Report

Corporate Finance Lecture 2 Selcuk Caner Bilkent University 7/20/2015 1 Chapter 5 Outline Financial markets Types of financial institutions Interest Rates and Determinants of interest rates Yield curves 7/20/2015 2 Financial Markets Markets in general Physical assets (commodities, real estate) Financial assets Money (short term) vs. Capital (medium and long term) Primary vs. Secondary Spot vs. Future 7/20/2015 3 Intermediation between Savers and Creditors Direct transfer (direct sale to investors, no financial intermediaries) Investment banking house (underwriters) Financial intermediary (banks or mutual funds) – 7/20/2015 Types of banking systems (Anglo American, German, Japanese) 4 OTC and Exchanges Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq system ISE Differences are narrowing 7/20/2015 5 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? Required Dividend Capital = + return yield gain 7/20/2015 6 Cost of money is determined by demand for and supply of funds Cost (%) Supply Demand Dollar 7/20/2015 7 Nominal Interest Rates 200 150 100 50 0 1993 1994 1995 1996 Turkey Argentina Russian Federation 7/20/2015 1997 1998 1999 2000 2001 U.S. Germany 8 Real Interest Rates 40.0% 20.0% 0.0% -20.0% 1993 1994 1995 1996 1997 1998 1999 2000 2001 -40.0% -60.0% Turkey U.S. Argentina Germany Russian Federation 7/20/2015 9 Factors Affecting Cost of Money Production opportunities Available projects to make enough money. Time preferences for consumption Time preference for consumption is high when population is poor. Savings would be low, interest rates high, capital formation low. Risk Expected inflation 7/20/2015 10 “Real” Versus “Nominal” Rates “Real” Versus “Nominal” Rates k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. k = Any nominal rate. kRF = Rate on Treasury securities. 7/20/2015 11 k = k* + IP + DRP + LP + MRP. Here: k = required rate of return on a debt security. k* = real risk-free rate. IP = inflation premium. DRP = default risk premium. LP = liquidity premium. MRP = maturity risk premium (bonds). 7/20/2015 12 Premiums Added to k* for Different Types of Debt S-T Treasury: only IP for S-T inflation L-T Treasury: IP for L-T inflation, MRP S-T corporate: S-T IP, DRP, LP L-T corporate: IP, DRP, MRP, LP 7/20/2015 13 When interest rates rise, the value of the bond falls. Assume no default risk (DR=0) Inflation rates Year 1 Year 2 8% 5% Year 3 Year 4 Year 5 4% 4% 4% 2-year T-bonds yield 10%. 5-year T-bonds yield 10%. 7/20/2015 14 What is the difference in the maturity risk premiums of the two bonds? Nominal rate= real interest rate+IP+MRP Two-year bond IP2 = (8+5)/2=6.5% IP5=(8+5+4+4+4)/5=5% For the two-year bond, – 10%=3+6.5+MRP2 – MRP2=0.5% 7/20/2015 15 For the five-year bond, – 10%=3+5+MRP5 – MRP5=2% MRP5-MRP2=2%-0.5%=1.5% 7/20/2015 16 What is the “term structure of interest rates”? What is a “yield curve”? Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve. 7/20/2015 17 Treasury Yield Curve Interest Rate (%) 15 1 yr 5 yr 10 yr 30 yr 5.2% 5.8% 5.9% 6.0% Yield Curve (August 1999) 10 5 Years to Maturity 0 10 7/20/2015 20 30 18 Yield Curve Construction Step 1:Find the average expected inflation rate over Years 1 to n: n IPn = 7/20/2015 INFL ```` t 1 n t . 19 Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter IP1 = 5%/1.0 = 5.00%. IP10 = 5+6+8(8)/10 = 7.5%. IP20 = 5+6+8(18)/20 = 7.75%. Must earn these IPs to break even vs. inflation; These IPs would permit you to earn k* (before taxes). 7/20/2015 20 Step 2: Find MRP Based on This Equation: MRPt = 0.1%(t – 1). MRP1 = 0.1% x 0 = 0.0%. MRP10 = 0.1% x 9 = 0.9%. MRP20 = 0.1% x 19 = 1.9%. 7/20/2015 21 Step 3: Add the IPs and MRPs to k*: kRFt = k* + IPt + MRPt . kRF = Quoted market interest rate on treasury securities. Assume k* = 3%: kRF1 = 3.0% + 5.0% + 0.0% = 8.0%. kRF10 = 3.0% + 7.5% + 0.9% = 11.4%. kRF20 = 3.00% + 7.75% + 1.90% = 12.65%. 7/20/2015 22 Hypothetical Treasury Yield Curve Interest Rate (%) 15 Maturity risk premium 10 Inflation premium 1 yr 10 yr 20 yr 8.0% 11.4% 12.65% 5 Real risk-free rate Years to Maturity 0 1 7/20/2015 10 20 23 What factors can explain the shape of this yield curve? This constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium. 7/20/2015 24 Hypothetical Treasury and Corporate Yield Curves Interest Rate (%) 15 BB-Rated 10 AAA-Rated 5 Treasury 6.0% yield curve 5.9% 5.2% 0 0 7/20/2015 1 5 10 15 20 Years to maturity 25 The Expectations Hypothesis (EH) Shape of the yield curve depends on the investors’ expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates and vice versa. Thus, the yield curve can slope up or down. 7/20/2015 26 EH assumes that MRP = 0. Long-term rates are an average of current and future short-term rates. If EH is correct, you can use the yield curve to “back out” expected future interest rates. 7/20/2015 27 Observed Treasury Rates Maturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 6.2% 6.4% 6.5% 6.5% If EH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now? 7/20/2015 28 x% 6.0% 0 1 6.2% 2 3 4 5 (6.0% + x%) 6.2% = 2 12.4% = 6.0 + x% 6.4% = x%. EH tells us that one-year securities will yield 6.4%, one year from now (x%). 7/20/2015 29 6.2% 0 3 4 5 6.5% [ 2(6.2%) + 3(x%) ] 6.5% = 5 32.5% = 12.4% + 3(x%) 20.1% = 3(x%) 6.7% = x%. EH tells us that three-year securities will yield 6.7%, two years from now (x%). 7/20/2015 1 x% 2 30 Liquidity Preference Theory – Long term bonds yield should always be higher because they are less liquid. Market Segmentation Theory – There is a different market every maturing bond. – Slope of the yield curve depends on the demand and supply conditions in the long term and short term bonds. 7/20/2015 31 Types of risks when investing internationally Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment. Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate. 7/20/2015 32 Some Examples Nominal yield on a 2-year T-bond is 4.5%. Nominal yield on a one-year T-bond is 3%. Real risk-free interest rate is one percent. According to EH, what is the interest rate on a one year bond one year from now? k1 =3% and k2 4.5% k2= (k1+k1 in year 2)/2= 4.5%. So, k1 in year two is 6%. 7/20/2015 33 What is the expected inflation rate in year one and two? In year one, – 3%= 1% + IP1 – So, IP1= 2% In year two, – IP2= 5% 7/20/2015 34 Problem 5-11: Inflation at 3%. Real risk-free interest rate = 2%. Inflation is expected to be higher than 3%. 3-year T-bond yields 2 percentage points above 1year T-bond. What is the expected inflation rate after year 1? k1=2+3=5 k3= 5+2=7 k=2+(3+2x)/3 x=6% 7/20/2015 35