TCH302. Chapter 2. Hien

CHAPTER 2
FINANCIAL MARKETS AND

INSTITUTIONS
CODE: TCHE302
CLASS: JIB58-VJCC/FTU
I N S T R U C T O R : A S S O C . P R O F, D R . N G U Y E N T H I H I E N
LEARNING OBJECTIVES
• Financial system (Direct and Indirect finance

channels)
• Financial markets
• Securities traded in the financial markets
• Financial intermediaries
• Time Value of Money
• Interest rates and Its Behavior
Chapter 2 2
AN OVERVIEW OF FINANCIAL
SYSTEM
3
THE FINANCIAL SYSTEM
• The purpose of the financial system is to bring

together individuals, businesses, and government
entities (economic units) that generate and spend
funds.
 Surplus economic units have funds left over after
spending all they wish to spend.
 Deficit economic units need to acquire additional

funds to sustain their operations.
 https://www.youtube.com/watch?v=MsPgw4FodgE
Chapter 2 4
THE FINANCIAL SYSTEM
• To enable funds to move through the financial
system, funds are exchanged for securities.
• Securities/financial assets are documents that

represent the right to receive funds in the future.
• Financial intermediaries discussed in Chapter 3

often help to facilitate this process.
Chapter 2 5
FINANCIAL MARKETS
• Classified according to the characteristics of participants and

securities involved.
• The primary market is where deficit economic units sell new
securities to raise needed funds.
Chapter 2 6
FINANCIAL MARKETS
Funds
Primary
Market
Securities
Chapter 2 7
FINANCIAL MARKETS
• Classified according to the characteristics of participants and

securities involved.
• The primary market is where deficit economic units sell new
securities.
• The secondary market is where investors trade previously issued
securities with each other.
Chapter 2 8
FINANCIAL MARKETS
Funds
Secondary
Market
Securities
Chapter 2 9
FINANCIAL MARKETS
• Money Market vs. Capital Market

• Money market: https://www.youtube.com/watch?v=ulECfGOeqgs
• Exchange https://www.youtube.com/watch?v=F3QpgXBtDeo
Chapter 2 10
FINANCIAL MARKETS
• Money Market
– Trade short term (1 year or less) debt instruments (e.g.
T-Bills, Commercial Paper, Banker’s Acceptance)
– Major money centers in Tokyo, London and New York
• Capital Market
– Trades long term securities (Bonds, Stocks)
– NYSE, ASE, over-the-counter (Nasdaq and other OTC)
Chapter 2 11
FINANCIAL MARKETS
Intermediaries such as commercial banks and
insurance companies help to facilitate the
flow of funds in the financial marketplace.
$$ Securities
Securities $$
Chapter 2 12
• https://www.youtube.com/watch?v=Dugn51K_6WA
13
EXTERNAL FUNDING FOR BUSINESS
Sources of External Funding for Business
100%
90%
80%
70%
60%
USA
50% Germany
Japan
40%
30%
20%
10%
0%
bank loans non-bank loans bonds new equity
Source: Available online at http://www.wiwi.uni-frankfurt.de/schwerpunkte/finance/wp/550.pdf
MARKET EFFICIENCY
• Market efficiency refers to the ease, speed, and cost of trading

securities.
– The market for the securities of large companies is generally efficient: Trades can be
executed in a matter of seconds and commissions are very low.
– The real estate market is not generally efficient: It can take months to sell a house and the
commission is 6-7% of the price.
Chapter 2 15
MARKET EFFICIENCY
 Why is market efficiency important?
– The more efficient the market, the easier it
is to transfer idle funds to those parties that need the funds.
– If funds remain idle, this results in lower growth for the economy
and higher unemployment.
– Investors can adjust their portfolios easily

and at low cost as their needs and preferences change.
Chapter 2 16
SECURITIES IN THE FINANCIAL
MARKETS
• Money Market Securities
– Highly liquid, low risk
– Treasury Bills (T-Bills)
– Negotiable Certificates of Deposit (NCDs)
– Commercial Paper
– Eurodollars
– Banker’s Acceptances
– International Payment methods (T/T; PD;
Letter of credit (L/C) L/G
Chapter 2 17
MARKET
• T-Bills: are short-term securities issued by the Federal

