principles of managerial finance 9th edition chapter 2 institutions, securities, markets and rates

Principles of Managerial Finance

9th Edition

Chapter 2

Institutions, Securities,

Markets and Rates

Learning Objectives• Understand the relationship between financial

institutions and markets, and the role of the money

market.

• Describe the key characteristics and types of

corporate bonds.

• Differentiate between debt and equity capital.

• Discuss the rights, characteristics, and features of

both common and preferred stock.

Learning Objectives

• Review the operation of the capital market, particularly

the securities exchanges and the role of the

investment banker.

• Describe the interest rate fundamentals and the basic

relationship between risk and rates of return.

Financial Institutions & Markets

• Firms that require funds from external sources can

obtain them in three ways:

– through a bank or other financial institution

– through financial markets

– through private placements

• This chapter will focus on financial institutions and

markets

Financial Institutions & Markets

• Financial institutions are intermediaries that channel

the savings of individuals, businesses, and

governments into loans or investments.

• The key suppliers and demanders of funds are

individuals, businesses, and governments.

• In general, individuals are net suppliers of funds, while

businesses and governments are net demanders of

funds.

Financial Institutions

Financial Intermediaries in the U.S.

Depository Institutions Investment Institutions

Commercial Banks Investment Companies and Mututal Funds

S&Ls Real Estate Investment Trusts

Savings Banks Money Market Funds

Credit Unions

Contractual Savings Institutions Finance Companies

Life Insurance Companies Sales Finance Companies

Private Pension Funds Consumer Finance Companies

State & Local Government Retirement Funds Commercial Finance Companies

Major Intermediaries in the U.S. Financial System

The Changing Role of Financial InstitutionsDIDMCA

• A revolution in the financial services industry began

with the passage of the Depository Institutions

Deregulation and Monetary Control Act of 1980.

• This legislation was crafted and passed as a result of

the tumultuous conditions in the financial markets

during the late 1970s which resulted in rapid

disintermediation.

• DIDMCA (1980) actually consisted of two parts:

Depository Institutions Deregulation and Monetary

Control.

• DID was designed to do a number of things:

– curtail regulation Q (interest rate ceilings)

– increase various sources of funding available to

banks

– expand the scope and activity of S&Ls by allowing

them to invest in other than home mortgages


• The monetary control (MC) portion of DIDMCA was

designed to extend the Fed’s control to thrifts and

nonmember banks by extending reserve requirements

and other controls to them.

• This permitted both greater competition for deposits

and more flexibility in terms of the types of investments

various institutions could make.


Financial Markets

• Financial markets provide a forum in which suppliers

of funds and demanders of funds can transact

business directly.

• The two key financial markets are the money market

and the capital market.

• Transactions in short term marketable securities take

place in the money market while transactions in long-

term securities take place in the capital market.

Financial Markets• Whether subsequently traded in the money or capital

market, securities are first issued through the primary

market.

• The primary market is the only one in which a

corporation or government is directly involved in and

receives the proceeds from the transaction.

• Once issued, securities then trade on the secondary

markets such as the New York Stock Exchange or

NASDAQ.

Financial Markets

U.S. Treasury Bills U.S. Treasury Notes & Bonds

Negotiable CDs U.S. Government Agency Bonds

Bankers Acceptances State & Local Government Bonds

Federal Funds Corporate Bonds

Commercial Paper Corporate Stocks

Repurchase Agreements Real Estate Mortgage Security

Mortgage Backed Security

• While real assets include the direct ownership of

tangible assets such as land or buildings, financial

assets represent claims against the income and

assets of those who issued the claims.

• Types of financial assets include stocks, bonds, and

bank deposits.

• Some financial assets, such as stocks and bonds, can

be traded in the secondary markets while others, such

as bank deposits, cannot.

Claims to Wealth

The Relationship between Financial Institutions and Financial Markets

Indirect finance

Direct finance

• The money market exists as a result of the interaction

between the suppliers and demanders of short-term

funds (those having a maturity of a year or less).

