LECTURE 1A :CHAPTER 1

Introduction to Financial Management

Forms of Businesses

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Alternative Forms of Business

Organization

Proprietorship

Unincorporated business owned by one individual

Partnership

Unincorporated business owned by two or more

persons

Corporation (listed and unlisted)

Incorporated business owned by many

shareholders

Legal entity created that is separate and distinct

from its owners and managers

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Proprietorships & Partnerships

Advantages

Disadvantages

Easy to set up
Subject to few regulations
No corporate income taxes

Difficult to raise capital

Unlimited liability
Limited life
Recently, Partnership often set up as Limited Liability
Company (LLC) or Limited Liability Partnership (LLP):
(limited liability like corporation but taxed like a
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partnership)

Corporation

Advantages

Disadvantages

Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Higher tax rate (typically)
Double taxation: one at corporate level, one on

dividends received by individual shareholders

Cost of set-up and report filing

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LECTURE 1B : CHAPTER 7
Interest Rates

Determinants of interest rates

The term structure and yield curves
Using Yield Curve to estimate Future Interest
Rates

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What four factors affect the level of

interest rates?
Production
opportunities
Time preferences
for consumption
Risk

Expected inflation

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What four factors affect the level of

interest rates?

Production opportunities:

Affects Demand for funds: those with higher rate of return from
investment are more prepared to pay higher cost of borrowing.

If economy booms, more attractive projects means more need for

capital. Greater competition for funds pushes up interest rates.

Demand for funds declines during recessions. Lesser competition

for funds leads to lower interest rates.

Time preferences for consumption

Preference for Current Consumption (Spend Now) vs Future

Consumption (Spend Later).

If current consumption is preferred, lower savings means less

funds available for investment. Borrowers competing for limited
funds lead to higher interest rates and lesser investments.
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What four factors affect the level of

interest rates?

Risk

Higher risk means higher required rate of return.

Expected inflation

To maintain real purchasing power, higher expected

inflation will lead to higher interest rate.

Higher oil prices tend to lead to higher expected

inflation.

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Determinants of interest rates

r = r* + IP + MRP + DRP + LP
r

= required return on a debt security

r*

= real risk-free rate of interest

IP

= Inflation Premium

MRP = Maturity Risk Premium

DRP = Default Risk Premium
LP

= Liquidity Premium
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Determinants of interest rates

r = r* + IP + MRP + DRP + LP
r* = real risk-free rate of interest, is the rate on a riskless security in
a world without inflation.

IP = Inflation Premium.
It is the average expected inflation rate over the life of the
security.
rRF = r* + IP + MRP, is the nominal or quoted risk-free rate (this
overrides textbook definition which excludes the MRP).
Further, the default for risk-free rate is nominal risk-free rate and not
real risk-free rate, so risk-free rate means the nominal risk-free rate.
rRF = represents the interest rate earned on Treasury securities.
I.O.U. document issued by Government when it borrows.
Can be bought/sold. It is default-free and very liquid

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Determinants of interest rates

r = r* + IP + MRP + DRP + LP
MRP =

Maturity Risk Premium : ________ bonds face greater price

declines when interest rates or inflation spike, hence higher
return is required to compensate for this risk.

DRP

Default Risk Premium : Compensation for risk of

non-payment of interest or principal (Credit Risk).
Correlated with rating of the bond.

LP

Liquidity Premium : Liquidity measures how easily a security

can be converted to cash at short notice at reasonable price.
LP is low for U.S. Treasuries, large strong firms (liquid assets)
but high for small, privately owned firms (illiquid assets).
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Premiums added to r* for different

types of DEBT
IP
S-T Treasury

L-T Treasury

S-T Corporate Bond

L-T Corporate Bond

MRP

DRP

LP

r = r* + IP + MRP + DRP + LP
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Review/Recap & Thinking Questions

What is the Golden Formula on interest rates?

What type of securities have significant MRP?

What type of securities have significant DRP?

What type of securities have significant LP?

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Yield curve and the term

structure of interest rates
Term structure
relationship between
interest rates (or yields) and
maturities.

Interest
14%

March 1980

12%
10%
8%

The yield curve is a graph of

the term structure.
Treasury yield curve on
different dates are shown at
the right.

February 2000

6%
4%

October
2008

2%
0%
0

10

20

30

Years to Maturity

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Constructing the Treasury yield curve:

r = r* + IP + MRP
Assuming r* is given, we first find IP

Step 1 Find the average expected inflation

rate over years 1 to N:

IPN =

N INFL
N
t=1
N

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Constructing the yield curve: Inflation

Assume inflation is expected to be 5% next year,
6% the following year, and 8% thereafter.

IP1 = 5% / 1 = 5.00%
IP10= [5% + 6% + 8%(8)] / 10 = 7.50%

IP20= [5% + 6% + 8%(18)] / 20 = 7.75%

Return of (r* + IP) helps overcome higher prices
due to inflation. Effectively, investor earns r*,
which measures real purchasing power, which
measures money in terms of amount of goods
and services it can buy.
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Constructing the yield curve:

Maturity Risk
Step 2 Find the appropriate maturity risk
premium (MRP).

For this example, the following equation will be

used to find a securitys appropriate maturity risk
premium.

