Glossary

12.2 Capital markets and interest rates

5 min read•july 30, 2024

Capital markets play a crucial role in allocating financial resources efficiently. They connect investors with borrowers, facilitating the exchange of financial assets through primary and secondary markets, intermediaries, and various market structures.

Interest rates, determined by supply and demand for loanable funds, are influenced by factors like inflation, economic growth, and monetary policy. Understanding these dynamics is essential for making informed investment decisions and managing risk in capital markets.

Capital markets and financial resource allocation

Structure and functions of capital markets

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  • Capital markets facilitate financial asset exchange between investors and borrowers allocating resources efficiently in an economy
  • Primary markets involve new security issuance while secondary markets enable existing security trading
  • Capital market structure includes intermediaries (investment banks, brokers, exchanges) facilitating transactions and providing liquidity
  • Markets categorized into equity markets (stock exchanges) and debt markets (bond markets) serve different financing needs
  • measures how quickly and accurately prices reflect all available information
  • Regulatory bodies (Securities and Exchange Commission) oversee capital markets ensuring fair practices and investor protection
  • Globalization increased capital market interconnectedness across countries affecting capital flows and investment opportunities

Types and components of capital markets

  • Equity markets allow companies to raise capital by selling ownership shares () to investors
  • Debt markets enable entities to borrow funds by issuing or other debt instruments
  • Money markets focus on short-term debt securities with maturities typically less than one year (Treasury bills, commercial paper)
  • Derivatives markets trade financial contracts deriving value from underlying assets (futures, options, swaps)
  • Over-the-counter (OTC) markets involve direct trading between parties without a formal exchange
  • Exchange-traded funds (ETFs) combine features of mutual funds and individual stocks, trading on exchanges
  • Alternative investment markets include private equity, venture capital, and hedge funds

Determinants of interest rates

Supply and demand for loanable funds

  • Equilibrium interest rate determined by intersection of supply and demand for loanable funds in competitive markets
  • accounts for inflation representing actual cost of borrowing or return on lending
  • includes real interest rate and expected inflation described by Fisher equation: i=r+πei = r + \pi_e
  • Time preference influences loanable funds demand as people prefer present consumption over future consumption
  • Capital productivity affects loanable funds demand with higher productivity increasing willingness to borrow for investment
  • Risk factors (default risk, liquidity risk) contribute to risk premium component of interest rates
  • Macroeconomic factors (GDP growth, unemployment, government policies) influence interest rates through supply and demand effects

Factors influencing interest rate levels

  • impact nominal interest rates as lenders seek compensation for anticipated purchasing power loss
  • Economic growth affects interest rates by influencing demand for credit and investment opportunities
  • Government borrowing can increase interest rates by competing with private sector for loanable funds (crowding out effect)
  • International capital flows influence domestic interest rates through changes in supply and demand for currency
  • Term structure of interest rates reflects relationship between short-term and long-term rates ()
  • Credit quality of borrowers affects interest rates with higher-risk borrowers paying higher rates (credit spread)
  • Liquidity preferences of investors impact interest rates with higher demand for liquid assets lowering their yields

Monetary policy's impact on capital markets

Central bank tools and mechanisms

  • Central banks use monetary policy tools (open market operations, reserve requirements, discount rates) to influence interest rates and money supply
  • set by Federal Reserve serves as benchmark for other short-term interest rates in economy
  • Expansionary monetary policy lowers interest rates increasing borrowing and investment potentially stimulating economic growth
  • Contractionary monetary policy raises interest rates helping control inflation but potentially slowing economic growth
  • Yield curve shows relationship between interest rates and bond maturities influenced by monetary policy expectations
  • Quantitative easing involves large-scale asset purchases by central banks lowering long-term interest rates
  • Transmission mechanism of monetary policy describes how policy rate changes affect other interest rates, asset prices, and aggregate demand

Effects of monetary policy on financial markets

  • Interest rate changes impact bond prices with inverse relationship (bond prices rise when interest rates fall)
  • Equity markets often respond to monetary policy changes with lower rates generally supporting higher stock valuations
  • Exchange rates affected by interest rate differentials between countries influencing currency values
  • Real estate markets sensitive to interest rate changes impacting mortgage rates and property valuations
  • Credit markets react to monetary policy with changes in lending standards and credit availability
  • Commodity prices influenced by interest rates through effects on storage costs and opportunity costs
  • Volatility in financial markets often increases around monetary policy announcements and decisions

Risk and return in investment decisions

Risk-return tradeoff and portfolio theory

  • Risk-return tradeoff principle states higher potential returns associated with higher risk levels in investment decisions
  • (market risk) affects all investments and cannot be diversified away
  • Unsystematic risk specific to individual securities or sectors can be reduced through diversification
  • Capital Asset Pricing Model (CAPM) estimates required return on investment based on systematic risk (beta): E(Ri)=Rf+βi(E(Rm)−Rf)E(R_i) = R_f + \beta_i(E(R_m) - R_f)
  • Portfolio theory by Harry Markowitz demonstrates diversification reduces overall portfolio risk without sacrificing expected returns
  • Efficient frontier represents set of optimal portfolios offering highest expected return for given level of risk
  • Asset allocation involves distributing investments among different asset classes to balance risk and return