government.
• After initial sale, they have an active secondary market.
• They are bought at a discount and at maturity the

investor receives the full face value.
Chapter 2 18
Gallagher 6e: © Textbook Media Press
MARKET
• Negotiable CDs: are interest-bearing
securities issued by financial institutions.
• They have maturities of one year or less.
Chapter 2 19
MARKET
– Certificates of Deposit (CDs)
• Commercial paper: is unsecured debt issued by
corporations with good credit ratings.
• Most buyers are large institutions.
Chapter 2 20
MARKET
• Eurodollars: are dollar denominated, deposits, located in non-
US banks.
• Buyers and sellers are large institutions.
Chapter 2 21
SECURITIES IN THE FINANCIAL MARKET

– Eurodollars
• Banker’s Acceptances: are debt securities that have
been guaranteed by a bank. They are used to facilitate
international transactions.
Chapter 2 22

– Eurodollars
– Banker’s Acceptances
Chapter 2 23
MARKET
• Capital Market Securities
• Bonds: are “IOUs” issued by the borrower and sold

to investors.
• The issuer promises to repay the

face amount on the maturity date and to pay interest
each year in the amount of the coupon rate times the
face value.
Chapter 2 24
MARKET
 Capital Market Securities
– Bonds
• Treasury Bonds: are issued by the federal government.
• Municipal Bonds: are issued by state and local governments.
• Corporate Bonds: are issued by corporations.
Chapter 2 25
MARKET
• Companies can also raise funds by selling shares of

stock
Chapter 2 26
MARKET
– Stock
• Common stockholders: own a portion of the company

and can vote on major decisions.
• They receive a return on their investment in the form of

dividends and capital gains.
Chapter 2 27
– Stock
Common Stock
• Preferred stockholders do not generally have voting

rights, but have priority in receiving dividends and
are paid dividends at a pre-set rate.
Chapter 2 28
0
1
Financial
Markets
Quizs
The Time Value
of Money & Interest rates
Chapter 8
(Textbook 1-
Thimothy)
Chapter 4,5,6
(Textbook 2 –F.
Mishkin) 30
Chapter 8
LEARNING OBJECTIVES
• The “time value of money” and its importance to business.

• Interest rates
• The future value and present value of a single amount.
• The future value and present value of an annuity.
• The present value of a series of uneven cash flows.
31
Chapter 8 Gallagher 6e © Textbook Media Press
THE TIME VALUE OF MONEY
• Money grows over time when it earns interest.
• Therefore, money that is to be received at some time
in the future is worth less than the same dollar
amount to be received today.
• Similarly, a debt of a given amount to be paid in the
future are less burdensome than that debt to be paid
now.
Gallagher 6e © Textbook Media Press 32

Chapter 8
THE FUTURE VALUE OF A SINGLE
AMOUNT
• Suppose that you have $100 today and plan to put it
in a bank account that earns 8% per year.
• How much will you have after 1 year? 5 years?
15 years?
• After one year:
$100 + (.08 x $100) = $100 + $8 = $108

OR:
$100 x (1.08)1 = $108
33
THE FUTURE VALUE OF A
SINGLE AMOUNT
• Suppose that you have $100 today and plan to put it in a
bank account that earns 8% per year.
• How much will you have after 1 year? 5? 15?
 After one year:
$100 x (1.08)1 = $108
 After five years:
$100 x 1.08 x 1.08 x 1.08 x 1.08 x 1.08 = 146.93
$100 x (1.08)5 = $146.93
 After fifteen years:
$100 x (1.08)15 = $317.22
 Equation:
FV = PV (1 + k)n
34
THE FUTURE VALUE OF A SINGLE AMOUNT
GRAPHICAL PRESENTATION: DIFFERENT INTEREST RATES
$1000
900
k = 8%
800
700
600 k = 4%
500
400
300 k = 0%
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year
35
Double your money?
Quick! How long does it take to double $5,000

at a compound rate of 12% per year
(approx.)?
We will use the “Rule-of-72”.
36
The Rule of 72
Quick! How long does it take to double $5,000

at a compound rate of 12% per year
(approx.)?
Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]
37
PRESENT VALUE OF A SINGLE AMOUNT
• Value today of an amount to be received or

paid in the future.
PV = FVn x 1
(1 + k)n
Example: Expect to receive $100 in one year. If can
invest at 10%, what is it worth today?
0 1 2
PV = 100 = 90.90 $100

