Chapter 04 The Financial System And Interest

The Financial System and Interest Chapter 4

The Financial System Production vs. Consumption sectors Cash flows between sectors Workers receive wages from production sector which are spent in the consumption sector Production spends income on inputs (consumption) to produce more, and so the cycle goes

Figure 4.1: Every Day Money Flows Between Sectors

Savings and Investment Consumption sector Most people do not consume all of their income — they save a portion Need a place to deposit those savings and to earn a return Production sector Companies need to raise money to finance production Spend money on everyday operations, new factories, additional equipment, new enterprises

Savings and Investment Financial markets connect production’s need for money with consumption’s available savings The buyers and sellers of financial assets meet in a financial marketplace Companies issue stocks or bonds to raise money Savers purchase these securities hoping to earn a return on their savings (investment) Consumer savings equals industrial investments

Figure 4.2: Flows Between Sectors

Raising and Spending Money in Business Businesses spend money on: Day-to-day operations (inventory, wages, etc .) Money is raised for these operations using operating funds (money generated from day-to-day operations) Capital investments (new fixed assets such as new production line, expansion overseas, etc .) Money is raised for capital investments in the financial marketplace Borrowed money is debt financing Money raised through the sale of stock is known as equity financing

Term Term refers to the length of time between now and the end (or term ination) of something Long-term projects (typically those lasting over 5-10 years) are usually financed with long-term funds Debt (bonds) Equity Short-term projects (typically those lasting less than 1 year) are usually financed with short-term funds Bank loans Process is known as maturity matching

Financial Markets Capital Markets Trade in stocks and long-term debt Money Markets Trade in marketable securities such as commercial paper, notes, bills Federal government is extremely active in issuing short-term debt Federal borrowing supports yearly deficit spending and the national debt

Primary and Secondary Markets Purpose of a financial market is to facilitate the flow of funds from savers to production sector (investment in business projects) This occurs in the: Primary market (market in which securities are initially sold Investors trade securities between each other in the Secondary market

Primary and Secondary Markets Corporations, even though they do not raise money in the secondary market, are interested in the stock’s price in the secondary market Influences how much money can be raised in future stock issues Senior management’s compensation is usually tied to the stock price

Direct and Indirect Transfers, Financial Intermediaries Primary market transactions can occur Directly (issuing firm sells directly to buyers or through an investment bank) An investment bank helps companies market their securities Lines up investors and functions as a broker Brings buyers and sellers together Indirectly (financial intermediary—such as a mutual fund—buys securities and sells shares in the fund to buyers) No one mutual fund owner can identify specific stocks/bonds within the mutual fund as belonging only to him. The portfolio is owned collectively by individuals

Figure 4.3: Transfer of Funds From Investors to Businesses

Direct and Indirect Transfers, Financial Intermediaries Institutional investors Mutual funds and similar financial intermediaries Play a major role in today’s financial markets Own ¼ of all stocks but make over ¾ of all trades Examples include Mutual funds Pension funds Insurance companies Banks

The Stock Market and Stock Exchanges Stock market—a network of exchanges and brokers Exchange—a physical marketplace (NYSE, AMEX, regional exchanges) Broker—individual whose job is to assist people in buying and selling securities Work for brokerage firms Members of stock exchange

Trading—The Role of Brokers What brokers do… An investor will open an account with a broker and place trades via telephone or online Local broker will forward order to floor broker on trading floor of exchange Floor broker trades on the floor of the exchange Each stock is traded in a particular spot on the exchange floor using an auction-like process Trading is supervised by a specialist Specialists make markets in designated securities Confirmation of trade is forwarded to local broker and investor

Figure 4.4: Schematic Representation of a Stock Market Transaction

Exchanges New York Stock Exchange (NYSE) Trades securities for  1,200 of largest, strongest companies in U.S. Handles about 85% of trading activity American Stock Exchange (AMEX) Handles slightly smaller, younger firms than NYSE Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc .) Exchanges are linked electronically

Exchanges The Market The stock market refers to the entire interconnected set of places, organizations and processes involved in trading stocks Regulation Securities are regulated under state and federal laws Securities Act of 1933 Required companies to disclose certain information Securities Act of of 1934 Set up Securities and Exchange Commission Securities law is primarily aimed at disclosure

Private, Public, and Listed Companies, and the NASDAQ Market Assume a business is successful and the owner decides to raise money for expansion by incorporating and selling stock to others Privately held companies—can’t sell securities to the general public (also, sale of securities is severely restricted by regulation) Publicly traded companies—have received approval of the SEC to offer securities to the general public Process of obtaining approval and registration is known as ‘going public’

Private, Public, and Listed Companies, and the NASDAQ Market Process of ‘going public’ Use an investment banking firm to determine If a market exists for shares of your company The likely price for your firm’s stock Develop a prospectus—provides detailed information about company Financial statements Key executives/background SEC reviews prospectus An unapproved prospectus is call a ‘red herring’