Risk measurement and management techniques

  • Sharpe ratio measures risk-adjusted performance comparing excess returns to standard deviation of returns: SharpeRatio=Rp−RfσpSharpe Ratio = \frac{R_p - R_f}{\sigma_p}
  • Value at Risk (VaR) quantifies potential loss in investment value over specific time horizon at given confidence level
  • Beta measures systematic risk of an investment relative to overall market
  • Standard deviation calculates volatility of returns indicating level of investment risk
  • Correlation analysis assesses relationships between different assets or investments for diversification purposes
  • Stress testing evaluates portfolio performance under various adverse scenarios
  • Real options analysis incorporates flexibility value in investment decisions recognizing managers can adapt to changing market conditions

Key Terms to Review (16)

Bonds: Bonds are debt securities that represent a loan made by an investor to a borrower, typically corporate or governmental. In essence, when you buy a bond, you are lending money in exchange for periodic interest payments and the return of the bond's face value when it matures. Bonds play a crucial role in corporate finance, market efficiency, capital markets, and asset pricing by influencing firm value, interest rates, and the risk-return profile of investments.
Central Bank Policy: Central bank policy refers to the actions and strategies implemented by a country's central bank to control the money supply, manage interest rates, and ensure economic stability. This policy is crucial as it influences inflation, employment levels, and overall economic growth, impacting how capital markets operate and shaping interest rates across the economy.
Diversifiable Risk: Diversifiable risk, also known as unsystematic risk, refers to the portion of an asset's risk that can be eliminated through diversification in a portfolio. This type of risk is specific to individual assets, such as stocks or bonds, and includes factors like company performance, management decisions, or industry changes. By holding a diverse range of investments, the impact of any single asset's poor performance can be mitigated, allowing investors to reduce overall portfolio risk.
Efficient Market Hypothesis: The Efficient Market Hypothesis (EMH) suggests that financial markets are 'informationally efficient', meaning that asset prices reflect all available information at any given time. This concept is crucial for understanding how market prices respond to new information, which ties into the behavior of capital markets, the relationship between interest rates, and the tradeoffs between risk and return in asset pricing.
Federal funds rate: The federal funds rate is the interest rate at which banks lend reserves to each other overnight. This rate is crucial as it influences overall economic activity by affecting other interest rates, including those for loans and savings, and ultimately impacts inflation and employment levels in the economy.
Inflation expectations: Inflation expectations refer to the rate at which people believe prices will rise in the future. These expectations can influence economic behavior, such as spending and investment decisions, as individuals and businesses adjust their strategies based on what they predict will happen to prices. When inflation expectations are high, consumers may buy now rather than later, while investors may seek higher returns to compensate for anticipated price increases.
LIBOR: LIBOR, or the London Interbank Offered Rate, is the average interest rate at which major global banks lend to one another in the short-term money market. This benchmark rate is critical as it influences the pricing of various financial instruments, including loans, derivatives, and mortgages, and serves as a reference for interest rates across different financial products worldwide.
Market Capitalization: Market capitalization, often referred to as 'market cap', is the total market value of a company's outstanding shares of stock, calculated by multiplying the current share price by the total number of outstanding shares. This metric helps investors gauge a company's size and investment potential, influencing corporate finance decisions and firm valuation as well as reflecting its position in capital markets.
Nominal interest rate: The nominal interest rate is the stated or quoted rate of interest on a loan or investment, without adjusting for inflation. This rate represents the percentage increase in money that borrowers pay to lenders over a specific period, typically expressed annually. It is a critical concept in understanding how capital markets operate, as it influences borrowing costs, investment decisions, and overall economic activity.
Price-to-earnings ratio: The price-to-earnings ratio (P/E ratio) is a financial metric that compares a company's current share price to its earnings per share (EPS), providing insight into how much investors are willing to pay for a dollar of earnings. A higher P/E ratio indicates that investors expect future growth, while a lower P/E suggests that the company may be undervalued or facing challenges. This ratio plays a crucial role in investment analysis, helping investors assess the relative value of companies in capital markets.
Primary market: The primary market is the segment of the capital market where new securities are created and sold for the first time. It serves as a platform for issuers, such as corporations or governments, to raise capital by offering shares or bonds directly to investors. The prices in the primary market are typically determined through a process involving underwriters and can have significant implications for interest rates and overall market dynamics.
Real interest rate: The real interest rate is the rate of interest an investor expects to receive after allowing for inflation. It reflects the true purchasing power of the interest earned, distinguishing it from the nominal interest rate, which does not account for inflation. This concept is crucial for understanding capital markets and how interest rates influence investment decisions, borrowing costs, and overall economic activity.
Secondary market: The secondary market is a marketplace where previously issued financial securities, such as stocks and bonds, are bought and sold among investors. It provides liquidity to investors, allowing them to trade securities after their initial issuance in the primary market, which is crucial for determining the market price of these financial instruments.
Stocks: Stocks are financial instruments representing ownership in a corporation, giving shareholders a claim on part of the company’s assets and earnings. They are a crucial element in the economy, influencing corporate finance decisions, reflecting market efficiency, impacting capital markets and interest rates, and embodying the principles of asset pricing and risk-return tradeoffs.
Systematic risk: Systematic risk refers to the inherent risk associated with the overall market or economy that cannot be eliminated through diversification. It encompasses factors such as economic downturns, political instability, or changes in interest rates that impact all investments to varying degrees. Understanding systematic risk is crucial for assessing investment strategies and making informed financial decisions.
Yield Curve: The yield curve is a graphical representation that shows the relationship between interest rates and the time to maturity of debt securities, typically government bonds. It illustrates how yields vary across different maturities, which can provide insight into market expectations regarding future interest rates and economic activity. The shape of the yield curve can indicate investor sentiment, with upward slopes suggesting growth and downward slopes indicating potential recessions.
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