• Most money market transactions are made in

marketable securities which are short-term debt

instruments such as T-bills and commercial paper.

• Money market transactions can be executed directly or

through an intermediary.

The Money Market

Money market instrument

• Treasury bill

• Banker’s acceptance

• Negotiable certificate of deposit

• Commercial paper

• Federal funds

• The international equivalent of the domestic (U.S.)

money market is the Eurocurrency market.

• The Eurocurrency market is a market for short-term

bank deposits denominated in U.S. dollars or other

marketable currencies.

• The Eurocurrency market has grown rapidly mainly

because it is unregulated and because it meets the

needs of international borrowers and lenders.

The Money Market

Corporate Bonds

• Bonds are long-term debt instruments issued by

corporations.

• Corporate bonds typically pay interest semiannually,

pay fixed coupon interest, have a par or face value of

$1,000 and have an original maturity of 10 to 30 years.

• Furthermore, they have a prior claim on the firm’s

assets (in from of stockholders) but do not represent

ownership in the firm.

Corporate Bonds

• The bond indenture specifies the conditions under

which it has been issued.

• It outlines both the rights of bondholders and duties of

the issuing corporation.

• It also specifies the timing of interest and principal

payments, any restrictive covenants, and sinking fund

requirements.

Legal Aspects

Corporate Bonds

• Common standard debt provisions in the

indenture typically include:

– the maintenance of satisfactory accounting records

– periodically furnishing audited financial statements

– the payment of taxes and other liabilities when due

– the maintenance of all facilities in good working

order

– identification of any collateral pledged against the

bond

Legal Aspects

Corporate Bonds

• Common restrictive provisions (or covenants) in the

indenture typically include:

– the maintenance of a minimum level of liquidity

– prohibiting the sale of accounts receivable

– the imposition of certain fixed asset investments

– constraints on subsequent borrowing

– limits on annual cash dividend payments

Legal Aspects

Corporate Bonds

• An additional restrictive provision often included in the

indenture is a sinking fund requirement, which

specifies the manner in which a bond is systematically

retired prior to maturity.

• Sinking funds typically dictate that the firm make semi-

annual or annual payments to a trustee who then

purchases the bonds in the market.

Legal Aspects

Corporate Bonds

• In general, the longer the bond’s maturity, the higher

the interest rate (or cost) to the firm.

• In addition, the larger the size of the offering, the lower

will be the cost (in % terms) of the bond.

• Finally, the greater the risk of the issuing firm, the

higher the cost of the issue.

Cost of Bonds

Corporate Bonds

• The conversion feature of convertible bonds allows

bondholders to exchange their bonds for a specified

number of shares of common stock.

• Bondholders will exercise this option only when the

market price of the stock is greater than the conversion

price.

• A call feature (callable bond), which is included in most

corporate issues, gives the issuer the opportunity

to repurchase the bond prior to maturity at the call price.

General Features

Corporate Bonds

• In general, the call premium is equal to one year of

coupon interest and compensates the holder for having

it called prior to maturity.

• Furthermore, issuers will exercise the call feature when

interest rates fall and the issuer can refund the issue at

a lower cost.

• Issuers typically must pay a higher rate to investors for

the call feature compared to issues without the feature.

General Features

Corporate Bonds

• Bonds also are occasionally issued with stock

purchase warrants attached to them to make them

more attractive to investors.

• Warrants give the bondholder the right to purchase a

certain number of shares of the same firm’s common

stock at a specified price during a specified period of

time.

• Including warrants typically allow the firm to raise debt

capital at a lower cost than would be possible in their

absence.

General Features

Variety of Corporate Debt

Mortgage Bonds

• Mortgage bonds are backed by real estate and/or the

physical assets of the corporation.

• The real assets pledged will have a market value

greater than the bond issue.

• If the company defaults on the bonds, the real assets

are sold off to pay off the mortgage bond holders.