(1.10)1
38
• Value today of an amount to be received or paid in the future.
PV = FVn x 1
n
(1 + k)
Example: Expect to receive $100 in EIGHT years. If
can invest at 10%, what is it worth today?
0 1 2 3 4 5 6 7 8
100
PV =(1+.10)8 = 46.65 $100
39
GRAPHICAL PRESENTATION
$100
k = 0%
90
80
70
60 k = 5%
50
40
k = 10%
30
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year
40
Financial Calculator
01 LÃIApplication
SUẤT VÀ THỜI GIÁ CỦA MỘT KHOẢN TIỀN
ANNUITIES
• An annuity is a series of equal cash flows

spaced evenly over time.
• For example, you pay your landlord an
annuity since your rent is the same amount,
paid on the same day of the month for the
entire year.
Jan Feb Mar Dec
$500 $500 $500 $500 $500

42
FUTURE VALUE OF AN ANNUITY
0 1 2 3
$0 $100 $100 $100
You deposit $100 each year (end of year) into a

savings account.
How much would this account have in it at the end of 3
years if interest were earned at a rate of 8% annually?
43
0 1 2 3
$0 $100 $100 $100

$100(1.08)2 $100(1.08)1 $100(1.08)0
$100.00
$108.00
$116.64
$324.64
You deposit $100 each year (end of year) into a savings account.
How much would this account have in it at the end of 3 years if
interest were earned at a rate of 8% annually?
44
0 1 2 3
$0 $100 $100 $100

$100(1.08)2 $100(1.08)1 $100(1.08)0
$100.00
$108.00
$116.64
$324.64
How much would this account have in it at the end of 3 years
if interest were earned at a rate of 8% annually?
= 100 (1+.08) - 1
( )
3
n
FVA = PMTx( (1+k) - 1 ) .08
k = 100(3.2464) = 324.64 45
CALCULATOR SOLUTION
0 1 2 3
$0 $100 $100 $100
Enter:
N =3 324.64
I/Y = 8
PMT = -100
N I/YR PV PMT FV
CPT FV = ?
3 8 -100 ?
46
PRESENT VALUE OF AN ANNUITY
• How much would the following cash flows be

worth to you today if you could earn 8% on
your deposits?
0 1 2 3
$0 $100 $100 $100
47
 How much would the following cash flows be worth
to you today if you could earn 8% on your

$100/(1.08)
deposits? 1
1
$100 / (1.08) 2
$100 / (1.08) 3
0 2 3
$0 $100 $100 $100
$92.60
$85.73
$79.38
$257.71
48
• How much would the following cash flows be worth to you today if
you could earn 8% on your deposits?
0 1 2 3
$0 $100 $100 $100

$100/(1.08)1 $100 / (1.08)2 $100 / (1.08)3
$92.60
$85.73
$79.38
$257.71 1
1-
1 - (1+k)n
1 = 100 (
(1.08)3
)
PVA = .08
PMTx( )k = 100(2.5771) = 257.71
49
CALCULATOR SOLUTION
0 1 2 3
$0 $100 $100 $100
PV=?
Enter: -257.71
N =3
I/Y = 8
PMT = 100 N I/YR PV PMT FV
CPT PV = ?
3 8 ? 100
Chapter 8 Gallagher 6e © Textbook Media Press 50
ANNUITIES
• An annuity is a series of equal cash payments
spaced evenly over time.
• Ordinary Annuity: The cash payments occur at

the END of each time period.
• Annuity Due: The cash payments occur at the

BEGINNING of each time period.
51
FUTURE VALUE OF AN ANNUITY DUE
0 1 2 3
$100 $100 $100 FVA=?
You deposit $100 each year (beginning of year) into a

savings account.
52
0 1 2 3
$100 $100 $100

$100(1.08)3 $100(1.08)2 $100(1.08)1
$108
$116.64
$125.97
$350.61
You deposit $100 each year (beginning of year) into a
savings account.
53
0 1 2 3
$100 $100 $100

