OVERVIEW
Objective
¾
To understand the economic environment within which organisations operate.¾
To understand the financial environment in which financial management is practised.1
MACROECONOMIC POLICY
1.1
Definition
The setting of economic objectives by the government (e.g., full employment, economic growth, the avoidance of inflation) and the use of control
instruments to achieve those objectives (e.g. fiscal policy and monetary policy).
1.2
Objectives of macroeconomic policy
In economies such as that of the UK it is generally accepted that macroeconomic policies have been adopted in order achieve the following objectives:
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full employment;¾
economic growth and thereby improved living standards;¾
an acceptable distribution of wealth;¾
price stability and therefore limited inflation;¾
a solid balance of payments - a continual external deficit, where a country is importing more goods and services than it is exporting, is unsustainable and is likely to lead to an exchange rate crisis.The above objectives can often be in conflict, and therefore the achievement of them all at the same time is difficult. Economic growth can, for example, lead to excess demand for
resources and lead to an increase in inflation.
1.3
Recent performance of the UK economy
Macroeconomic policies adopted by governments may affect the business sector by altering both the costs and the level of demand a business may experience. Therefore in order for managers in industry to make effective policy decisions, they must understand current government economic policy and, due to the increasing interdependence of national economies through both the movement of trade and capital, world macroeconomic trends. Recent world economic events include:
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the growing importance of China and India in world trade;¾
the fall in the value of the US dollar ;¾
the launch of the European single currency – the Euro – in which UK is not currently participating.¾
the ‘dot.com bubble’ – following over-optimism by both business and investors of the potential returns from the high technology sector.In recent years the UK economy has experienced unemployment at a lower rate than the European average.
UK interest rates (set by an independent Bank of England) are historically also low but still above those of the European Central Bank. Inflation is also relatively low and some sectors of the economy are even under deflationary pressure.
2
MONETARY POLICY
2.1
Definition
Monetary policy can be defined as those actions taken by the government or the central bank to achieve economic objectives using monetary instruments. These actions may either directly control the amount of money in circulation (the money supply) or attempt to reduce the demand for money through its price (interest rates). For instance, if the rate of interest on funds is increased, the cost of borrowing is increased and therefore the demand for goods is decreased and the result of this tends to be a decrease in the rate of inflation. By exercising control in these ways governments can regulate the level of demand in the economy. Those who see the use of monetary policies as crucial in the control of macroeconomic activity are known as monetarists.
2.2
Direct control of the money supply
Governments or central banks can directly control the money supply in the following ways:
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Open market operations:If the central bank sells government securities the money supply is contracted, as some of the funds available in the market are “soaked up” by the purchase of the government securities. Equally, if the central bank were to buy back securities then funds would be released into the market. The sale of government securities will lead to a reduction in bank deposits due to the level of funds that have been “soaked up”. This in turn can lead to a further reduction in the money supply, as the banks’ ability to lend is reduced. This is known as the multiplier effect.
¾
Reserve asset requirements:The central bank can set a minimum level of liquid assets which banks must maintain. This limits their ability to lend and thereby reduces the money supply.
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Special deposits:¾
Direct control:The central bank may set specific limits on the amount which banks may lend.
Credit controls are difficult to impose effectively these days as, with fairly free international movement of funds, they can easily be circumvented. Hence credit control measures have not been used in UK recently.
2.3
Reducing the demand for money
Governments can reduce the demand for money, and therefore indirectly the money supply, by encouraging an increase in short-term interest rates. This has been the main way in which monetary policy has operated in the UK in recent years.
2.4
The problems of monetary policy
Problems arise due to the following:
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there is often a significant time lag between the implementation of a policy and its effects;¾
the ineffectiveness of credit control in the modern international economy;¾
the fact that the relationship between interest rates, level of investment and consumer expenditure is not actually stable and predictable;¾
the undesirable side effects of increasing interest rates: less investment, leading to reduced industrial capacity, leading to increased unemployment;
an overvalued currency which reduces demand for exports. The currency becomes overvalued since, if interest rates are higher than elsewhere, people want to invest in sterling and, as the demand for the currency rises, so does its value. However, once a currency is overvalued exports priced in sterling become more expensive to overseas customers and demand for such exports falls.
