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Financial Markets Saunders

The document provides an overview of financial markets, detailing the structures, types, and instruments involved in primary and secondary markets, money and capital markets, as well as derivative securities. It also discusses the roles of financial institutions, their regulation, and the risks they face, along with the globalization of financial markets and the specifics of the Philippine financial system. Key components include various types of banks, investment companies, and government institutions that facilitate financial transactions and services.
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0% found this document useful (0 votes)
13 views15 pages

Financial Markets Saunders

The document provides an overview of financial markets, detailing the structures, types, and instruments involved in primary and secondary markets, money and capital markets, as well as derivative securities. It also discusses the roles of financial institutions, their regulation, and the risks they face, along with the globalization of financial markets and the specifics of the Philippine financial system. Key components include various types of banks, investment companies, and government institutions that facilitate financial transactions and services.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Chapter 1&2 Financial Markets Saunders

Financial Markets (ACCO 20083)

CHAPTER 1: OVERVIEW OF FINANCIAL  Repurchase agreements — sale of


MARKETS securities by one party to another with
a promise by the seller to repurchase
Financial markets - structures through which the same securities from the buyer at a
funds flow specified date and price
 Commercial paper — short-term
DIMENSIONS:
unsecured promissory notes issued by a
 Primary Markets VS Secondary Markets company to raise short-term cash
 Money VS Capital Markets  Negotiable certificate of deposit —bank-
issued time deposit that specifies an
Illiquid securities – not readily convertible to interest rate and maturity date and is
cash because the company will open for public negotiable, (i.e., can be sold by the
offering or no buyers available holder to another party)
 Banker’s acceptance —time draft
Types of Financial Markets payable to a seller of goods, with
 Primary Markets —markets in which payment guaranteed by a bank
corporations raise funds through new issues
 Capital Markets —markets that trade debt
of securities.
and equity instruments with maturities of
 private placement/ initial public
more than 1 year
offerings / additional securities of
 corporations and governments - major
publicly traded firms
suppliers of capital market securities (or
 Secondary Markets —markets that trade
users of funds)
financial instruments once they are issued.
 wider price fluctuations in the
 offer buyers and sellers liquidity—the
secondary markets in which they trade
ability to turn an asset into cash quickly
than do money market instruments
 as well as information about the prices
or the value of their investments CAPITAL MARKET INSTRUMENTS
 Increased liquidity = more desirable and
 Corporate stock —ownership claim in a
easier sale of security
public corporation.
 Money Markets —markets that trade debt
 Mortgages —loans to individuals or
securities or instruments with maturities of
businesses to purchase a home, land, or
less than 1 year.
other real property
 fluctuations in their prices in the
 Corporate bonds —long-term bonds
secondary markets in which they trade
issued by corporations
are usually quite small
 Treasury bonds —long-term bonds
 over-the-counter (OTC) markets
issued by the govt
MONEY MARKET INSTRUMENTS  State and local government bonds —
long-term bonds issued by state and
 Treasury bills —short-term obligations
local governments
issued by the government
 Federal funds —short-term funds  Bank and consumer loans —loans to
transferred between financial commercial banks and individuals.
institutions usually for no more than
one day.  Foreign Exchange Markets - trading one
currency for another

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 Foreign exchange risk - sensitivity of the  full and fair disclosure of information on
value of cash flows on foreign securities issues to actual and potential
investments to changes in the foreign investors
currency’s price in terms of dollars  firms planning to issue new stocks or
 Spot FX - the immediate exchange of bonds - register their securities with the
currencies at current exchange rates. SEC and to fully describe the issue, and
 Forward FX - the exchange of currencies any risks associated with the issue, in a
in the future on a specific date and at a legal document called a prospectus
pre-specified exchange rate.  monitors trading on the major
exchanges
 Derivative Security (Markets)  not intended to protect investors
 a financial security (such as a futures against poor investment choices, but
contract, option contract, swap rather to ensure that investors have full
contract, or mortgage-backed security) and accurate information
whose payoff is linked to another,
Financial institutions - perform the essential
previously issued security such as a
function of channeling funds from those with
security traded in the capital or foreign
surplus funds (suppliers of funds) to those with
exchange markets
shortages of funds (users of funds)
 agreement between two parties to
exchange a standard quantity of an Financial Institutions are distinguished by:
asset or cash flow at a predetermined
 Whether they accept insured deposits -
price and at a specified date in the
future Depository versus non-depository financial
 value of the underlying security to be institutions.
exchanged changes, the value of the  Whether they receive contractual
payments from customers
derivative security changes
 the newest of the financial security
 Depository institutions: - commercial
markets
 potentially the riskiest of the financial banks, savings associations, savings banks,
securities credit unions.
 main purpose of the derivatives markets  Non-depository institutions
• Contractual: insurance companies,
is to transfer risk between market
participants pension funds,
• Non-contractual: securities firms
and investment banks, mutual
funds.
Financial Market Regulation
Direct transfer of funds - from suppliers of
 The Securities Act of 1933 - Full and fair
funds to users of funds
disclosure and securities registration.
- financial claims would flow directly from
 The Securities Exchange Act of 1934 -
users of funds to suppliers of funds
Securities and Exchange Commission (SEC)
is the main regulator of securities markets
Indirect transfer of funds to the ultimate user of
funds via FIs.