$100(1.08)3 $100(1.08)2 $100(1.08)1
$108
$116.64
$125.97
$350.61
How much would this account have in it at the end of 3
years if interest were earned at a rate of 8% annually?
n
= 100 (1+.08)
.08
3
(-1
)
(1.08)
FVA = PMTx( (1+k) - 1 )(1+k)
k =100(3.2464)(1.08)=350.61
54
PRESENT VALUE OF AN ANNUITY DUE
• How much would the following cash flows be

worth to you today if you could earn 8% on your
deposits?
0 1 2 3
$100 $100 $100
PV=?
55

to you today if you could earn 8% on your deposits?
0 1 2 3
$100 $100 $100

$100/(1.08)0 $100/(1.08)1 $100 / (1.08)2
$100.00
$92.60
$85.73
$278.33
56
to you today if you could earn 8% on your deposits?
0 1 2 3
$100 $100 $100

$100/(1.08)0 $100/(1.08)1 $100 / (1.08)2
$100.00
$92.60
$85.73
$278.33
1
1-
1
1 - (1+k)n
= 100 (
(1.08)3
.08
)
(1.08)
PVA = PMTx( )(1+k)
k = 100(2.5771)(1.08) = 278.33
57
AMORTIZED LOANS
• A loan that is paid off in equal amounts that include principal as
well as interest.
• Solving for loan payments.
58
AMORTIZED LOANS
• You borrow $5,000 from your parents to purchase a used car. You
agree to make payments at the end of each year for the next 5 years. If
the interest rate on this loan is 6%, how much is your annual
payment?
0 1 2 3 4 5
$5,000 $? $? $? $? $?
ENTER:
N =5 –1,186.98
I/Y = 6
PV = 5,000
CPT PMT = ? N I/YR PV PMT FV
5 6 5,000 ?
59
AMORTIZED LOANS
• You borrow $20,000 from the bank to purchase a used car. You
agree to make payments at the end of each month for the next 4
years. If the annual interest rate on this loan is 9%, how much is
your monthly payment?
1
1-
(1.0075)48
$20,000 = PMT ( .0075
)
1
1 - (1+k)n
PVA = PMTx( ) $20,000 = PMT(40.184782)
k
PMT = 497.70
60
AMORTIZED LOANS
• You borrow $20,000 from the bank to purchase a used car. You
agree to make payments at the end of each month for the next 4
years. If the annual interest rate on this loan is 9%, how much is
your monthly payment?
ENTER:
N = 48
I/YR = .75 – 497.70
PV = 20,000
CPT PMT = ?
Note:
N I/YR PV PMT FV
N = 4 * 12 = 48
I/YR = 9/12 = .75 48 .75 20,000 ?
61
PERPETUITIES
• A perpetuity is a series of equal payments at
equal time intervals (an annuity) that will be
received into infinity.
PVP = PMT
k
62
PERPETUITIES
 A perpetuity is a series of equal payments at equal time
intervals (an annuity) that will be received into infinity.
Example: A share of preferred stock pays a

constant dividend of $5 per year. What is
the present value if k =8%?
PVP = PMT
k
63
PERPETUITIES
 A perpetuity is a series of equal payments at equal
time intervals (an annuity) that will be received into
infinity.
Example: A share of preferred stock pays a constant
dividend of $5 per year. What is the present
value if k =8%?
PVP = PMT
k
If k = 8%: PVP = $5/.08 = $62.50
Chapter 8 Gallagher 6e © Textbook Media Press 64

SOLVING FOR K
Example: A $200 investment has grown to $230 over
two years. What is the ANNUAL return on
this investment?
0 1 2
$200 $230
230 = 200(1+ k)2
1.15 = (1+ k)2
FV = PV(1+ k)n 1.15 = (1+ k)2
1.0724 = 1+ k
k = .0724 = 7.24% 65
SOLVING FOR K - CALCULATOR
SOLUTION
Example: A $200 investment has grown to $230 over
two years. What is the ANNUAL return on
this investment?
Enter known values:

