Unit 2: The Financial Environment Answers to Tutorial Questions

1. What is a market? Differentiate between the following types of markets: physical asset vs. financial markets, spot vs. futures markets, money vs. capital markets, primary vs. secondary markets, and public vs. private markets Financial Market definition: The market where people and organisations wanting to borrow money (users of capital) are brought together with those having surplus funds (suppliers of capital) Consists of groups of institutions and individuals working to create and trade financial assets Brings together suppliers of capital and users of capital via financial intermediaries o o Suppliers of capital: Individuals, industrial and agricultural corporations, finance companies, mortgage companies, universities and churches Users of capital: Government, businesses

Physical (Tangible, Real) Assets Markets: Markets for products such as wheat, autos, real estate, computers and machinery

Financial Assets Markets: Markets for stocks, bonds, notes, mortgages and other claims on real assets

Spot Markets Markets in which assets are bought or sold for cash (on the spot delivery usually within a few days)

Futures Markets Markets in which assets are bought or sold today for delivery at a future date

Primary Markets Markets in which securities are initially issued or in which new capital is raised E.g. A companys Initial Public Offering

Secondary Markets Markets in which existing securities are traded among investors after they are issued E.g. trading stocks on the Jamaica Stock Exchange 1

Money Markets Markets for debt securities with maturities of less than one year

Capital Markets Markets for long-term debt securities and corporate stocks

Public Markets Transactions are conducted on organized exchanges and securities traded are standardized

Private Markets Transactions occur directly between two parties and can take any form the parties agree to

2. The real risk free rate of interest is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium (MRP) is zero. What is the yield on a 2 year Treasury security? What is the yield on 3 year Treasury securities?

Where: the nominal or stated rate on interest on a given security

the real risk-free rate on interest; the rate that would exist on a riskless security if expected inflation was zero

the nominal risk-free rate on interest; the stated rate of interest on a risk-free security with no default risk (such as a Treasury Bill); includes a premium for expected inflation:

inflation premium the average expected inflation rate over the life of the security

default risk premium reflects the possibility that the issuer will not pay interest or principal on a security at the stated time and in the stated amount

Liquidity premium a premium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a reasonable price

maturity risk premium charged by lenders to reflect that fact that longer term bonds are exposed to more risk of price declines

since this is a Treasury security

3. If Apple Computer decided to issue additional common stock, and someone purchased 100 shares of this stock from Merrill Lynch, the underwriter, would this transaction be a primary market transaction or a secondary market transaction? Would it make a difference if the investor purchased previously outstanding Apple stock in the dealer market?

The purchase of the stock from Merrill Lynch, the underwriter would be considered a primary market transaction since this is where the stocks were first issued and new capital raised for Apple Computer. The purchase of previously owned Apple stock would be a secondary market transaction since the stock is being traded after being issued. 3

4. The real risk free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2 year Treasury security yields 6.2%. What is the maturity risk premium for the 2 year security?

since this is a Treasury security

5. A government bond that matures in 10 years has a yield of 6%. A 10 year corporate bond has a yield of 8%. Assume that the liquidity premium on a corporate bond is 0.5%. What is the default risk premium on the corporate bond?

since this is a government bond 4

since both are 10 year securities

since both are 10 year securities

(Eq. I)

(Eq. II)

From Eq. I:

Substituting in Eq. II:

6. What do we call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?

The interest rate is the price paid to borrow capital (the price of debt capital). In the case of equity capital, investors return comes in the form of (1) dividends and (ii) capital gains

Factors affecting the cost of money (level of interest rates): Production opportunities o o The returns available within an economy from investment in productive (cashgenerating) assets. The more productive a producing firm believes it assets will be, the more it will be willing to pay for the capital necessary to acquire those assets 5

Time preferences for consumption o o The preference of consumers for current consumption as opposed to saving for future consumption. Consumers with low preference for current consumption will be willing to lend at a lower rate than those with a higher preference for current consumption

Risk o The higher the perceived risk, specifically default risk, the higher the required rate of return will be (the higher the rate at which the firm will have to borrow)

Expected inflation o The higher the expected rate of inflation, the higher the required rate of return

7. What is the real risk-free rate of interest (k*) and the nominal risk-free rate (krf)? How are these two rates measured?

the real risk-free rate on interest; the rate that would exist on a riskless security if expected inflation was zero

There is no truly riskless security (the closest is a short-term US Treasury Bill) which is free of most risks. The real risk-free rate, k*, is estimated by subtracting the estimated rate of inflation from the rate on short-term Treasury securities. The Treasury Bond rate is used as a proxy for The long-term risk-free rate. All long-term bonds, however, are subject to interest rate risk. The Treasury Bond is, therefore, not truly riskless. It is, however, free of default risk.

the nominal risk-free rate on interest; the stated rate of interest on a risk-free security with no default risk (such as a Treasury Bill); includes a premium for expected inflation:

8. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when determining the interest rate on (1) short-term GOJ Treasury securities, (2) long-term GOJ Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed above

inflation premium the average expected inflation rate over the life of the security

default risk premium reflects the possibility that the issuer will not pay interest or principal on a security at the stated time and in the stated amount

Liquidity premium a premium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a reasonable price

maturity risk premium charged by lenders to reflect that fact that longer term bonds are exposed to more risk of price declines

1. Short-term GOJ Treasury securities IP IP would change over time based on expected inflation 2. Long-term GOJ Treasury securities IP, MRP IP would change over time based on expected inflation MRP would change based on the time to maturity of the security, increasing the longer the time to maturity due to higher interest rate risk 3. Short-term corporate securities IP, DRP, LP IP would change over time based on expected inflation DRP and LP would change based on the financial strength of the issuing firm and how marketable its securities are (a more actively (frequently) traded security would have higher liquidity than one that is trade less frequently) 4. Long-term corporate securities IP, DRP, LP, MRP IP would change over time based on expected inflation DRP and LP would change based on the financial strength of the issuing firm and how marketable its securities are (a more actively (frequently) 7

traded security would have higher liquidity than one that is trade less frequently) MRP would change based on the time to maturity of the security, increasing the longer the time to maturity due to higher interest rate risk

9. What is the term structure of interest rates? What is a yield curve? How should users and savers of funds behave if they are faced with a downward sloping yield curve? The term structure of interest rates is the relationship between yields and maturities of securities. A yield curve is a graph of the relationship between yields and maturities of securities. The yield curve is obtained from plotting interest rates against differing maturities.

Long-term rates are usually higher than short-term, because MRP increases as maturity lengthens. Longer term corporate bonds also tend to be less liquid than shorter term ones, so LP rises as maturity lengthens. These contribute to a normal yield curve with an upward slope, with interest rates gradually increasing as maturity increases. An inverted or abnormal yield is a downward sloping where short-term rates are higher than long-term rates. If faced with an inverted yield curve investors (savers of funds) should purchase shortterm securities in favour of longer-term securities while borrowers (users of funds) should opt for longer=term loans.

10. Suppose most investors expect the inflation rate to be 5% next year, 6% the following year, and 8% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero for bonds that mature in 1 year or less, 0.1 percent for 2-year bonds, and then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate on 1year, 10-year, and 20-year Treasury bonds?

since this is a Treasury security