Chapter 30 - The basics of finance. After studying this chapter you will be able to understand: How to define financial markets and the market for loanable funds? What factors affect supply and demand for loanable funds? What differences exist between debt, equity, and their associated assets?...
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Chapter 30
The Basics of Finance
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• How to define financial markets and the market
for loanable funds
• What factors affect supply and demand for
loanable funds
• What differences exist between debt, equity, and
their associated assets
• What the main institutions are in financial
markets
• What the risk-return trade-off is in financial
assets
• Why savings equals investment in a closed
economy
What will you learn in this chapter?
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• A financial marketis a market in which people
trade future claims on funds or goods
• These “claims” can take many different forms
– When you get a loan, the bank gives you money
now in return for repayment in the future.
– Buying a company stock today gives you a right to
a share of profits in the future.
– When you purchase insurance, you pay premiums
now in return for the right to submit a claim for
compensation in the future.
The role of financial markets
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• People with spare funds don’t always have the
most valuable way to spend them
• Financial markets allow funding to flow to the
places where it is most highly valued
• A well-functioning market matches buyers and
sellers, who can both gain from trade
– Buyers want to spend funds on something valuable
now.
– Sellers let others borrow funds for a price.
The role of financial markets
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• Currentfinancial markets are extremely
complicated
• The origins of financial markets are not as
complicated
• At the fundamental level, financial markets
start with a bank, savers, and borrowers
– Savers earn more now than they need to spend.
– Borrowers need to spend more now than they
earn.
A whirlwind history of banks
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savers and borrowers.
when and where you want it.
liquidity.
diversify risk.
A whirlwind history of banks
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• Real-world financial markets involve many
products with different prices
• This analysis simplifies all savings and
borrowing into one market with one price
• The market for loanable fundsis a market in
which savers supply funds to those who want
to borrow
– “Loanable funds” are the dollars that are available
between lenders and borrowers.
The market for loanable funds:
A simplified financial market
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• Savingsis the portion of income that is not
immediately spent on consumption of goods
and services
– The supply of loanable funds comes from savings.
• Investmentis spending on productive inputs
– Productive inputs include factories, machinery, and
inventories.
– The demand for loanable funds comes from
investment.
Loanable funds: Savings and investment
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1 A young couple takes out a
mortgage to buy a new house
2 You loan money out to a family
member
3 You deposit 50% of your paycheck
into your checking account
4 A local restaurant takes out a small
business loan to expand to a new
location
Active Learning: Savings and investment
Classify each of the following as either savings or
investment
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• The quantity of savingsthat people are willing
to supply depends on the price they receive
• The quantity of investment funding that
people demand depends on the price they
must pay
• The interest rateis the price of borrowing
money for a specific period of time
– It is expressed as a percentage per dollar borrowed
per unit of time.
The price of loanable funds
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The intersection of the demand and supply curves determines
t he equilibrium interest rate and quantity of loanable funds.
The price of loanable funds
Investment Savings
Q*
r*
Interest rate
Quantity of dollars
The market for loanable funds • Savings is upward sloping.
– Suppliers are willing to provide additional funds at higher interest rates.
• Investment is downward sloping.
– Demanders are willing to borrow less
at higher interest rates.
• The equilibrium is where savings intersects investment Establishes:
– Equilibrium interest rate.
– Amount of money traded in the market.
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people want to save and invest change
over time and between countries.
demand in the market for loanable funds.
interest rate and quantity changes.
Changes in the supply and demand
for loanable funds
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A change in the underlying determinants of savings
shifts the supply for loanable funds.
Determinants of savings
S 2
Q2
r2
Interest rate
I
S 1 r1
Q1
Quantity of dollars
supply of loanable funds are:
– Culture.
– Social welfare policies.
– Wealth.
– Current economic conditions.
– Expectations about future economic conditions.
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• In the early 1980s, the savings rate in the United States was 8 to 10 percent.
