Financial Markets

1
Financial Markets and International Capital Flows
2
Introduction

• The stock market boom included sound investment
  decisions and speculation (gambling).
• The role of financial markets is to ensure
  national saving is allocated to the most
  productive uses.

3
The Financial System and theAllocation of Saving
to Productive Uses

• Key Components of Economic Growth
• High rates of saving
• An efficient financial system that distributes
  national savings to the most productive
  investments

4
The Financial System and theAllocation of Saving
to Productive Uses

• The U.S. financial system
• Is a decentralized market oriented system.
• Includes financial institutions and financial
  markets.

5
The Financial System and theAllocation of Saving
to Productive Uses

• The financial system in the U.S. improves the
  allocation of savings in two ways
• Provides information
• Helps savers share the risk

6
The Financial System and theAllocation of Saving
to Productive Uses

• The Banking System
• Banks are a financial intermediary between savers
  and borrowers.
• Financial Intermediaries
• Firms that extend credit to borrowers using funds
  raised from savers

7
The Financial System and theAllocation of Saving
to Productive Uses

• The Banking System
• By acting as a financial intermediary, banks can
  increase the efficiency of the capital market in
  several ways
• Banks specialize in evaluating the quality of a
  borrower and perform the task at a lower cost.

8
The Financial System and theAllocation of Saving
to Productive Uses

• The Banking System
• By acting as a financial intermediary, banks can
  increase the efficiency of the capital market in
  several ways
• Banks pool savings, which increases the
  efficiency of making large loans.

9
The Financial System and theAllocation of Saving
to Productive Uses

• The Banking System
• By acting as a financial intermediary, banks can
  increase the efficiency of the capital market in
  several ways
• Banks develop expertise in making small business
  and consumer loans.
• Banks offer services to savers which attract
  their deposits.

10
The Financial System and theAllocation of Saving
to Productive Uses

• Economic Naturalist
• How has the banking crisis in Japan affected the
  Japanese economy?

11
The Financial System and theAllocation of Saving
to Productive Uses

• Economic Naturalist
• How has the banking crisis in Japan affected the
  Japanese economy?
• 1980s
• Japanese banks made loans in the bullish real
  estate market and acquired stock in corporations.

12
The Financial System and theAllocation of Saving
to Productive Uses

• Economic Naturalist
• How has the banking crisis in Japan affected the
  Japanese economy?
• 1990s
• Real estate prices plummeted and many borrowers
  defaulted on their loans.
• Falling stock prices reduced the value of the
  banks shareholdings

13
The Financial System and theAllocation of Saving
to Productive Uses

• Economic Naturalist
• How has the banking crisis in Japan affected the
  Japanese economy?
• Credit crunch occurred and small businesses
  could not get loans
• Japan relies more on the banking system to
  allocate savings than the U.S.
• Japan fell into a severe recession
• Slow regulatory response by the Japanese
  government

14
The Financial System and theAllocation of Saving
to Productive Uses

• Bond
• A legal promise to repay a debt, usually
  including both the principal amount and regular
  interest payments

15
The Financial System and theAllocation of Saving
to Productive Uses

• Principal Amount
• The amount originally lent
• Maturation Date
• The date at which the principal will be repaid

16
The Financial System and theAllocation of Saving
to Productive Uses

• Coupon Rate
• The interest rate promised when a bond is issued
• Coupon Payments
• Regular interest payments made to the bondholder

17
The Financial System and theAllocation of Saving
to Productive Uses

• Bonds -- An Example
• Principle amount of a bond 1,000
• Maturation date January 1, 2025
• Coupon rate 5
• Annual coupon payment
  (0.05)(1,000) 50

18
The Financial System and theAllocation of Saving
to Productive Uses

• Bonds
• Corporations and governments sell bonds to raise
  funds.
• The longer the term of the bond the higher the
  coupon rate.

