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Lecture 2

Financial Markets,
Institutions, and Interest
Rates

The Capital Allocation Process


In a well-functioning economy, capital flows efficiently
from those who supply capital to those who demand it.
Suppliers of capital individuals and institutions with
excess funds. These groups are saving money and
looking for a rate of return on their investment.
Demanders or users of capital individuals and
institutions who need to raise funds to finance their
investment opportunities. These groups are willing to
pay a rate of return on the capital they borrow.

Finance for Technical Management - Lecture 2

What is a market?
A market is a venue where goods and
services are exchanged.
A financial market is a place where
individuals and organizations wanting to
borrow funds are brought together with those
having a surplus of funds.

Finance for Technical Management - Lecture 2

Types of financial markets


Physical assets vs. Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Public vs. Private

Finance for Technical Management - Lecture 2

How is capital transferred between


savers and borrowers?
Direct transfers
Investment banking
house
Financial
intermediaries

Finance for Technical Management - Lecture 2

Financial Markets
Primary
Secondary

Finance for Technical Management - Lecture 2

Financial Markets

Finance for Technical Management - Lecture 2

Primary Markets
Savers

Channel funds to

Borrowers

Households as a group are net savers


Businesses and government, as a group, tend to be
net borrowers

Finance for Technical Management - Lecture 2

Primary Claims of A Corporation


Debt

Mortgage bonds
Debenture bonds
Commercial paper
Lines of credit

Equity offerings

Common stock
Preferred stock
Finance for Technical Management - Lecture 2

Offering Common Stock to the


Public
IPO
Seasoned equity offering

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Finance for Technical Management - Lecture 2

What is an IPO?
An initial public offering (IPO) is where a
company issues stock in the public market for the
first time.
Going public enables a companys owners to
raise capital from a wide variety of outside
investors. Once issued, the stock trades in the
secondary market.
Public companies are subject to additional
regulations and reporting requirements.
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Finance for Technical Management - Lecture 2

Stock Market Transactions


Apple Computer decides to issue additional
stock with the assistance of its investment
banker. An investor purchases some of the
newly issued shares. Is this a primary market
transaction or a secondary market transaction?
What if instead an investor buys existing shares
of Apple stock in the open market is this a
primary or secondary market transaction?

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Finance for Technical Management - Lecture 2

Indirect Flow of Funds to


Borrowers
Financial intermediaries include:

commercial banks
thrift institutions
investment companies
pension funds
Insurance companies
finance companies.

Savers invest in secondary claims of financial


intermediaries, which in turn invest in primary
claims of borrowers
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Finance for Technical Management - Lecture 2

Financial Intermediaries

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Finance for Technical Management - Lecture 2

Potential Benefits of Financial


Intermediaries
Diversification
Expertise
Liquidity
Convenience
Risk management

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Finance for Technical Management - Lecture 2

FINANCIAL MARKETS
Money markets

Short-term securities

Capital markets

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Long-term securities

Finance for Technical Management - Lecture 2

Market Instruments

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Finance for Technical Management - Lecture 2

Benefits of Secondary Markets


Liquidity
Efficient pricing and information disclosure
Efficient allocation of capital

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Finance for Technical Management - Lecture 2

Interest
Interest represents the return or compensation a lender
demands before agreeing to loan money
It is the charge for the privilege of borrowing money.
Whenever people agree to lend money to others, they take
risk as a number of factors might prevent them from taking
all their money back. This risk requires a monetary
compensation that is referred to as interest.
Interest is normally expressed in percentage terms, called
the interest rate. Thus if a person lends Rs.1,000 to another
person, and the return he requires for doing so is Rs.100, we
could say the interest rate charged is 10% (100/1000).
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Finance for Technical Management - Lecture 2

DETERMINANTS OF INTEREST
The prevailing rate of interest in any situation
is called nominal rate of interest. For example
in the above example the nominal interest rate
is 10%.
The following are the components of nominal
interest rate. The nominal interest rate is
composed of real interest rate plus a number
of premiums.

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Finance for Technical Management - Lecture 2

DETERMINANTS OF INTEREST
Maturity Risk
Premium
Liquidity Risk
Premium

Maturity Risk
Premium
Inflation
Premium

Liquidity Risk
Premium

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Inflation
Premium

Default Risk
Premium

Real Rate of
Interest

Nominal Risk-Free
Interest Rate

Default Risk
Premium

Risk Premiums

Real Rate of
Interest
=

Nominal Interest Rate

Finance for Technical Management - Lecture 2

THE YIELD CURVE


A yield curve is a graphical depiction of
interest rates on securities that differ only in
the time remaining until their maturity.
It is a line that plots and depicts the interest
rates, at a set point in time, of securities
having equal credit quality but differing
maturity dates.
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Finance for Technical Management - Lecture 2

THE SHAPE OF THE YIELD


CURVE
A normal yield curve is one in which longer maturity bonds have a
higher yield compared to shorter-term bonds, due to the risks associated
with time. It is sometimes referred to as "positive yield curve".
An inverted yield curve is one in which the shorter-term yields are
higher than the longer-term yields, which can be a sign of upcoming
recession.
A flat (or humped) yield curve is one in which the shorter- and longerterm yields are very close to each other, which is also a predictor of an
economic transition. The slope of the yield curve is also seen as important:
the greater the slope, the greater the gap between short- and long-term
rates.
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Finance for Technical Management - Lecture 2

THE SHAPE OF THE YIELD


CURVE
Normal Yield Curve

Yield

Inverted Yield Curve

Yield

Maturity

Maturity
Flat Yield Curve

Yield

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Maturity

Finance for Technical Management - Lecture 2

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