Types of Financial Institutions

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 Commercial banks —depository their retirement years and are exempt
institutions whose major assets are loans from current taxation.
and whose major liabilities are deposits.
Unique Economic Functions Performed by
Commercial banks’ liabilities include more
Financial Institutions
non deposit sources of funds, such as
subordinate notes and debentures, than Services Benefiting Suppliers of Funds:
do those of other depository institutions.
 Thrifts —depository institutions in the  Monitoring costs —Aggregation of
form of savings associations, savings funds in an FI provides greater incentive
banks, and credit unions. Thrifts generally to collect a firm’s information and
perform services similar to commercial monitor actions. The relatively large size
banks, but they tend to concentrate their of the FI allows this collection of
loans in one segment, such as real estate information to be accomplished at a
loans or consumer loans. lower average cost (economies of scale).
 Insurance companies —financial o In an economic sense, fund
institutions that protect individuals and suppliers have appointed the
corporations (policyholders) from adverse financial institution as a
events. delegated monitor to act on
 Securities firms and investment banks — their behalf.
financial institutions that help firms issue  Liquidity and price risk —FIs provide
securities and engage in related activities financial claims to household savers
such as securities brokerage and securities with superior liquidity attributes and
trading. with lower price risk.
 Finance companies —financial o FIs provide further claims to
intermediaries that make loans to both fund suppliers, thus acting as
individuals and businesses. Unlike asset transformers
depository institutions, finance companies  Transaction cost services —Similar to
do not accept deposits but instead rely on economies of scale in information
short- and long-term debt for funding. production costs, an FI’s size can result
 Mutual funds —financial institutions that in economies of scale in transaction
pool financial resources of individuals and costs.
companies and invest those resources in  Maturity intermediation —FIs can
diversified portfolios of assets. better bear the risk of mismatching the
 Hedge funds —financial institutions that maturities of their assets and liabilities.
pool funds from a limited number of  Denomination intermediation —FIs
wealthy individuals and other investors such as mutual funds allow small
and invest these funds on their behalf, investors to overcome constraints to
usually keeping a large proportion buying assets imposed by large
(commonly 20 percent) of any upside minimum denomination size.
return and charging a fee (2%) on the Services Benefiting the Overall Economy:
amount invested.
 Pension funds —fund participants  Money supply transmission —
accumulate savings during their working Depository institutions are the conduit
years before withdrawing them during through which monetary policy actions

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impact the rest of the financial system financial institutions in 70 years,
and the economy in general. allowed for the creation of
 Credit allocation —FIs are often viewed “financial services holding
as the major, and sometimes only, companies” that could engage
source of financing for a particular in banking activities, insurance
sector of the economy, such as farming activities, and securities
and residential real estate. activities.
 Intergenerational wealth transfers — o
FIs, especially life insurance companies
GLOBALIZATION OF FINANCIAL MARKETS AND
and pension funds, provide savers with
INSTITUTIONS
the ability to transfer wealth from one
generation to the next.  The pool of savings from foreign investors is
 Payment services —The efficiency with increasing and investors look to diversify
which depository institutions provide globally now more than ever before.
payment services directly benefits the  Information on foreign markets and
economy. investments is becoming readily accessible
and deregulation across the globe is
Risks Incurred by Financial Institutions
allowing even greater access to foreign
 Credit risk markets.
 Foreign exchange  International mutual funds allow diversified
 country or sovereign risk foreign investment with low transactions
 Interest rate risk costs.
 Market risk or asset price risk  Global capital flows are larger than ever.
 Off-balance-sheet risk
 Liability withdrawal or liquidity risk
 Technology PHILIPPINE FINANCIAL SYSTEM
 operational risk
 Insolvency risk Finance – allocation of scarce resources