MRPt 0.1% ( t - 1 )

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Constructing the yield curve:

Maturity Risk
Using the given equation:
MRP1 = 0.1% x (1-1) = 0.0%

MRP10 = 0.1% x (10-1) = 0.9%

MRP20 = 0.1% x (20-1) = 1.9%

Equation is linear.
Maturity Risk Premium is increasing as the time
to maturity increases, as it should be.
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Add the IPs and MRPs to r* to find the

appropriate Treasury yield
Step 3 Adding the premiums to r*.
rRF, t = r* + IPt + MRPt

(MRP often taken to be zero for Treasury Bill (T-Bill) as it

is short-term)
Assume r* = 3%,

rRF, 1 = 3% + 5.0% + 0.0% = 8.0%

rRF, 10 = 3% + 7.5% + 0.9% = 11.4%
rRF, 20 = 3% + 7.75% + 1.9% = 12.65%
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Hypothetical (Treasury) yield curve

Interest
Rate (%)
15

Maturity risk premium

10

Inflation premium

An upward sloping yield

curve.
Upward slope due to an
increase in expected
inflation and increasing
maturity risk premium.

Real risk-free rate

10

Years to
20 Maturity
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Relationship between the Treasury yield curve

and the yield curves for corporate issues

Corporate yield curves are higher than that of

Treasury securities, though not necessarily parallel
to the Treasury curve.

Spread (or difference) between corporate and

Treasury yield curves increases if the corporate
bond has a lower or lousier rating.

Since corporate bond yields include a default risk

premium (DRP) and a liquidity premium (LP), the
corporate bond yield spread can be calculated as:

Corporate bond
yield spread

Corporate bond yield Treasury bond yield

DRP LP

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Relationship between corporate and Treasury

yield curves

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Pure Expectations Hypothesis : PEH

(Theory to explain Term Structure)

PEH states that the shape of the yield curve

depends on investors expectations about
future interest rates.

If interest rates are expected to increase,

Long-Term rates will be higher than
Short-Term rates, and vice-versa.

Hence, yield curve can slope up, down, or

even humped.
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Assumptions of the PEH

Assumes maturity risk premium for Treasury

securities is zero.

Long-term rates are a (geometric) average of

current and future short-term rates.

If PEH is correct, can use the yield curve to

calculate/infer expected future interest rates.

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PEH: (1 + RL)L = (1 + RS)S (1+SRL)(L-S)

RS

SRL.

RL

(1 + RL)L = (1 + RS)S (1+SRL)(L-S)

Let S = 3, L = 7, (L-S) = 7-3 = 4

Suppose RS = R3 = 5.6% per annum (p.a.), RL = R7 =8.2% p.a.

(1 + 0.082)7 = (1 + 0.056)3 (1+3R7)4
3R7

= 0.1019 = 10.19%

The 4-year interest rate starting at Yr-3 and ending at Yr-7 is expected
to be 10.19%
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Pure Expectations Theory

(1 + 0.05) (1 + 0.07) = (1.06)2

(1 + 0.05) (1 + ____) = (1.05)2

(1 + 0.05) (1 + ____) = (1.0796)2 (1.08)2

(1 + 0.05) (1 + ____) = (1.03995)2 (1.04)2

Short
Rate

Future
Rate

Long
Rate

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Observed Treasury rates and the PEH

Maturity

Yield

1 year

6.0%

2 years

6.2%

3 years

6.4%

4 years

6.45%

5 years

6.5%

If PEH holds, what does the market expect will be the

interest rate on one-year securities, one year from now?
Three-year securities, two years from now?
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One-year forward rate

6.0% p.a.
0

x% p.a.
1

6.2% p.a.

(1.062)2

= (1.060) (1+x)

1.12784/1.060 = (1+x)

6.4004% = x

PEH implies that one-year securities will yield 6.4004%,

one year from now.
If an arithmetic average is used, the answer is still very
close. Solve: 6.2% = (6.0% + x), solving x =
6.4%.

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What is the yield of three-year security, two

years from now?
6.2% p.a.
0

x% p.a.
2

6.5% p.a.

You just need to write the starting equation

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Conclusions about PEH

Some argue that MRP 0, and hence the

PEH is incorrect.

Most evidence supports the general view that

lenders prefer Short-Term securities, and view
Long-Term securities as riskier.

Thus, investors demand a premium to persuade

them to hold Long-Term securities :

MRP > 0
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LECTURE 1C: Types of Financial

Mkts

Chapter 2

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What is a Market?

Market: Venue where goods and/or services

are traded.

Financial Market: a place where individuals

and organizations wanting to borrow/raise
funds are brought together with those having
a surplus of funds.

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Different Types of Markets

Physical assets vs. Financial assets Markets

Physical Assets: tangible or real assets e.g. Wheat,
computer, house.
Financial Assets: stocks, bonds, mortgages and other
claims on real assets as well as derivative securities
whose values are derived from price changes of other
assets.
Money vs. Capital Markets
Money Mkt: short-term, highly liquid debt securities.
Capital Mkt: intermediate- or long-term debt and
corporate stocks.
Primary vs. Secondary Markets
Primary Mkt: where corporations raise new capital.
Secondary Mkt: where existing securities are traded
among investors.
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Types of financial markets

Spot vs. Futures

Spot Mkt: assets are bought/sold on-the-spot

delivery: within a few days.

Futures Mkt: participants agree today to buy/sell
an asset at some future date at a price agreed
today.

Public vs. Private

Public Mkt: standardized contracts are traded on

organized exchanges, more liquid. Example: stock

market.
Private Mkt: transactions are negotiated directly
between 2 parties, less liquid. Example: mkt for
bank loans.
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Primary vs Secondary Markets

If Microsoft issues additional shares and an investor

purchases some of the newly issued shares at the time
of issue, would this be a primary market transaction or
a secondary market transaction?

If instead an investor buys existing shares of Microsoft

stock in the open market is this a primary or
secondary market transaction?

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Review

Forms of Business:
Proprietorship
Partnership
Corporation

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Review

Determinants of Interest Rate

r = r* + IP + MRP + DRP + LP

Pure Expectations Hypothesis:

Yield Curve that slopes Up: interest rate expected
to go Up

Yield Curve that slopes Down: interest rate

expected to go Down

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