The Financial Environment

Readings: Chapter 4

At the end of this unit students should be able to: 

1. List some of the many different types of financial markets

2. Identify some of the most important money and capital market instruments, and list the characteristics of each.

3. Distinguish between the two basic types of stock markets.

4. Briefly describe the fundamental factors that affect the cost of money.

5. Write out two equations for the nominal, or quoted, interest rate, and briefly discuss each component.

6. Define what is meant by the term structure of interest rates, and graph a yield curve for a given set of data.

7. Explain the two key factors that determine the shape of the yield curve.

Financial system

The purpose of a financial system is to bring two groups of people together  - borrowers & lenders  

Financial Institutions

In order to facilitate the transfer of funds and securities in this 'bringing together' process, various financial institutions have evolved. Nonetheless, there may be occasions where transfers occur directly between borrowers and lenders i.e. a business sells its stock or bonds directly to investors who in turn give the business the necessary funds. This is obviously not very efficient.

To make the process more efficient, Investment Banking Houses are utilised.e.g. Dehring, Bunting & Golding (DB&G) in Jamaica. These institutions serve as a middle man and facilitate the issuance of new securities i.e. they would buy securities from the borrowers and then sell these same securities to the lenders (also referred to as underwriting). Because new securities are involved and the borrowers receive the proceeds of the sale, this is a primary market (discussed later below).  

There are other types of institutions known as financial intermediaries. These institutions sell its own small value securities to lenders then use this pool of money to buy large value securities from borrowers. Listed below are different types of financial intermediaries, although some overlapping often times exist.     

1. Commercial Banks

2. Savings & Loans Banks e.g. Cayman National Building Society, Jamaica National Building Society

3. Mutual Savings Banks

4. Credit Unions

5. Pension Funds

6. Insurance Companies

7. Mutual funds - some utilize a Money Market Fund, where you can write cheques against your account (interest bearing chequing account)

8. Financial Services Corporation - a firm offers a wide range of financial services including investment banking, brokerage operations, insurance and commercial banking.

Financial Markets

These are the various outlets in which securities are traded. Financial Markets can be categorized in different ways but the two (2) most popular categories are:

1.     By their maturity dates - Money Markets (M) vs Capital Markets (C)

2.     By the originality of the issue - Primary Markets (P) vs Secondary Markets (S)

Money (M) - Securities which have maturity date < 1 year e.g. Treasury bills, commercial paper and other short term debt instruments.

Capital (C) - Securities which have maturity date > 1 year e.g. bonds, stocks etc.

Primary (P) - Any 1^st time issues e.g. where a company goes public and issues shares for the first time. (IPO - Initial Public Offering) (See Investment Banking House above)

Secondary (S) - Where these shares are now traded by brokers and investors (e.g. Stock Market -see below)

Stock Markets

These facilitate the trading of stocks and bonds among investors. There are two types of stock markets:

1. Physical location exchanges

2. Electronic (non-physical) markets 

1. Physical location exchanges - as the name suggests, these are housed in a physical location. Our local example is the Jamaica Stock exchange.( See www.jamstockex.com for more). Other international exchanges include New York Stock Exchange (NYSE) (www.nyse.com), American Stock Exchange (AMEX), London, Hong Kong etc. These exchanges are essentially a modified auction market where agents/brokers trade stocks on their clients behalf. The brokers make their income by charging a commission to their clients.

2. Electronic (non-physical) markets - as the name suggests, these are markets which are not housed in a physical location but exist electronically by telephones and computers. They are very popular in the USA but not in Jamaica. They have been traditionally referred to as over-the-counter markets (OTC) but more recently known as dealer markets. The 'dealers' in these markets trade in stocks which are not listed on the major stock exchanges. The dealers are the actual owners of the stocks, and the spread between the ask price (the price that the dealer will sell at) and the bid price (the price that the dealer will buy at) accrues to them. The computerized network used by the National Association of Securities Dealers (NASD) in the USA is known as the NASD Automated Quotation System, Nasdaq for short. (See www.nasdaq.com ). 