N = 2 7.24
I/Y = ?
PV = -200
FV = 230 N I/YR PV PMT FV
Solve for: 2 ? -200 230

CPT I/Y = ?
66
COMPOUNDING MORE THAN ONCE PER
YEAR
• $500 invested at 9% annual interest for 2 years. Compute FV.
Compounding
Frequency
$500(1.09)2 = $594.05 Annual

$500(1.045)4 = $596.26 Semi-annual
$500(1.0225)8 = $597.42 Quarterly
$500(1.0075)24 = $598.21 Monthly
$500(1.000246575)730 = $598.60 Daily
67
CONTINUOUS COMPOUNDING
• Compounding frequency is infinitely large.
• Compounding period is infinitely small.
Example: $500 invested at 9% annual interest for

2 years with continuous compounding.
kn
FV = PV x e
.09 x 2
FV = $500 x e = $598.61
68
INTEREST RATES
 Interest Rates Determined by
– Real Rate of Interest
– Expected Inflation
– Default Risk
– Maturity Risk
– Illiquidity Risk
Chapter 2 69
Chapter 2 Gallagher 6e: © Textbook Media Press
INTEREST RATES
 Real Rate of Interest
– Compensates for the lender’s lost opportunity to
consume.
Chapter 2 70
INTEREST RATES
 Default Risk
– For most securities, there is some risk that the borrower
will not repay the interest and/or principal on time, or at
all.
– The greater the chance of default, the greater the interest

rate the investor demands and the issuer must pay.
Chapter 2 71
INTEREST RATES
• Expected Inflation
 Inflation erodes the purchasing power of money.
 Example: If you loan someone $1,000 and they pay it

back one year later with 10% interest, you will have
$1,100. But if prices have increased by 5%, then
something that would have cost $1,000 at the outset of
the loan will now cost $1,000(1.05) = $1,050.
Chapter 2 72
INTEREST RATES
• Maturity Risk
 If interest rates rise, lenders may find that
their loans are earning rates that are
lower than what they could get on new
loans.
 The risk of this occurring is higher for

longer maturity loans.
Chapter 2 73
INTEREST RATES
• Maturity Risk
 Lenders will adjust the premium they
charge for this risk depending on whether
they believe rates will go up or down.
Chapter 2 74
INTEREST RATES
• Illiquidity Risk
 Investments that are easy to sell without losing
value are more liquid.
 Illiquid securities have a higher interest rate to

compensate the lender for the inconvenience of
being “stuck.”
Chapter 2 75
Determination of Rates
k = k* + IRP + DRP + MRP + IRP
k = the nominal, or observed rate

on security
k* = real rate of interest
IRP = Inflation Risk Premium
DRP = Default Risk Premium
MRP = Maturity Risk Premium
IRP = Illiquidity Risk Premium
Chapter 2 76
INTEREST RATES
• Term Structure
 Relationship between long and short

term interest rates
 Yield curve
Chapter 2 77
FOUR TYPES
OF CREDIT MARKET INSTRUMENTS
• Simple Loan
• Fixed Payment Loan
• Coupon Bond
• Discount Bond
78
YIELD TO MATURITY
• The interest rate that equates the

present value of cash flow payments received from a debt instrument with its value today
79
SIMPLE LOAN—YIELD TO MATURITY
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
80
FIXED PAYMENT LOAN—
YIELD TO MATURITY
The same cash flow payment every period throughout
the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV =  2
 3
 ...+ n
1 + i (1 + i ) (1 + i ) (1 + i)
81
COUPON BOND—YIELD TO MATURITY
Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P=  2
 3
. . . + n

1+i (1+i ) (1+i ) (1+i ) (1+i ) n
82
• When the coupon bond is priced at its face value, the yield to
maturity equals the coupon rate
• The price of a coupon bond and the yield to maturity are
negatively related
• The yield to maturity is greater than the coupon rate when the
bond price is below its face value
83
CONSOL OR PERPETUITY
• A bond with no maturity date that does not repay principal but
pays fixed coupon payments forever
Pc  C / ic
Pc  price of the consol

