Financial Markets

2. Financial Markets • Financial markets exist to facilitate economic activities by managing the risks of failure.

3. Learning Outcomes • 32-01. Know how present discounted values are computed. • 32-02. Know the difference between stocks and bonds. • 32-03. Know key financial parameters for stocks and bonds. • 32-04. Know how risks and rewards are reflected in current values.

4. The Role of Financial Markets • An entrepreneur needs start-up funds to launch a business. • Sources: • Personal wealth. • Borrowed funds. • Inviting other investors to join the venture. • Financial intermediaries make raising start-up funds easier.

5. The Role of Financial Markets • Financial intermediaries: institutions that steer funds from savers to entrepreneurs and other investors. • Business, household, and government savers put unspent income into banks, pension funds, bond markets, and stock markets. • This pool of national savings is passed on to firms to start or expand a business. • Search and information costs to access funds are reduced.

6. The Supply of Loanable Funds • The factors that influence saving decisions are • Time preferences (put off spending until later). • Interest rates (high rates spur more saving). • Risk (savers do not want to put “all their eggs in one basket”; they want to reduce the risk of losing their money). • Risk premium: the difference in the rate of return on risky and safe investments. • The interest rate will be increased to cover this risk premium.

7. Present Value of Future Profits • A dollar today is worth more than a dollar received two years from today. • You can earn interest on today’s dollar for the next two years. • As long as interest-earning opportunities exist, present dollars are worth more than future dollars. • To decide whether or not taking the risk of investing is worth doing, we must assess the potential rewards – that is, future profits.

8. Present Value of Future Profits • Time value of money: to calculate the present discounted value (PDV) of future earnings, the opportunity cost of money (the forgone interest) must be taken into account. • Present discounted value (PDV): the value today of future payments, adjusted for interest accrual. • The longer one has to wait for a future payment, the less present value it has.

9. Present Value of Future Profits Future paymentN PDV = (1 + Interest rate )N N is the number of years in the future when the payment is made. • A payment of $1,000 in one year (N = 1) has a present discounted value of $909.09 in a 10 percent interest rate world. PDV = $1,000 / (1.10) = $909.09 If N = 2 (2 years), PDV = $1,000 / (1.10)2 = $826.45

10. Present Value of Future Profits • The present discounted value (PDV) of a future payment declines with • Higher interest rates. • Longer delays in future payment. • Uncertainty must be taken into account. What if the payment does not happen? • Add a risk factor to calculate the expected value: • Expected value = (1 – Risk factor) X PDV • A 50 - 50 chance of failure cuts PDV in half.

11. The Stock Market • Stocks are part ownership in a corporation. • As an owner, you have limited liability; all you can lose is the cost of buying the stock. You are not liable for the firm’s taxes, debt, or lawsuit damages. • You buy stocks to receive future payments as an owner. There are two kinds: • Dividends • Capital gains.

12. The Stock Market • Dividends. • Earnings can be either retained for future investment in the firm or paid out to stockholders as a dividend. • Dividends = Corporate profits – Retained earnings. • As a rule, corporations in mature (slowly expanding) industries pay out dividends. • Corporations in growth (rapidly expanding) industries keep profits for future internal investment and pay no dividends.

13. The Stock Market • Capital gains. • Why buy stock in growth industries? Their growth may trigger bigger profits in the future, and the price of the stock may soar in the stock market. • Stockholders will reap a capital gain when they sell the stock at a price higher than they paid. • Even if they keep the stock, capital gains increase shareholder wealth.

14. The Stock Market • Stock trading. • There are two kinds of stock trading: • The initial public offering (IPO),which is the first sale of stock to the public by the corporation. • Secondary trading, which is the everyday buying and selling of previously issued stock in the stock market. • The corporation receives the funds from an IPO. • The stock seller receives the funds from a secondary sale.

15. The Stock Market • Market fluctuations. • Secondary trading is subject to stock market supply and demand: • Buyers will buy more shares if the price of a stock falls. • Sellers may be induced to sell shares if the price of a stock rises. • Prices also fluctuate as expectations of potential buyers and sellers change. • The future looks bad? Sellers want to sell more and buyers want to buy less, so the price drops. • The future looks rosy? Sellers hold their stock but buyers want to buy more, so the price soars.

16. The Stock Market • Market fluctuations. • Booms and busts. Broad changes in the economic outlook tend to change expectations for all stocks, not just one or two. • Expect a boom, and all prices get pushed up. • Expect a bust, and all prices start to plunge. • Wild swings in stock prices are usually due to sudden, widespread changes in people’s expectations.

17. The Economic Role of Financial Markets • Financial markets facilitate resource reallocations. • Finding a source of funds allows a new venture to start up and expand. Resources can be acquired that would most likely have gone to another venture. • The mix of output will be changed. • Resource reallocation follows the decision to fund a venture more likely to be successful in providing a desired return on investment.

18. The Bond Market • In the bond market people buy and sell promissory notes (IOUs) – that is, corporate and government bonds. • Bonds are issued in order to borrow funds. • There are two types of bond sales: • Initial sale: the purchaser is lending funds directly to the bond issuer. The issuer gets the funds. • Secondary sale: this is the interaction between owner-sellers and buyers of previously issued bonds. The seller gets the funds.

19. The Bond Market • The math of a bond. • Face value: the amount being borrowed by the issuer, the amount that will be repaid at maturity. • Coupon rate: the rate of interest the borrower will pay the bondholder each year until maturity. • Bond price: the current price one could get in the bond market by selling the bond. • Yield: the interest payment divided by the bond price.

20. The Bond Market • Bond trading. • A bond has liquidity: the ability to be easily turned into cash by offering it for sale in the bond market. • These resales increase the availability of funds. • Bond prices fluctuate because of • Changes in expectations. • Changes in alternative uses of funds. • Changes in prevailing interest rates.

21. The Bond Market • Bond trading. • A $1,000 face value bond with a 10% coupon rate pays out $100 a year in interest. • If the prevailing interest rate falls to 9%, any new bond would pay out only $90 a year, so the 10% bond’s value would rise and its market price would rise also. • If the prevailing interest rate rises to 11%, any new bond would pay out $110 a year, so the 10% bond’s value would fall and its market price would fall also. • Bond prices move in the opposite direction as interest rates.