Volcker Rule: Insured institutions may not - Obtain funds at the lowest cost
engage in proprietary trading - Use the funds efficiently to obtain
desired benefits
Regulation of Financial Institutions
Resources:
 Enterprise risk management. - Recognizes
the importance of managing the combined Financial – money, shares/stocks, bonds
impact of the full spectrum of risks as an Real – property, mineral, goods
interrelated risk portfolio
2 types of Finance Decisions:
The Rise of Financial Services Holding
Companies. Household/individual – personal

 Financial Services Modernization (FSM) Corparations/firms – enterprise


Act of 1999
Financial systems operate via:
o bill, promoted as the biggest
change in the regulation of - a set of markets
- Financial intermediaries

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- Investors and borrowers - up to 100% equity investments in
- Other parties: financial intermediaries other than
o Financial service organizations commercial banks
o Regulatory bodies
b. Commercial banks – constitute the
Four levels of financial decision making: bulk of the banking system. - these are
institutions that accept deposits, which are
- Personal
subject to withdrawal by checks
- Sole Proprietorship
- Partnership c. Specialized government banks –
- Corporation unique government banks which are subject
to the supervision and regulation of the BSP
Financial markets
d. Thrift banks (Thrift Bank Act of 1995)
Capitalism brought:
d1. savings and mortgage
- The existence of private wealth
banks (SMBs)/savings and loan
- Freedom of choice associations - accumulate the
- Incentives (motivators)
savings of depositors and invest
- Efficient markets (one where the price
them in various ways
of any good (asset) fully reflects all
information associated with it) d2. Rural banks and
- The role of the government cooperatives - promote
comprehensive development

- provide credit to small-scale


Conditions that the market should possess: farmers and enterprises in the
 Supply and demand determines the rural sector
price of homogenous goods d3. Private Development Banks
 Prices reflect all available information (PDBs) – cater particularly to
 Many individuals and firms are able to the medium and long-term
trade
financing needs of Filipino
 There are no transaction costs (or costs entrepreneurs.
are minimal)
 Participants are free to enter and exit - serve like the DBP at the
the market at any time community or provincial level
2. Non-bank Financial Institutions

Components of the Philippine Financial System a. Government non-bank financial institutions


–protect the welfare of the employees.
1. Banks (banking system)
1. GSIS – insurance for workers
a. Expanded commercial banks or
established in 1936
universal banks – (foreign banks)
2. SSS – compulsory social security
- underwriting
insurance in the private sector
established in 1957.

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> GSIS and SSS generate forced savings redeemable securities of which it is the
to fund the retirement benefits of its issuer
members.
(b) close company – an investment
3. Workmen’s Compensation Programs company whose shares issued are not
– to insure workers against accidents. redeemable

4. Medicare – to pay for medical care 4. Securities Dealers and Brokers -


programs of its members
 security dealer - buys and sells shares
5. PAG-IBIG Fund – “Pagtutulungan sa of stocks of another, or acquires
Kinabukasan-Ikaw, Bangko, Industriya, securities for profit.
Gobyerno”  securities broker – facilitates
transactions between a buyer and
– provide housing loans to members
seller of securities for a commission.
6. National Home Mortgage Financing
5. Venture Capital Corporations–
Corporation – a national mortgage bank
organized jointly by private banks, the
that could refinance the mortgage
National Development Corporation
papers of other financial institutions.
and the Technology Livelihood
b. Component Institutions Research Center

1. Investment Houses - underwriting of - promote and assist small and


securities of other corporations on a medium scales enterprises through
guaranteed basis debt to equity financing.

– capital formation than can engage in 6. Pawnshops – these are businesses


portfolio management, stock brokerage, engaged in lending money on personal
financial consultancy and lending property delivered s security or pledge
operations
7. Lending investors – lending money
- “quasi-banks” or “investment banks” for themselves or others; extending all
or “merchant banks” types of loans.