C  yearly interest payment
ic  yield to maturity of the consol
Can rewrite above equation as ic  C / Pc
For coupon bonds, this equation gives current yieldŃ

an easy-to-calculate approximation of yield to maturity
84
DISCOUNT BOND—YIELD TO MATURITY
For any one year discount bond
F-P
i=
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
85
YIELD ON A DISCOUNT BASIS
Less accurate but less difficult to calculate
F-P 360
idb = X
F days to maturity
idb = yield on a discount basis
F = face value of the Treasury bill (discount bond)
P = purchase price of the discount bond
Uses the percentage gain on the face value
Puts the yield on an annual basis using 360 instead of 365 days
Always understates the yield to maturity
The understatement becomes more severe the longer the maturity
86
FOLLOWING THE FINANCIAL NEWS:
BOND PRICES AND INTEREST RATES
RATE OF RETURN
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P -P
RET = + t1 t
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt1 - Pt
= rate of capital gain = g
Pt
88
RATE OF RETURN
AND INTEREST RATES
• The return equals the yield to maturity only if the
holding period equals the time to maturity
• A rise in interest rates is associated with a fall in bond
prices, resulting in a capital loss if time to maturity is
longer than the holding period
• The more distant a bond’s maturity,
the greater the size of the percentage
price change associated with an
interest-rate change
89
RATE OF RETURN
AND INTEREST RATES (CONT’D)
• The more distant a bond’s maturity, the lower the rate of return the
occurs as a result of an increase in the interest rate
• Even if a bond has a substantial initial
interest rate, its return can be negative if interest rates rise
90
91
INTEREST-RATE RISK
• The possibility that the market value of a financial instruments will

change as interest rate vary
• Prices and returns for long-term
bonds are more volatile than those for
shorter-term bonds
• There is no interest-rate risk for any bond whose time to maturity
matches the holding period
92
REAL AND NOMINAL INTEREST RATES
• Nominal interest rate makes no allowance

for inflation
• Real interest rate is adjusted for changes in price level so it more
accurately reflects the cost of borrowing
• Ex ante real interest rate is adjusted for expected changes in the
price level
• Ex post real interest rate is adjusted for actual changes in the price
level
93
FISHER EQUATION
i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
94
THE BEHAVIOR OF INTEREST RATES
• Asset demand
• Bond market
• Money demand and supply
ASSET DEMAND
• Wealth
• Expected Return
• Risk
• Liquidity
96
THE BOND MARKET
• Bond Demand
• Bond supply
97
BOND DEMAND
• a change in wealth
• a change in exp. interest rates
• a change in expected inflation
• a change in the risk of bonds relative to other assets
• a change in liquidity of bonds relative to other assets
98
BOND DEMAND
99
BOND SUPPLY
• bond issuers/ borrowers

• look at Qs as a function of price, yield
• lower bond prices
– higher bond yields
– more expensive to borrow
– lower Qs of bonds
• so bond supply slopes up with price
100
101
102
FISHER EFFECT
expected inflation rises,
nominal interest rates rise
103
MONEY DEMAND & MONEY SUPPLY (LIQUIDITY
PREFERENCE FRAMEWORK)
104
MD AND MS
105
INCOME EFFECT
liquidity effect
Income effect
Price level effect
Expected price effect
106
107
EXPECTED INFLATION EFFECT
• if people expect increase in Ms,

– expect increase in Price level
– expect inflation
• Fisher effect
– increase in exp. inflation
increase in i
108
RISK STRUCTURE OF INTEREST RATES
“The relationship among yields on financial instruments that have the same maturity but differ
because of variations in default risk, liquidity, and tax rates”
109
RISK STRUCTURE OF INTEREST RATES
• Default risk—occurs when the issuer of the bond is unable or

