The Financial System

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The Financial System
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Purpose of Financial System

• Match up savers with investors
• direct matching up
• indirect matching up

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Debt finance The bond market

• Bonds are I.O.U.s issued by firms to raise funds
  to build new factories.

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Characteristics of bonds

• 1) term to maturity
• long-term vs. short-term
• 2) credit risk
• probability of bankruptcy
• junk bonds vs. govt. bonds
• 3) tax treatment

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Tax implications of owning an interest bearing
asset

• Assume -- marginal tax rate of 28.
• -- interest rate of 10
• -- Principal of 100
• interest earnings 100 x 0.10 10
• tax is 10 x 0.28 2.80
• after tax earnings 10 - 2.80 7.20
• After tax interest rate 10 - 2.8 7.2

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Municipal bonds

• Issued by states and local governments. Interest
  earnings not subject to federal income tax.
  Hence tend to pay lower interest rates.

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Stock market

• Equity finance the firm obtains saving from
  lenders, but in return gives the saver (stock
  holder) a claim to the profits that the firm
  makes.
• -- in general, higher risks and higher
  returns are possible for the lenders

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Stock indexes

• DJIA Dow Jones Industrial Average
• prices of stocks of 30 major US companies
• consists of blue chip stocks.
• Standard and Poor 500
• broader index
• indicators of perceptions of the future
  profitability of firms and of the economy overall

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Dow Jones Industrial Average
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Nasdaq in red
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The Financial System
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Banks

• Lenders are usually smaller and lesser known.
  Such businesses (and individuals) will borrow
  from a bank because it is more difficult to
  borrow directly from savers--information issue

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Mutual Funds

• Allows savers to participate in "stock
  ownership". Diversification is possible while
  not requiring a huge individual pool of funds.
• Strategic purchasing of stock vs. buying into an
  index

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Real vs. nominal interest rates

• Nominal interest rate--rate quoted by the bank
• Real interest rate--true return once inflation is
  taken into account
• inominal ireal inflation rate

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Nominal interest rate
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Saving and Investment in the national accounts

• Y C I G NX open economy
• assume no exports and no imports
• (1) Y C I G
• (2) Y - C - G I
• (3) S I
• national saving investment

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National saving

• Recall
• (4) S Y - C - G
• on the r.h.s. subtract and add taxes
• (5) S Y - T - C T - G
• S (Y - T - C) (T - G)
• national S Private S Public S

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Government budget

• Revenues - expenditures
• Taxes - Government purchases of goods
  and services

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Saving and Investment

• Recall
• (3) S I
• Sprivate Spublic I
• The financial system makes sure that (3) holds
  for the economy on a whole
• But how does it coordinate this task?

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Model of the Financial System

• Model for loanable funds
• savers
• investors
• i real interest rate
• SLF f (iR)
• DLF f (iR)

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Model of the Financial System

• Model for loanable funds
• i real interest rate
• SLF f (iR)
• DLF f (iR)
• -

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Market for loanable funds

• SLF f (iR ts, gb)
• ts taxes on saving
• gb government budget
• DLF f(iR itc)
• -
• itc investment tax credits

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Market for loanable funds

• SLF f (iR ts, gb)
• -
• ts taxes on saving
• gb government budget
• DLF f(iR itc)
• -
• itc investment tax credits

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Clarification

• Government budget
• Government debt

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Economic consequences of government budget
deficits

• Higher interest rates
• crowding out of private investment

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Money over time
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Future value of a current investment?

• Future value of a sum put into the bank today?
• Year 1value 100(1r)

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Future value of a current investment?

• Future value of a sum put into the bank today?
• Year 1 value 100(1r)
• Year 2 value 100(1r)(1r)

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Future value of a current investment?

• Future value of a sum put into the bank today?
• Year 1value 100(1r)
• Year 2 value 100(1r)(1r)
• Year 3 value 100(1r)(1r)(1r)
• or 100(1r)3
• Year n value 100(1r)n

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Future value of a current investment?

• Future value of a sum put into the bank today?
• Year 1value 100(1r)
• Year 2 value 100(1r)(1r)
• Year 3 value 100(1r)(1r)(1r)
• or 100(1r)3
• Year n value 100(1r)n
• Future value Present value(1r)n

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Future value of a current investment?

• Future value of a sum put into the bank today?
• Year 1value 100(1r)
• Year 2 value 100(1r)(1r)
• Year 3 value 100(1r)(1r)(1r)
• or 100(1r)3
• Year n value 100(1r)n
• Future value Present value(1r)n

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Present Value of a future payment

• Recall
• Future value Present value(1r)n
• F P(1r)n
• Solve for Present value.

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Examples of comparing money values over
different points in time?

• 1) Choice of a lottery payout.
• 2) Firms decision to make an investment.
• Example It will cost a firm 100 to build a
  factory. After 15 years the value of that
  investment will be 200. Should the firm make
  the investment?

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• If the interest rate is 3
• present value of 200 today is
• Makes sense to make the investment.

• If the interest rate is 10 the present value of
  200 today is
• Does not make sense to make the investment.

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Impact of interest rates on investments
(acquisition of capital stock) by firms

• Higher interest rates reduce the present value of
  future sums. Hence higher interest rates
  discourage investment.

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Rule of 70

• If a variable grows at x percent per year the
  variable will double in approximately 70/x years.
  
• A bank account with 100 dollars earning 3 per
  year. Will double in size (be 200) in 70/3
  23.3 years.

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Risk Aversion
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Risk aversion

• A distaste for risk. The basis for risk aversion
  is diminishing marginal utility of income.
• The amount of utility you gain from an
  additional 100 in income is less than the
  utility you lose from losing 100 in income.

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Insurance

• Purpose of insurance to spread risks
• Problems with the market for insurance
• 1) adverse selection
• 2) moral hazard

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Diversification

• Diversification reduces idiosyncratic risk
  (standard deviation)
• Idiosyncratic risk
• Market risk (aggregate risk)uncertainty
  associated with the entire economy.

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Risk-return trade-off

• Return and standard deviation

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Asset Valuation

• Fundamental analysis
• Value of the business and the price of shares
• undervalued
• overvalued
• fairly valued
• Have someone pick the stock portfolio vs. buy a
  mutual fund

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Efficient markets

• Efficient markets
• random walks

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Investor behavior clouds the wisdom of offering
wider choice in 40l(k)'s.By Hal Varian New York
Times February 14, 2002

• AFTER the Enron collapse, Congress is debating
  whether to limit the amount of their own
  company's stock that employees can put into their
  401(k) retirement plans.Those in favor of such
  caps, like Senators Barbara Boxer and Jon S.
  Corzine, see them as a way to encourage
  diversification and reduce risk. Those opposed,
  like Labor Secretary Elaine L. Chao, say such
  caps violate freedom of choice.