Lecture 3

Future value of money

1. Allocation of Funds and Interest Rates

2. The interest rate

3. Distinctions among valuation concepts

Research work

1. Financial planning: methods, principals, mechanisms.

2. Methods of profit forming and management.

The Secondary Market

Various security exchanges (фондов биржи) and markets facilitate the smooth functioning of the financial system. Purchases and sales of existing financial assets occur in the secondary market. Transactions in this market do not increase the total amount of financial assets outstanding (неоплаченный), but the presence of a viable secondary market increases the liquidity of financial assets and therefore enhances (усиливает) the primary or direct market for securities (цен бум). In this regard, organized exchanges, such as the New York Stock Exchange, the American Stock Exchange, and the New York Bond Exchange, provide a means by which buy and sell orders can be efficiently matched. In this matching, the forces of supply and demand determine price. In addition, the over-the-counter market (ОТC) (внебиржевой) serves as part of the secondary market for stocks and bonds not listed on an exchange as well as for certain listed.

Most corporate bonds and a growing number of stocks are traded OTC as opposed to (в отличие от) being traded on organized exchange. The OTC market has become highly mechanized, with market participant linked together by a telecommunications network. They do not come together in a single place as they would on an organized exchange. The National Association of Securities Dealers Automated Quotation Service (NASDAQ, pronounced "nas-dac") maintains this network, and price quotations are instantaneous (мгновенный). Whereas once it was considered a matter of prestige, as well as necessity in many cases, for a company to list its shares on a major exchange, the electronic age has changed that. Many companies now prefer to have their shares traded OTC, despite the fact that they qualify for listing, because they feel that they get as good or sometimes better execution of buy and sell orders.

Allocation of Funds and Interest Rates

The allocation of funds in an economy occurs primarily on the basis of price, expressed in terms of expected return. Economic units in need of funds must outbid (предл более высок цену) others for their use. Although the allocation process is affected by capital rationing (нормирование средств на инвестирование), government restrictions, and institutional constraints (ограничения), expected return (ожидаемая доходность) constitutes the primary mechanism by which supply and demand are brought into balance for a particular financial instrument across financial markets. If risk is held constant, economic units willing to pay the highest expected return are the ones entitled to the use of funds. If people are rational, the economic units bidding the highest prices will have the most promising investment opportunities. As a result, savings will tend to be allocated to the most efficient uses.

It is important to recognize that the process by which savings are allocated in an economy occurs not only on the basis of expected return but on the basis of risk as well. Different financial instruments have different degrees of risk. In order for them to compete for funds, these instruments must provide different expected returns, or yields(доходность). The higher the risk of a security, the higher the expected return that must be offered to the investor. If all securities had exactly the same risk characteristics, they would provide the same expected returns if markets were in balance. Because of differences in default risk, marketability, maturity, taxability, and embedded options (вложенный опцион), however, different instruments pose different degrees of risk and provide different expected returns to the investor.

Default Risk(кредитн риск). When we speak of default risk, we mean the danger that the borrower may not meet payments due on principal or interest. Investors demand a risk premium (or extra expected return) to invest in securities (цен бумаги) that are not default free. The greater the possibility that the borrower will default, the greater the default risk and the premium demanded by the marketplace. Because Treasury securities (гос цен бум) are usually regarded as default free, risk and return are judged in relation to them. The greater the default risk of a security issuer, the greater the expected return or yield of the security all other things the same

Marketability. The marketability(реализуемость) (or liquidity) of a security relates to the owner's ability to convert it into cash. There are two dimensions to marketability: the price realized and the amount of time required to sell the asset. These two are interrelated in that it is often possible to sell an asset in a short period if enough price concession is given. For financial instruments, marketability is judged in relation to the ability to sell a significant volume of securities in a short period of time without significant price concession. The more marketable the security, the greater the ability to execute a large transaction near the quoted price. In general, the lower the marketability of a security, the greater the yield necessary to attract investors. Thus, the yield differential between different securities of the same maturity is caused not by differences in default risk alone, but also by differences in marketability.

Maturity (срок погашения). Securities with about the same default risk, having similar marketability, and not faced with different tax implications can still trade at different yields. Why? Time' Is the answer The maturity of a security can often have a powerful effect on led return in yield The relationship between yield and maturity for securities differing only in the length of time (or term) to maturity is called the term structure of interest rates. The graphical representation of this relationship at a moment in time is called a yield curve.

The most commonly observed yield pattern is the positive (i.e., upward-sloping) yield curve—where short-term yields are lower than long-term yields. Most economists attribute the tendency for positive yield curves to the presence of risk for those who invest in long-term securities as opposed to short-term securities. In general, the longer the maturity, the greater the risk of fluctuation in the market value of the security. Consequently, investors need to be offered risk premiums to induce them to invest in long-term securities. Only when interest rates are expected to fall significantly are they willing to invest in long-term securities yielding less than short- and intermediate-term securities.

Taxability. Another factor affecting the observed differences in market yields is the differential impact of taxes. The most important tax, and the only one that we will consider here, is the income tax. The interest income (доход по процентам) on all but one category of securities is taxable to taxable investors. Interest income from state and local government securities is tax exempt (освобожден). Therefore, state and local issues sell in the market at lower yields to maturity than Treasury and corporate securities of the same maturity. For corporations located in states with income taxes, interest income on Treasury securities is exempt from state income taxes. Therefore, such instruments may hold an advantage over the debt instruments issued by corporations or banks because the interest they pay is fully taxable at the state level. Under present law, capital gains arising from the sale of any security at В profit are taxed at the ordinary tax rates for corporations, or at a maximum of 15 percent investor to obtain common stock. Other options include the, which enables a company to prepay its debt, and a sinking-fund provision, which allows a call feature (условие досрочного погашения займа) company to retire (выкупать) bonds periodically with cash payments or by buying bonds in the secondary market. If the investors receive options, the issuing company should be able to borrow at a lower interest cost. Conversely, if the issuing company receives an option, such as a call feature, the investors must be compensated with a higher yield.

Inflation. In addition to the preceding factors, which affect the yield of one security relative to that of another, inflation expectations have a substantial influence on interest rates overall. It is generally agreed that the nominal (observed) rate of interest on a security embodies a premium for inflation. The higher the expected inflation, the higher the nominal yield on the security; and the lower the expected inflation, the lower the nominal yield. Many years ago Irving Fisher expressed the nominal rate of interest (номинальная доходность) on a bond as the sum of the real rate of interest (i.e., the interest rate in the absence of price level changes) and the rate of price change expected to occur over the life of the instrument. If the annual real rate of interest in the economy was 4 percent for low-risk securities and inflation of 6 percent per annum was expected over the next 10 years, this would imply a yield of 10 percent for 10-year, high-grade bonds. (Note: It is the expected rate of inflation, not the observed or reported rate of inflation, that is added to the real rate of interest.) This states merely that lenders require a nominal rate of interest high enough for them to earn the real rate of interest after being compensated for the expected decrease in the buying power of money caused by inflation.