Chapter 4

The Financial Environment

Markets
Institutions
Interest Rates
The Financial Environment

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 Chapter Outline:

Financial markets
Types of financial institutions
Determinants of interest rates

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 What is a Financial market?

A market is a venue where goods and

services are exchanged.
A financial market is a place where
individuals and organizations wanting to
borrow funds are brought together with
those having a surplus of funds.
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 Flow of Funds:
Funds flow indirectly from ultimate lenders
[households] through financial intermediaries
[banks or insurance companies] or directly
through financial markets [stock exchange/bond
markets] to ultimate borrowers [business firms,
government, or other households].
In order for financial system to function smoothly,
must be adequate information about the markets
and their operation.

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 Flow of Funds:
Financial system provides a transmission
mechanism between saver-lenders and borrower-
spenders.
 Savers benefit—earn interest
 Investors benefit—access to money otherwise
not available
 Economy benefits—efficient means of
bringing savers and borrowers together
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Flow of funds from lenders to
borrowers:

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 The Financial Markets:

Physical VS. Financial asset markets

Spot VS. future markets
Money VS. capital markets
Primary VS. secondary markets
Public VS. private markets

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 The Financial Markets:
Physical Asset Markets:
It is a market for such products as wheat, autos,
real estate, and machinery.
Financial Asset Markets:
It deals with stocks, bonds, notes, mortgages,
and derivatives.

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 The Financial Markets:
 Spot Markets:
It is a market in which assets are bought and
sold for on the spot delivery.
Futures Markets:
It is a market in which participants agree today
to buy or sell an asset at some future date.

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 The Financial Markets:
The Money Market:
 Exchange of short-term instruments—less than one
year
 Highly liquid, minimal risk
Commercial paper—short-term liabilities of prime
business firms and finance companies
Bank Certificates of Deposits—liabilities of issuing
bank, interest bearing to corporations that hold them
U.S. Treasury bills—short-term debts of US
government
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 The Financial Markets:
The Capital Market:
 Exchange of long-term securities—in excess of one
year
 Generally used to secure long-term financing for capital
investment.
Stock market—Largest part of capital market and
held by private and institutional investors
Residential and commercial mortgages—Held by
commercial banks and life insurance companies
Corporate bond market—Held by insurance
companies, pension and retirement funds
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 The Financial Markets:
Primary Markets:
 Market for issuing a new security and
distributing to saver-lenders.
 Initial Public Offering Market (IPO).
 Investment Banks—Information and
marketing specialists for newly issued
securities.

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 The Financial Markets:
Secondary Markets:
 Market where existing securities can be
exchanged
New York Stock Exchange
American Stock Exchange
Over-the-counter (OTC) markets
(NASDAQ).

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 Financial Institutions:
Funds are transferred between those who have funds and
those who need funds by three processes:

 Direct transfers,
 Investment banking houses, or
 Financial intermediaries.

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 Financial Intermediaries:

 Commercial banks
 Savings and loan associations
 Credit unions
 Pension funds
 Life insurance companies
 Mutual funds
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 Role of Financial Intermediaries:
 Act as agents in transferring funds from savers-
lenders to borrowers-spenders.
 Acquire funds by issuing their liabilities to
public and use money to purchase financial
assets
Earn profits on difference between interest paid and
earned
Diversify portfolios and minimize risk
Lower transaction costs
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 Commercial Banks:
Most prominent
Range in size from huge to small
Major source of funds used to be demand
deposits of public, but now rely more on
“other liabilities”
Also accept savings and time deposits—
interest earning
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 Savings and Loan Associations
[S&L’s]:
Traditionally acquired funds through savings
deposits
Used funds to make home mortgage loans
Now perform same functions as commercial
banks
 issue checking accounts
 make consumer and business loans

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 Credit Unions:
Organized as cooperatives for people
with common interest
Members buy shares [deposits] and can
borrow
Changes in the law in early 1980’s
broadened their powers
 checking [share] accounts
 make long-term mortgage loans
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 Pension and Retirement Funds:

Concerned with long run

Receive funds from working individuals building
“nest-egg”
Accurate prediction of future use of funds
Invest mainly in long-term corporate bonds and
high-grade stock
Invest in wide variety of securities—minimize risk

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 Life Insurance Companies:
Insure against death
Receive funds in form of premiums
Use of funds is based on mortality statistics
—predict when funds will be needed
Invest in long-term securities—high yield
 Long-term corporate bonds
 Long-term commercial mortgages

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 Mutual Funds:

Stock or bond market related institutions

Pool funds from many people
Invest in wide variety of securities—
minimize risk

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 Physical location stock exchanges
vs. Electronic dealer-based markets

Auction market vs.

Dealer market
(Exchanges vs.
OTC)
NYSE vs. Nasdaq

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 The Stock Market:
 Organized Security Exchanges:
 NYSE, AMEX, and regional
 Actual physical locations
Over-the-Counter Markets:
 Network of brokers and dealers
 Auction market
 Organized Investment Network
 Electronic Communications Networks

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 The Cost of Money:

Four factors that affect the cost of money:

 Production opportunities
 Time preferences for consumption
 Risk
 Expected inflation
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 The Cost of Money:

 What do we call the price, or cost, of debt capital?

The Interest Rate

 What do we call the price, or cost, of equity capital?

Return on Equity =Dividends +Capital Gains

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“Real” versus “Nominal” Rates:

k* = real risk-free rate.

T-Bond rate if no inflation;
2% to 4%.

k = any nominal rate.

kRF = Rate on T-securities—risk-free.

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 The Determinants of
Market Interest Rates:
Quoted Interest Rate = k = k* + IP + DRP + LP + MRP

k= Quoted or nominal rate

k* = Real risk-free rate (“k-star”)
IP = Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
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 Hypothetical yield curve:
Interest
Rate (%)
15 Maturity risk premium

10 Inflation premium

Real risk-free rate

0 Years to
1 10 20 Maturity
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 Other Factors that Influence
Interest Rate Levels:
 Federal Reserve Policy
 Controls money supply
 Federal Deficits
 Larger federal deficits mean higher interest
rates
 Foreign Trade Balance
 Larger trade deficits mean higher interest rates
 Business Activity
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 Interest Rate Levels
and Stock Prices:
 The higher the rate of interest, the lower a
firm’s profits

 Interest rates affect the level of economic

activity, and economic activity affects
corporate profits
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 Risks associated with investing
overseas:
Exchange rate risk – If an investment is denominated
in a currency other than U.S. dollars, the investment’s
value will depend on what happens to exchange rates.
Country risk – Arises from investing or doing
business in a particular country and depends on the
country’s economic, political, and social
environment.

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End of Chapter 4:

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