2.5
How the money supply may be measured
If governments are wanting to control the money supply it is necessary to be able to measure the supply of money in the economy.
A number of alternative indicators have emerged including the following: M0 Notes and coins in circulation and in banks’ tills.
M3 M0 plus deposits at banks.
M4 M3 plus deposits at building societies.
Whilst M5 may be the most suitable measure to use it is the hardest to control. Equally, whilst M0 is the easiest measure to control it is probably the least representative of overall economic activity. In recent times UK governments have attempted to monitor both M0 and M4.
3
FISCAL POLICY
3.1
Definition
Action by the government to achieve economic objectives through the use of the fiscal instruments of taxation, public spending and the budget deficit or surplus. Governments can use public expenditure and taxation to regulate the level of demand within the economy. Those who view fiscal policy as crucial in the control of macroeconomic activity are known as Keynesians.
3.2
The Keynesian approach
If the economy is in recession fiscal policy can be used to reflate the economy and the following actions could be taken:
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increase government spending in order to directly increase the level of demand in the economy; for instance, if a government agrees a number of large road-building projects, the demand for goods and services within the economy is increased;¾
reduce taxation in order to boost both consumption and investment. However, problems can occur due to the following:¾
government spending is an intervention into the free market and can easily lead to the misallocation of resources – e.g. support for inefficient industries;¾
there is often a significant time lag between the authorisation of additional spending and its actual occurrence;¾
tax cuts are not efficient at boosting domestic demand, as in times of recession some of the extra disposable income made available will be saved, and of the extra monies actually spent some of it will inevitably be on imports;¾
a large budget deficit is likely to occur which will lead to a large Public Sector Borrowing Requirement (PSBR);¾
the rate of inflation is likely to rise, as demand may increase for resources which are in limited supply and for which the prices will therefore tend to increase.If there is too much demand in the economy (it is overheating), then fiscal policy can be used to depress demand or deflate the economy, and the following actions could be taken:
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increase taxation in order to reduce consumption and to assist with the redistribution of wealth.However, problems can arise due to the following:
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it is not possible to cut government spending dramatically as some goods and services provided by government are unsatisfactorily provided for by the private sector;¾
increasing taxation discourages enterprise.Keynesians favour adjusting the level of government spending in preference to adjusting tax rates, as they believe it has a quicker and greater impact on the level of demand in the economy.
3.3
The relationship between fiscal and monetary policy
Fiscal and monetary policies are interdependent and governments will use both fiscal and monetary policies to achieve their monetary and budgetary targets. Which policies dominate depends on the economic theory preferred by the government of the day. In the UK there was a Keynesian approach to the management of the economy from the 1930s to the 1970s. However, this was believed to have contributed to the “boom-bust” economic cycles that were experienced. Hence recent governments have followed a more monetarist approach.
4
SUPPLY SIDE APPROACH
4.1
Definition
Supply side policies are policies which focus on creating the right conditions in which private enterprise can grow and therefore raise the capacity of the economy to provide the output demanded. The private sector, being driven by the profit motive, is deemed to be more efficient at providing the output required than the public sector.
4.2
Supply side policy examples
Supply side policies include:
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low tax rates to encourage private enterprise;¾
the promotion of a stable, low inflation economy with minimal government intervention;¾
limited government spending;¾
a balanced fiscal budget;¾
deregulation of industries;¾
an increase in the training and education of the workforce;¾
an increase in the provision of the infrastructure required by business – for example business parks;¾
a reduction in planning legislation.4.3
Supply side policies and fiscal policy
Supporters of supply side policies believe that, if business is to flourish, the economy must be in a stable condition and therefore fiscal policy should be in equilibrium. In other words, government spending should not exceed government receipts from taxation. Additionally, if the private sector is to be encouraged, tax rates should be kept to a minimum and
government expenditure also should be kept to a minimum.