Secured Bond

Equipment Trust Certificates

• Equipment trust certificates are very similar to

automobile loans.

• When you borrow money for your new car, you make

a down payment. Then you make your monthly

installment payments.

• At no time throughout the life of the loan is your car

worth less than the outstanding amount of the loan.

Variety of Corporate DebtSecured Bond

• Many railroad and transportation companies use

equipment trust certificates to meet their financing

needs. airline trustee investor

• Usually, 20% of the purchase price is put down by the

company in the form of a down payment. Then the

balance is paid off over 15 years.


Equipment Trust CertificatesSecured Bond

lease

Serial payment

fund

ETCfund buy

Airplane manufacturer

• When the company is finished paying off the loan, it

receives clear title from the trustee.

• If the company defaults on its loan, the equipment is

sold off and the bond holders are paid off.



• Equipment Trust Certificates are serial bonds.

• That is, each time a payment is made, a portion of that

payment is interest and a portion of that payment is

principal.

• In this way, as previously stated, the loan amount

never exceeds the collateral value.



Debentures

• Debentures are unsecured promissory notes that are

supported by the general creditworthiness of the

issuing company.

• Because no assets are pledged, these bonds are

riskier than collateralized bonds.

• As a result, they are often referred to as subordinate

debt and carry higher interest rates and/or other

features to make them more desirable to investors.

Variety of Corporate DebtUnsecured Bond

Income Bonds

• Income bonds will only pay interest if income is earned

by the issuing company and only to the extent that

income is earned.

• Income bonds are the only bonds issued where failure

to pay the interest in a timely fashion does not lead to

immediate default.

• As a result, income bonds are considered to be

extremely risky.

Variety of Corporate DebtUnsecured Bond

• In general, income bonds are issued by a company in

bankruptcy.

• The company facing bankruptcy will meet with its

creditors (usually bond holders) and agree to issue

new income bonds in exchange for the old bonds.

• Because failure to pay interest would land the

company back into bankruptcy court, the creditors

agree that interest will only be paid to the extent

earned.

Variety of Corporate DebtIncome Bonds

Convertible Bonds

• Convertible bonds are one type of hybrid security.

• They are like bonds in that they pay a fixed rate of

interest and have a maturity date.

• They are also like stock because they give the

investor an option to convert the bond into a specified

number of shares of stock.

• The market price of a convertible bond therefore

depends both on the firm’s stock price and prevailing

interest rates.


Variable Interest Rate Bonds (floating-rate bonds)

• Variable interest rate bonds are bonds with coupon

rates that vary with changes in short-term interest

rates (like adjustable rate mortgages).

• Usually, the interest rate is pegged to another rate

such as U.S. Treasury bills.

• In general, the market price of a variable rate bond will

be less volatile.

• On most bonds, an increase in interest rates will result

in a decrease in market price.


Discount and Zero Coupon Bonds

• A zero coupon bond pays no coupon interest from

year to year the way most bonds do.

• Investors earn their returns by purchasing the bonds

at deep discounts from the bond’s face value, and

then receiving the full face value at maturity.

• Since the return on a zero depends strictly on the

issuing firm’s ability to pay the face value at maturity,

only the most creditworthy firms are able to issue

them.


High-Yield (Junk) Bonds

• High-yield bonds are not a different type of bond -- simply a

bond of lower quality.

• Bonds rated BB (S&P) or Ba (Moody’s) or lower are considered

to be junk.

• Junk bonds are usually debentures and are subordinated to the

firm’s other debt.

• In general, junk bonds pay around 3 to 4 percent higher yields

to investors than higher-grade bonds.



• Extendible Notes: Short-tern ( 1-5 years) note

renewable at the option of holders in the new market

rate.

Extendible Notes


• Putable bond: bonds redeemable at par value at the option of holder 在發行後的某個時間點，或者當公司被併購、併購別人、或大幅舉債時。

Putable Bonds

Retiring DebtSerial-Bonds

• A serial bond is simply one in which some of the

bonds in the issue mature or are retired each year

rather than all at once.

