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Unit II Interest Rate for Financial Institutions and Markets Mcom sem 3 Delhi University

Unit II Interest Rate for Financial Institutions and Markets Mcom sem 3 Delhi University

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University : When making a financial decision, you need to know what your options are. Whether you are a business trying to raise funds, or an investor saving for your retirement, you should know what the different kinds of stocks and bonds are, how they differ in terms of the interest rates they pay and the risks they carry, and how the markets where they are bought and sold work. This section begins by looking at the basic financial instruments: stocks and bonds. We will then go through though some of the various kinds of stock and bond markets. Finally, we end with one of the key tools in understanding interest rates – supply and demand. 

The Basic Financial Instruments: Stocks and Bonds Most businesses need to raise funds to expand their operations. The two main ways of doing this are by issuing either debt or equity. This chapter looks at both of these securities in more detail Debt and Bonds Bonds are an example of a debt contract. A debt contract is simply a promise to repay an amount in the future in exchange for funds now. Examples of a debt contract are an IOU or a loan from a bank. A bond is a kind of a debt contract that is marketable, that is it can be bought and sold in a market. For example, to raise funds, General Motors might sell a bond, which is a promise to repay the money plus interest some time in the future.

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University

While a bond is very much like a loan, what makes it different is that whoever buys the bond initially can turn around and sell it to someone else (that is, a bond is negotiable debt, it can be bought and sold). Bonds generally offer two kinds of payments, a regular payment (generally made every six months) called a coupon payment and the par value or face value that is paid when the bond matures (the date when the bond makes its final payments is called the maturity date). Some kinds of bonds do not have coupon payments and are called zero coupon bonds or discount bonds. The coupon rate is expressed as a percentage of the face value.

Example: To raise money to build a plant, General Motors issues a bond that has a coupon yield of 5%, paid semiannually, and a face value of $1,000 with a maturity of 10 years. What payments will be made on this bond? It will pay a coupon of $25 twice a year for the next 10 years along with the payment $1,000 at the end of the 10 years when the bond matures. The coupon payments are found by taking 5% of $1,000 (=$50) and splitting it into two equal parts Once the bonds are sold, the initial investors can turn around and sell the bond to someone else. When someone else buys the bond, the coupon and the face value payments remain the same; General Motors pays that amount to whoever owns the bond. However, the price the investor gets for the bond is determined in the market and could be different from what the investor initially paid for it, if the desirability of this bond from GM has changed. Example (continued): After you bought the General Motors bond, you decide to turn around and sell it to someone else.

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University

Unfortunately, in the mean time, people have become concerned that GM may not be able to pay the money back. Because of this, they are less willing to hold GM bonds. In order to sell your bond you need to offer a lower price. When you sell the bond, the coupon ($25) and face value ($1,000) remain the same, but the new investor is getting a higher return (if GM doesn’t default) because they paid a lower price. Many different kinds of organizations issue bonds. Bonds are divided up into three main types. When a business issues a bond it is called a corporate bond. When the US Government issues a bond it is called a government bond or a Treasury Security (called Treasury Bonds, Notes, or Bills, depending on the particular type). If a local government such as a city or state, or a public utility or organization such as a school board, issues a bond it is called a municipal bond. In addition, one can buy bonds from foreign governments or foreign corporations. Stocks and Equity To raise money,

General Motors could have also issued stock. In some sense, the process is pretty much the same. GM offers a piece of paper in exchange for a payment; when bonds and stock are first offered they both raise money for GM. However, stock differs in two major ways from bonds. Stock represents ownership in the company so that stockholders can vote on who manages the company. However, stock does not offer fixed payments like debt, and because of that, there is higher risk. Some stocks make payments to the owners (which are called dividends) but they are not guaranteed. The Process of Creating Securities Securities markets actually reflect two different processes. First, when a firm issues the security to raise funds, and second, when investors trade the security among themselves.

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University

While many businesses are incorporated, a majority of them do not have shares publicly available for sale. For example, imagine that you are starting up a new computer company with two friends, each of you provide financing of $10,000 and so each get 1/3 ownership of the company and so 1/3 of the shares. Even though the company may be structured as a corporation, the shares are owned by just a few people, and there are limits on the buying and selling of shares. At some point, the company may want to raise additional funds by selling shares in the company to outsiders. A firm that has approval to offer its shares to the general public is known as a public company. The process of switching from a private to a public company, and issuing shares, is called “going public”. The shares are issued in an Initial Public Offering, or IPO. Firms are generally aided by an investment bank in this. Often, institutional investors buy the shares initially and then may resell them to the general public. After the shares are initially sold, they can be resold to other investors. Resale markets are called secondary markets, and are what we usually think of as stock markets. 