4.4
Supply side policies and monetary policy
In order to provide the stable low inflation economy in which business can flourish, monetary policy is used to control inflation.
4.5
Problems with the supply side approach
Problems with using supply side policies include the following:
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there is a time delay before the policies have any impact;¾
the private sector will not provide all the goods and services required by society – for example health provision.5
INFLATION
5.1
Definition
The rate of increase of the general level of prices in the economy.
5.2
Measurement
The normal way of measuring inflation is to use the Consumer Price Index (CPI) which attempts to measure changes over time in the monetary cost of a representative “basket” of goods and services. The CPI relates to retail goods and services, and hence only gives a broad indication of how fast prices are rising across the economy. In the UK inflation was high in the 1970s and 1980s and has generally been low in the 1990s and early twenty-first century.
The maintenance of a low level of inflation is one of the government’s key economic objectives.
5.3
Causes of inflation
The following are considered to be the major causes of inflation by Keynesians:
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Demand-pull inflation:Inflation arises due to demand exceeding the maximum output of the economy with full employment.
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Cost-push inflation:Increases in the cost of raw materials or the cost of labour lead to increases in the unit costs of firms, and therefore inevitably leads to an increase in prices as these higher costs are passed on to the consumer. The increased costs suffered by industry may be as a result of the increase in the cost of imported goods, in which case the term imported cost-push inflation is used.
Monetarists, on the other hand, believe that inflation arises as a result of “too much money chasing too few goods”. Therefore, in the short term inflation should be controlled by controlling the money supply, whilst in the long term inflation should be controlled by enhancing the ability of the economy to produce the goods and services in demand. Inflation is also thought to be brought about by people’s expectations, as anticipation of future price increases is built into wage negotiations in order to protect future real incomes. In turn, expected increases in costs such as wage costs are built into output prices. This is sometimes known as the “wage-price spiral” and it suggests that inflation is ongoing and inevitable.
5.4
The general economic consequences of inflation
The general economic consequences of inflation include the following:
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The redistribution of income from those in a weak bargaining position, for example students, to those in a strong bargaining position who are therefore able to maintain the real value of their income;¾
A disincentive to save as the purchasing power of investments may be reduced;¾
Where inflation reaches very high levels money is no longer able to carry out its keyfunctions of being a medium of exchange and a store of value;
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A fall in the exchange rate;5.5
The consequences of inflation for companies
Inflation impacts upon companies in many ways and these are outlined below:
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Entrepreneurial activity is reduced as it is harder to estimate the likely returns from a new venture and higher interest rates make borrowing more expensive;¾
International competitiveness suffers where prices rise faster than those of foreign competitors;¾
Uncertainty is increased and hence new investment by existing businesses is reduced;¾
Higher interest rates reduce the number of profitable investment opportunities andtherefore the level of investment;
¾
In periods of rapid inflation the need to search for the best price currently available for the purchases required and the need to be constantly updating selling prices adds significant costs to industry.5.6
How does inflation distort the evaluation of business performance?
Conventional historic cost accounts have the following problems during periods of significant inflation:
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The current value of assets is ignored;¾
The historic cost of assets understates the value of the assets;¾
Changes in asset values are ignored until they are realised;¾
Gains arising from holding assets are treated as being fully distributable.The result of the above is that profits become overstated (current revenues are charged with a measure of historic cost), and capital becomes understated and therefore ROCE (return on capital employed) is also overstated.
Alternative approaches which have been suggested include the following:
¾
The valuation of assets at their deprival value;6
GOVERNMENT INTERVENTION IN THE ECONOMY
6.1
Why do governments intervene in the operation of the free market?
Governments intervene in the operation of the free market for the following reasons:
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Where monopolies, mergers or restrictive practices operate against the public interest;¾
Where there is a natural monopoly and competition is wasteful;¾
Where an industry is of key national strategic importance;¾
Where the free market creates social injustice;¾
Where companies fail to take account of the effect of their actions which impact outside of the company, these are known as “externalities”; a common example is the pollution which a company may cause;¾
Where the free market fails to provide sufficient public or merit goods, such as health care or education;¾
Where the free market is unable to provide the amount of capital required, e.g. when a large infrastructure project, such as the construction of a new tunnel or bridge, is being undertaken.6.2
Competition policy
Governments develop competition policies in order to increase the efficiency of the economy by stimulating competition.
