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) Page 2 of 2
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