19
The Financial System and theAllocation of Saving
to Productive Uses

• Bonds
• The greater the risk of default, the higher the
  coupon rate.
• Municipal bonds are exempt from federal taxes and
  have a lower coupon rate.
• Bondholders may sell their bonds at any time in
  the bond market at their market price.

20
The Financial System and theAllocation of Saving
to Productive Uses

• Example
• Bond prices and interest rates
• Jan 1, 2006 purchase a 2 year government bond
• Principle amount 1,000
• Coupon rate 0.05
• Coupon payment 1,000 x 0.05 50 (Jan 1,
  2007)
• At maturity 1,000 50 1,050 (Jan 1, 2008)

21
The Financial System and theAllocation of Saving
to Productive Uses

• Example
• Bond prices and interest rates
• Want to sell the bond on Jan 1, 2007
• The prevailing interest rate 6
• Bond price x 1.06 1,050
• Bond price 1,050/1.06 991
• The prevailing interest rate 4
• Bond price 1,050/1.04 1,010
• Observation
• Bond prices and interest rates are inversely
  related

22
The Financial System and theAllocation of Saving
to Productive Uses

• Stock (or equity)
• A claim to partial ownership of a firm

23
The Financial System and theAllocation of Saving
to Productive Uses

• Two sources of return to stockholders
• Dividend
• A regular payment received by stockholders for
  each share that they own
• Capital gain
• The difference between the purchase price and
  selling price, when the selling price is higher

24
The Financial System and theAllocation of Saving
to Productive Uses

• Example
• How much should you pay for a share of
  FortuneCookie.com
• Dividend 1.00/share in one year
• Price/share 80 in one year
• Each share will be worth 81 in one year
• Rate of return 6

25
The Financial System and theAllocation of Saving
to Productive Uses

• Example
• How much should you pay for a share of
  FortuneCookie.com
• Stock price x 1.06 81
• Stock price 81/1.06 76.42
• If dividend 5, stock price 85/1.06 80.19

26
The Financial System and theAllocation of Saving
to Productive Uses

• Observations
• An increase in future dividends or future stock
  prices will raise the price of the stock today.
• An increase in required rate of return will lower
  todays stock price.

27
The Financial System and theAllocation of Saving
to Productive Uses

• Observations
• The uncertainty of future earnings and dividends
  increases the risk of purchasing a stock.
• Stock market investors account for this risk by
  requiring a higher rate of return or risk premium.

28
Bond Markets, Stock Markets, and the Allocation
of Savings

• The Information Role of Bond and Stock Markets
• In order to gain high rates of return, investors
  must closely scrutinize potential borrowers.

29
Bond Markets, Stock Markets, and the Allocation
of Savings

• Risk Sharing and Diversification
• Sharing risk encourages investment
• Diversification
• The practice of spreading ones wealth over a
  variety of different financial investments to
  reduce overall risk

30
Bond Markets, Stock Markets, and the Allocation
of Savings

• Economic Naturalist
• Why did the U.S. stock market rise sharply in the
  1990s, then fall in the new millennium?

31
Bond Markets, Stock Markets, and the Allocation
of Savings

• Economic Naturalist
• During the 1990s boom
• Economic growth fueled expectations of higher
  dividends
• Diversification reduced the risk premium
• Risk may have been underestimated

32
Bond Markets, Stock Markets, and the Allocation
of Savings

• Economic Naturalist
• The millennium decline
• Tech failures and scandals lowered the dividend
  expectations.
• Risk premium rose in response to the recession,
  terrorist attacks, and corporate scandals.

33
International Capital Flows

• International Capital Flows
• Purchases or sales of real and financial assets
  across international borders

34
International Capital Flows

• Two Macroeconomic Roles for International Capital
  Flows
• A country with greater investment opportunities
  than savings can fill the savings gap by
  borrowing from abroad.
• International capital flows allow countries to
  run trade imbalances.

35
International Capital Flows

• International financial markets allocate savings
  to productive capital in different countries.
• International financial markets are subject to
  the laws of at least two countries.