• The savings rate decreased steadily to 2 percent in the mid-2000s
• After the housing market crash, the savings rate jumped by 4 percent.
Determinants of savings
Jan 0.0
2.0
4.0
6.0
8.0
10.0
12.0
1980 1985 1990 1995 2000 2005
2007 Jun 2008 Oct 2009 March 2010 Jan 2012
Personal savings rate (%)
Annually Quarterly
Savings rates in the United States since 1980
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• Investment decisions are based on the
trade-offbetween the potential profits and the costs
of borrowing
• Expectationsabout the future profitability of
current investments adjusts the level of
investment
• Crowding outis the reduction in private
borrowing caused by an increase in
government borrowing
Determinants of investment
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Depending on the willingness to invest, the demand curve shifts.
Determinants of investment
1
Q2
r2
I2
r
I2
Q2
r2
Interest rate
I1
S
1
Q1
Quantity of dollars
Interest rate
I1
S
r
Q1 Quantity of dollars
• If there is a higher willingness to invest at
every interest rate, the demand for
investment increases.
• Interest rate and quantity of loanable
funds traded increases.
• If there is a weak economy, people are less willing to make new investments.
• The demand for investment decreases.
• Interest rate and the quantity of loanable funds traded decrease.
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What does the market for loanable funds predict
will happen to interest rates during an
expansion?
Active Learning: Market for loanable funds
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For each of the following scenarios, indicate the effect
on the interest rate (increase or decrease) and quantity
of loanable funds traded (increase or decrease).
Active Learning: Shifts in savings and
investment
Situation
Change in interest rate
Change in quantity of loanable funds traded
An inventor’s new idea increases
the demand for loanable funds.
There is a fall in private savings.
A change makes people want to
invest less.
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paid by all prospective borrowers.
differences in interest rates.
1 The loan term: The opportunity cost of
lending money
2 The riskiness of the transaction: A default
occurs when a borrower fails to pay back a
loan according to the loan terms
A price for every borrower: A more realistic
look at interest rates
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• The risk of a borrower defaulting on a loan is
referred to as credit risk
• The risk-free rateis the interest rate that
would prevail if there were no risk of default
• Credit risk is measured against the risk-free
rate
– The risk premium is the difference between the
risk-free rate and the interest rate an investor must
pay.
A price for every borrower: A more realistic
look at interest rates
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• A financial systemrepresents the markets
where financial products are traded
• It is a group of institutions that brings
together savers, borrowers, investors, and
insurers
money and risk
The modern financial system
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• There are several ways that financial
institutions help fill the three basic roles of
financial markets
– Match buyers and sellers: Financial intermediaries
channel funds from people who have them to
people who want them.
– Provide liquidity: Liquidityis a measure of how
easily an asset can be converted quickly to cash.
– Diversify risk: Diversificationis when risks are
shared across many different assets or people.
Functions of the financial system
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• The financial system fulfill its roles of
intermediation, providing liquidity, and
diversifying risk by creating financial assets that
can be bought and sold
• For example, owning part of a company permits
the holder to have a share in its profits, or an
equity stake in the company
– A stockis a financial asset that represents partial
ownership of a company.
– Stockholders are entitled to receive a portion of a
company’s profits.
– A dividendis a payment made periodically to all
shareholders of a company.
Major financial assets: Equity
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• A loanis issued when a lender provides funds
to a borrower in exchange for future
repayment of the amount loaned plus interest
– Loans are generally less risky and less rewarding
than buying a stock.
• A bondis a form of debt where the bond issuer
promises to repay the loan plus scheduled
interest payments
– The interest payments on bonds are called
coupons.
Major financial assets: Debt
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• Derivativesare financial assets that are
based on the value of some other asset
is a futures contract
–The buyer of a futures contract agrees to pay the
seller based on the future price of some asset
–Futures contracts allow sellers to transfer risks
relating to future prices to the contract partner
Major financial assets: Derivatives
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not exist without four key players.