The securities in the market

Securities are an integral part of a financial system. Theses represent the documents/instruments that are traded for cash between the various financial institutions, borrowers and lenders. In general, securities contain both a maturity date and a maturity value. The holder of such a security is called the bearer and he/she is entitled to receive the maturity value on the maturity date. He may however wish to sell this security before maturity date, because of a need for cash. In turn, the new buyer may also wish to do the same and the process can then go on and on becoming more complicated.

A. Money Market Instruments

·        Are very liquid i.e. they can be easily sold for cash

·        They have a low degree of risk because only large reputable institutions issue them

Examples:

1.     Treasury Bills ( T/bill) - This is a vehicle that the government uses to acquire funds to finance their budget on an ongoing basis. They are issued for a period of say 6 months at the end of which the government will repay what is called the par value along with interest. They are considered to be risk free because it is the government who issues them.

2.     Certificate of Deposit/Fixed Deposit - (CD - for short) - this is where an individual deposits a certain amount of money at a bank and receives interest on it after a stated period of time. He/she may also have the option to 'roll' i.e. continue with the deposit with interest earned being added to the principal).

3.     Commercial Paper - a type of unsecured short-term promissory note. Therefore the lender/investor will buy this commercial paper say a $1,000,000 and is expected to receive the $1,000,000 plus interest after say 30 days. However the issuer does not provide any collateral . That is the reason why only large established firms issue these.

B. Capital Market Instruments

·        The instruments are not very liquid

·        They also have a high degree of risk involved

 Examples:

1.     Bonds- are basically IOUs where the issuer promises to pay interest say annually, in addition to the face value at the maturity date. Although many types of bonds exist, most bonds have three special features

a)     Face value          b) maturity date          c) coupon interest

a)     The face value ( a.k.a. par value/maturity value) is normally in multiples of $1,000

b)    The maturity date is when the issuer promises to repay the face value.

c)     The coupon interest refers to the interest payment that the investor will receive. It is calculated by multiplying the face value by the coupon interest rate. Bonds that do not pay interest are called zero bonds. The government as well as large organizations issue bonds.

2.     Stocks - a company can also raise money by issuing stocks. The owners of these are now the owners of the company.

Ordinary/Common stock - the holders are entitled to dividend only if the management declares dividends. It is for this reason that their dividend 'rate' is normally higher than that for preferred stocks.

Preferred Stock -  the holders are entitled to dividends whether or not the company makes a profit. They do not have any voting rights and the shares are considered to be less risky, hence a low dividend rate.  

3. Local Registered Stock (LRS) - These are government instruments which have some characteristics which are similar to bonds. A LRS can pay a Variable Rate or a Fixed Rate of Interest.

Derivatives - these are special types of securities whose value is derived from the price of some other underlying asset. A company may purchase a derivative whose value increases when the value of say the US$ dollar decreases. A wide range of derivatives exists today, especially in the USA. 

The Cost of Money/Interest Rates (expressed in percentages)

Funds are raised in two ways, by the owners pumping in money (equity capital) or by borrowing money (debt capital). The cost of obtaining money can therefore be broken down into types, the cost of equity capital and the cost of debt capital. The cost of equity capital is known as the required rate of return and is equal to the sum of the dividend gains and the capital gains that the investor/owner is expected to receive. The cost of debt capital is what is called the nominal interest rate. 

Factors affecting the cost of money (i.e. the supply and demand) 

1. Production Opportunities - The availability of returns form investing in productive assets ( the existence of viable business)

2. Time preference for consumption - When do investors require their returns?

3. Risk - the potential outcome of the investment - Is the business likely to succeed?

4. Inflation - The value of future money i.e. will the repayments decline in real terms?

Note - Increases in all the above will generally lead to increased Interest Rates

Interest Rate levels

Market forces are the primary determinant for interest rate levels i.e. borrowers who can afford to pay higher interest rates will always obtain capital over those who can't afford it. However, preferred treatment is often given to certain types of borrowers e.g. those in a particular productive sector, say agriculture.

