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FMI Class 4

FINANCIAL MARKET AND INSTITUTIONS

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CHANDAN SAHOO
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25 views

FMI Class 4

FINANCIAL MARKET AND INSTITUTIONS

Uploaded by

CHANDAN SAHOO
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Financial Markets and Institutions

Dr. Pranith Kumar Roy, Ph.D


Asst. Professor of Finance & Accounts, IIM Raipur M. Tech. (IIT Delhi), FRM®
(GARP, USA), Ph. D.(IIT-ISM), Dhanbad

October 23, 2024 1


Interest Rate

Measuring interest rates; The distinction between


interest rates and returns; The distinction between
nominal and real interest rates; Forward rate
Types of Credit Instruments
A simple loan, in which the lender provides the borrower with an amount of funds,
which must be repaid at the maturity date along with an additional payment
100*(1+0.1)^3
for the interest. 100 10 11 12.1
=133.1

A fixed-payment loan (also called a fully amortized loan), in which the amounts
must be repaid by making the same payment every period (month, quarter),
40.2 40.2 40.2
consisting of part of the principal and100
interest for a set1 number 1of periods.1

A coupon bond pays the owner of the bond a fixed interest payment (coupon
payment) every year until the maturity
100 date, when10a specified
10 final amount
10 (face
100
value or par value) is repaid.

A discount bond (also called a zero-coupon


75.1 bond) is bought at a price below its
100
3
face value (at a discount), and the face value is repaid at the maturity date.
Coupon: The amount of the yearly coupon payment expressed as a percentage
of the face value of a coupon bond.
Yield to maturity: The interest rate that equates the present value of payments
received from a credit market instrument with its value today.
Interest Rate
The aggregate quantity of funds supplied increases as the interest
rates of the Banks/Fis increases, while the aggregate quantity of funds
demanded is inversely related to interest rates.

As long as competitive forces are allowed to operate freely in a financial


system, the interest rate that equates the aggregate quantity of loanable
funds supplied with the aggregate amount of loanable funds demanded by
a financial security, Q *, is the equilibrium interest rate for that security, i *,
point E in Figure.
Factors to shift Demand and Supply curve
Factors that cause the supply curve of loanable funds to shift, at any given
interest rate:

1. As wealth of fund suppliers increases (decreases), the supply of


loanable funds increases (decreases)
2. As risk of the financial security increases (decreases), the supply
of loanable funds decreases (increases)
3. As near-term spending needs increase (decrease), the supply of
loanable funds increases (decreases)
4. When monetary policy objectives allow the economy to expand
(restrict expansion), the supply of loanable funds increases
(decreases)
5. As economic conditions improve in a domestic (foreign) country,
the supply of funds increases (decreases)
Interest Rate of Securities
Determinants of interest rate of individual securities: The specific
factors that affect differences in interest rates across the range of real-
world financial marketsij* = f (RIR, IP, DRPj , LRPj,MP j, SCPj )
Real Interest Rate —the nominal interest rate that would exist on security if no
inflation were expected.
Inflation —the increase in the price level of a basket of goods and services.

Default Risk —the risk that a security issuer will default on the security by missing
interest or
principal payment.
Liquidity Risk —the risk that a security cannot be sold at a predictable price with
low transaction
costs at short notice.
Term to Maturity —length of time until maturity. Interest rates are also related to
the term to maturity. This relationship is often called the term structure of interest
rates or the yield curve.
Special Provisions —provisions (e.g., taxability, convertibility, and callability) that
Interest Rate
To examine the effect of default risk on interest rates, let’s look at the
supply-and-demand diagrams for the default-free (Treasury) and
corporate long-term bond markets
1. An increase in default risk shifts the demand curve for corporate
bonds left and
2. shifts the demand curve for Treasury bonds to the right .

This raises the price of Treasury bonds and lowers the price of corporate bonds, and
therefore lowers the interest rate on Treasury bonds and raises the rate on
corporate bonds, thereby increasing the spread between the interest rates on
corporate versus Treasury bonds.
Interest Rate
The nominal interest rate is the interest rate in terms of currency value,
that is usually reported in the newspaper.
Inflation (IP): Increased cost of real goods and services today and buying
these more highly-priced goods and services in the future.
Real Interest Rates (RIR): the interest rate that would exist on security if
no inflation were expected over the holding period. The nominal interest
rate adjusted for inflation.
Real Interest Rate = Nominal Interest Rate – Inflation
If the nominal interest rate is at 4%, and the inflation rate is at 2.5%, the
real interest rate will be 1.5%, because real interest rate = 4% - 2.5% =
1.5%.

Society’s relative time preference for consuming today rather than


tomorrow
Fisher Effect: Nominal interest (i) rates is the rate observed in financial
markets. It must compensate investors for
Term Structure
Term structure: The relationship between a security’s interest rate and its
remaining term to maturity.
A plot of the yields on bonds with differing terms to maturity but the same risk,
liquidity, and tax considerations is called a yield curve, describes the term structure.
The shape of the yield curve falls predominantly into three theories.
The unbiased expectations theory: The market’s current expectations of future
short-term rates. In equilibrium, the return to holding a multi-year bond to maturity
should equal the expected return to investing in such successive one-year bonds.
If investors have a four-year
investment horizon, they could
either buy a current, four-year
bond (1R4) and held to maturity),
buy or invest in four
successive one-year bonds
i.e.
In (1R2) (2R1) (3R1)the
equilibrium, (4R1)return to holding a four-year bond to maturity should equal the
expected return to investing in four successive one-year bonds

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