The key components of competition policy in the UK have been as follows:
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Monopolies and mergers legislation - to prevent the development of monopolies which would have the power to act against the public interest;¾
Restrictive practices legislation - to eliminate practices such as the setting of retail prices by manufacturers;¾
Deregulation in certain industries - to remove regulations which restrict competition in the industry. An example of deregulation in the UK is that of the stock market which took place in 1986, causing dealing costs to reduce and therefore the volume of trading to increase greatly;¾
The creation of internal markets within certain areas of the public sector. Within both the health and education sectors operating units such as hospitals or schools must compete for the resources they require based on the services they provide to their users such as patients and students.6.3
Privatisation
A large number of state-owned firms have been sold to the private sector either by sale to the general public, direct sale to another company or management buy-out. Examples include British Telecom, British Gas and the electricity distribution companies.
The arguments in favour of privatisation include:
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an increase in competition where a state monopoly is split into a number of operating companies prior to sale or where the monopoly position is removed;¾
a short-term boost to government revenues and therefore a favourable impact on the PSBR;¾
a widening of share ownership, thereby increasing individuals’ stake in the economy as a whole;¾
reduction in the PSBR in future as borrowings by the newly-privatised industries are no longer public borrowings.The arguments against privatisation include:
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many privatisations have replaced state monopolies with private sector monopolies, which have then required regulation to ensure that their monopoly position is not abused;¾
the breaking-up of large businesses into smaller companies results in the loss of economies of scale;¾
the quality of service may deteriorate.6.4
Other government intervention
Governments also intervene in the economy through the use of official aid schemes. These aid schemes include the use of cash grants, consultancy advice and tax incentives in order to encourage investment in high technology or investment in areas of particularly high
unemployment.
Grants are also available from European Institutions. For example, the European Regional Development Fund has assisted with many infrastructure projects in the remoter regions of the UK.
7
THE EURO
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From 1 January 1999 the Euro has operated as a common currency across a number of European countries.¾
From 1 January 2002 Euro notes and coins replaced the national currencies of Euro-block countries.¾
Although the UK has not yet joined the single currency, UK companies that have a foreign parent company may be asked to do business in Euros. Such companies therefore face foreign exchange risk as sterling rises and falls against the Euro. Such transaction exposure can be hedged.¾
The introduction of the Euro allows easier comparison of prices between member countries. This should reduce price differentials in Europe and increase competition.¾
If the UK decides to join the Euro then UK interest rates will fall towards those in the Euro region. This will have implications for company finance as debt becomes cheaper.¾
Within the Euro region there is also a move towards tax harmonisation e.g. introducing the same corporation tax rates across the area. This obviously has implications for financial management e.g. project appraisal.8
FINANCIAL INTERMEDIARIES
8.1
Definition
Organisations which bring together potential lenders and potential borrowers. The following financial institutions act as financial intermediaries:
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Commercial clearing banks found on the high street of most towns.¾
The National Savings Bank operated by the Post Office.¾
Merchant banks, which provide banking services, including advice on items such as share issues and mergers, for business customers.¾
Building societies, which take deposits from the domestic sector and lend to those buying their own house.¾
Insurance companies, which can invest much of their premium income in long-term assets, as their outgoings are reasonably easy to predict.¾
Investment and unit trusts, which attract investors and then reinvest the funds raised in other companies.¾
Pension funds, which receive regular premiums and thus have predictable cash outflows and can invest in the long term.¾
Finance companies, which provide business and domestic credit, leasing finance and factoring/invoice discounting services. These companies are very often a subsidiary of another financial institution.8.2
The role of financial intermediaries
Financial intermediaries are important as they carry out the following roles:
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Small deposits are combined and lent to large borrowers. (Aggregation).¾
A continuing stream of short-term deposits can be used to lend monies in the long term. (Maturity transformation).¾
The risk of each particular borrower is effectively spread across many lenders.¾
The off-setting of financial risk by the use of hedging in, for example, foreign currency transactions.¾
Providing a liquid market with flexibility and choice for both lenders and borrowers.9
THE COMMERCIAL CLEARING BANKS
The commercial clearing banks carry out the following roles:
¾
They accept deposits from their customers which are held in current or deposit accounts. Certificates of Deposit, which may be traded, relate to large deposits which have a term to maturity of at least three months. These deposits are the liabilities of the banks.¾
They lend money in a number of different ways, thus ensuring that adequate returns are made. At the same time some cash must be held in order to ensure that sufficient liquidity is maintained. Banks therefore have to find the right balance betweenprofitability and liquidity. These loans and cash balances held comprise the assets of the banks.
