12.2 Capital markets and interest rates

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

• 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
• Efficient Market Hypothesis 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 (stocks) to investors
• Debt markets enable entities to borrow funds by issuing bonds 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
• Real interest rate accounts for inflation representing actual cost of borrowing or return on lending
• Nominal interest rate includes real interest rate and expected inflation described by Fisher equation: $i = r + \pi_e$
• 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

• Inflation expectations 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 (yield curve)
• 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
• Federal Funds Rate 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
• Systematic risk (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): $E(R_i) = R_f + \beta_i(E(R_m) - R_f)$
• 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: $Sharpe Ratio = \frac{R_p - R_f}{\sigma_p}$
• 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