Financial Markets and Institutions
FIN 323
Dominican University
Lawrence Morgan
Unit II: Markets
Interest Rates; Securities
Unit II: Markets
OBJECTIVES
1.
2.
3.
4.
5.
6.
7.
8.
Explain verbally the meaning of "time preference" in finance.
Calculate the future value of an investment of X dollars for T years at an interest rate r%.
Calculate the present value of X dollars to be received after T years, discounted at an
interest rate i %.
Describe in words and illustrate graphically what happens to interest rates and the amount
of borrowing/lending if
a.
Economic growth increases or decreases
b.
Inflation increases or decreases
c.
Monetary policy becomes more expansionary/contractionary
d.
Fiscal policy becomes more expansionary/contractionary
Given a nominal interest rate and an expected rate of inflation, calculate the real interest
rate. And given a real rate of interest and an expected rate of inflation, calculate the
nominal interest rate.
Explain the meaning of a "security" in finance.
Describe the difference between the "primary market" and "secondary market" for
securities. Identify whether various cases involve the primary market or secondary
market.
Briefly describe the "efficient markets hypothesis".
Unit II: Markets
“. . . the European philosophical tradition . . .
consists of a series of footnotes to Plato”
-- Alfred North Whitehead
“All finance is a series of footnotes to
compounding and discounted present value”.
--Lawrence Morgan
Unit II: Markets
Basic principles of interest rates & fixed-income
markets:
▪time preference & time-value of money
▪ future value (compounding)
▪ present value (discounting)
Unit II: Markets
You will use compounding (future value) and
discounting (present value) in all financial applications
FOREVER.
Unit II: Markets
People prefer consumption now to consumption later.
So, if they are to defer consumption – that is, if they are to
save – they require getting something additional in the future.
That is the rate of interest.
e.g. to forego $1.00 now you require $1.10 one year from
now.
That is a 10% (= 0.10) rate of interest. And $1.10 is the
future value of $1.00.
Future Value of $1 for 1 year = $1.10
𝐹𝑉 $1,1 𝑦𝑒𝑎𝑟, 𝑖 = $1 × 1 + 𝑖 1
𝐹𝑉 $𝑥, 1 𝑦𝑒𝑎𝑟, 𝑖 = $𝑥 × 1 + 𝑖 1
𝐹𝑉 $100,1 𝑦𝑒𝑎𝑟, 10% = $100 × 1 + 𝑖 1 = $110
Unit II: Markets
The same principle works for periods longer or shorter than 1
year:
𝐹𝑉 $𝑥, 𝑇𝑦𝑒𝑎𝑟𝑠, 𝑖 = $𝑥 × (1 + 𝑖)𝑇
e.g. for $100 for 2 years at 5%
FV($100, 2 years, 5%) =
e.g. for $100 for 6 months (=
FV($100, 0.5 years, 5%) =
6
12
= 0.5 year), at 5%
Unit II: Markets
Present value
If you turn future value around, you get present value
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 = $1.10 = 1.10 × $1
divide both sides of the equation by 1.10
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒
1.10
=
$1.10
1.10
=
1.10
×
1.10
$1 = $1 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
In general
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 × (1 + 𝑖)𝑇
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 =
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒
1+𝑖 𝑇
Unit II: Markets
Present value
So Present Value of $x to be paid in T years discounted at r is
...
𝑃𝑉 $𝑥, 𝑇 𝑦𝑒𝑎𝑟𝑠, 𝑖 =
examples:
𝑃𝑉 $1, 2 𝑦𝑒𝑎𝑟𝑠, 10% =
𝑃𝑉 $1, 0.5 𝑦𝑒𝑎𝑟𝑠, 10% =
$𝑥
(1+𝑖)𝑇
Unit II: Markets
NOTE:
Interest rates are always quoted as
i % PER YEAR (per annum)
Unit II: Markets
Present value
Note: as i rises, PV falls; as i falls, PV rises
Bond prices: the price of a bond is the Present value of the
payments it will make
For short-term instruments (e.g. Treasury bills) there is only
one payment; for long-term bonds there are many payments
(interest payments, and eventually the “face value” or
principal of the bond). The price or PV of the bond is the sum
of the PVs of all those payments.
Unit II: Markets
Present value
Note: as i rises, PV falls; as i falls, PV rises.
Compare PV of $100 to be received in 2 years at (a) 10% and
(b) at 5%:
𝑃𝑉 $100,2 𝑦𝑒𝑎𝑟𝑠, 10% =
𝑃𝑉 $100,2 𝑦𝑒𝑎𝑟𝑠, 5% =
Unit II: Markets
The Rate of Interest (continued)
Where does “the interest rate” come from? (actually many interest
rates)
LOANABLE FUNDS THEORY
Unit II: Markets
The Rate of Interest (continued)
LOANABLE FUNDS THEORY is basic supply and demand theory
DEMAND FOR LOANABLE FUNDS (demand for credit) from . . .
a) Households (for car, house, appliances, . . . )
b) Businesses (for investment, trade finance, inventory finance, . . . )
c) Government (for infrastructure, uneven tax receipts, general
spending)
d) Foreign sources (all of the above)
Unit II: Markets
The Rate of Interest (continued)
Interest Rate i
LOANABLE FUNDS THEORY is basic supply and demand theory
Demand for loanable funds
Quantity of Loans
Unit II: Markets
The Rate of Interest (continued)
LOANABLE FUNDS THEORY is basic supply and demand theory
SUPPLY OF LOANABLE FUNDS (supply of credit) from . . .
a)
b)
c)
d)
Households from savings (directly or indirectly)
Business (retained earnings)
Government (budget surplus, tax receipts)
Foreign supply (all of the above).