¾
They provide a money transmission service through the clearing system. Bank lending takes the following forms:¾
Overdraft facilities and term loans to individuals and business customers.¾
Investments in other financial intermediaries, such as leasing companies.¾
The purchase of short-term government securities.¾
The purchase of trade or commercial bills.10 CREDIT CREATION
Banks need to keep only a small proportion of their assets in the form of cash as only a small proportion of their depositors will require repayment on any particular day. The rest of their assets can be in the form of investments with which the bank hopes to make the returns required by their shareholders.
As previously stated a major form of investment for the bank will be loans to customers. Hence, if a bank has $10,000 deposited with it and it only needs to maintain 12% of its funds as cash, then the bank is able to invest up to $10,000 × (1 – 0.12) = $8,800. Let us assume that this investment is made in the form of a loan to a customer and that the full $8,800 is loaned. Consider now the total funds available in the market. It will be seen that the initial depositor will be able to call on and spend the original $10,000 and that the borrower has the ability to spend $8,800. Thus in total $18,800 is available to be spent.
This process can be repeated as the $8,800 in circulation is likely to be spent and finally deposited back with a bank, which will then be able to loan up to $8,800 × (1 – 0.12) = $7,744, thus creating additional credit.
This process is known as the “multiplier effect”.
The proportion of deposits that a bank retains as cash or other very liquid assets is known as the “liquidity ratio” or “reserve asset ratio”. Where the liquidity ratio is known, the
following formula can be used to determine the total final deposits and hence the credit created from an initial deposit:
Final deposits = Initial deposit ×
ratio Liquidity
1
Credit created = Final deposits – Initial deposit Using the figures in the above illustration:
Final deposits = $10,000 ×
12 .
01 = $83,333 Credit created = $ (83,333 – 10,000) = $73,333
11 THE FINANCIAL MARKETS
The financial markets include both the capital markets and the money markets. The following activity takes place on these markets:
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Primary market activity – the selling of new issues to raise new funds.¾
Secondary market activity – the trading of existing financial instruments.11.1 The capital markets
The main capital markets are:
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The Official List at the London Stock Exchange.¾
The Alternative Investment Market (AIM), which has fewer regulations and less cost than the Official List and is therefore attractive to smaller companies.¾
The Eurobond market where bonds denominated in any currency other than that of the national currency of the issuer are traded. Eurobonds are generally issued by large international companies and have a 10 to 15 year term.Capital markets exist in many other countries, and large international companies may trade and raise funds in more than one capital market. In the US the NASDAQ market was set up in order to provide a market where rapidly expanding, high technology and generally high-risk companies could raise funds: “The Stock Market for the twenty-first century”.
Following the success of the NASDAQ market a similar market was set up in Europe and is known as the EASDAQ market.
These markets provide long-term capital in the form of equity capital, ordinary and preference shares for example, or loan capital such as debentures. Companies requiring funds for five years or more will use the capital markets.
