The Financial Environment: Markets, Institutions,

and Interest Rates

After reading this chapter, students should be able to:

List some of the many different types of financial markets, and

identify several recent trends taking place in the financial
markets.

Identify some of the most important money and capital market

instruments, and list the characteristics of each.

Describe three ways in which the transfer of capital takes

place.

Compare and contrast major financial institutions.

Distinguish between the two basic types of stock markets.

Explain how capital is allocated in a supply/demand framework,

and list the fundamental factors that affect the cost of money.

Write out two equations for the nominal, or quoted, interest

rate, and briefly discuss each component.

Define what is meant by the term structure of interest rates,

and graph a yield curve for a given set of data.

Explain the two key factors that determine the shape of the
yield curve.

Discuss country risk.

List four additional factors that influence

interest rates and the slope of the yield curve.

Briefly explain
decisions.

how

interest

rate

levels

the

affect

level

of

business

The Financial Markets

Financial Market: An organized institutional structure or mechanism
for creating and exchanging financial assets.
Money Markets: Markets for debt securities with maturities of one
year or less. Treasury bills, repurchase agreements, bankers
acceptances, commercial paper, negotiable CDs, money market funds
and Eurodollar deposits.
Capital Markets: The markets for long-term debt (corporate, state,
local and federal government) and corporate stock (common and
1

preferred). U.S. Treasury notes and bonds, municipal bonds,

mortgages, corporate bonds, preferred stock and common stock.
Primary Markets: The first buyer of a newly issued security buys that
security in the primary market. All subsequent trading of those
securities is done in the secondary market.
Secondary Markets: The market where securities are traded after they
are initially offered in the primary market. Most trading is done in
the secondary market. The New York Stock Exchange, as well as all
other stock exchanges, the bond markets, etc., are secondary markets.
Seasoned securities are traded in the secondary market.

Financial Institutions
An enterprise such as a bank whose primary business and function is
to collect money from the public and invest it in financial assets
such as stocks and bonds. Financial intermediaries are institutions
that provide the market function of matching borrowers and lenders or
traders, as well as create new financial products.
Investment banker: Financial intermediaries who perform a variety of
services, including aiding in the sale of securities, facilitating
mergers and other corporate reorganizations, acting as brokers to
both individual and institutional clients, and trading for their own
accounts.

The Stock Market

Also called the equity market, the market for trading equities.
Stock Exchanges: Formal organizations, approved and regulated by the
Securities and Exchange Commission (S.E.C.), that are made up of
members that use the facilities to exchange certain common stocks.
The two major national stock exchanges are the New York Stock
Exchange (N.Y.S.E.) and the American Stock Exchange (A.S.E. or
A.M.E.X.). Five regional stock exchanges include the Midwest,
Pacific, Philadelphia, Boston, and Cincinnati.
Over-the-Counter (OTC) Market: A decentralized market (as opposed to
an exchange market) where geographically dispersed dealers are linked
together by telephones and computer screens. The market is for
securities not listed on a stock or bond exchange. The N.A.S.D.A.Q.
market is an O.T.C. market for U.S. stocks.
National Association of Securities Dealers Automatic Quotation System
(N.A.S.D.A.Q.): An electronic quotation system that provides price
quotations to market participants about the more actively traded

common stock issues in the O.T.C. market. About 4,000 common stock
issues are included in the N.A.S.D.A.Q. system.

The Cost of Money

Quoted, or Nominal Rate of Interest (k): The price paid for
borrowing money. It is expressed as a percentage rate over a period
of time and reflects the rate of exchange of present consumption for
future consumption.
Real Risk-Free Rate of Interest (k*): The rate of interest excluding
the effect of expected inflation; that is, the rate that is earned in
terms of constant-purchasing-power dollars (pure time value of
money). Interest rate expressed in terms of real goods, i.e. nominal
interest rate adjusted for expected inflation.
Risk-Free Rate (kRF): The rate earned on a riskless investment,
typically the rate earned on the 90-day U.S. Treasury Bill (includes
the premium for expected inflation).

Inflation Premium: Premium for expected inflation.

Default Risk Premium: The risk that a borrower will default on a
loan.
Liquidity Premium: Premium due to lack of liquidity (Liquidity is
measured by the speed with which the asset can be converted to
cash without loss of principle).
Maturity Risk Premium: Reflects the degree of interest rate risk
(Interest rate risk: The chance that a security's value will
change due to a change in interest rates. For example, a bond's
price drops as interest rates rise. Reinvestment rate risk: The
risk that proceeds received in the future will have to be
reinvested at a lower potential interest rate.).
Nominal Rate = k = kRF + DRP +LP + MRP
Note:

kRF = k* + IP

Term Structure of Interest Rates

The relationship between interest rates on bonds of different
maturities usually depicted in the form of a graph often called a
yield curve (the graphical depiction of the relationship between the
yield on bonds of the same credit quality but different maturities).
The Yield Curve, the yields of U.S. Treasury bill, notes and bonds,
can reveal a lot about markets. The absolute level of yields, as in
"rates are low" or "rates are high" is relative. In 1981, 30 year
Treasury bonds yielded over 14%, while short term bills were over
3

20%. In 1993, bills were around 3% with bonds at 5.75%. Not only
were rates different at those two times, but so was the "shape" of
the curve.
In 1981, short term rates were higher than long term (inverted). The
"usual shape" is positive; that is, with short rates lower than long.
Almost all recessions have been preceded by an inverted curve, and
such a curve usually points to lower rates in the future. A steeply
positive curve points to future higher rates.
Also, since Treasury securities are the safest available,
unconditionally backed by the U.S. Treasury, other debt securities
should yield more - they are by definition risky. Investors can judge
whether they are getting sufficient "risk premium", in other words,
enough incremental yield over Treasuries, by comparing the yield of
any bond with that of Treasuries of similar maturity.

Yield Curve
Term

Rate

6
1
2
3
4
5
10
20
30

5.1%
5.5
5.6
5.7
5.8
6.0
6.1
6.5
6.3

months
year
years
years
years
years
years
years
years

10
8
6
4
2
0
0

10

15

20

25

30