of financial assets that exist in
  the economy.

17
Money Market and Capital Market

• Money Market Short-term debt instruments
• with maturities of one year or less
• Treasury Bills, Federal Agency Securities,
  Bankers Acceptances, Negotiable Certificates of
  Deposit, Commercial Paper.
• Capital Market Long Term financial instruments
  with maturities than extend beyond one year.
• Term Loans, Financial Leases, Corporate Equities
  and Bonds

18
Organized Security Exchanges and Over-The-Counter
Markets

• Organized Security ExchangesTangible entities
  where financial instruments are traded on the
  premises
• National and Regional exchanges
• New York Stock Exchange - national
• American Stock Exchange - national
• Chicago Stock Exchange - regional
• Over-The-Counter MarketsAll security markets
  except the organized exchanges
• Money Market
• Bonds
• NASDAQ

19
Organized Exchanges

• Benefits
• Provides a continuous market with a series of
  continuous security prices
• Establishes and publicizes fair security prices
  that are set by competitive force
• Helps businesses raise new capital by helping to
  determine the offering price of a new issue
• Disadvantages
• Listing fees need to be paid
• Listing requirements need to be met

20
Private Placements

• Sale of Securities to a restricted group of
  investors through a privileged subscription
• Advantages
• Speed registration with SEC not required
• Reduced Flotation Costs investment banking
  underwriting and distribution costs not needed
• Financing Flexibility
• Disadvantages
• Higher Interest Costs
• Restrictive Covenants

21
Market Regulation

• Securities Act of 1933 (Regulates New Issues)
  Aims to provide potential investors with
  accurate, truthful disclosure about the firm and
  new securities being offered (prospectus)
• Securities Exchange Act of 1934 (Regulates
  Secondary Market Trading)
• Created SEC to enforce federal securities laws
• Place reporting requirements on public firms
• Insider trading is regulated
• Prohibits manipulative trading

22
Sarbanes-Oxley Act of 2002

• Congress passed in July 2002 the Public
  Accounting and Reform and Investor Protection Act
• Purpose to protect investors by improving the
  accuracy and reliability of corporate
  disclosures
• The Act contains 11 titles which tighten
  significantly the latitude given corporate
  advisors who have access to or influence company
  decisions.
• Created the Public Company Accounting Oversight
  Board
• Regulate the accounting industry that audits
  public companies

23
Sarbanes-Oxley Act of 2002Key Elements

• Public Company Accounting Oversight Board
• Auditor Independence
• Corporate Responsibility
• Enhanced Financial Decisions
• Analysts Conflicts of Interest
• Commission Resources and Authority
• Studies and Reports
• Corporate and Criminal Fraud Accountability
• White-Collar Crime Penalty Enhancements
• Corporate Tax Returns
• Corporate Fraud and Accountability

24
Rates of Return in Financial Markets

• Opportunity Cost Rate of return on next best
  investment alternative to the investor
• Firms must offer competitive rates to attract
  scarce investor funds
• Historical Rates of Return
• Treasury Bills have low returns
• Bonds have higher returns
• Common Stock has the highest returns

25
Average Annual Returns and Standard Deviations of
Returns (1926 2000)
26
Rates of Return in Financial Markets

• Real Return Return earned above the rate of
  increase in the general price level for goods and
  services in the economy (the inflation rate)
  general idea of return
• Nominal Rate of Interest Observed or quoted
  rate of interest
• Real Rate of Interest Rate of increase in
  actual purchasing power, after adjusting for
  expected inflation
• Nominal Rate Inflation Rate Real Rate

27
Risk PremiumsWhat determines Interest Rates?

• Real Risk Free Rate of Return compensation for
  delayed consumption
• Inflation Risk Premium Additional return
  required by investors to compensate for expected
  loss of purchasing power
• Default Risk Premium Additional return required
  by investors to compensate for the possibility of
  default
• Liquidity Risk PremiumAdditional return required
  by investors in securities that cannot be quickly
  converted into cash at a reasonably predictable
  price.
• Maturity Risk Premium Additional return
  required by investors in long-term securities to
  compensate them for the increased risk of price
  fluctuations on those securities caused by
  interest rate changes

28
Term Structure of Interest Rates

• The relationship between a debt securitys rate
  of return and the length of time until the debt
  matures.
• Also called Yield to Maturity
• Observe in historical data the fact that longer
  terms to maturity command higher returns
  reflecting a maturity risk premium

29
The Term Structure of Interest Rates
30
Term Structure of Interest Rates

• The Shape of the Term Structure can be explained
  by
• Unbiased Expectations Theory
• Liquidity Preference Theory
• Market Segmentation Theory

31
Unbiased Expectations Theory

• The term structure is determined by an investors
  expectations about future interest rates
• The observed long term rates reflect what
  investors expect future rates will be
• Example Compare one 2 year long investment vs.
  two 1 year long investments (page 63-64)

32
Liquidity Preference Theory

• Investors require maturity premiums to compensate
  them for buying securities that expose them to
  the risks of fluctuating interest rates
• Compensation for not knowing the future rate
• Investors that are risk averse dislike not
  knowing and be exposed to more uncertainty in the
  longer time frame

33
Market Segmentation Theory

• Legal restrictions and personal preferences limit
  choices for investors to certain ranges of
  maturities
• Some institutions and individuals have strong
  preferences for certain maturities
• For example, life insurance companies prefer
  long-term investments since they have long-term
  liabilities