unwilling to make interest payments or pay off the face value
– U.S. T-bonds are considered default free
– Risk premium—the spread between the interest rates on bonds with default
risk and the interest rates on T-bonds
• Liquidity—the ease with which an asset can be converted into cash
• Income tax considerations
110
111
112
113
114
TERM STRUCTURE OF INTEREST
RATES
“The relationship among yields on financial instruments with identical risk, liquidity and tax
characteristics but differing terms to maturity”
115
TERM STRUCTURE OF INTEREST RATES
• Bonds with identical risk, liquidity, and tax characteristics may have different
interest rates because the time remaining to maturity is different
• Yield curve—a plot of the yield on bonds with differing terms to maturity but
the same risk, liquidity and tax considerations
– Upward-sloping  long-term rates are above
short-term rates
– Flat  short- and long-term rates are the same
– Inverted  long-term rates are below short-term rates
116
FACTS THEORY OF THE TERM STRUCTURE
OF INTEREST RATES MUST EXPLAIN
1. Interest rates on bonds of different maturities move together over
time
2. When short-term interest rates are low, yield curves are more likely
to have an upward slope; when short-term rates are high, yield curves
are more likely to slope downward and be inverted
3. Yield curves almost always slope upward
117
THREE THEORIES
TO EXPLAIN THE THREE FACTS
1. Expectations theory explains the first two facts but not the third
2. Segmented markets theory explains fact three but not the first two
3. Liquidity premium theory combines the two theories to explain all three facts
118
EXPECTATIONS THEORY
• The interest rate on a long-term bond will equal an
average of the short-term interest rates that people
expect to occur over the life of the long-term bond
• Buyers of bonds do not prefer bonds of one maturity
over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different
maturity
• Bonds like these are said to be perfect substitutes
119
EXPECTATIONS THEORY—IN GENERAL
For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond
120
EXPECTATIONS THEORY—EXAMPLE
• Let the current rate on one-year bond be 6%.

• You expect the interest rate on a one-year bond to be 8% next year.
• Then the expected return for buying two one-year bonds averages
(6% + 8%)/2 = 7%.
• The interest rate on a two-year bond must be 7% for you to be
willing to purchase it.
121
(CONT’D)
Expected return over the two periods from investing $1 in the
two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t )  1
 1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t
122
(CONT’D)
If two one-period bonds are bought with the $1 investment
(1  it )(1  ite1 )  1
1  it  ite1  it (ite1 )  1
it  ite1  it (ite1 )
it (ite1 ) is extremely small
Simplifying we get
it  ite1
123
(CONT’D)
Both bonds will be held only if the expected returns are equal
2i2t  it  ite1
it  ite1
i2t 
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it  ite1  ite 2  ...  ite ( n 1)
int 
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond
124
EXPECTATIONS THEORY
• Explains why the term structure of interest rates
changes at different times
• Explains why interest rates on bonds with different
maturities move together over time (fact 1)
• Explains why yield curves tend to slope up when
short-term rates are low and slope down when short-
term rates are high (fact 2)
• Cannot explain why yield curves usually slope
upward (fact 3)
125
SEGMENTED MARKETS THEORY
• Bonds of different maturities are not substitutes at all

• The interest rate for each bond with a different maturity is determined by the
demand for and supply of that bond
• Investors have preferences for bonds of one maturity over another
• If investors have short desired holding periods and generally prefer bonds with
shorter maturities that have less interest-rate risk, then this explains why yield
curves usually slope upward (fact 3)
126
LIQUIDITY PREMIUM &
PREFERRED HABITAT THEORIES
• The interest rate on a long-term bond will equal an average of short-term interest rates expected
to occur over the life of the long-term bond plus a liquidity premium that responds to supply
and demand conditions for that bond
• Bonds of different maturities are substitutes but not perfect substitutes
127
LIQUIDITY PREMIUM THEORY
it  ite1  it2
e
 ... ite( n1)
int   lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity
128
PREFERRED HABITAT THEORY
• Investors have a preference for bonds of one maturity over another

• They will be willing to buy bonds of different maturities only if they earn a somewhat higher
expected return
• Investors are likely to prefer short-term bonds over longer-term bonds
129
130
LIQUIDITY PREMIUM AND PREFERRED HABITAT
THEORIES, EXPLANATION OF THE FACTS
• Interest rates on different maturity bonds move together over

time; explained by the first term in
the equation
• Yield curves tend to slope upward when short-term rates are
low and to be inverted when short-term rates are high;
explained by the liquidity premium term in the first case and
by a low expected average in the second case
• Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens
131
132
TREASURY YIELD CURVE
4.50%
Link to US Treasury Department
4.00%
3 month
3.50% T-Bill
3.00%
2.50%
2.00%
1.50%
August 03, 2012:
1.00%
0.09%
0.50% or 9 basis points
0.00%
3 6 1 2 3 5 7 10 20
mos. yr. maturities
Chapter 2 133
4.50%
4.00%
3.50% 6 month
T-Bill
3.00%
2.50%
2.00%
1.50% August 03, 2012:

