CORPORATE FINANCE

FINANCIAL MARKETS AND
INTEREST RATES

Market Players
An investor / lender is an individual, company, government, or any entity that owns more funds than it can use.
An issuer / borrower is an entity that has a need for capital.
Brokers and dealers are financial intermediaries, who purchase securities from issuers and sell them to investors

Securities
Debt security or bond – promises periodic payments of interest and/or principal from a claim on the issuer's earnings
Equity or stock – promises a share in the ownership and profits of the issuer

Types of Financial Markets
Money markets trade short-term, marketable, liquid, low-risk debt securities - "cash equivalents“
Capital markets trade in longer-term, more risky securities:
bond (or debt) markets,
equity markets,
derivative markets

INTEREST RATES
The stated or offered rate of
interest (r) reflects three factors:
Pure rate of interest (r*)
Premium that reflects expected inflation (IP)
Premium for risk (RP)
r = r* + IP + RP

Pure Interest Rate
the rate for a risk-free security when no inflation is expected
constantly changes over time, depending on economic conditions

Inflation
Investors build in an inflation premium to compensate for this loss of value
the inflation premium is not constant; it is always changing based on investors' expectations of the future level of inflation

Risk
Counterparty (default) risk is the chance that the borrower will not be able to pay the interest or pay off the principal of a loan.
Ratings companies identify and classify the creditworthiness of corporations and governments to determine how large the risk premium should be (AAA – CCC)

Risk
Liquidity risk – possible losses if there is no opportunity to buy or to sell assets at the proposed volume for the proposed price due to bad market conditions

Risk
Interest rate risk - possible changes of asset value due to changes of the interest rate:
As interest rates increase, bond prices decrease.
As interest rates decrease, bond prices increase.

Risk
Currency risk – possible changes of the assets value due to changes of the currency exchange rate.
Operational risk – possible losses due to possible technical mistakes.
Business-event risk – possible losses due to force-mageure events, changes in legislation, etc.

Normal Yield Curve Theories
upward sloping yield curve is considered normal:
expectations theory,
the market segmentation theory,
the liquidity preference theory

Expectations Theory
The yield curve reflects lenders' and borrowers' expectations of inflation
Changes in these expectations cause changes in the shape of the yield curve

Market Segmentation Theory
The slope of the yield curve depends on supply / demand conditions in the short-term and long-term markets
An upward sloping curve results from a large supply of funds in the short-term market relative to demand and a shortage of long-term funds.
A downward sloping curve indicates strong demand in the short-term market relative to the long-term market

Liquidity Preference Theory
long-term securities often yield more than short-term securities
Investors generally prefer short-term securities, which are more liquid and less expensive to buy and sell. Investors require higher yield on long-term instruments to compensate for the higher cost

Liquidity Preference Theory
Borrowers dislike short-term debt because it exposes them to the risk of having to roll over the debt or raise new principal under adverse conditions (such as a rise in rates). Borrowers will pay a higher rate for long-term debt than for short-term debt, all other factors being held constant.