Chapter 30: The Basics of Finance

11© 2014 by McGraw-Hill Education Chapter 30 The Basics of Finance 2© 2014 by McGraw-Hill Education • 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. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • 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. The role of financial markets 24© 2014 by McGraw-Hill Education • 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. The role of financial markets 5© 2014 by McGraw-Hill Education • 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. A whirlwind history of banks 6© 2014 by McGraw-Hill Education • 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. A whirlwind history of banks 37© 2014 by McGraw-Hill Education • 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. The market for loanable funds: A simplified financial market 8© 2014 by McGraw-Hill Education • 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. Loanable funds: Savings and investment 9© 2014 by McGraw-Hill Education 1. A young couple takes out a mortgage to buy a new house. 2. You loan money out to a family member. 3. You deposit 50% of your paycheck into your checking account. 4. A local restaurant takes out a small business loan to expand to a new location. Active Learning: Savings and investment Classify each of the following as either savings or investment. 410© 2014 by McGraw-Hill Education • 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. The price of loanable funds 11© 2014 by McGraw-Hill Education The intersection of the demand and supply curves determines the equilibrium interest rate and quantity of loanable funds. The price of loanable funds Investment Savings Q* r* Interest rate Quantity of dollars The market for loanable funds • Savings is upward sloping. – Suppliers are willing to provide additional funds at higher interest rates. • Investment is downward sloping. – Demanders are willing to borrow less at higher interest rates. • The equilibrium is where savings intersects investment. Establishes: – Equilibrium interest rate. – Amount of money traded in the market. 12© 2014 by McGraw-Hill Education • 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. Changes in the supply and demand for loanable funds 513© 2014 by McGraw-Hill Education A change in the underlying determinants of savings shifts the supply for loanable funds. Determinants of savings S 2 Q2 r2 Interest rate I S 1 r1 Q1 Quantity of dollars The market for loanable funds • The determinants of the supply of loanable funds are: – Culture. – Social welfare policies. – Wealth. – Current economic conditions. – Expectations about future economic conditions. 14© 2014 by McGraw-Hill Education • In the early 1980s, the savings rate in the United States was 8 to 10 percent. • The savings rate decreased steadily to 2 percent in the mid-2000s. • After the housing market crash, the savings rate jumped by 4 percent. Determinants of savings Jan 0.0 2.0 4.0 6.0 8.0 10.0 12.0 1980 1985 1990 1995 2000 2005 2007 Jun 2008 Oct 2009 March 2010 Jan 2012 Personal savings rate (%) Annually Quarterly Savings rates in the United States since 1980 15© 2014 by McGraw-Hill Education • Investment decisions are based on the trade- off 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. Determinants of investment 616© 2014 by McGraw-Hill Education Depending on the willingness to invest, the demand curve shifts. Determinants of investment 1 Q2 r2 I2 r I2 Q2 r2 Interest rate I1 S 1 Q1 Quantity of dollars Interest rate I1 S r 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. 17© 2014 by McGraw-Hill Education What does the market for loanable funds predict will happen to interest rates during an expansion? Active Learning: Market for loanable funds 18© 2014 by McGraw-Hill Education 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). Active Learning: Shifts in savings and investment 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. 719© 2014 by McGraw-Hill Education • In reality, there is not a single interest rate paid by all prospective borrowers. • There are two basic factors driving differences in interest rates. 1. The loan term: The opportunity cost of lending money. 2. The riskiness of the transaction: A default occurs when a borrower fails to pay back a loan according to the loan terms. A price for every borrower: A more realistic look at interest rates 20© 2014 by McGraw-Hill Education • 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. A price for every borrower: A more realistic look at interest rates 21© 2014 by McGraw-Hill Education • 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. The modern financial system 822© 2014 by McGraw-Hill Education • 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. Functions of the financial system 23© 2014 by McGraw-Hill Education • 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. Major financial assets: Equity 24© 2014 by McGraw-Hill Education • 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. Major financial assets: Debt 925© 2014 by McGraw-Hill Education • 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. Major financial assets: Derivatives 26© 2014 by McGraw-Hill Education • A well-functioning financial system would not exist without four key players. 1. Banks and other financial intermediaries. 2. 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. Major players in the financial system 27© 2014 by McGraw-Hill Education 3. 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. 4. Speculators: – A speculator is anyone who buys and sells financial assets purely for financial gain. Major players in the financial system 10 28© 2014 by McGraw-Hill Education The basic trade-off in valuing any asset is between risk and return. Valuing Assets: The trade-off between risk and return Cash Inflation -linked bonds U.S. fixed-income bonds Real estate Commodities Developing-country equities U.S. equities Wealthy non-U.S. country equities Privately held equities Expected annual return (%) Expected risk Risk and reward of various financial assets 29© 2014 by McGraw-Hill Education • 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. Valuing Assets: The trade-off between risk and return 30© 2014 by McGraw-Hill Education • 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. 1. 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. 2. Technical analysis: Analyze movements in a stock’s prices to predict future movements. 3. Throw a dart: Make a list of all stocks, pin it to a wall, and throw a dart at it. Predicting returns: The efficient-market hypothesis 11 31© 2014 by McGraw-Hill Education • 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. Predicting returns: The efficient-market hypothesis 32© 2014 by McGraw-Hill Education • 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 • This is the savings-investment identity. A national accounts approach to finance: The savings-investment identity 33© 2014 by McGraw-Hill Education • 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 Private savings, public savings, and capital flows 12 34© 2014 by McGraw-Hill Education • 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. Private savings, public savings, and capital flows 35© 2014 by McGraw-Hill Education • 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. Summary 36© 2014 by McGraw-Hill Education • 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. Summary 13 37© 2014 by McGraw-Hill Education • 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. Summary