2. Financing Companies – corporations 8. Government Non-Bank Institutions


or general partnerships extending credit –created under special charters.
facilities to consumers and to industrial,
- consist of the National Development
commercial or agricultural enterprises
Corporation (NDC), Philippine Veterans
and leasing movable properties
Investment Development, Philippine
3. Investment Companies – issuers of Export and Foreign Loan Guarantee
securities for investing or trading in Corporation, National Home Mortgage
securities. Finance Corporation, and Small
Business Guarantee and Finance
Two (2) types of investment
Corporation.
companies:
9. Mutual Building and Loan
(a) open-end company (mutual fund) – Associations – capital stock must be
offers for sale or has outstanding subscribed by the stockholders in

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regular equal installments with the 5. Savings and Loan Association Act – governs
purpose of accumulating to the organization and operation of non-stock
stockholders’ savings and repaying savings and loans associations
them with their accumulated savings
6. RA 7721 – liberalizes the entry and scope of
and profits upon surrender of their
operations of foreign banks in the Philippines
shares
7. Bangko Sentral ng Pilipinas - provides policy
- to encourage industry, savings and
directions in the areas of money, banking and
home building among its stockholders.
credit
10. Stock Savings and Loan
- has supervision over the operations of
Associations (SSLAs) – operating
banks and exercise regulatory powers
under the Savings and Loan
over the operations of non-bank
Association Act and are licensed and
financial institutions performing quasi-
supervised by the BSP
banking functions
- not allowed to do business with the
Main functions and responsibilities are:
general public but accept deposits
from and grant loans to their member  Promotes price stability
depositors only  Supervises all banks
 Issues bank notes and coins
 Manages international reserves
Non-bank financial institutions with quasi-  Determines the exchange rates policy
banking functions:  The bank of banks (provides loans and
financial assistance to banks)
a. Investment houses
 Acts as the main depository bank of
b. Financing companies
the government
c. Investment companies
 Tasks in promoting low inflation and a
d. Securities dealers
healthy financial system

Three (3) major Operating Sectors of the


Banking Laws:
Monetary Board of the BSP:
1. New Central Bank Act – the principal laws
a. Supervision and Examination Sector (SES)
governing banks; this defines the power of the
b. Banking Service Sector (BSS)
BSP in the administration of the monetary,
c. Resource Management Sector (RMS)
banking, and credit system

2. General Banking Act – regulates the


Pillars (objectives) of BSP:
operations of banks and other financial
institutions  Price stability – keeping inflation low,
promote economic efficiency, improve
3. Thrift Banks Act of 1995 – regulates the
the well-being of Filipinos
organization and operations of rural banks
 Financial/monetary stability – ensures
4. Cooperative Code of the Philippines – banks compliance with prudential rules
governs the organization and operations of and regulations, ensures that banks
cooperative banks (RA 8520)

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conducts business in safe and sound  money tends to lose value and
manner invest in non-productive assets
 Efficient payments and settlements such as jewelries and idle lands.
system – enables people to make safe, b. Pervasive unchecked circulation of fake
timely and accurate settlements of money
financial transactions Effects:
 money loses its value
8. Philippine Deposits Insurance Corporation
 an exception rather than the
(PDIC) – an official insurance corporation of the
rule that is a medium of
banking system.
exchange
- requires insured banks to pay an  dollar currency may be used
assessment rate so that their deposits directly as another medium
are insured up to P500,000 per of exchange
depositor.
Common major characteristics of central
9. Securities and Exchange Commission (SEC) – banks:
established on October 26, 1936 by virtue of the
a. Publicly-owned – the BSP is fully owned and
Commonwealth Act # 83 or the Securities Act.
controlled by the government.
- issues certificate of incorporation to financial
- operate for a public purpose not to earn a
corporation, votes on and approves
profit
amendments thereto, discharges other
functions in connection with the licensing of b. Bank of currency issues and ultimate source
financing companies and investment houses, of money - note issue function for the country
and supervises and regulates their specific areas
- provide all the money the government
of operations.
requires
Major functions:
c. Banker’s Bank –maintaining accounts for
o Registration of securities other commercial banks
o Analysis of every registered security
d. Custodian of the country’s reserves of
o Evaluation of the financial condition and
foreign currencies –converting paper notes into
operations of applicants for security
metallic equivalent on demand
issue
o Screening of applications for broker’s or - Philippines - reserves are traditionally held in
dealer’s exchanges. US dollars

e. Regulation of monetary and financial


activities – regulate the operations of all banks
Instances that cause the lose confidence in
and other financial institutions to assure their
money:
solvency and to protect the general public
a. Unrestrained growth in money supply
Effects:
 sever inflation BANGKO SENTRAL NG PILIPINAS (BSP):
 distorts investments,
- regulate the monetary and financial
production, and employment
systems.