11.2 The money markets
The money market is not actually a physical market but is the term used to describe the trading between financial institutions, primarily done over the telephone. The main areas of trading include:
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The discount market – where bills of exchange are traded.¾
The inter-bank market – where banks lend each other short-term funds.¾
The Eurocurrency market – where banks trade in all foreign currencies, usually in the form of certificates of deposit. The need for this trading arises when, for instance, a UK company borrows funds in a foreign currency from a UK bank.¾
The certificate of deposit market – where certificates of deposit are traded.¾
The finance house market – where short-term loans raised by finance houses are traded.¾
The Commercial Paper market – commercial paper is short-term unsecured debt issuedby high quality companies.
These markets are for short-term lending and borrowing where the maximum term is normally one year.
Companies requiring medium term (one to five years) capital will generally raise these funds through banks.
12 STOCK EXCHANGE OPERATIONS
12.1 The functions and purpose of the Stock Exchange
The primary function of the Stock Exchange is to ensure a fair, orderly and efficient market for the transfer of securities, and the raising of new capital through the issue of new
securities. In order to do this the Stock Exchange has stringent regulations which are designed to ensure that:
¾
only suitable companies are allowed to have their securities traded on the Stock Exchange;¾
all relevant information is made publicly available as soon as possible – in this way investors can make informed decisions and thus that funds will be attracted to the most successful companies;¾
all investors deal on the same terms and at the same prices.The more efficient and fair the Stock Exchange is seen to be, the more willing people will be to invest their money in the Exchange and the more successful it will become.
12.2 Who owns shares?
Since the Second World War the importance of the private investor has declined and the importance of the institutional investor, for instance pension funds, has risen. Since 1979 it has been government policy to encourage private share ownership, the privatisation
programme reflected this in that private investors were given priority. However, it is estimated that only about 25% of shares are held by private investors and only about 5% of individuals hold a reasonable portfolio of shares.
12.3 How are shares bought and sold?
Most trading is done over the telephone and once a market maker strikes a bargain, that bargain falls due for settlement in ten days’ time. This is known as the rolling settlement system.
12.4 How are shares valued?
Shares are valued using market forces at the price at which there are as many willing sellers as there are willing buyers. For instance, if a share is overvalued there will be more people keen to sell their holding than there will be willing to buy, and this will inevitably depress the market price.
Some trading will be done for speculative reasons:
A “bull” is someone who believes that prices will rise. He buys shares in the hope of selling them in the future for a profit.
A “bear” is someone who believes prices will fall. He sells shares in the belief he will be able to buy them back later for less.
When there are more bulls than bears prices will rise, and when there are more bears than bulls prices will fall.
Such speculative dealing has an important role as:
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it reduces fluctuations in the market; for instance, as the market falls and prices fall, more and more speculators will become “bullish” and start to buy again, thus arresting the fall in the market¾
it ensures that there is always a ready market in all shares; in other words, there will always be someone willing to buy or sell at the right price.13 FINANCIAL MARKET EFFICIENCY
13.1 Introduction
An efficient market is one in which the market price of all securities traded on it reflects all the available information. A perfect market is one which responds immediately to the information made available to it.
An efficient and perfect market will ensure that quoted share prices are as fair as possible, in that they accurately and quickly reflect a company’s financial position with respect to both current and future profitability.
Efficiency can be looked at in several ways:
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Allocative efficiency:¾
Operational efficiency:Does the market have low transaction costs and a convenient trading platform? These promote a ‘deep’ market with high liquidity i.e. a high volume of transactions.
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Informational efficiency:Is all relevant information available to all investors at low cost?
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Pricing efficiency:Do share prices quickly and accurately reflect all known information about the company? This is also referred to as “information processing efficiency”.
13.2 The Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) considers information processing efficiency/pricing efficiency. In order to test this hypothesis three potential levels of efficiency are considered.
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Weak-form efficiency:Share prices reflect all the information contained in the record of past prices. Share prices will follow a “random walk”.
If this level of efficiency has been achieved it should not be possible to forecast price movements by reference to past trends i.e. “chartists” (also known as technical analysts) should not be able to consistently out-perform the market.
¾
Semi-strong form efficiency:Share prices reflect all information currently publicly available. Therefore the price will alter only when new information is published.
