Chapter 4 The Financial System and Interest © 2000 South-Western College Publishing

THE "EVERYDAY" FINANCIAL SYSTEM Goods and Services Purchase $ Wages Labor Services Figure 4-1 Everyday Money Flows Between Sectors TM 4-1 ConsumptionProduction

SAVINGS AND INVESTMENT Consumers save some of their incomes Companies need funds for large projects These needs are "happily coincidental" Financial markets channel consumer savings to companies for major projects through the sale of financial assets TM 4-2 Slide 1 of 2

Goods and Services Purchase $ Wages Labor Services Purch $ Purch $ Securities Interest and Dividends Figure 4-1 Money Flows Between Sectors TM 4-2 Slide 2 of 2 Production Consumption Financial Markets

The Term INVEST To use a resource to better one's position in the future rather than for current consumption. To earn a "return." Individuals invest by putting savings in financial assets: stocks, bonds, bank accounts. Companies invest by purchasing or building assets used in business. The funds available for business investment come from savings put into financial assets by individuals. Hence, in the economy, Savings Equals Investment More precisely, (Consumer) Savings Equals (Business) Investment TM-4-3

FINANCIAL MARKETS MONEY MARKET : Short term debt < one year CAPITAL MARKET : Long term funds > one year Stocks and long term debt PRIMARY MARKET : The first sale of a security Issuing company gets proceeds SECONDARY MARKET : Subsequent sales of the security Between investors Company not involved TM-4-4

PRIMARY MARKET TRANSFERS $$$ Security (a) Direct Transfer (b) Direct Transfer Through Investment Banker (c) Direct Transfer Through Financial Intermediary Figure 4-3 TRANSFER OF FUNDS FROM INVESTORS TO BUSINESSES TM 4-5 Slide 1 of 2 Investor Company Investment Bank Financial Intermediary $$$ Security $$$ Security of FI $$$ Security of Co.

FINANCIAL INTERMEDIARY Pools the invested money of individuals -Invests it in securities -Issues its own security to individual investors Types of Financial Intermediary: *Mutual funds *Pension funds *Insurance companies *Banks Financial Intermediaries are institutional investors Have great influence in the financial markets TM 4-5 Slide 2 of 2

THE STOCK MARKET A network of investors, brokers and exchanges Broker (house): licensed to trade in securities for a commission Exchange: Administrative marketplace Figure 4-4 Schematic Representation of a Stock Market Transaction TM 4-6 Slide 1 of 2 © 1997 South-Western Publishing Company TM 4-56 Slide 1 of 2 Exchange Floor Broker Specialist (trade made) Floor Broker Seller Local Broker Local Broker Buyer

EXCHANGES The New York Stock Exchange (NYSE) The American Stock Exchange (AMEX) Regional Exchanges TM 4-6 Slide 2 of 2

READING STOCK MARKET QUOTATIONS Weeks Yld Vol Net Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg 89 1 / / 16 GenMotor GM / / / 16 TM 4-7

Trading in Stocks Privately (closely) Held Privately (closely) Held : Not generally available Securities Newly Offered to the Public Initial Public Offering (IPO) Prospectus - Red Herring SEC Approval SEC Regulation aimed at Disclosure Public (but unlisted) Public (but unlisted) : Available on the Over The Counter (OTC) Market (NASDAQ) Listed Listed : Available on one or more exchanges T-4-8

INTEREST The Return on a Debt Investment. Interest Drives the Price of Securities A lower price => a higher return given a stream of cash flows Security prices (both stocks and bonds) adjust to changing interest rates by changing their prices in the opposite direction Hence: Interest (among other things) drives the stock market Interest Also Drives the Economy Determines the feasibility of doing projects on borrowed money T-4-9

COMPARING SUPPLY AND DEMAND FOR A PRODUCT WITH SUPPLY AND DEMAND FOR MONEY (DEBT) Interest Price Rate S k% p* k* D Q* Quantity Figure 4-6 Supply and Demand Curves Figure 4-7 Supply and Demand Curves for a Product for Money (Debt) TM 4-10 Lenders Buy bonds Borrowers Sell bonds $$$ $* S D

THE COMPONENTS OF AN INTEREST RATE Base Rate Risk Premium k = k PR + INFL + DR + LR + MR k PR = Pure Interest Rate INFL = Inflation Adjustment* DR = Default Risk Premium LR = Liquidity Risk Premium MR = Maturity Risk Premium * Average planned inflation rate over life of the loan. TM 4-11 Slide 1 of 3

THE COMPONENTS OF AN INTEREST RATE Default risk - Chance of not receiving full payment of principal and interest Liquidity risk - Chance of not being able to sell at full price Maturity risk - Chance of loss on price changes due to interest rate movements -greater with longer maturities Essentially zero for short-term debt TM 4-11 Slide 2 of 3

FEDERAL GOVERNMENT DEBT DR = 0: Federal government can print money LR effectively zero: Ready market exists RISK FREE RATE Base Rate Rate on short term government debt - 90 day T-bills REAL RATE Without inflation adjustment TM 4-11 Slide 3 of 3

THE TERM STRUCTURE OF INTEREST RATE THE YIELD CURVE THE TERM STRUCTURE OF INTEREST RATE THE YIELD CURVE A graph of interest rates vs the term of debt for borrowers of similar quality Interest Rate (k%) or YIELD 90 daysThirty years Figure 4-8 Yield Curves TM 4-12 Slide 1 of 2 Inverted Normal

THEORIES OF THE SHAPE OF THE YIELD CURVE Expectations: Shape depends on expectations of future interest (or inflation) rates Liquidity Preference: Lenders prefer more liquid short term loans because: 1. Less exposure to price changes due to interest rate movements 2. Can wait out maturity if need money An extra incentive is required to lend long so curve slopes up Segmentation: Market segmented into many sub-markets by term Supply and demand independent in each Equilibrium rates can be anything relative to one another so curve can slope up or down TM 4-12 Slide 2 of 2