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University

The Capital Market

Sometimes we want to refer to the entire financial sector where demanders and suppliers of funds get together. We call this the capital market. This is a very general term that gets its name from the fact that firms are raising funds to make capital projects. It is also a very broad term since the capital market includes bond markets, stock markets, and the banking system. Security Exchanges Once the stock has been purchased in the IPO, the institutions may want to resell them. In fact, most sales of stock take place after the IPO, in two different kinds of markets. Securities can either be listed in a stock exchange or sold in an over-the-counter market. When you buy a stock listed on the New York Stock Exchange (NYSE) typically you would talk to a stockbroker at a brokerage firm.

Brokerage firms are companies that specialize in handling purchases and sales of stock, along with offering financial advice, and have people on the floor of the exchange. You would place your order with a broker who would relay the order to a floor broker (someone who buys and sells on the trading floor). The floor broker would buy the stock from another floor broker, executing a sell order from another individual. In the US, the largest over-the-counter market is the NASDAQ, which stands for the National Association of Security Dealers Automated Quotation system. This market handles the stocks of a large number of businesses; mostly small firms, but some very large and famous firms such as Microsoft and Intel. NASDAQ is known for handling many of the new technology companies.

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University

Capital markets around the world have been increasing in importance. In most countries, banks play a more important role in financing than in the US although this has changed somewhat in recent times. Most rich countries, such as England and Japan, have well established equity markets. In addition, smaller, poorer countries have been developing their own equity markets. These are sometimes called emerging markets. Reading stock quotes Stock prices are reported in the Wall Street Journal, the main financial paper in the US, in the business sections of the major daily newspapers, and online. While most people get their information online these days, you need to be familiar with the basic terms and abbreviations used in the financial press as they will show up in a variety of contexts. When the Wall Street Journal gives stock quotes, it also provides some historical information to help the reader put the price into context.

Interest rate is a rate of return paid by a borrower of funds to a lender of them, or a price paid by a borrower for a service, the right to make use of funds for a specified period. Thus it is one form of yield on financial instruments. Two questions are being raised by market participants:  What determines the average rate of interest in an economy?  Why do interest rates differ on different types and lengths of loans and debt instruments? Interest rates vary depending on borrowing or lending decision. There is interest rate at which banks are lending (the offer rate) and interest rate they are paying for deposits (the bid rate). The difference between them is called a spread. Such a spread also exists between selling and buying rates in local and international money and capital markets. The spread between offer and bid rates provides a cover for administrative costs of the financial intermediaries and includes their profit. The spread is influenced by the degree of competition among financial institutions. In the short-term international money markets the spread is lower if there is considerable competition. Conversely, the spread between banks borrowing and lending rates to their retail customers is larger in general due to considerably larger degree of loan default risk. Thus the lending rate (offer or ask rate) always includes a risk premium.

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University

There are several factors that determine the risk premium for a non- Government security, as compared with the Government security of the same maturity. These are (1) the perceived creditworthiness of the issuer, (2) provisions of securities such as conversion provision, call provision, put provision, (3) interest taxes, and (4) expected liquidity of a security’s issue. In order to explain the determinants of interest rates in general, the economic theory assumes there is some particular interest rate, as a representative of all interest rates in an economy. Such an interest rate usually depends upon the topic considered, and can represented by e.g. interest rate on government short-term or long-term debt, or the base interest rate of the commercial banks, or a short-term money market rate (EURIBOR). In such a case it is assumed that the interest rate structure is stable and that all interest rates in the economy are likely to move in the same direction.

The rates of interest quoted by financial institutions are nominal rates, and are used to calculate interest payments to borrowers and lenders. However, the loan repayments remain the same in money terms and make up a smaller and smaller proportion of the borrower’s income. The real cost of the interest payments declines over time. Therefore there is a real interest rate, i.e. the rate of interest adjusted to take into account the rate of inflation. Since the real rate of return to the lender can be also falling over time, the lender determines interest rates to take into account the expected rate of inflation over the period of a loan. When there is uncertainty about the real rate of return to be received by the lender, he will be inclined to lend at fixed interest rates for short-term. The loan can be ‘rolled over’ at a newly set rate of interest to reflect changes in the expected rate of inflation. On the other hand, lenders can set a floating interest rate, which is adjusted to the inflation rate changes.

Unit II Interest Rate for Financial Institutions and Markets MCOM sem 3 Delhi University

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