McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Closer Look at Financial Institutions and Financial Markets Chapter 27 Appendix

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Assets and Financial Liabilities n Financial assets – assets, such as stocks or bonds, whose benefit to the owner depends on the issuer of the asset meeting certain obligations. n Financial liabilities – liabilities incurred by the issuer of a financial asset to stand behind the issued asset.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Assets and Financial Liabilities n Stocks – a financial asset that conveys ownership rights in a corporation. n Bond – a promise to pay a certain amount of money plus interest in the future.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Valuing Stocks and Bonds n A financial asset’s worth comes from the stream of income it pays in the future. n An average share of stock in a company in a mature industry sells for about 15 to 20 times its normal profits. n Bond prices rise as market interest rates fall.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Valuing Stocks and Bonds n Present value – a method of translating a flow of future income or savings into its current worth. n All future dollars must be discounted by the interest rate in the economy. n Discounting is required because a dollar in the future is worth less than a dollar today.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Present Value Formula n The present value (PV) of future income formula is: A n = the amount of money received in n periods in the future. i = the interest rate in the economy (assumed constant)

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Present Value Formula n It is easier to use a business calculator or a present value table to determine present value for periods greater than two years.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Present Value Formula n The further into the future you go, the lower the present value. n The higher the interest rate, the lower the present value.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Some Rules of Thumb for Determining Present Value n There are a few rules of thumb and simplified formulas for which don’t need a present value table or a calculator. l The infinite annuity rule. l The Rule of 72.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Annuity Rule n Annuity rule – the present value of any annuity is the annual income yield divided by the interest rate. PV = X/i X = annual income i = interest rate

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Rule of 72 n Rule of 72 – the number of years it takes for a certain amount to double in value equals 72 divided by the rate of interest.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Importance of Present Value n Many business decisions require present value calculations. n Income flows in the future are compared to present costs or to other future money flows.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Importance of Present Value n Why average stock sells for about 15 times normal profit: l If a share of stock is expected to earn $1 per share per year and the interest rate is 6.5 percent, then its present value is:

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Importance of Present Value n Why bond prices and interest rates are inversely related: l If the interest rate rises to 10 percent, then the value of bond earning a fixed amount will go down.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Institutions n A financial institution is a business whose primary activity is buying, selling, or holding financial assets. n A depository institution is a financial institution whose primary financial liability is deposits in checking or savings accounts.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Institutions n Financial institution channel savings from savers to borrowers. l Savers – individuals who give other people money now in return for promises to pay it back with interest later. l Borrowers – investors or consumers who get the money now in return for their promise to pay it and the interest later.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Institutions n A contractual intermediary is a financial institution that holds and stores individuals’ financial assets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Financial Institutions n Depository institutions. n Contractual intermediaries. n Investment intermediaries. n Financial brokers.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Depository Institutions n Commercial banks, savings and loans, mutual savings banks, and credit unions. n The primary liabilities of depository institutions are checking and savings accounts. n They hold about 36 percent of all financial assets in the U.S.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Contractual Intermediaries n Pension funds, life insurance, and fire and casualty insurance companies. n These institutions promise to pay an individual a certain amount of money in the future. n About 33 percent of all financial assets in the U.S. are in contractual intermediaries.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Investment Intermediaries n Money market mutual funds, mutual funds, and finance companies. n These institutions promise allow small savers to pool their funds to purchase a variety of financial assets. n About 21 percent of all financial assets in the U.S. are in investment intermediaries.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Investment Intermediaries n A mutual fund allow small savers to diversify their savings. n Diversification – spreading the risks by holding many different types of financial assets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Investment Intermediaries n A finance company borrow from savers by selling bonds and commercial paper. n Commercial paper – a short-term promissory note that a certain amount of money plus interest will be paid back on demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Brokers n Investment banks and brokerage houses. n Investment banks help companies to sell their stocks and bonds. n Brokerage houses help individuals to sell previously issued financial assets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Brokers n Brokerage houses create a secondary market in financial assets. n Secondary financial market – a market in which previously issued financial assets can be bought and sold.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Markets n A financial market is a market where financial assets and financial liabilities are bought and sold.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary and Secondary Financial Markets n A primary financial market is a market in which newly issued financial assets are sold. n Sellers include venture capital firms and investment banks.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary and Secondary Financial Markets n Venture capital firms sell part ownerships in new companies. n Investment banks sell new stock and bonds for existing companies.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary and Secondary Financial Markets n A secondary financial market transfers existing financial assets from one saver to another. n This transfer does not represent any new saving – it is saving for one person and dissaving for another.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary and Secondary Financial Markets n Secondary financial markets encourage people to own financial assets by providing liquidity. n Liquidity – the ability to turn an asset into cash quickly.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Money Markets and Capital Markets n Financial markets can be divided into money markets and capital markets. l Money markets – where financial assets having a maturity of less than one year are bought and sold. l Capital markets – where financial assets having a maturity of more than one year are bought and sold.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Money Markets and Capital Markets n Maturity refers to the date the issuer must pay back the money that was borrowed plus any remaining interest, as agreed when the asset was issued.

Principal Capital Market Instruments McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 7% 11% 7% 6% 1980s 22% 33% 1970s 9% 15% 39% 6% 13% 5% 7% Corporate stocks (market value) Residential mortgages Corporate bonds Commercial and farm mortgages Bank commercial loans Consumer loans State and local government bonds U.S. government securities (marketable long-term) 4% 5% % 20%14% 15% 4% 34%

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Type of Financial Assets n Financial assets are generally divided into money market assets and capital market assets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Money Market Assets n Money market assets mature in less than one year. n Because they offer more liquidity, they pay lower interest rates than longer-term capital assets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Money Market Assets n The most important money market assets are negotiable CDs, commercial paper, and U.S. Treasury bills.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Negotiable CDs n A certificate of deposit (CD) is a piece of paper certifying that you have a sum of money in a savings account in the bank for a specified period of time.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Commercial Paper n Commercial paper is a short-term IOU of a corporation. n By selling commercial paper, Corporations avoid borrowing from commercial banks.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Commercial Paper n Disintermediation – the process of lending directly and going through a financial intermediary.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. U.S. Treasury Bills n U.S. Treasury bills are government IOUs that mature in less than a year. n Selling U.S. Treasury bills is one way the U.S. government finances the deficit.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Differences Among Money Market Assets n Money market instruments differ slightly from each other. n For the most part, they are interchangeable. n The interest paid on them tend to increase and decrease together.

Principal Money Market Instruments McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Negotiable bank certificates of deposit (large denomination) Commercial paper U.S. Treasury bills Federal funds Other (includes repurchasing agreements, Eurodollars, bankers’ acceptances)

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Market Assets n Capital market assets have a maturity of over one year. n The most important are stocks, bonds, and mortgages.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Stocks n A stock is a partial ownership right to a company. n Stocks are sold in secondary markets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Bonds n A bond is an IOU, of either the government or a firm, that matures in more than one year. n Unlike stock, bonds must be repaid at maturity. n Bonds are also traded in secondary markets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Leading You Through Two Financial Transactions n Insuring a car and buying a house are two financial transactions that many people are likely to make.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Insuring Your Car n You buy automobile insurance from an insurance company. n The company earns income in two ways: l In the difference between the money it receives in payments and claims it pays out. l In the interest it makes on financial assets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Insuring Your Car n Financial assets purchased by insurance companies include promissory notes evidencing loans that finance real investment and bonds.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Buying a House n Most people borrow money from a bank or other financial institution to purchase a house. n The funds banks use to make loans come primarily from depositors. n A mortgage is a special name for a secured loan on real estate.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Buying a House n Banks get additional funds to make mortgage loans by selling existing mortgages on the secondary market.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Buying a House n Buyers in the secondary market include the Federal National Mortgage Association (FNMA or Fannie Mae) and the Government National Mortgage Association (GNMA or Ginnie Mae).

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Buying a House n Fannie Mae and Ginnie Mae put a number of mortgages into a $100 million bond fund secured by the mortgages. n They then sell shares in that fund to others.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Closer Look at Financial Institutions and Financial Markets End of Chapter 27 Appendix