Financial Markets
Markets in which funds are transferred from people who have an excess of funds to people who have a shortage
Role of the Financial System
1. Provides individual firms and gov with the capital to do things now that they otherwise could not
2. Store, protect, and provide profitable uses for excess capital
3. Insurance against risk
4. Speculation
Security
A claim on the issuer's future income
- EX: stocks, bonds
Assets
Any financial claim or piece of property that is subject to ownership
Interest Rate
Cost of borrowing/price paid for the rental of funds
Common Stock
A share of ownership in a corporation
Financial Intermediaries
institutions that borrow funds from people who have saved and in turn make loans to people who need funds
- ex: commercial bank, mutual fund, etc.
Functions of the Financial Intermediaries
1. Reduce transaction costs through economies of scale (increased production)
2. Reduce information costs
Financial Crises
Major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and non-financial firms
Money Supply
Anything generally accepted as payment for goods or in the repayment of debts
Business Cycles
Upward and downward movement of aggregate output produced in the economy
Recessions
Period of declining output
Inflation and Inflation Rate
Continual increase in the price level
- rate: rate of change of the price level usually measured as a percentage per year
GDP (Gross Domestic Product)
a measure of aggregate output
Direct Finance
Borrow funds directly from lenders by selling the lenders securities (AKA financial instruments)
- ex: stock market, bond market, foreign exchange
Indirect Finance
Borrower uses financial intermediary to borrow funds
Maturity of a Debt Instrument
Short term: less than a year to maturity
Intermediate term: 1-10 years to maturity
Long term: 10 years or longer to maturity
Equities
Claims to share in the net income and assets of a business
- make periodic payments (dividends) to shareholders (considered long term securities because they never mature)
- Ex: common stock
Primary Market
Market where newly issued securities are traded
- Ex: Investment Bank
Secondary Market
Market where securities that have previously been issued can be resold
- ex: New York Stock Exchange and NASDAQ
Functions of the Secondary Market
1. Provide info to borrowers and lenders about expectations and attitudes of the economic climate
2. Provide liquidity info (ease of turning an asset into cash) to owners of existing financial instruments
3. Determine price of the security that the issuin
Money Market Instruments (short-term)
1. Commercial Paper
- issued by larger banks and well-known corporations
2. Treasury Bills
- sold @ a discount with no interest
- 1, 3, and 6-month maturities
3. Repurchase Agreements
- vendor of security agrees to repurchase it from buyer
- maturity less
Capital Market Instruments (longer term)
1. Gov Security
- issued by US treasury
- used to finance debt of federal gov
2. Stocks
- equity claims on net income and assets of a group
3. Agency Securities
- specific securities issued by federal agencies
4. Corporate Bond
- issued by corporations wi
Present Value
Based on the notion that a dollar is worth less to you in a year than it is today
Simple Loan
Borrower receives principal, then repays principal plus interest at maturity
- Use PV = FV / (1+i)^n to find amount repaid at maturity
Discount Bond
Borrower repays the FACE VALUE of the bond at maturity
- bond is issued at a "discounted" to its face value
- NO coupon payments (return on bond = rate of capital gain)
- Use PV = FV / (1+i)^n to find the discounted issue price (PV)
Coupon Bonds
Borrower receives principal (face value)
- pays coupon payment every year until maturity
- at maturity borrower repays principal plus coupon payment
- Use C = FV x Coupon rate to find coupon payment
Current Yield Formula
C/P(t)
- C = coupon Payment
- P(t) = Price at time bond was bought
Rate of Capital Gain Formula
P(t+i) - P(t) / P(t)
- P(t+i) = Price at time bond is sold
- P(t) = Price at time bond is bought
Rate of Return Formula
Current Yield + Rate of Capital Gain
- R = C/P(t) + P(t+i) - P(t) / P(t)
Real Interest Rate Formula
Nominal interest rate - Inflation rate
Yield to Maturity
- Simple Loan: PV = FV / (i+1)^n
- Fixed Payment Loan: LV = FP / (1+i)^n
- Coupon Bond: PV = C+FV / (1+i)^n
- Discount Bond: FV - PV / PV
Bond Demand Curve
- Savers (lenders) demand bonds
- Higher the price of a bond, the less the quantity demanded
Bond Supply Curve
- Investor (borrower) supplies bonds
- Higher the price of a bond, the greater the quantity supplied
Factors that shift Demand for Bonds
Factors that shift Supply for Bonds
Levels of Liquidity
- High: cash, treasury bills
- Moderate: stocks and bonds
- Low: property, land, and equipment
Income Effect
*increase* in money supply =>
increase
increase
in money supply => *increase* in i
Liquidity Effect
increase
in growth rate of money supply =>
decrease
in i
Price Level Effect
*increase* in money supply => *increase* in price level =>
increase
increase
in money supply => *increase* in price level =>
increase
in i
Expected Inflation Effect
*increase* in money supply => *increase* in expected inflation =>
increase
increase
in money supply => *increase* in expected inflation =>
increase
in i
Fisher Effect
Describes relationship between inflation and interest rates
- Real interest rate = nominal rate - inflation rate
- Real interest rates fall as inflation increases
Effect of Business Cycle Expansion on Interest Rate
1. Business Cycle Expansion shifts Supply to the right
2. It also shift the demand curve to the right by a
smaller amount
3. New equilibrium price is lower causing interest rates to go up
Liquidity Preference Framework
Determines the equilibrium interest rate in terms of supply and demand for
money
rather than supply and demand for bonds
- Q of bonds demanded + Q of money demanded = Quantity of bonds supplied + Q of bonds demanded
Opportunity Cost
Amount of interest (expected return) sacrificed by not holding the alternative asset
- ex: as interest rate on bonds rises, the opportunity cost of holding money rises => money is less desirable and Q demanded of money falls
Excess Supply and Interest Rate
- Excess supply causes interest rate to fall
Excess Demand and Interest Rate
- Excess demand causes interest rate to rise
Factors that shift demand for and supply of money
- Income increases => Money demanded increases
- Price level increases => Money demanded increases
Relationship between the Effects
- If liquidity > all other effects => interest rate falls
- If liquidity < all other effects and there is
slow
adjustment to inflation => interest rate rises by a little
- If liquidity < all other effects and there is
fast
adjustment to inflation => inter
Real Rate of Return
RET = [(FV-PV) - Interest] / PV