• Serial bonds are usually used by companies to finance

costly equipment, or by municipalities to finance

capital improvements.

• Also, the assets financed are usually used as

collateral to secure the bonds.

Sinking Funds

• A sinking fund is simply a series of periodic payments

to retire part of a debt issue.

• In most cases, the periodic payments plus the interest

earned on those deposits retire the debt at maturity.

• In some cases, the firm sets aside funds and randomly

selects bonds to be called.

• Strong sinking funds set aside a large amount to be

retired (say 10% per year).

Retiring Debt

• Weak sinking funds will leave most of the issue

outstanding until maturity.

• This is sometimes referred to as a balloon payment.

• Bonds with strong sinking funds are generally

considered to be less risky than those with weak

sinking funds.

Retiring DebtSinking Funds

Repurchasing Debt

• Firm’s that have outstanding bonds which have

substantially declined in price and are selling at a

discount are sometimes repurchased by the issuer in

the open market.

• Thus, a firm with bonds selling at $500 with a face

value of $1000 can cut their financing costs in half.

• However, this decision must be weighed against any

alternative uses for the cash used to execute the

repurchase. also the subsequent financing needs.

Retiring Debt

When interest rate

Callable Bonds

• A call feature gives the issuer the right (or option) to retire a

debt issue prior to maturity.

• Issuer’s tend to call bonds that were issued during a period of

high interest rates because it gives them the opportunity to

refund the debt at a lower rate.

• To protect investors, callable bonds usually require the issuer to

pay a call premium which amounts to one year of extra interest

expense (but usually declines over time).

• *putable bond: holders have the option to redeem it at par at

every 1 to 5 years or when firms liquidate, M&A,…

Retiring DebtEurobondForeign bond

Sources of Risk

• Default Risk

– Risk that the interest will not be paid

– Risk that the principal will not be paid

– Risk that the price of the bond will decline due to

poor company prospects

• Inflation Risk

• Call Risk

• Interest Rate Risk.

Bond Risk

Corporate BondsBond Ratings

Junk bond

The Nature of Equity CapitalContrasting Debt & Equity

The Nature of Equity CapitalVoice in Management

• Unlike bondholders and other credit holders, holders

of equity capital are owners of the firm.

• Common equity holders have voting rights that permit

them to elect the firm’s board of directors and to vote

on special issues.

• Bondholders and preferred stockholders receive no

such privileges.

The Nature of Equity CapitalClaims on Income & Assets

• Equity holders are have a residual claim on the firm’s

income and assets.

• Their claims can not be paid until the claims of all

creditors, including both interest and principle

payments on debt have been satisfied.

• Because equity holders are the last to receive

distributions, they expect greater returns to

compensate them for the additional risk they bear.

The Nature of Equity CapitalMaturity

• Unlike debt, equity capital is a permanent form of

financing.

• Equity has no maturity date and never has to be

repaid by the firm.

The Nature of Equity CapitalTax Treatment

• While interest paid to bondholders is tax-deductible to

the firm, dividends paid to preferred and common

stock holders is not.

• In effect, this lowers the cost of debt relative to the

cost of equity as a source of financing to the firm.

Voting Rights

In general, voting rights are relatively meaningless since share ownership is very widely dispersed among a large number of individual shareholders. As a result, directors and top management are relatively well-insulated.

This has begun to diminish to some extent in recent years due to the rapid expansion of large institutional investors such as mutual funds and insurance companies.

Common StockStockholder Rights

Nonvoting common stockSuper-voting common stock

• Voting Rights

– traditional voting

Under traditional voting, each share owned gives the shareholder the right to vote for one individual for each seat on the board of directors.

Under this system, if the majority of shareholders vote as a block, the minority could never elect a director.