Private, Public, and Listed Companies, and the OTC Market The IPO Once prospectus is approved by SEC securities can be sold to public Initial sale is known as an IPO or initial public offering Market for IPOs is very volatile and risky Prices can rise (or fall) very dramatically Investment banks usually line up buyers prior to the actual sale of securities Buyers are usually institutional investors IPO occurs in primary market, but once securities are placed with investors, trading begins in the secondary market

The NASDAQ Market After a company goes public, its shares are usually traded in the over-the-counter (OTC) market Eventually a firm may wish to be listed on an exchange Loosely organized network of brokers The National Association of Securities Dealers Automated Quotation System (NASDAQ) is the market’s computer system

Reading Stock Quotations Stock prices are quoted online and in newspapers Quotes report the Stock price, including yearly high and low Ticker symbol Dollar dividend and dividend yield Price-earnings ratio Volume Daily high and low Closing price Net change

Figure 4.7: Stock Market Quotation for General Motors Corporation, March 11, 2003

Interest Interest rates typically refer to the rate charged on a debt instrument There are MANY interest rates, including the prime rate, the federal funds rate, etc . Interest rates tend to move in tandem

The Relationship Between Interest and the Stock Market The stock market reacts to changes in interest rates (even though interest rates are related to the bond market) Stocks (equity) and bonds (debt) compete for investor’s dollars Stocks offer higher returns but have more risk If you could earn 10% by investing in a bond of IBM, what return would you want to invest in IBM’s stock? More than 10% because the stock is more risky

The Relationship Between Interest and the Stock Market If interest rates were to rise to 12% on IBM’s bonds, what would happen to your required rate of return on IBM’s stock? Your required return on IBM’s stock would rise and therefore, the value of IBM’s stock would drop in the market Interest rates and security prices move in opposite directions Good reason for us to have an interest in interest rates

Interest and the Economy Would you be more likely to buy a house/car when interest rates are high or low? Interest rates have a significant effect on the economy Lower interest rates stimulate business and economic activity Businesses and individuals use credit a great deal Interest rates represent the cost of borrowing money (credit)

Debt Markets Interest rates are set by supply and demand Supply and Demand—A Brief Review A demand curve relates price and quantity for a product or service Reflects desires and abilities of buyers at a particular point in time Demand curves usually slope downward to the right People buy more when the price of a product is low A supply curve relates prices with quantities supplied by producers Generally upward sloping to the right Suppliers are willing to produce more when the price is high Where the supply and demand curve intersect represents equilibrium If conditions change the curves shift and a new equilibrium price is reached

Figure 4.8: S&D Curves for a Product or Service

Supply and Demand for Money In the debt market the supply curve represents those willing to lend money The demand curve represents those people or companies desiring to borrow money The price represents the interest rate Debt securities are bills, notes and bonds Borrowers sell bonds and lenders buy bonds Borrowers include the government and companies Will borrow more when interest rates are lower

The Determinants of Supply and Demand Demand for borrowed funds depend on Opportunities available to use these funds Attitudes of people and businesses about using credit If people feel good about the economy they will go on vacation, buy houses and cars, etc . Businesses will borrow for expansion and new projects

The Determinants of Supply and Demand Supply of loanable funds depends on the time preference for consumption of individuals Whether a person would rather spend money now or invest it Most people spend for current consumption and save only a small portion of their income Money saved by individuals becomes loanable funds (or the supply of debt) A decrease in the preference for consumption will lead to an increase in loanable funds Leads to a rightward shift in the supply curve Constant changes cause the supply and demand curves to slide back and forth Market interest rate moves up and down all the time In the 1970s the movement in interest rates became more dramatic Unable to consistency forecast interest rates with accuracy

The Components of an Interest Rate Interest rates include base rates rates and risk premiums Interest rate will be represented by the letter k k = base rate + risk premium Components of the Base Rate The base rate is pure interest plus expected inflation The rate at which people lend money when no risk is involved Pure interest rate is AKA earning power of money An unobservable rate that would exist in the real world if there were no inflation Generally considered to be between 2% and 4%

The Components of an Interest Rate The Inflation Adjustment Inflation refers to a general increase in prices Refers to the fact that, if prices rise, $100 at the beginning of the year will not buy as much at the end of the year If you loaned someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year Interest rates include estimates of average annual inflation over loan periods

Risk Premiums Risk in loans refers to the chance that the lender will not receive the full amount of principal and interest payments agreed upon Some loans are more risky than others Lenders demand a risk premium of extra interest for making risky loans