36
International Capital Flows

• Capital Inflows
• Purchases of domestic assets by foreign
  households and firms
• Capital Outflows
• Purchases of foreign assets by domestic
  households and firms

37
International Capital Flows

• Net Capital Inflows
• Capital inflows minus capital outflows

38
International Capital Flows

• Trade Balance (or net exports)
• The value of a countrys exports less the value
  of its imports in a particular period (quarter or
  year)

39
International Capital Flows

• Trade Surplus
• When exports exceed imports, the difference
  between the value of a countrys exports and the
  value of its imports in a given period

40
International Capital Flows

• Trade Deficit
• When imports exceed exports, the difference
  between the value of a countrys imports and the
  value of its exports in a given period

41
The U.S. TradeBalance, 1960 - 2004

• Observations
• Trade has become increasingly important
• Since the 1970s, the U.S. has run trade deficits

42
International Capital Flows

• Capital Flows and the Balance of Trade
• NX trade balance (net exports)
• KI net capital inflows
• NX KI 0

43
International Capital Flows

• Understanding NX KI 0
• U.S. resident buys a 20,000 Japanese automobile
• The Japanese car manufacturer receives 20,000
  and has two options
• He can buy 20,000 of U.S. goods
• U.S. exports imports or NX 0 and KI 0
• NX KI 0

44
International Capital Flows

• Understanding NX KI 0
• U.S. resident buys a 20,000 Japanese automobile
• The Japanese car manufacturer has 20,000 and has
  two options
• He can buy U.S. assets (land, bond, etc.)
• NX -20,000
• Capital inflow KI 20,000
• NX (-20,000) KI (20,000) 0

45
International Capital Flows

• The Determinants of International Capital Flows
• Real interest rate
• High domestic real interest rates will cause net
  capital inflows.
• Low domestic real interest rates will cause net
  capital outflows.

46
Net Capital Inflows and the Real Interest Rate
Domestic real interest rate r
Net capital inflow KI
47
International Capital Flows

• Risk
• For a given real interest rate, an increase in
  riskiness in domestic assets will reduce net
  capital inflows and vice versa

48
An Increase In Risk Reduces Net Capital Inflows
KI
Domestic real interest rate r
0
Net capital inflow KI
49
International Capital Flows

• Saving, Investment, and Capital Inflows
• Y C I G NX
• Subtract C G NX from both sides
• Y - C - G - NX I
• National saving (S) Y - C - G
• NX KI 0 so, KI -NX
• Substitute S for Y - C - G KI for -NX
• S KI I

50
International Capital Flows

• Observation
• The pool of saving available for domestic
  investment includes national savings and the
  funds from savers abroad.

51
The Saving-Investment Diagram For An Open Economy
Real interest rate ()
Saving and investment
52
International Capital Flows

• Observations
• A country that attracts foreign capital will have
  lower real interest and higher investment.
• Countries with a stable political environment and
  well defined property rights will attract more
  foreign capital.

53
International Capital Flows

• The Saving Rate and the Trade Deficit
• A low rate of national saving is the primary
  cause of trade deficits.

54
International Capital Flows

• The Saving Rate and the Trade Deficit
• Y C I G NX
• Subtracting C I G from both sides
• Y - C - I - G NX
• S Y - C - G
• S - I NX
• Assuming I is constant
• If S increases, NX increases, and vice versa.

55
International Capital Flows

• The Saving Rate and the Trade Deficit
• Low national saving implies high consumer and
  government spending
• High rates of spending will
• Increase imports.
• Decrease exports.

56
International Capital Flows

• The Saving Rate and the Trade Deficit
• Low national saving will also increase capital
  inflows.
• High spending creates investment opportunities
• Shortage of domestic saving will occur
• Real interest rates will rise
• Capital inflows will occur

57
International Capital Flows

• Economic Naturalist
• Why is the U.S. trade deficit so large?

58
National Saving, Investment, and the Trade
Balance in the U.S., 1960 - 2004
59
International Capital Flows

• What Do You Think?
• Is the U.S. trade deficit a problem?

60
End of Chapter