• Voting Rights


– cumulative voting

This system empowers minority stockholders by permitting each stockholder to cast all of his or her votes for one candidate for the firm’s board of directors.


• Voting Rights


– cumulative voting

– Example:

Under traditional voting, a shareholder with 100 shares can vote 100 shares for each of 5 members of the board of directors.

Under cumulative voting, a shareholder with 100 shares can vote 500 shares for just one member running for the board of directors.


• Voting Rights

• Preemptive Rights

A preemptive right gives a shareholder the right to maintain his or her proportionate share of the company by requiring that all new shares issued must be done so through a “rights offering.”

Under a rights offering, a shareholder who owns 10% of the shares outstanding has the right to purchase 10% of any additional shares issued.


• Rights offering: the firm gives existing shareholders a right to purchase additional shares at pro rata basis at price lower than the market

• Ownership

• Outstanding shares= issued shares-treasury shares

• Additional shares that can be issued in the future = authorized shares –

outstanding shares


Privately ownedClosely ownedPublicly owned

• Voting Rights

• Preemptive Rights

• Proxies

Proxies are frequently used in the voting process since many smaller stockholders do not attend the annual meeting. Shareholders must sign a proxy statement giving their votes to another party who will then vote their shares.


• Payment of dividends is at the discretion of the Board

of Directors.

• Dividends may be made in cash, additional shares of

stock, and even merchandise.

• Stockholders are residual claimants -- they receive

dividend payments only after all claims have been

settled with the government, creditors, and preferred

stockholders.

Common StockDividends

• The international market for common stock is not as

large as that for international debt.

• However, cross-border trading and issuance of stock

has increased dramatically during the past 20 years.

• Much of this increase has been driven by the desire of

investors to diversify their portfolios internationally.

Common StockInternational Stock Issues

• A growing number of firms are beginning to list their

stocks on foreign markets.

• Issuing stock internationally both broadens the

company’s ownership base and helps it to integrate

itself in the local business scene.


Stock Issued in Foreign Markets

• Only the largest foreign firms choose to list their

stocks in the U.S. because of the rigid reporting

requirements of the U.S. markets.

• Most foreign firms instead choose to tap the U.S.

markets using ADRs -- claims issued by U.S. banks

representing ownership shares of foreign stock trading

in U.S. markets.


Foreign Stocks in U.S. Markets

Preferred Stock• Preferred stock is an equity instrument that usually

pays a fixed dividend and has a prior claim on the

firm’s earnings and assets in case of liquidation.

• The dividend is expressed as either a dollar amount or

as a percentage of its par value.

• Therefore, unlike common stock a preferred stock’s

par value may have real significance.

• If a firm fails to pay a preferred stock dividend, the

dividend is said to be in arrears.

no par value

• In general, and arrearage must be paid before

common stockholders receive a dividend.

• Preferred stocks which possess this characteristic are

called cumulative preferred stocks. v.s. non-cumulative P.S.

• Preferred stocks are also often referred to as hybrid

securities because they possess the characteristics of

both common stocks and bonds.

• Preferred stocks are like common stocks because

they are perpetual securities with no maturity date.

Preferred Stock

• Preferred stocks are like bonds because they are fixed

income securities. Dividends never change.

• Because preferred stocks are perpetual, many have

call features which give the issuing firm the option to

retire them should the need or advantage arise.

• In addition, some preferred stocks have mandatory

sinking funds which allow the firm to retire the issue

over time.

• Finally, participating preferred stock allows preferred

stockholders to participate with common stockholders

in the receipt of dividends beyond a specified amount.

Preferred Stock ConvertibleRestrictive covenant

Preferred Stocks & Bonds Contrasted

• Preferred stocks are riskier than bonds from the

investor perspective because:

– Bond terms are legal obligations

– The investor cannot expect the firm to redeem

preferred stock for a preset face value. It must be

sold in the market at an uncertain price.

• Preferred stock prices are therefore more variable and

thus riskier than bond prices.

