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Lecture 9

Lecture 9. Chapter 11: Financial Markets. Introduction. The stock market boom included sound investment decisions and speculation (gambling). The role of financial markets is to ensure national saving is allocated to the most productive uses.

vernon-stafford
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Lecture 9

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  1. Lecture 9 Chapter 11: Financial Markets

  2. Introduction The stock market boom included sound investment decisions and speculation (gambling). The role of financial markets is to ensure national saving is allocated to the most productive uses. Some serious problems appeared in the U.S. and global financial system in 2007 and 2008

  3. The Financial System and theAllocation of Saving to Productive Uses • Key Components of Economic Growth • Savings must flow to most productive investments

  4. The Financial System and theAllocation of Saving to Productive Uses • The U.S. financial system: • Is a decentralized market oriented system. • Includes financial institutions and financial markets.

  5. The Financial System and theAllocation of Saving to Productive Uses • Financial System • Provides information • Helps savers share the risk • The Banking System • Banks are a financial intermediary between savers and borrowers. • Financial Intermediaries • Firms that extend credit to borrowers using funds raised from savers

  6. The Financial System and theAllocation of Saving to Productive Uses • The Banking System • By acting as a financial intermediary, banks can increase the efficiency of the capital market in several ways: • Specialize at rating credit • Pool savings… giving larger loans • Specialize in business or consumer loans • Services to savers to attract deposits

  7. The Financial System and theAllocation of Saving to Productive Uses • Economic Naturalist • How has the banking crisis in Japan affected the Japanese economy? • 1980s • Japanese banks made loans in the bullish real estate market and acquired stock in corporations.

  8. The Financial System and theAllocation of Saving to Productive Uses • Economic Naturalist • How has the banking crisis in Japan affected the Japanese economy? • 1990s • Real estate prices plummeted and many borrowers defaulted on their loans. • Falling stock prices reduced the value of the banks’ shareholdings

  9. The Financial System and theAllocation of Saving to Productive Uses • Economic Naturalist • How has the banking crisis in Japan affected the Japanese economy? • “Credit crunch” occurred and small businesses could not get loans • Japan relies more on the banking system to allocate savings than the U.S. • Japan fell into a severe recession • Slow regulatory response by the Japanese government

  10. The Financial System and theAllocation of Saving to Productive Uses • Bond • A legal promise to repay a debt, usually including both the principal amount and regular interest payments • Corporations and governments sell bonds to raise funds.

  11. The Financial System and theAllocation of Saving to Productive Uses • Principal Amount • The amount originally lent • Also called Face or Par Value • Maturation or Maturity Date • The date at which the principal will be repaid

  12. The Financial System and theAllocation of Saving to Productive Uses • Coupon Rate • The interest rate promised when a bond is issued (Multiplied by the face value of the bond) • Coupon Payments • Regular interest payments made to the bondholder • In practice, typically issued quarterly, but we will just be looking at the annual coupon rate

  13. The Financial System and theAllocation of Saving to Productive Uses • Bonds -- An Example • Principle amount of a bond = $1,000 • Maturation date = January 1, 2025 • Coupon rate = 5% • Annual coupon payment = (0.05)($1,000) = $50

  14. Different Types of Bonds • Zero-Coupon Bonds • Treasury Bills and Short-term lending • Coupon rate = 0% • Discount Bond • Treasury Notes, Corporate, Municipal Bonds • May issue coupons, but priced below “par” • Premium Bond • May issue coupons, but priced above “par” • Par Bond • Priced at par • Typically issue coupons

  15. The Financial System and theAllocation of Saving to Productive Uses • Bonds • The greater the risk of default, typically calls for a higher coupon rate. • Municipal bonds are exempt from federal taxes and have a lower coupon rate. • Bondholders may sell their bonds at any time in the bond market at their market price. • (As long as the bond is standardized and a market exists for the bond)

