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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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