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Corporate Finance
Lecture 2
Selcuk Caner
Bilkent University
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1
Chapter 5 Outline
Financial markets
 Types of financial institutions
 Interest Rates and Determinants of
interest rates
 Yield curves

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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

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Intermediation between Savers
and Creditors



Direct transfer (direct sale to investors,
no financial intermediaries)
Investment banking house
(underwriters)
Financial intermediary (banks or mutual
funds)
–
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Types of banking systems (Anglo American,
German, Japanese)
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OTC and Exchanges
Auction market vs. Dealer market
(Exchanges vs. OTC)
NYSE vs. Nasdaq system
ISE
Differences are narrowing
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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
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Cost of money is determined by demand for and
supply of funds
Cost (%)
Supply
Demand
Dollar
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Nominal Interest Rates
200
150
100
50
0
1993
1994 1995
1996
Turkey
Argentina
Russian Federation
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1997 1998
1999
2000 2001
U.S.
Germany
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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
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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
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“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.
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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).
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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

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
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%.
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





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%
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
For the five-year bond,
– 10%=3+5+MRP5
– MRP5=2%

MRP5-MRP2=2%-0.5%=1.5%
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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.

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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
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30
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Yield Curve Construction
Step 1:Find the average expected
inflation rate over Years 1 to n:
n
IPn =
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INFL

````
t 1
n
t
.
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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).
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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%.
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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%.
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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
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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.

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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
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5
10
15
20
Years to
maturity
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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.

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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.

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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?
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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%).
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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%).
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x%
2
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
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.
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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.
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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%.
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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%
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





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%
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