Other factors that affect Interest rate levels:

1. Government Policies

2. International Factors

3. Business Activity Levels

Components of the nominal/quoted interest rate, k

 The nominal interest rate, k comprises of:

1.  The cost of borrowing money (interest rate which the lender charges to compensate for his inability to use his funds now)  and 

2. The compensation that the lender demands for being subject to all the risks involved with lending money.  

  and is represented by the following equation: 

k* =     real risk-free rate of interest without any inflation - this does not truly exist

IP =     the premium that is added to the real risk-free rate of return based on expected inflation.

k_{rf  =}   k* + IP  = nominal risk-free rate which includes inflation (e.g. T/Bills which are free of the other risks)

(Note - the term 'risk-free rate' used loosely is the same as  k_rf  i.e. the T/Bill rate.)

DRP = Default risk premium, the premium that the investor applies in the event that the borrower does not repay the principal or interest - this may be regarded as the difference between the interest rate on a government bond and a corporate bond of equal maturity and marketability.

LP = liquidity premium, this refers to the ability of the instrument to be converted to cash (which is equivalent to the fair market value) at short notice.

MRP = The premium that the investor applies to compensate him/herself for interest rate risks i.e. the risk that the value of a debt/bond will decline due to higher interest rates (applicable if investor wants to sell the debt/bond which will therefore result in capital losses). Longer term bonds have a higher interest rate risks (hence higher MRPs) because interest rates will occasionally rise over an extended period of time. Therefore Government of Jamaica (GOJ) long-term bonds will carry an interest as follows:

k = k* + IP + MRP  

Shorter term bonds are subjected to reinvestment rate risks  i.e. the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested at these lower rates. The principal however will remain intact. 

Long-term bonds have some form of reinvestment rate risks i.e. the interest thereon when re-invested is subjected to the lower interest rates.

Note - the reinvestment rate risk is lower on a longer term bond than on a short-term bond because only the interest payment (as opposed to interest plus principal) on long-term bonds are expose to reinvestment rate risk.  

Summary

The term structure of interest rates

The term structure of interest rates describes the relationship between bond yields (interest rates) and maturities. This is represented by a graph called the Yield Curve

1. Normal Yield Curve - upward sloping

A yield curve that is upward sloping indicates that lenders should purchase short-term instruments to benefit from the expected increase in interest rates and borrowers should issue long-term securities to lock into present interest rates that will prove cheaper over the long-term.

2. Abnormal/Inverted Yield curve  - downward sloping

A yield curve that is downwards sloping indicates that investors’ expect future interest rates to decline. Given this, lenders should lend funds by purchasing long-term securities to offset the effects of falling interest rates and borrowers should issue short-term securities to benefit from the expectation of falling interest rates.

3. Humped Yield Curve

What determines the shape of the yield curves above?

1. Due to an expected increase in inflation and more importantly, because longer maturing bonds are subject to greater interest rate risks, therefore a greater a MRP than short term bonds. 

2. Due to an expected decrease in inflation.

Constructing a yield curve

Consider the following information for long term Government of Jamaica bonds:

• It is expected that the rate of inflation will be 3%  for each of the next 2 years, 4% for the following year and 9% thereafter.

• The real risk-free rate is 2%. The maturity risk premium (MRP) is zero for bonds that mature in 1 year or less, 0.2% for 2-year bonds, and then the MRP increases by 0.1% per year thereafter for 25 years, after which it is stable.

What is the interest rate on 1-year, 2-year, 10-year, and 20-year GOJ bonds?

Solution:

The yield curve would look as follows:

Note - In practice, quite often investors/analysts plot the yield curve and then use the information to estimate the market's expectations regarding future inflation and risk.