  16. Example • Bond prices and interest rates • Jan 1, 2006 purchase a 2 year government bond • Principle amount = $1,000 • Coupon rate = 0.05 • Coupon payment = $1,000 x 0.05 = $50 (Jan 1, 2007) • At maturity: $1,000 + $50 = $1,050 (Jan 1, 2008) • Return on original investment? • $1000 is original investment amount • You gain $50 after one year, and $50 after the second year. After the second year you receive the $1000 in principle • ((1000+50+50)-1000)/1000 x 100 = 10% over 2 years or 5% ANNUALLY • If original prevailing interest rate is 5%, then the price of the bond will be $1,000 (or PAR)

  17. Example • Bond prices and interest rates • Want to sell the bond on Jan 1, 2007 • If you could sell the bond, the recipient (buyer) would want the prevailing interest rate. • The buyer is going to receive a $50 coupon in 1 year, along with $1,000 in principle. How much would they pay for this cash flow? • The prevailing interest rate = 6% • Bond price x 1.06 = $1,050 • Bond price = $1,050/1.06 = $991 • The prevailing interest rate = 4% • Bond price = $1,050/1.04 = $1,010

  18. Example • Bond prices and interest rates • RETURN for you? The original investor • If interest rates rose from 5% to 6%, you paid $1000 up front, and receive a $50 coupon, and $991 from selling the bond • (1041-1000)/1000 x 100 = 4.1% • If interest rates fell, you paid $1000 up front, receive a $50 coupon, and $1,010 from the sale • (1060-1000)/1000 x 100 = 6.0% • Lesson? • If you own bonds, rising rates are bad for you • Falling rates are good for you. The bond you hold, has high interest coupons.

  19. The Financial System and theAllocation of Saving to Productive Uses • Stock (or equity) • A claim to partial ownership of a firm • Two sources of return to stockholders • Dividend • A regular payment received by stockholders for each share that they own. (Usually paid quarterly but quoted in annual rates) • Capital gain • The difference between the purchase price and selling price, when the selling price is higher • Capital loss if selling price is lower.

  20. The Financial System and theAllocation of Saving to Productive Uses • Example • How much should you pay for a share of FortuneCookie.com • Dividend = $1.00/share in one year • Price/share = $80 in one year • This is what you believe the price will be • Each share will be worth $81 in one year • Rate of return = 6% • This is the rate of return that you EXPECT to get

  21. The Financial System and theAllocation of Saving to Productive Uses • Example • How much should you pay for a share of FortuneCookie.com • Stock price x 1.06 = $81 • Stock price = $81/1.06 = $76.42 • You would pay $76.42 TODAY, for a stock that gives you $1 in dividends, and could be sold for $80 in one year. • Problem… what makes you think you can sell it for $80 in one year? • Another problem… Dividends aren’t like coupons • However, most companies issues constant dividends • If dividend = $5, stock price = $85/1.06 = $80.19

  22. The Financial System and theAllocation of Saving to Productive Uses • Observations • An increase in future dividends or future stock prices will raise the price of the stock today. • An increase in required rate of return will lower today’s stock price. • REMEMBER OPPORTUNITY COST… If the return on other assets is rising, then the price of a stock with constant returns would fall • Many different ways to price a stock

  23. The Financial System and theAllocation of Saving to Productive Uses • Observations • The uncertainty of future earnings and dividends increases the risk of purchasing a stock. • Stock market investors account for this risk by requiring a higher rate of return or risk premium. • Many difficulties estimating the value for this risk premium

  24. Bond Markets, Stock Markets, and the Allocation of Savings • The Information Role of Bond and Stock Markets • In order to gain high rates of return, investors must closely scrutinize potential borrowers. • Risk Sharing and Diversification • Sharing risk encourages investment • Diversification • The practice of spreading one’s wealth over a variety of different financial investments to reduce overall risk

  25. International Capital Flows • Two Macroeconomic Roles for International Capital Flows • A country with greater investment opportunities than savings can fill the savings gap by borrowing from abroad. • International capital flows allow countries to run trade imbalances.

  26. International Capital Flows International financial markets allocate savings to productive capital in different countries. International financial markets are subject to the laws of at least two countries.