Disadvantages of Preferred Stock

• Preferred stock offers no protection from inflation.

• Preferred stock tends to be less marketable than

either bonds or common stock resulting in a large bid-

ask spread.

• Inferior position to bondholders.

• Yields are insufficient for most (non-corporate)

investors to justify risk.

Securities Exchanges

• role:

1. Financing

2. Investment

3. Efficient market

4. Price discovery

5. Liquidity

P

Q

S

D

Securities ExchangesOrganized Exchanges

• Organized securities exchanges are tangible

secondary markets where outstanding securities are

bought and sold.

• They account for over 60% of the dollar volume of

domestic shares traded.

• Only the largest and most profitable companies meet

the requirements necessary to be listed on the New

York Stock Exchange.


• Only those that own a seat on the exchange can make

transactions on the floor (there are currently 1,366 seats).

• Trading is conducted through an auction process where

specialists “make a market” in selected securities.

• As compensation for executing orders, specialists make

money on the spread (ask price - bid price).

•Bid price = dealer’s highest purchasing price

•Ask price = dealer’s lowest selling price


Requirements NYSE AMEX

shares held by public 1,100,000 400,000

stockholders with 100+ shares 2,000 1,200

pretax income (latest year) $2,500,000

$750,000

pretax income (prior 2 years) $2,000,000 N/A

MV of public shares held $18,000,000 $300,000

tangible assets $16,000,000 $4,000,000

Securities ExchangesOver-the-Counter Exchange

• The over-the-counter (OTC) market is an intangible

market for securities transactions.

•The OTC is a computer-based market where dealers

make a market in selected securities and are linked to

buyers and sellers through the NASDAQ System.

• Dealers also make money on the “spread”.

Securities Price

Quotations

Bond

Quotations

Securities Price

Quotations

Stock

Quotations

Functions of Investment BankersUnderwriting, Private Placement & Best Efforts

• Corporations typically raise debt and equity capital

using the services of investment bankers through

public offerings.

• When underwriting a security issue, an investment

bankers guarantees the issuer will receive a

specified amount of money from the issue.

• The investment banker purchases the securities from

the firm at a lower price than the planned resale price.

not in the text book

Functions of Investment Bankers

• When underwriting an issue, the investment banker

bears the risk of price changes between the time of

purchase and the time of resale.

• With a private placement, the investment banker

arranges for the direct sale of the issue to one or

more individuals or firms and receives a commission

for acting as the intermediary in the transaction.

• When a firm issues securities on a best efforts basis,

compensation is based on the number of securities

sold.

Underwriting, Private Placement & Best Efforts

Functions of Investment Bankers

• Underwriters also act as advisors and consultants for

corporations.

• They can assist firms in planning both the timing of

an issue and the amount and features of an issue.

• They also can assist in evaluating mergers and

acquisitions.

Advising

Other Aspects of Investment Banking

• An investment banker may be selected through

competitive bidding, where the banker or group of

bankers that bids the highest price for an issue is

chosen for the underwriting.

• With a negotiated offering, the investment

banker is merely hired rather than awarded the issue

through a competitive bid.

Selecting an Investment Banker


• Underwriting syndicates are typically formed when

companies bring large issues to the market.

• Each investment banker in the syndicate normally

underwrites a portion of the issue in order to reduce

the risk of loss for any single firm and insure wider

distribution of shares.

• The syndicate does so by creating a selling group

which distributes the shares to the investing public.

Syndicating the Underwriting


• Before a new security can be issued, the firm must file

a registration statement with the SEC at least 20 days

before approval is granted.

• One part of the registration statement called the

prospectus details the firm’s operating and financial

position.

• However, a prospectus may be distributed to potential

investors during the approval period as long as a red

herring is printed on the front cover.

Registration Requirements


• As an alternative to filing cumbersome registration

statements, firms with more than $150 million in

outstanding stock can use a procedure called shelf

registration.

• This allows the firm to file a single document that

covers all issues during the subsequent 2 year period.