Different Kinds of Lending Risk Bond lending losses can be associated with fluctuations in the prices of bonds as well as with the failure of borrowers to repay the loans Default Risk The chance the lender won't pay principal of interest Losses can be the entire amount or anywhere in between Investors demand a default risk premium which depends on the investor's perception of the creditworthiness of the borrower Perception is based on the firm's financial condition and credit record

Different Kinds of Lending Risk Default Risk (continued) Premiums range from 0% to 6 or 8 % Once a company's default risk becomes too high, they will be unable to borrow at any interest rate Default doesn't actually have to occur for problems to exist If investors realize that a firm is having difficulty making interest payments (although it is still making them) the bond's price will probably fall A time dimension is involved in the risk of default The longer the time period involved with the debt instrument the more likely that the firm will face financial difficulty

Different Kinds of Lending Risk Liquidity Risk Associated with being unable to sell the bond of an little known issuer Debt of small firms are particularly hard to market Said to be illiquid Sellers must reduce their prices to encourage investors to buy the illiquid securities Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk Very short-term securities usually bear little liquidity risk

Different Kinds of Lending Risk Maturity Risk Bond prices and interest rates move in opposite directions Long-term bond prices change more with interest rate swings than short-term bond prices Gives rise to maturity risk Investors demand a maturity risk premium Ranges from 0% to 2% or more for long-term issues

Comparison of Similar Risk Bonds With Different Maturities

Putting the Pieces Together The factors that make up an interest rate, k, can be expanded to include the particular types of risk K = K Pure Interest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium K is known as the nominal or quoted interest rate Setting Interest Rates Interest rates are set by the forces of supply and demand Thus the interest rate model above is only an economic model of reality Represents an explanation of what generally has to be behind the interest rate needs of investors

Federal Government Securities, Risk Free and Real Rates Federal Government Securities Cities, states and federal governments issue long-term bonds Federal treasury also issues short-term securities Known as Treasury securities Treasury bills have terms from 90 days to a year Treasury notes have terms from 1 to 10 years No default risk associated with federal government debt Can print money to pay off all of its debt No liquidity risk for federal government debt Always an active market

The Risk-Free Rate The risk-free rate is approximately the yield on short-term Treasury bills Includes the pure rate and an allowance for inflation Same as the base rate discussed earlier Viewed as a conceptual floor for the structure of interest rates Denoted as k RF

The Real Rate of Interest Real refers to values that have the effects of inflation removed Tells investors whether or not they are getting ahead If you earn a real rate of 8% on an investment and inflation turns out to be 10%, you are losing purchasing power on your investment There are periods in time when the real rate of interest has been negative Because we don't really know what the rate of inflation is at a point in time when nominal rates are set The Real Risk-Free Rate Implies that both the inflation adjustment and the risk premium is zero

Yield Curves—The Term Structure of Interest Rates The relationship between interest rates and the term of debt is known as the term structure of interest rates The yield curve is a graphical representation of the term structure of interest rates Most of the time short-term rates are lower than long-term rates However at times the opposite is true Known as an inverted yield curve

Yield Curves—The Term Structure of Interest Rates Theories have developed attempting to explain the term structure of interest rates Expectations theory Today's rates rise or fall with term as future rates are expected to rise or fall Liquidity preference theory Investors prefer shorter term securities and must be induced to make longer loans Market segmentation theory Loan terms define independent segments of the debt market which set separate rates

APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island If we lived in a primitive world without money would interest still exist? On A Desert Island You are stranded on a deserted island with no need for protective clothing or shelter However, food is a problem You have to spend all your time digging up edible roots bare handed No time for leisure and no ability to make anything extra

Making a tool If you were to make a tool, you could dig more efficiently But it would take you five days to make a shovel, and you need to spend those five days digging for food So if you make a shovel, during the five days you will go hungry APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island

Life with Tools—Savings and Investment You make the shovel and now you can dig twice as fast as before Now have the option of leisure time Shovel is a piece of capital equipment You invested your savings to make it You saved productive capacity by not digging food while you made the shovel Willing to forego current consumption to devote resources to a future something APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island

A New Arrival—And a Request to Borrow Another castaway arrives on the island He is a loner and digs for edible roots using his bare hands Decides he wants to borrow your shovel The Cost of Borrowed Shovels If you lend your shovel, some compensation is in order—perhaps food or labor services However, you have the following ideas He has to receive productive benefit from using the shovel He will want to be able to dig more roots or the same amount of roots in a shorter amount of time than he could barehanded You might not get the shovel back--he might break it or refuse to return it (risk!) The shovel may not be returned in its original condition APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island

Tying back to Interest K = K Pure Interest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium The incremental productive power is the same as the pure interest rate The compensation required for the chance of losing the shovel is the same as default risk The worry that the shovel might not be returned in its original condition is the same as the inflation adjustment APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island

Chapter 04 The Financial System And Interest

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Chapter 04 The Financial System And Interest