The Financial Environment: Markets, Institutions & Intrest Rates

THE FINANCIAL ENVIRONMENT MARKETS, INSTITUTIONS & INTREST RATES

Market ? INTERACTION OF BUYERS & SELLERS

How are they going to find each other? Problem: Search is expensive & inefficient Solution: Need facilitator: mechanisms & institutions

WHAT IS A MARKET? A mechanism by which investors (firms, individuals, government) exchange assets (real, financial)

CLASSIFICATIONS OF FINANCIAL MARKETS Capital Markets ( Mortgages, Bonds, Leases & Stocks)  Primary Market – New Capital Raised  Secondary Market – Exchange of Ownership (Brokerage services)  Initial Public Offer Market  Mortgage & lease Market  Real Estate Market

Money Markets T.Bs Banks  Negotiable Instruments  Money Market Funds Physical Goods Markets : ( Tangible or Real Assets) Future and Forward Vs Spot Markets Futures and forward contracts can be used to reduce risk associated with unforeseen events by looking into an agreement today for the future delivery of a specific asset at a specific time, place, quantity and quality.

Options: The right, but not the obligation, to take a specific action in the future. In finance, the actions refer to: " the right to buy a specific asset at a discount and to sell a specific asset at an agreed upon price in the future" Why SECP Markets do not always function perfectly. To regulate these - Securities and Exchange Commission (SEC).

FINANCIAL INSTITUTIONS Direct transfers of money and securities Investment Banking House (Underwriters) Financial intermediary o Commercial Banks o Savings and Loan Associations o Credit Unions o Pension Funds o Life Insurance Companies o Mutual Funds

Capital Formation Process •

Direct Transfer

Securities (Stocks or Bonds) Savers

Business Dollars 8.

Indirect Transfer through Investment Banks (Underwriters) ? Securities

Business Dollars

Investment Banking Houses (AJD, JS)

Securities (Same) Savers Dollars

1. Indirect Transfer Through a Financial Intermediary Business Securities

Intermediary's Securities Financial Intermediar y

Business Dollars

Savers Dollars

THE STOCK MARKET  Physical Location Stock Exchanges  Formal Organisation  Tangible Physical Location  Conducts Auction Markets in designated (Listed) Securities  KSE, LSE, ISE- NSE in the offing

 Over the counter Markets (OTC)  Just a collection of brokers/ dealers  Connected electronically by Telephones & Computers  Trading in unlisted securities

THE STOCK MARKET  Dealer Markets Includes all facilities needed to conduct Security transactions Conducted on an unorganized Exchange

SECONDARY MARKET ROLE OF A BROKER

THE COST OF MONEY “Capital in free economy allocated through the price system” The interest rate is the price paid to borrow debt capital. With equity capital, investors expect to receive dividends and capital gains, whose sum is the cost of equity money

Factors affecting the cost of Money Production Opportunities The returns available within an economy from investments in productive ( Cashgenerating) assets- Effects?

Time Preference For Consumption The preference of consumers for current consumption as opposed to saving for future consumption- Effects?

 Risk In a financial market context the chance that an investment will provide low or negative returnEffects?

 Inflation The amount by which prices increase over time- Effects?

EXPECTED RETURN (%)

Allocation of Funds & Interest Rates

Spec. Common Stock Conservative Common Stock Preferred Stock Long term Govt. Bonds Govt. Bond T-Bills

RISK

Interest Rate levels Market A: LOW - RISK SECURITIES Interest Rate (k)

Market B: High - RISK SECURITIES Interest Rate (k) (%)

(%)

S1

S2

S1

KB=12 KA = 10

D1

8

D1 D2 0

Dollars

0

Dollars

The Determinants of Market Interest Rates  Real Risk-Free rate of Return( only T-Bills)  Inflation Premium (IP)  Default Risk Premium (DRP)  Liquidity Premium (LP)  Maturity Risk Premium (MRP)  Reinvestment Rate Risk

The Determinants of Market Interest Rates • Quoted Interest Rate = k = k*+IP+DRP+LP+MRP where K= The quoted, or nominal, rate of interest on a given security K* = The real risk-free rate of interest on a risk less security if Zero inflation was expected kRF = k* + IP = The quoted risk-free rate of interest on a security such as a Govt. Treasury bill, which is very liquid and also free of most risks. IP= Inflation Premium = The average expected inflation rate over the life of the security.