• As a result, the approved securities are kept “on the

shelf” until the need for or market conditions are

appropriate for issue.

Registration Requirements


• In general, underwriters wait until the end of the

registration period to price securities to ensure

marketability.

• If the issue is fully sold, it is considered an

oversubscribed issue; if not fully sold, it is considered

undersubscribed.

• In order to stabilize the issue at the initial offering price

as it is being offered for sale, investment bankers often

place orders to purchase the security themselves.

Pricing & Distributing an Issue


• Investment bankers earn their income by profiting on

the spread.

• The spread is difference between the price paid for the

securities by the investment banker and the eventual

selling price in the marketplace.

• In general, costs for underwriting equity is highest,

followed by preferred stock, and then bonds.

• In percentage terms, costs can be as high as 17% for

small stock offerings to as low as 1.6% for large bond

issues.

Cost of Investment Banking Services

• 現增：•IPO ：

• 若有競拍，則公開申購之價格為競拍之平均價，並不得低於底價之 1.3倍

• IPO之股票幾乎皆是老股，為了達到“股權分散”

•承銷商賺取利潤：

1.公開申購2.詢價圈購

1.公開申購2.競價拍賣3.券商包銷 (10%~25%)

(90%~75%)，其中最多一半採競拍

1.公開申購、競拍、詢圈之手續費2.輔導期之費用：包月、包案、免費3.承銷價與上市後處分之價差 (spread)


• Although diminishing in frequency, firms can also

negotiate private placements rather than public

offerings.

• Private placements can reduce administrative and

issuance costs for firms since registration and

approval from the SEC is not required.

• However, they do pose problems for purchasers since

the securities cannot not be resold via secondary

markets.

Private Placements

Risk Structure of Interest Rates

k1=nominal interest ratek*=real interest rateIP=expected inflationRP1=risk premium

k1=k*+IP+RP1

k*+IP=rf=risk-free rate

Default risk premiumLiquidity risk premiumTax risk premiumInterest rate risk premiumContractual provisions

Interest rate risk = Price risk + Reinvestment riskPrice risk if maturity Price risk if coupon interest rate Price risk if market rate

Interest Rates & Required Returns

• The term structure of interest rates relates the interest

rate to the time to maturity for securities with a

common default risk profile.

• Typically, treasury securities are used to construct yield

curves since all have zero risk of default.

• However, yield curves could also be constructed with

AAA or BBB corporate bonds or other types of similar

risk securities.

Term Structure of Interest Rates

Interest Rates & Required ReturnsTerm Structure of Interest Rates

Impact of Inflation

Interest Rates & Required ReturnsTerm Structure of Interest Rates

Yield Curves

Theories of Term Structure

• This theory suggest that the shape of the yield curve

reflects investors expectations about the future

direction of inflation and interest rates.

• Therefore, an upward-sloping yield curve reflects

expectations of higher future inflation and interest

rates.

• In general, the very strong relationship between

inflation and interest rates supports this theory.

Expectations Hypothesis


• This theory contends that long term interest rates tend

to be higher than short term rates for two reasons:

– long-term securities are perceived to be riskier than

short-term securities

– borrowers are generally willing to pay more for long-

term funds because they can lock in at a rate for a

longer period of time and avoid the need to roll over

the debt.

Liquidity Preference Theory


• This theory suggests that the market for debt at any

point in time is segmented on the basis of maturity.

• As a result, the shape of the yield curve will depend on

the supply and demand for a given maturity at a given

point in time.

Market Segmentation Theory

Risk Premiums

• Default Risk

• Interest rate Risk

• Liquidity Risk

• Contractual Provisions

• Tax Risk

Issue & Issuer Characteristics

Risk and return

risk

return

principles of managerial finance 9th edition chapter 2 institutions, securities, markets and rates

Documents

key financial markets

financial intermediaries

capital market

financial services industry

money market

primary market

net suppliers of funds

net demanders of funds