0.14%
0.50%
0.00%
3 6 1 2 3 5 7 10 20
mos. yr. maturities
Chapter 2 134
4.50%
4.00%
3.50% One
Year
3.00% T-Bill
2.50%
2.00%
1.50% August 03, 2012:

0.17%
0.50%
0.00%
3 6 1 2 3 5 7 10 20
mos. yr. maturities
Chapter 2 135
4.50%
4.00%
3.50% Two
Year
3.00% T-Note
2.50%
2.00%
1.50% August 03, 2012:

0.24%
0.50%
0.00%
3 6 1 2 3 5 7 10 20
mos. yr. maturities
Chapter 2 136
4.50%
4.00%
3.50% Three
Year
3.00% T-Note
2.50%
2.00%
1.50% August 03, 2012:

0.33%
0.50%
0.00%
3 6 1 2 3 5 7 10 20
mos. yr. maturities
Chapter 2 137
4.50%
4.00%
3.50% Five
Year
3.00%
T-Bond
2.50%
2.00%
August 03, 2012:
1.50%
0.65%
0.50%
0.00%
3 6 1 2 3 5 7 10 20
mos. yr. maturities
Chapter 2 138
4.50%
4.00%
August 03, 2012
3.50% 7 YR: 1.07%
10 YR: 1.60%
3.00%
20 YR: 2.30%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
3 6 1 2 3 5 7 10 20
mos. yr. maturities
Chapter 2 139
Chapter 2 140
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1
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TCH302. Chapter 2. Hien

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CHAPTER 2

FINANCIAL MARKETS AND

• Financial system (Direct and Indirect finance

• The purpose of the financial system is to bring

 Deficit economic units need to acquire additional

• Securities/financial assets are documents that

• Financial intermediaries discussed in Chapter 3

• Classified according to the characteristics of participants and

• Classified according to the characteristics of participants and

• Money Market vs. Capital Market

• Market efficiency refers to the ease, speed, and cost of trading

– Investors can adjust their portfolios easily

• T-Bills: are short-term securities issued by the Federal

• After initial sale, they have an active secondary market.

• They are bought at a discount and at maturity the

• They have maturities of one year or less.

• Most buyers are large institutions.

• Buyers and sellers are large institutions.

• Money Market Securities

• Money Market Securities

• Bonds: are “IOUs” issued by the borrower and sold

• The issuer promises to repay the

• Treasury Bonds: are issued by the federal government.

• Municipal Bonds: are issued by state and local governments.

• Corporate Bonds: are issued by corporations.

• Companies can also raise funds by selling shares of

• Common stockholders: own a portion of the company

• They receive a return on their investment in the form of

• Preferred stockholders do not generally have voting

• The “time value of money” and its importance to business.

Gallagher 6e © Textbook Media Press 32

$100 + (.08 x $100) = $100 + $8 = $108

$100 x (1.08)1 = $108

Quick! How long does it take to double $5,000

We will use the “Rule-of-72”.

Quick! How long does it take to double $5,000

Approx. Years to Double = 72 / i%

• Value today of an amount to be received or

PV = 100 = 90.90 $100

• An annuity is a series of equal cash flows

$500 $500 $500 $500 $500

$0 $100 $100 $100

You deposit $100 each year (end of year) into a

$0 $100 $100 $100

$0 $100 $100 $100

$0 $100 $100 $100

• How much would the following cash flows be

$0 $100 $100 $100

to you today if you could earn 8% on your

$0 $100 $100 $100

$0 $100 $100 $100

$0 $100 $100 $100

• Ordinary Annuity: The cash payments occur at

• Annuity Due: The cash payments occur at the

$100 $100 $100 FVA=?

You deposit $100 each year (beginning of year) into a

$100 $100 $100

$100 $100 $100

• How much would the following cash flows be

$100 $100 $100

 How much would the following cash flows be worth

$100 $100 $100

$100 $100 $100

• Solving for loan payments.