1 Banks and other financial intermediaries
2 Savers and their proxies:
– A mutual fundis a portfolio of stocks and other
assets managed by a professional who makes
decisions on behalf of clients.
– Apension fund is a professionally managed
portfolio intended to provide income to retires
Major players in the financial system
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3 Entrepreneurs and businesses:
– They are often looking to borrow money to
finance their latest ventures.
– Without these borrowers, much of the financial
system would not exist.
4 Speculators:
– A speculator is anyone who buys and sells financial
assets purely for financial gain.
Major players in the financial system
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The basic trade-off in valuing any asset is between
risk and return
Valuing Assets: The trade-off between risk
and return
Cash
Inflation
-linked
bonds
U.S.
fixed-income
bonds
Real estate
Commodities
Developing-country equities U.S.
equities
Wealthy non-U.S country equities
Privately held equities Expected annual return (%)
Expected risk
Risk and reward of various financial assets
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• There are several ways to classify risk:
–Market (systemic) riskrefers to risk that is broadly
shared by the entire market or economy.
–Idiosyncratic riskrefers to risk that is unique to a
particular company or asset.
• Standard deviationis a measure of how spread
out a set of numbers are
– This is the most commonly used measure of risk in
financial markets
Valuing Assets: The trade-off between risk
and return
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• The principle of asset valuation assists savers to
decide on which assets to purchase
• There are three basic approaches used to pick
stocks that are most likely to increase in value
1 Fundamental analysis: Estimate how much money a
company will earn in the future.
• The net present value (NPV)is a measure of the current value
of a stream of expected future cash flows.
2 Technical analysis: Analyze movements in a stock’s
prices to predict future movements.
3 Throw a dart: Make a list of all stocks, pin it to a wall,
and throw a dart at it.
Predicting returns: The efficient-market
hypothesis
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• The efficient-market hypothesisstates that
market prices always incorporate all available
information, and therefore represent stock
value as correctly as possible
– This idea underlies the dartboard approach.
– Fundamental and technical analysis only work if
the current price differs from the “correct” price.
• Arbitrageis the process of taking advantage of
market inefficiencies to earn a profit
Predicting returns: The efficient-market
hypothesis
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• Private savingsrefers to the savings of
individuals or corporations within a country:
Income = Consumption + Savings
• Individuals earn money when people buy goods
and service from them:
Consumption + Investment = Income
• Combining the above equations yields:
Savings = Investment
• This is the savings-investment identity
A national accounts approach to finance:
The savings-investment identity
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• Government budget surplus is another form of
saving, and government budget deficit is a
form of dissaving
–Public savingsis the difference between government
tax revenue and government spending.
• National savingsis equal to private and public
savings
• Incorporating government spending and saving
into the savings-investment identity yields:
Investment = National Savings
Private savings, public savings, and capital
flows
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• A closed economy is an economy that does not
interact with other countries’ economies
– The identity between national savings and
investment holds only in a closed economy.
• An open economyis when an economy
interacts with other countries’ economies
– When money moves across borders, there can be a
capital outflow or capital inflow.
– The difference between capital inflows and capital
outflows is the net capital flow.
Private savings, public savings, and capital
flows
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• A financial market is where people trade future
claims on funds or goods
– The market acts as intermediary between savers
and borrowers.
– The market provides the benefits of liquidity and
helps savers and borrowers diversify risk.
• The market for loanable funds brings together
those looking to lend money and those looking
to borrow money
Summary
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• The price in the market for loanable funds is
the interest rate
• The major types of financial assets are debt
and equity
• People interact with banks and other individual
actors, such as mutual funds, in financial
markets
• There is a direct relationship between risk and
reward in the financial market
Summary
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• The efficient-market hypothesis states that
market prices incorporate all available
information
– Therefore, accurately predicting stock returns is
impossible.
• Savings equals investment in a closed
economy
– This relationship is called the savings-investment
identity.
Summary