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Chapter 9

Chapter 9. The Financial System, Money, and Prices. Learning Objectives. Describe the role of financial intermediaries Differentiate between bonds and stocks Explain how their prices relate to interest rates

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Chapter 9

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  1. Chapter 9 The Financial System, Money, and Prices

  2. Learning Objectives • Describe the role of financial intermediaries • Differentiate between bonds and stocks • Explain how their prices relate to interest rates • Explain how the financial system improves the allocation of savings to productive uses

  3. Money in Economics • The term "money" in economics has a specific meaning different from every day use • To an economist • Your paycheck is income • The income you don't spend is savings • The increase in the value of your stock is capital gains • When your house appreciates, your wealth increases

  4. Financial System and Allocation of Saving • A successful economy uses its savings for investments that are likely to be the most productive • The interest on deposits is one important reason people put savings in banks • The financial system improves the allocation of saving • Provides information to savers about the possible uses of their funds • Help savers share the risks of individual investment projects • Risk sharing makes funding possible for projects that are risky but potentially very productive

  5. Banking System • Financial intermediaries are firms that extend credit to borrowers using funds raised from savers • Thousands of commercial banks accept deposits from individuals and businesses and make loans • Banks and other intermediaries specialize in evaluating the quality of borrowers • Principle of Comparative Advantage • Banks have lower cost of evaluating opportunities than an individual would • Banks pool the savings of many individuals to make large loans

  6. The Banking System • Having bank deposits makes payments easier • Checks • ATMs • Debit card • Checks and debit cards are safer than cash • Banks provide a record of your transactions

  7. Japanese Banking Crisis, 1990s • Japanese banks fell into severe trouble • Property values decreased and some loans on real estate went into default • Banks held stocks and the stock values decreased • In Japan, banks were the main way saving was translated into investment • Small- and medium-sized businesses suffered • Credit shortages prolonged the recession as businesses struggled to fund new projects

  8. Bonds • A bond is a legal promise to repay a debt • Each bond specifies • Principal amount, the amount originally lent • Maturation date, the date when the principal amount will be repaid • The term of a bond is the length of time from issue to maturation • Coupon payments, the periodic interest payments to the bondholder • Coupon rate, the interest rate that is applied to the principal to determine the coupon payments

  9. Bonds • Corporations and governments issue bonds • The coupon rate depends on • The bond's term • 30 days to 30 years; longer term, higher coupon rate • The issuer's credit risk • Probability the issuer will default on repayment • Higher risk, higher coupon rate • Tax treatment for the coupon payments • Municipal bonds are free from federal taxes • Lower taxes, lower coupon rates

  10. Bond Market • Bonds can be sold before their maturation date • Market value at any time is the price of the bond • Price depends on the relationship between the coupon rate and the interest rate. • A two-year government bond with principal $1,000 is sold for $1,000, 1/1/09 • Coupon rate is 5% • $50 will be paid 1/1/10 • $1,050 will be paid 1/1/11 • Bond's price on 1/1/10 depends on the prevailing interest rate

  11. Selling a Bond • Offer for sale: a government bond with payment of $1,050 due in one year • The competition: a new one-year bond with principal of $1,000 and coupon rate of 6% • Pays $1,060 in one year • Year-old bond with 5% coupon rate is less valuable than the new bond • Price of the used bond will be less than $1,000 (Bond price) (1.06) = $1,050 Bond price = $991 • Bond prices and interest rates are inversely related

  12. Stocks • A share of stock is a claim to partial ownership of a firm • Receive dividends, a periodic payment determined by management • Receive capital gains if the price of the stock increases • Prices are determined in the stock market • Reflect supply and demand

  13. FortuneCookie.com • New company with estimated dividend of $1 in 1 year • Selling price of stock will be $80 in 1 year • Interest rate is 6% • Value of the new stock is $81 in 1 year (Stock price) (1.06) = $81 Stock price = $76.42 • Value would be higher if • Dividend were higher • Price of stock in one year were higher • Interest rate were lower

  14. Risk Premium • Risk premium is the difference between the required rate of return to hold risky assets and the rate of return on safe assets • Suppose interest on a safe investment is 6% • FortuneCookie.com is risky, so 10% return is required • Stock will sell for $80 in 1 year; dividend will be $1 (Stock price) (1.10) = $81 Stock price = $73.64 • Risk aversion increases the return required of a risky stock and lowers the selling price

  15. Bond Markets and Stock Markets • Channel funds from savers to borrowers with productive investment opportunities • Sale of new bonds or new stock can finance capital investment • Like banks, bond and stock markets allocate savings • Provision of information on investment projects and their risks • Provide risk sharing and diversification across projects • Diversification is spreading one's wealth over a variety of investments to reduce risk

  16. Benefits of Diversification • Vikram has $200 to invest in stocks, each $100 • Buy 2 shares of either stock • 50% chance of $20 gain and 50% chance of $0 • Diversify and buy 1 share of each • One stock will be worth $100 and the other will be worth $110 • Return is $10 with no risk

  17. Rise and Fall of the US Stock Market • Standard & Poor's 500 index rose 60% between 1990 and 1995 • More than doubled 1995 – 2000 • Lost 40% of its value Jan 2001 – Jan 2003 • Returned to Jan 2000 level by Jan 2008 • Increase in stock prices can be due to • Increased optimism about future value • A fall in required return

  18. Rise and Fall of the US Stock Market • In the 1990s, optimism was high • Strong dividends • Promise of new technologies • Risk premium declined • Increased diversification through mutual funds • Investors may have underestimated risk • Optimism and risk premium trends reversed in 2000 • Many high-tech firms less profitable than expected • Corporate accounting scandals of 2002 • Terrorist attack in US

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