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- Plays a vital role in the growth and 4. Special Assistants Governor – 17 in all
development of the country. holding essentially top policy advisory positions
- Regulate monetary and credit
conditions of the country through
Five (5) Functional Sectors of the BSP:
effective use of its monetary tools.
- The only authorized government entity 1. Research Sector – entrusted with the
to print money preparation of data for the guidance of the
- Responsible for the proper Monetary Board
administration of the monetary banking
2. International Operations Sector –
credit system
- Provides policy directions in the areas of responsible for functions utilizing instruments
money, banking and credit. primarily at maintaining external monetary
- Has supervision over the operations of stability and liquidity and preserving the
banks and exercise regulatory powers convertibility of the peso.
over the operations of non-bank 3. Domestic Operations Sector – consists of the
financial institutions performing quasi- cash, loans and credits, and government
banking functions. securities departments
- Was created by RA 7653, otherwise
known as The New Central Bank Act; 4. Administrative Management Sector –
signed into law on June 14, 1993 composed of the accounting, administrative,
building maintenance, and building services
The Monetary Board: departments
- (7) members - term of six (6) years 5. Supervision and Examination Sector –
- The Governor – the CEO of the BSP and charged with the supervision and periodic
the Chair of the Monetary Board examination of all banking and non-bank
- Five (5) members from the private financial institutions performing quasi-banking
sector, serving full-time functions
- One member coming from the Cabinet
Units Directly Under the Supervision of the
Governor:
Guiding Principles of Monetary Administration:
A. Domestic-Monetary Stabilization – 1. General Counsel and Legal
attainment or maintenance of price stability 2. Security Plant Complex
3. Public Relations Office
B. International Monetary Stabilization - 4.
preserve the international value of the peso and
maintain its convertibility Organization of the Bangko Sentral ng Pilipinas:

Top Management Officials: A. The Basic Structure


B. Current Members of the Monetary Board
1. The Governor C. Microfinance
2. Senior Deputy Governors – perform duties as D. Anti-Money Laundering Act (AMLA)
may be assigned by the Governor and the Board E. Governors
3. Deputy Governors – 5 assigned specific areas F. The Security Plant Complex
of responsibility

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4. Credit availability: the greater the amount of
Chapter 2: Determinants of Interest Rates easily obtainable consumer credit the lower the
need to save.
Nominal interest rates - interest rates actually 5. Job security and belief in soundness of
observed in financial markets entitlements.
- Used to determine fair present value
and prices of securities. Determinants of Foreign Funds Invested in the
- Two components: U.S.
o Opportunity cost. 1. Relative interest rates and returns on global
o Adjustments for individual investments.
security characteristics. 2. Expected exchange rate changes.
Real Riskless Interest Rates 3. Safe haven status of U.S. investments.
- Additional purchasing power required 4. Foreign central bank investments in the U.S.
to forego current consumption
Demand for loanable funds - total net demand
LOANABLE FUNDS THEORY for funds by fund users (households, businesses,
- equilibrium interest rates in financial government and foreign participants)
markets as a result of the supply and - interest rate falls = higher demand of
demand for loanable funds loanable funds
- Categorizes financial market - cost of borrowing funds is lower
participants – e.g., consumers, - for businesses: greater profitable
businesses, governments, and foreign projects/better economic conditions =
participants – as net suppliers or greater demand for loanable funds
demanders of funds o high interest rates = businesses
prefer to finance investments
Supply of loanable funds - funds provided to through internally generated
the financial markets by net suppliers of funds funds
- interest rate increase = increase in
supply of loanable funds Equilibrium Interest Rate - interest rate that
- Supply from Households (consumer equates the aggregate quantity of loanable
sector): funds supplied with the aggregate quantity of
o Determined based on total loanable funds demanded for a financial
wealth and risk of securities security
investment; Immediate
spending needs Factors That Cause the Supply and Demand
 Greater perceived risk = Curves for Loanable Funds to Shift
less investment
 Supply of Funds
Determinants of Household Savings o Wealth
1. Interest rates and tax policy. o Risk
2. Income and wealth: the greater the wealth or o Near-Term Spending Needs
income, the greater the amount saved. o Monetary Expansion
3. Attitudes about saving versus borrowing. o Economic Conditions
 Demand for Funds