If this level of efficiency has been reached, price movements can only be forecast by using “inside” information i.e. material non-public information. This is known as insider trading which is illegal in most markets and is unethical in all markets.
¾
Strong-form efficiency:Share prices reflect all information, published and unpublished, that is relevant to the company.
13.3 The implications for financial managers
The level of efficiency of the stock market has implications for financial managers:
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The timing of new issues:Unless the market is fully efficient the timing of new issues remains important. This is because the market does not reflect all the relevant information, and hence advantage could be obtained by making an issue at a particular point in time just before or after additional information becomes available to the market.
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Project evaluation:If the market is not fully efficient, the price of a share is not fair, and therefore the rate of return required from that company by the market cannot be accurately known. If this is the case, it is not easy to decide what rate of return to use to evaluate new projects.
¾
Creative accounting:Unless a market is fully efficient creative accounting can still be used to mislead investors.
¾
Mergers and takeovers:Where a market is fully efficient, the price of all shares is fair. Hence, if a company is taken over at its current share value the purchaser cannot hope to make any gain unless economies can be made through scale or rationalisation when operations are merged. Unless these economies are very significant an acquirer should not be willing to pay a significant premium over the current share price.
¾
Validity of current market price:14 MONEY MARKET INTEREST RATES
14.1 Introduction
Different financial instruments offer different interest rates. In order to understand why this is, it is necessary to appreciate the factors which determine the appropriate interest rate for a particular financial instrument.
14.2 Factors determining interest rates
The factors which determine interest rates include:
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The general level of interest rates in the economy:These are affected by:
Inflation.
Government monetary policy. The demand for borrowing. Investors’ preference for cash.
International factors such as interest rates overseas and exchange rate movements.
¾
The level of risk:The higher the level of risk the greater return an investor will expect.
¾
The duration of a loan:If it is assumed that in the long-term interest rates are expected to remain stable then the longer the length of the loan the higher the interest rate will be. This is quite simply because lending money in the longer term has additional risk for the lender as for instance the risk of default increases.
¾
The need for the financial intermediaries to make a profit:For instance, a depositor at a building society will receive a lower rate of interest than a borrower will be charged.
¾
Size:14.3 Term Structure of Interest Rates
The return provided by a security will alter according to the length of time before the security matures.
If, for example, a graph is drawn showing the yield to maturity/redemption yield of various government securities against the number of years to maturity, a “yield curve” such as the one below might result.
Yield
Years to maturity
It is important for financial managers to be aware of the shape of the yield curve, as it
indicates to them the likely future movements in interest rates and hence assists in the choice of finance for the company.
The shape of the curve can be explained by the following:
¾
Expectations theory:If interest rates are expected to increase in the future, a curve such as that above may result. The curve may invert if interest rates are expected to decline. Everything else being equal, a flat curve would result if interest rates are not expected to change.
¾
Liquidity preference theory:¾
Segmentation theory:Different investors are interested in different segments of the yield curve. Short-term yields, for example, are of interest to financial intermediaries such as banks. Hence the shape of the yield curve in that segment is a reflection of the attitudes of the investors active in that sector. Where two sectors meet there is often a disturbance or apparent discontinuity in the yield curve as shown in the above diagram.
This can also be referred to as “preferred habitat theory” i.e. different investors have a preference for being in different segments of the yield curve.
Pension fund managers often have a preference for investing in long-dated bonds – to match against the long term liabilities of the fund. This can drive up the price of long-dated bonds which brings down their yield, possibly resulting on an ‘inversed’ (falling) yield curve
¾
RiskOn high quality government/sovereign debt e.g. UK Gilt-Edged Securities (‘Gilts’) the risk of default is not significant even for long-dated bonds.
However default risk may be more significant on corporate debt, therefore the corporate yield curve may rise more steeply than the government yield curve.
Key points
³
Ensure you can discuss how changes in economic conditions e.g. inflation affect business³
The impact of government policy on business is also important e.g. competition policyFOCUS
You should now be able to:
