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McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 9 The Financial System, Money, and Prices
9-2 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21- All Learning Objectives 1.Describe the role of financial intermediaries 2.Differentiate between bonds and stocks Explain how their prices relate to interest rates 3.Explain how the financial system improves the allocation of savings to productive uses
9-3 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21- All Money in Economics The term "money" in economics has a specific meaning different from every day use To an economist Your paycheck is income The income you don't spend is savings The increase in the value of your stock is capital gains When your house appreciates, your wealth increases
9-4 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 1 Financial System and Allocation of Saving A successful economy uses its savings for investments that are likely to be the most productive The interest on deposits is one important reason people put savings in banks The financial system improves the allocation of saving Provides information to savers about the possible uses of their funds Help savers share the risks of individual investment projects Risk sharing makes funding possible for projects that are risky but potentially very productive
9-5 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 1 Banking System Financial intermediaries are firms that extend credit to borrowers using funds raised from savers Thousands of commercial banks accept deposits from individuals and businesses and make loans Banks and other intermediaries specialize in evaluating the quality of borrowers Principle of Comparative Advantage Banks have lower cost of evaluating opportunities than an individual would Banks pool the savings of many individuals to make large loans
9-6 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 1 The Banking System Having bank deposits makes payments easier Checks ATMs Debit card Checks and debit cards are safer than cash Banks provide a record of your transactions
9-7 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 1 Japanese Banking Crisis, 1990s Japanese banks fell into severe trouble Property values decreased and some loans on real estate went into default Banks held stocks and the stock values decreased In Japan, banks were the main way saving was translated into investment Small- and medium-sized businesses suffered Credit shortages prolonged the recession as businesses struggled to fund new projects
9-8 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 2 Bonds A bond is a legal promise to repay a debt Each bond specifies Principal amount, the amount originally lent Maturation date, the date when the principal amount will be repaid The term of a bond is the length of time from issue to maturation Coupon payments, the periodic interest payments to the bondholder Coupon rate, the interest rate that is applied to the principal to determine the coupon payments
9-9 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 2 Bonds Corporations and governments issue bonds The coupon rate depends on The bond's term 30 days to 30 years; longer term, higher coupon rate The issuer's credit risk Probability the issuer will default on repayment Higher risk, higher coupon rate Tax treatment for the coupon payments Municipal bonds are free from federal taxes Lower taxes, lower coupon rates
9-10 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 2 Bond Market Bonds can be sold before their maturation date Market value at any time is the price of the bond Price depends on the relationship between the coupon rate and the interest rate. A two-year government bond with principal $1,000 is sold for $1,000, 1/1/09 Coupon rate is 5% $50 will be paid 1/1/10 $1,050 will be paid 1/1/11 Bond's price on 1/1/10 depends on the prevailing interest rate
9-11 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 2 Selling a Bond Offer for sale: a government bond with payment of $1,050 due in one year The competition: a new one-year bond with principal of $1,000 and coupon rate of 6% Pays $1,060 in one year Year-old bond with 5% coupon rate is less valuable than the new bond Price of the used bond will be less than $1,000 (Bond price) (1.06) = $1,050 Bond price = $991 Bond prices and interest rates are inversely related
9-12 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 2 Stocks A share of stock is a claim to partial ownership of a firm Receive dividends, a periodic payment determined by management Receive capital gains if the price of the stock increases Prices are determined in the stock market Reflect supply and demand
9-13 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 2 FortuneCookie.com New company with estimated dividend of $1 in 1 year Selling price of stock will be $80 in 1 year Interest rate is 6% Value of the new stock is $81 in 1 year (Stock price) (1.06) = $81 Stock price = $76.42 Value would be higher if Dividend were higher Price of stock in one year were higher Interest rate were lower
9-14 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 2 Risk Premium Risk premium is the difference between the required rate of return to hold risky assets and the rate of return on safe assets Suppose interest on a safe investment is 6% FortuneCookie.com is risky, so 10% return is required Stock will sell for $80 in 1 year; dividend will be $1 (Stock price) (1.10) = $81 Stock price = $73.64 Risk aversion increases the return required of a risky stock and lowers the selling price
9-15 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 3 Bond Markets and Stock Markets Channel funds from savers to borrowers with productive investment opportunities Sale of new bonds or new stock can finance capital investment Like banks, bond and stock markets allocate savings Provision of information on investment projects and their risks Provide risk sharing and diversification across projects Diversification is spreading one's wealth over a variety of investments to reduce risk
9-16 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 3 Benefits of Diversification Vikram has $200 to invest in stocks, each $100 Buy 2 shares of either stock 50% chance of $20 gain and 50% chance of $0 Diversify and buy 1 share of each One stock will be worth $100 and the other will be worth $110 Return is $10 with no risk Increase in Stock Price per Share Actual Weather Smith UmbrellaJones Suntan Lotion Rainy (50%) +$10$0 Sunny (50%) $0+$10
9-17 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 3 Rise and Fall of the US Stock Market Standard & Poor's 500 index rose 60% between 1990 and 1995 More than doubled 1995 – 2000 Lost 40% of its value Jan 2001 – Jan 2003 Returned to Jan 2000 level by Jan 2008 Increase in stock prices can be due to Increased optimism about future value A fall in required return
9-18 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 3 Rise and Fall of the US Stock Market In the 1990s, optimism was high Strong dividends Promise of new technologies Risk premium declined Increased diversification through mutual funds Investors may have underestimated risk Optimism and risk premium trends reversed in 2000 Many high-tech firms less profitable than expected Corporate accounting scandals of 2002 Terrorist attack in US
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