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o Utility Derived from Assets o Higher default risk = higher
Purchased with Borrowed Funds interest rate demanded by
o Restrictiveness of Nonprice buyer
Conditions on Borrowed Funds. o Not all securities exhibit default
o Economic Conditions risk
o Default/Credit Risk premium
MOVEMENT OF INTEREST RATES OVER TIME DRPj = ijt - iTt
- equilibrium interest rate is only a ijt = interest rate on security
temporary equilibrium issued by a non-Treasury issuer
(issuer j) of maturity m at time
DETERMINANTS OF INTEREST RATES FOR t
INDIVIDUAL SECURITIES
 Liquidity Risk —risk that a security can be
Factors Affecting Nominal Interest Rates sold at a predictable price with low
 Inflation —the continual increase in the transaction costs at short notice.
price level of a basket of goods and o if a security is illiquid, investors
services. add a liquidity risk premium
o High inflation = high interest (LRP) to the interest rate on the
rates security
Inflation (IP) ; CPI (Consumer Price Index);
t = year  Special Provisions —provisions (e.g.,
o IP = [(CPIt+1 - CPIt)/ CPIt] x 100 taxability, convertibility, and callability)
that impact the security holder
 Real Risk-Free Interest Rate —nominal beneficially or adversely and as such are
interest rate that would exist on a security reflected in the interest rates on securities
if no inflation were expected. that contain such provisions.
o Higher time value of money or
rate of time preference to  Term to Maturity —length of time a
consume today = higher real security has until maturity.
interest rate
Term structure of interest rates - A comparison
Fisher Effect (Irving Fisher) of market yields on securities, assuming all
characteristics except maturity are the same
i= RFR + Expected (IP)
Maturity premium (MP) - change in required
i= nominal interest rate interest rates as the maturity of a security
RFR = real risk-free interest rate changes
Expected (IP) = expected inflation rate
Unbiased Expectations Theory
- at a given point in time the yield curve
 Default Risk —risk that a security issuer reflects the market’s current
will default on the security by missing an expectations of future short-term rates
interest or principal payment. - Current long-term interest rates (1RN )
are geometric averages of current and

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expected future, E(Nr1 ), short-term
interest rate

R = [(1 + 1R1 )(1 + E(2r1 ))… ( 1+ E(Nr1 ))]1/N – 1


1 N

R actual N-period rate today


1 N=

N = term to maturity
1R1 = actual current one-year rate today

E(ir1 ) = expected one-year rates for years, i=1 to


N

Example:
Market Segmentation Theory
 Individual investors and FIs have specific
maturity preferences.
 Interest rates are determined by distinct
supply and demand conditions within many
maturity segments.
 Investors and borrowers deviate from their
preferred maturity segment only when
adequately compensated to do so.

Implied Forward Rates


 A forward rate (f) is an expected rate on a
Liquidity Premium Theory short-term security that is to be originated
- Extension of unbiased expectations at some point in the future.
theory  The one-year forward rate for any year, N
- investors will hold long-term maturities years into the future is:
only if they are offered at a premium to
compensate for future uncertainty in a
security’s value, which increases with an
asset’s maturity
- Long-term interest rates are geometric
averages of current and expected future
- short-term interest rates plus liquidity
risk premiums that increase with
maturity.
- Equation:

Example:

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- A single cash flow occurs at the
beginning and end of the investment
horizon with no other cash flows
exchanged. lump sum payment A single
cash flow occurs at the beginning and
Time Value of Money and Interest Rates end of the investment horizon with no
other cash flows exchanged.
Time value of money - basic notion that a dollar Annuity
received today is worth more than a dollar - A series of equal cash flows received at
received at some future date fixed intervals over the investment
horizon.
- Simple interest: interest earned on an
investment is not reinvested Present Value of a Lump Sum
- Compound interest: interest earned on - Discount future payments using current
an investment is reinvested, most interest rates to find the present value
common (PV)

Lump sum payment

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Future Value of a Lump Sum
- The future value (FV) of a lump sum
received at the beginning of the
investment horizon
- FVt = PV(1+r)t

Future Value of an Annuity


- The future value of a series of equal
cash flows received at equal intervals
throughout the investment horizon

Present Value of an Annuity


- The present value of a finite series of
equal cash flows received on the last
day of equal intervals throughout the
investment horizon

Effective or equivalent annual return

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- Rate earned over a 12-month period
taking the compounding of interest into
account

EAR = (1+r)c – 1

C = number of compounding periods per year

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