  27. International Capital Flows • International Capital Flows • Purchases or sales of real and financial assets across international borders

  28. International Capital Flows • Capital Inflows • Purchases of domestic assets by foreign households and firms • Capital Outflows • Purchases of foreign assets by domestic households and firms

  29. International Capital Flows • Net Capital Inflows • Capital inflows minus capital outflows

  30. International Capital Flows • Trade Balance (or net exports) • The value of a country’s exports less the value of its imports in a particular period (quarter or year) • Trade Surplus • When exports exceed imports, the difference between the value of a country’s exports and the value of its imports in a given period • Trade Deficit • When imports exceed exports, the difference between the value of a country’s imports and the value of its exports in a given period

  31. The U.S. TradeBalance, 1960 - 2004 • Observations • Trade has become increasingly important • Since the 1970s, the U.S. has run trade deficits

  32. International Capital Flows • Capital Flows and the Balance of Trade • NX = trade balance (net exports) • KI = net capital inflows • NX + KI = 0

  33. International Capital Flows • Understanding NX + KI = 0 • U.S. resident buys a $20,000 Japanese automobile • The Japanese car manufacturer receives $20,000 and has two options • He can buy $20,000 of U.S. goods • U.S. exports = imports or NX = 0 and KI = 0 • NX + KI = 0

  34. International Capital Flows • Understanding NX + KI = 0 • U.S. resident buys a $20,000 Japanese automobile • The Japanese car manufacturer has $20,000 and has two options • He can buy U.S. assets (land, bond, etc.) • NX = -$20,000 • Capital inflow = KI = $20,000 • NX (-$20,000) + KI ($20,000) = 0

  35. International Capital Flows • The Determinants of International Capital Flows • Real interest rate • High domestic real interest rates will cause net capital inflows. • Low domestic real interest rates will cause net capital outflows.

  36. Net capital inflows, KI KI < 0 Net capital outflows KI > 0 Net capital inflows 0 Net Capital Inflows and the Real Interest Rate Domestic real interest rate r Net capital inflow KI

  37. International Capital Flows • Risk • For a given real interest rate, an increase in riskiness in domestic assets will reduce net capital inflows and vice versa

  38. KI’ Increases in risk reduces the willingness of foreign and domestic savers to hold domestic assets. An Increase In Risk Reduces Net Capital Inflows KI Domestic real interest rate r 0 Net capital inflow KI

  39. International Capital Flows • Saving, Investment, and Capital Inflows • Y = C + I + G + NX • Subtract C + G + NX from both sides • Y - C - G - NX = I • National saving (S) = Y - C - G • NX + KI = 0; so, KI = -NX • Substitute S for Y - C - G & KI for -NX • S + KI = I

  40. International Capital Flows • Observation • The pool of saving available for domestic investment includes national savings and the funds from savers abroad.

  41. S + KI • I = demand for capital investment funds • S + KI = total supply of saving • R* = equilibrium real interest rate r* I The Saving-Investment Diagram For An Open Economy Real interest rate (%) Saving and investment

  42. International Capital Flows • Observations • A country that attracts foreign capital will have lower real interest and higher investment. • Countries with a stable political environment and well defined property rights will attract more foreign capital.

  43. International Capital Flows • The Saving Rate and the Trade Deficit • A low rate of national saving is the primary cause of trade deficits.

  44. International Capital Flows • The Saving Rate and the Trade Deficit • Y = C + I + G + NX • Subtracting C + I + G from both sides • Y - C - I - G = NX • S = Y - C - G • S - I = NX • Assuming I is constant • If S increases, NX increases, and vice versa.

  45. International Capital Flows • The Saving Rate and the Trade Deficit • Low national saving implies high consumer and government spending • High rates of spending will: • Increase imports. • Decrease exports.

  46. International Capital Flows • The Saving Rate and the Trade Deficit • Low national saving will also increase capital inflows. • High spending creates investment opportunities • Shortage of domestic saving will occur • Real interest rates will rise • Capital inflows will occur

  47. National Saving, Investment, and the Trade Balance in the U.S., 1960 - 2004

  48. International Capital Flows • What Do You Think? • Is the U.S. trade deficit a problem?

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