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The Financial Environment: Markets, Institutions, and Interest Rates
The Financial Environment: Markets, Institutions, and Interest Rates
100 Borrowing
Co
100 190.9
2-3
Types of Financial Markets
Debt vs. Equity Markets. Debt includes bond, debenture, bank
loan, mortgage, commercial and consumer credit. Equity
refers to the claim of ordinary stock. Interest on debt is a
compulsory payment but dividend is not. Cost of debt is
usually less than cost of equity.
Money vs. Capital Markets. Money market deals in short term
loan to provide firm’s liquidity. Capital market deals in long
term debt of different types, preferred stock and ordinary
stock
Primary vs. Secondary Markets. In the primary market, the
firm directly sells stock to the applicant of the share. In the
secondary market, shares are traded among stock holders.
2-4
Cost of Money:
Loanable Fund Theory
i
S (Savings)
D (Investment)
2-7
“Nominal” vs. “Real” rates
kRF= k*+IP
k* = represents the “real” risk-free rate
of interest. Like a T-bill rate, if there
was no inflation. Typically ranges
from 1% to 4% per year.
kRF = represents the rate of interest on
Treasury securities.
IP= Inflation premium
2-8
Determinants of interest rates
k = k* + IP + DRP + LP + MRP
k = required return on a debt security
k* = real risk-free rate of interest
IP = expected inflation premium
DRP = default risk premium
LP = liquidity premium
MRP= maturity risk premium
2-9
Concepts of risk premium
Inflation Premium refers to the additional interest to
cover the loss due to inflation.
Default risk premium is the addition in the interest
rate to compensate the possibility that the borrower
may fail to pay interest and principal.
Liquidity risk premium is the addition to compensate
the possibility that the security may not be sold with
in a short notice.
Maturity risk premium covers the possibility of price
fluctuation of bond. The price depends on market
interest rate. Bonds of longer maturity assumes more
maturity risk premium.
2-10
Risk-Return trade-off
k=kRF + Risk Premium (RP)
E(R) = Rf + RP
RP=DRP+LP+MRP
Return
Rf
Risk
2-11
Yield Curve:
Relation between interest and time
Normal k
Abnormal
Flat
Maturity
2-12
Theories of Yield Curves
Liquidity Preference Theory: Lenders to prefer to
make short term loan than long term loan. Yield
curve should be positive.
Expectations Theory: Yield curve depends on
the expectation about inflation. If inflation is
expected to rise in future, then yield curve
should be positive.
Market Segmentation Theory: The short term
market and the long term market are different
from one another. Yield curve should not have a
definite pattern.
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