Unit II: Markets
The Rate of Interest (continued)
Interest Rate i
LOANABLE FUNDS THEORY is basic supply and demand theory
Supply of loanable funds
Quantity of Loans
Unit II: Markets
The Rate of Interest (continued)
LOANABLE FUNDS THEORY is basic supply and demand theory
Equilibrium determination of interest rate
Interest Rate i
S
D
Quantity of Loans
Unit II: Markets
The Rate of Interest (continued)
This is supply and demand for credit.
It determines an interest rate (the price of credit).
Once you know the interest rate, you can calculate the price
of a bond or loan (more about this later).
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
a) Economic growth
generally, strong growth will shift the demand for credit
-- and probably the supply of credit – to the right.
This tends to push interest rates higher.
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
Interest Rate i
S
S´
i2
i1
D
Quantity of Loans
D´
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
b) Inflation
Distinguish nominal interest rates and real interest rates.
1. the nominal rate is that actual rate that borrowers
pay and lenders receive.
2.
if there is inflation, the dollars that a borrower pays
back and a lender receives are worth less than
when the loan was made, so the real rate of
interest is lower.
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
b) Inflation (continued)
The difference between nominal and real rates is the
rate of inflation. If the borrower receives 5% interest
but inflation has been 4%, the real rate is 1%. (actually
expected inflation)
inominal = E(INF) + ireal or
ireal = inominal – E(INF)
(called the “Fisher effect”)
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
b) Inflation (continued)
S´
S
i2
Interest Rate i
E(INF)
i1
D´
D
Quantity of Loans
Unit II: Markets
Figure 4.5 Expected Inflation and Interest Rates (ThreeMonth Treasury Bills), 1953–2013
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
c) Monetary policy
basically, if the central bank increases the rate of growth
of the money supply, that will lower short-term interest
rates
-- unless the money supply grows so rapidly that
expected inflation increases.
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
c) Monetary policy
Interest Rate i
S
S´
i1
i2
D
Quantity of Loans
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
d) Fiscal policy
a budget deficit represents additional demand for credit, so this
raises interest rates; a budget surplus reduces interest rates.
although this is demand from the government (particularly the
national government) all the rates are connected so this will have
an impact on corporate, municipal, and other interest rates.
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
d) Fiscal policy
S
Interest Rate i
i2
i1
D
Quantity of Loans
D´
Unit II: Markets
Factors that affect interest rates (or the price of bonds)
e) Foreign demand for credit
Foreign entities can borrow or lend in our market.
However, even activity in foreign markets affects our domestic
market since the markets are all connected. (This will also affect
the foreign exchange markets.)
Unit II: Markets
Recent history of U.S. short-term interest rate
Effective Fed Funds Rate
July 1954 - June 2020
20
18
16
Percent
14
12
10
8
6
4
2
0
1954 1960 1966 1972 1978 1984 1990 1996 2002 2008 2014
Date
Unit II: Markets
Securities
These are the basic items which are bought and sold in
financial markets: principally stocks and bonds.
They allow savings to move to investors more-or-less
anonymously and therefore allow investors to mobilize
large amounts of resources.
Unit II: Markets
Securities
❖Primary Market: securities are originally issued or sold
in the primary market (new stock is issued, new bonds
are sold)
– this is typically used to raise capital for an
enterprise.
Unit II: Markets
Securities
❖Secondary Market: after the securities are issued in the
primary market, they can be bought and sold in the
secondary market; the prices of the securities varies
– an investor will be more willing to buy securities
in the primary market if it is possible to liquidate the
investment at will; otherwise the investor would
have to hold shares forever or hold bonds until
maturity.
Unit II: Markets
Securities Valuation (overview)
1. Information (and even misinformation) is key to
valuations.
2. Securities regulation tries to see to it all relevant
information is public.
3. Cash flows are central to valuation – you will work
with these in detail shortly.
4. Efficient Markets Hypothesis – the hypothesis that the
market price reflects all the information about an
asset so that no one can reliably earn returns higher
than that of the overall market – HIGHLY
CONTROVERSIAL
FIN 323
Financial Markets and Institutions
Dominican University
Lawrence Morgan
UNIT II GRADED ASSIGNMENT (20 POINTS)
NAME: ____________________________
________POINTS _______ PERCENT
5 problems on FUTURE VALUE and PRESENT VALUE (2 points each) (show work for possible
partial credit)
1.
PRESENT VALUE of $10,000, at 2.3%, 2 years
2.
FUTURE VALUE of $10,000, at 1.25%, 1 year
3.
FUTURE VALUE of $1,000, at 3.5%, 4 years
4.
PRESENT VALUE of $1,000,000, at 0.5%, 6 months
5.
FUTURE VALUE of $750, at 0.75%, 9 months
Page 1 of 2
FIN 323
Financial Markets and Institutions
Dominican University
Lawrence Morgan
6.
This graph shows an initial equilibrium in the Market for Loanable Funds.
a.
Show the changes in the graph if the fiscal authorities (i.e. Congress and the
President) increase government spending substantially. (6 points)
b.
In this case the equilibrium interest rate (choose one) . . .
i.
increases
ii.
decreases
c.
In this case the equilibrium quantity of loans (choose one) . . .
i.
increases
ii.
decreases
7.
If the Market for Loanable Funds shows a nominal interest rate of 7%, use the
Fisher Equation -- inominal = E(INF) + rreal -- to find the real rate of interest if
expected inflation is 3%. (2 points)
8.
For each of the following, indicate whether it takes place in the primary market or the
secondary market for securities. (circle the correct answers) (2 points)
a.
b.
A successful startup corporation decides to issue shares to the public for the first
time. (primary/secondary)
You buy 100 shares of Apple Inc., which is listed on the NASDAQ exchange
(primary/secondary)
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