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?...
Chapter 30 The Basics of Finance © 2014 by McGraw-Hill Education What will you learn in this chapter? • 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 © 2014 by McGraw-Hill Education The role of financial markets • A financial market is 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 © 2014 by McGraw-Hill Education The role of financial markets • 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 © 2014 by McGraw-Hill Education A whirlwind history of banks • Current financial 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 © 2014 by McGraw-Hill Education A whirlwind history of banks • Banks serve many useful functions • They acts as an intermediary between savers and borrowers • Banks make cash more readily accessible when and where you want it • They let people enjoy the benefits of liquidity • Banks allow savers and borrowers to diversify risk © 2014 by McGraw-Hill Education The market for loanable funds: A simplified financial market • 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 funds is 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 © 2014 by McGraw-Hill Education Loanable funds: Savings and investment • Savings is the portion of income that is not immediately spent on consumption of goods and services – The supply of loanable funds comes from savings • Investment is spending on productive inputs – Productive inputs include factories, machinery, and inventories – The demand for loanable funds comes from investment © 2014 by McGraw-Hill Education Active Learning: Savings and investment Classify each of the following as either savings or investment A young couple takes out a mortgage to buy a new house You loan money out to a family member You deposit 50% of your paycheck into your checking account A local restaurant takes out a small business loan to expand to a new location © 2014 by McGraw-Hill Education The price of loanable funds • The quantity of savings that 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 rate is the price of borrowing money for a specific period of time – It is expressed as a percentage per dollar borrowed per unit of time © 2014 by McGraw-Hill Education 10 The price of loanable funds The intersection of the demand and supply curves determines the equilibrium interest rate and quantity of loanable funds • Savings is upward sloping The market for loanable funds – Suppliers are willing to provide additional funds at higher interest rates Interest rate Savings • Investment is downward sloping – Demanders are willing to borrow less at higher interest rates r* • The equilibrium is where savings intersects investment Establishes: Investment Q* Quantity of dollars – Equilibrium interest rate – Amount of money traded in the market © 2014 by McGraw-Hill Education 11 Changes in the supply and demand for loanable funds • The factors determining how much people want to save and invest change over time and between countries • These factors shift the supply and demand in the market for loanable funds • As these factors change, the equilibrium interest rate and quantity changes © 2014 by McGraw-Hill Education 12 Determinants of savings A change in the underlying determinants of savings shifts the supply for loanable funds • The determinants of the supply of loanable funds are: The market for loanable funds Interest rate S2 Culture Social welfare policies Wealth Current economic conditions – Expectations about future economic conditions – – – – S1 r2 r1 I Q2 Q1 Quantity of dollars © 2014 by McGraw-Hill Education 13 Determinants of savings • In the early 1980s, the savings rate in the United States was to 10 percent • The savings rate decreased steadily to percent in the mid-2000s • After the housing market crash, the savings rate jumped by percent Savings rates in the United States since 1980 Personal savings rate (%) 12.0 10.0 8.0 6.0 4.0 2.0 0.0 1980 1985 1990 © 2014 by McGraw-Hill Education 1995 Annually 2000 2005 Jan 2007 Jun 2008 Oct 2009 March 2010 Jan 2012 Quarterly 14 Determinants of investment • Investment decisions are based on the tradeoff between the potential profits and the costs of borrowing • Expectations about the future profitability of current investments adjusts the level of investment • Crowding out is the reduction in private borrowing caused by an increase in government borrowing © 2014 by McGraw-Hill Education 15 Determinants of investment Depending on the willingness to invest, the demand curve shifts Interest rate Interest rate S S r2 r1 r1 r2 I2 I1 I1 I2 Q1 Q2 Quantity of dollars Q2 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 © 2014 by McGraw-Hill Education 16 Active Learning: Market for loanable funds What does the market for loanable funds predict will happen to interest rates during an expansion? © 2014 by McGraw-Hill Education 17 Active Learning: Shifts in savings and investment 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) 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 © 2014 by McGraw-Hill Education 18 A price for every borrower: A more realistic look at interest rates • In reality, there is not a single interest rate paid by all prospective borrowers • There are two basic factors driving differences in interest rates The loan term: The opportunity cost of lending money The riskiness of the transaction: A default occurs when a borrower fails to pay back a loan according to the loan terms © 2014 by McGraw-Hill Education 19 A price for every borrower: A more realistic look at interest rates • The risk of a borrower defaulting on a loan is referred to as credit risk • The risk-free rate is 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 © 2014 by McGraw-Hill Education 20 The modern financial system • A financial system represents the markets where financial products are traded • It is a group of institutions that brings together savers, borrowers, investors, and insurers • Financial systems help people manage both money and risk © 2014 by McGraw-Hill Education 21 Functions of the financial system • 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: Liquidity is a measure of how easily an asset can be converted quickly to cash – Diversify risk: Diversification is when risks are shared across many different assets or people © 2014 by McGraw-Hill Education 22 Major financial assets: Equity • 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 stock is a financial asset that represents partial ownership of a company – Stockholders are entitled to receive a portion of a company’s profits – A dividend is a payment made periodically to all shareholders of a company © 2014 by McGraw-Hill Education 23 Major financial assets: Debt • A loan is 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 bond is 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 © 2014 by McGraw-Hill Education 24 Major financial assets: Derivatives • Derivatives are financial assets that are based on the value of some other asset • The most common example of a derivative 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 © 2014 by McGraw-Hill Education 25 Major players in the financial system • A well-functioning financial system would not exist without four key players Banks and other financial intermediaries Savers and their proxies: – A mutual fund is a portfolio of stocks and other assets managed by a professional who makes decisions on behalf of clients – A pension fund is a professionally managed portfolio intended to provide income to retires © 2014 by McGraw-Hill Education 26 Major players in the financial system 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 Speculators: – A speculator is anyone who buys and sells financial assets purely for financial gain © 2014 by McGraw-Hill Education 27 Valuing Assets: The trade-off between risk and return The basic trade-off in valuing any asset is between risk and return Risk and reward of various financial assets Privately held equities Expected annual return (%) Wealthy non-U.S country equities U.S equities Developing-country equities U.S fixed-income bonds Cash Real estate Inflation -linked bonds Commodities Expected risk © 2014 by McGraw-Hill Education 28 Valuing Assets: The trade-off between risk and return • There are several ways to classify risk: – Market (systemic) risk refers to risk that is broadly shared by the entire market or economy – Idiosyncratic risk refers to risk that is unique to a particular company or asset • Standard deviation is a measure of how spread out a set of numbers are – This is the most commonly used measure of risk in financial markets © 2014 by McGraw-Hill Education 29 Predicting returns: The efficient-market hypothesis • 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 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 Technical analysis: Analyze movements in a stock’s prices to predict future movements Throw a dart: Make a list of all stocks, pin it to a wall, and throw a dart at it © 2014 by McGraw-Hill Education 30 10 Predicting returns: The efficient-market hypothesis • The efficient-market hypothesis states 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 • Arbitrage is the process of taking advantage of market inefficiencies to earn a profit © 2014 by McGraw-Hill Education 31 A national accounts approach to finance: The savings-investment identity • Private savings refers 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 ã This is the savings-investment identity â 2014 by McGraw-Hill Education 32 Private savings, public savings, and capital flows • Government budget surplus is another form of saving, and government budget deficit is a form of dissaving – Public savings is the difference between government tax revenue and government spending • National savings is equal to private and public savings • Incorporating government spending and saving into the savings-investment identity yields: Investment = National Savings © 2014 by McGraw-Hill Education 33 11 Private savings, public savings, and capital flows • 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 economy is 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 â 2014 by McGraw-Hill Education 34 Summary ã 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 © 2014 by McGraw-Hill Education 35 Summary • 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 © 2014 by McGraw-Hill Education 36 12 Summary • 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 © 2014 by McGraw-Hill Education 37 13 ... between the potential profits and the costs of borrowing • Expectations about the future profitability of current investments adjusts the level of investment • Crowding out is the reduction in private... 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 © 2014 by McGraw-Hill Education 20 The modern financial... quantity of savings that 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