DRP= Default Risk Premium. This premium reflects the possibility that the issuer will not pay interest or principal at the stated time and in the stated amount. LP= Liquidity, or Marketability Premium. This is a premium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a “reasonable” price. MRP= Maturity Risk Premium.. Since kRF = k* + IP, the Equation can be written as follows: Nominal, or quoted, Rate = kRF + DRP + LP + MRP.

The Real Risk-free Rate Of Interest (K*) The rate of interest that would exist on default- free Treasury bills if no inflation were expected. It depends upon:  The rate of return Corporations and other borrowers expect to earn on productive assets  People preference for current versus future consumption

The Nominal, or Quoted, Risk Free Rate of Return(KRF) The real risk-free rate plus a premium for expected inflation KRF = K* + IP • The risk-free is the rate free of any type of risk • Risk –free interest used with out modifier “Real” or “Nominal” generally means Quoted (Nominal ) rate, which includes IP and is used for T-Bills

Inflation Premium (IP) A premium equal to expected inflation that investors add to the real Risk- Free rate of return

IP = K* - KRF Default Risk Premium (DRP) The difference between the interest rate on U.S treasury Bond( Government Bonds) and a corporate bond of equal maturity and marketability Bond

Rate

DRP

U.S Treasury

6.6%

-

AAA

7.6%

1.0%

AA

7.8%

1.2%

A

8.1%

1.5%

BBB

8.5%

1.9%

BB+

10.3%

3.7%

Liquidity Premium (LP) A Premium added to the equilibrium interest rate on a security if that security can not be converted to cash on short notice and at close to the”Fair Market Value” There is always some difference in the interest rates of least liquid and most liquid financial assets provided all other risk elements are the same

Maturity Risk Premium (MRP) The risk of capital losses to which investors are exposed because of changing interest rates - The longer is the maturity period the higher is this premium.

Reinvestment Rate Risk The risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested

With Increasing Expected Inflation Maturity

K*

IP

MRP

Yield

1 year

2.5%

3%

0%

5.50%

5 years

2.5%

3.4

0.18

6.08

10 years

2.5%

4.00

0.28

6.78

20 Years

2.5%

4.50

0.42

7.42

30 Years

2.5%

4.67

0.53

7.70

With Decreasing Expected Inflation Maturity

K*

IP

MRP

Yield

1 year

2.5%

5%

0%

7.50%

5 years

2.5%

4.60

0.18

7.28

10 years

2.5%

4.00

0.28

6.78

20 Years

2.5%

3.50

0.42

6.42

30 Years

2.5%

3.33

0.53

6.36

Corporate and Treasury Yield Curves INTEREST RATE TERM TO MATURITY

TREASURY AA – RATED BOND BOND

BBB – RATED BOND

1 YEAR

5.5 %

6.7%

7.4%

5 YEARS

6.1%

7.4%

8.1%

10 YEARS

6.8%

8.2%

9.1%

20 YEARS

7.4%

9.2%

10.2%

30 YEARS

7.7%

9.8%

11.1%

The Term Structure of Interest Rates The relationship between short term and long term interest rates Important o How ST and LT “IR” are related to each other? o What causes shift in their relative positions?

Interest Rate % Abnormal Yield Curve

Normal Yield Curve

Maturity Period

What Determines Shape of the Yield Curve Expectation Theory A theory which states that the shape of the yield curve depends on the investors’ expectations about future interest rates “Long –term interest rates are the weighted average of the current and expected future short-term interest rates”

Working…………… Expected Annual (1-Year) Inflation Rate

Expected Average Inflation Rate From 1998 to Indicated Year

1999

3%

3%/1= 3.0%

2000

5%

(3%+5%)/2= 4.00%

2001

7%

(3%+5%+7%)/3 =5.0%

Liquidity Preference Theory Investors prefers to hold short term securities for reason of liquidity Borrowers prefer to long-term debt because short term debt exposes them to the risk of paying in adverse conditions – Ready to pay higher interest for the long term debts Hence up sloping curve

Investors Overseas  Country Risk- The risk that arises from investing or doing business in a particular country  Exchange Rate Risk – The risk that exchange rate changes will reduce the number of dollars provided by a given amount of a foreign currency

Other Factors That Influence Interest Rate Levels  Federal Reserve Policy o The money has a major effect on both the economic activity and inflation rate; o The SBP controls the money supply; o Stimulation of Economy; o Tightening of Economy

 Budget Deficit or Surplus o More spending- Deficit – Borrowing or Printing more Notes – What are the effects?

 International Factors o Foreign Trade Deficit o Foreign Trade Surplus

What are the effects of change of interest rates upon the savers?