INVESTMENT,%20FINANCIAL%20INTERMEDIATION

1
Lecture 7
INVESTMENT, FINANCIAL INTERMEDIATION FINANCIAL
MARKETS
2
INVESTMENT

• An action taken today that has costs today but
  provides benefits in the future.
• Firm building plant today incurs costs today but
  earns revenue in the future
• Student incurs costs to attend university now for
  the sake of higher earnings in the future
• Government spends money today to build a dam to
  have a source of hydroelectric power in the future

3
NOMINAL INTEREST RATES

• Interest rates actually charged in the market.
• REAL INTEREST RATES
• Nominal interest rates adjusted for inflation.

4
FINANCIAL INTERMEDIARIES

• Organizations that receive funds from savers
  and channel them to investors.
• financial institutions such as banks, savings and
  loans, and insurance companies

5
ANIMAL SPIRITS

• John Maynard Keynes emphasized that sharp
  swings in moods of investors were often
  irrational and perhaps reflected our most basic,
  primal instincts.

6
ACCELERATOR THEORY

• One theory of investment spending that
  emphasizes the role of expected growth in real
  GDP on investment spending.
• When real GDP growth is expected to be high,
  firms anticipate that their investments in plant
  and equipment will be profitable and therefore
  increase their total investment spending.

7
PROCYCLICAL

• Increases during booms and falls during
  recessions
• Investment spending is highly procyclical

8
INVESTMENT IN STRUCTURES AND EQUIPMENT IN
THE EARLY 1990s
Billions of 1990 dollars
Billions of 1992 dollars
550
210
200
500
190
450
180
400
170
350
160
89
90
91
92
93
94
95
89
90
91
92
93
94
95
Year
Year
Non-residential structures
Producers durable Equipment
Source Data from Economic Report of the
President, Washington, DC U.S. Government
Printing Office, yearly
9
MULTIPLIER-ACCELERATOR MODEL

• In this model a downturn in real GDP would lead
  to a sharp fall in investment, which, in turn,
  would entail further reductions in GDP through
  the multiplier for investment spending.

10
BOND

• A promise to pay money in the future

11
NOMINAL INTEREST RATES

• Interest rates quoted in the market at savings
  and loans or banks or for bonds
• These are actual rates that individuals or firms
  pay or receive when they borrow money or lend
  money

12
REALITY PRINCIPLE

• What matters to people is the real value or
  purchasing power of money or income, not its face
  value.

13
REAL RATE OF INTEREST

• Nominal rate of interest minus the inflation rate
• Real rate Nominal rate - inflation rate

14
EXPECTED REAL INTEREST RATE

• The nominal rate minus the expected inflation
  rate.
• Country 3-Month Interest Inflation Rate Expected
  Rate over last 3 real rate months of
  interest
• Australia 8.12 3.3 4.82
• Belgium 5.13 2.4 2.73
• Canada 7.86 4.2 3.66
• Denmark 6.95 2.1 4.85
• France 7.80 2.3 5.50
• Germany 4.65 3.9 0.75
• Italy 11.00 6.3 4.70
• Japan 1.36 -1.7 3.06
• Spain 9.28 7.9 1.38
• United States 6.08 3.3 2.78
• Source The Economist, April 29, 1995, pp122-23

15
TYPICAL INVESTMENT
0
Cost
-100
16
TYPICAL INVESTMENT
Return
0
Cost
-100
17
TYPICAL INVESTMENT
104
Return
0
Cost
-100
A typical investment, in which a cost of 100
incurred today yields a return of 104 next year.
18
PRINCIPLE OF OPPORTUNITY COST

• The opportunity cost of something is what you
  sacrifice to get it.
• Used to help decide whether to undertake
  investment
• If the firm undertakes the investment, it must
  give up 100 today to get 104 the following year
• The interest rate provides a measure of the
  opportunity cost of the investment

19
INTEREST RATES AND INVESTMENT
Real Rate of Interest
Investment Spending
As the real interest rate declines, investment
spending in the economy increases.
20
INTEREST RATES AND INVESTMENT
Real Rate of Interest
Investment Spending
As the real interest rate declines, investment
spending in the economy increases.
21
INTEREST RATES AND INVESTMENT
Real Rate of Interest
Investment Spending
As the real interest rate declines, investment
spending in the economy increases.
22
INTEREST RATES AND INVESTMENT
Real Rate of Interest
Investment Spending
As the real interest rate declines, investment
spending in the economy increases.
23
REAL INVESTMENT SPENDING

• Inversely related to the real interest rate
• Nominal interest rates are not necessarily a good
  indicator of the true cost of investing
• Inflation would increase the nominal rate of
  return and nominal interest rate equally
• A firm makes its investment decisions by
  comparing its expected real net return from
  investment projects to the real rate of interest

24
NEOCLASSICAL THEORY OF INVESTMENT

• Pioneered by Dale Jorgenson of Harvard
• Real interest rates and taxes play a key role in
  determining investment spending
• Jorgenson used his theory to analyze the
  responsiveness of investment to a variety of tax
  incentives, including investment tax credits that
  are subsidies to investment

25
Q-THEORY OF INVESTMENT

• Originally developed by Nobel laureate, James
  Tobin of Yale University
• Theory states that investment spending increases
  when stock prices are high
• If stock prices are high, it can issue new shares
  of its stock at an advantageous price and use the
  proceeds to undertake new investment
• Recent research has shown a close connection
  between Q-theory and neoclassical theory and
  highlighted the key role that real interest rates
  and taxes play in the Q-theory as well

26
SOURCE OF INVESTMENT SPENDING

• Investment spending in an economy must ultimately
  come from savings
• When households earn income, they consume part
  and save the rest
• These savings become the source of funds for
  investment in the economy

27
LIQUIDITY

• Households want savings to be readily accessible
  in case of emergencies
• Funds deposited in a bank account provide a
  source of liquidity for households, since these
  funds can be obtained at anytime

28
SAVERS AND INVESTORS
Savers
29
SAVERS AND INVESTORS
Savers who face risk
Risk Loss of Liquidity costs of negotiation
30
SAVERS AND INVESTORS
Savers who face risk
Risk Loss of Liquidity costs of negotiation
Demand High Interest Rates
31
SAVERS AND INVESTORS
Savers who face risk
Investors
Risk Loss of Liquidity costs of negotiation
Demand High Interest Rates from
32
FINANCIAL INTERMEDIARIES

• Institutions such as banks, savings and loans,
  insurance companies, money market mutual funds,
  and many other financial institutions
• Accept funds from savers and make loans to
  businesses and individuals
• Pool funds of savers, reducing costs of
  negotiation
• Acquire expertise in evaluating and monitoring
  investments
• Some financial intermediaries, such as banks,
  provide liquidity to households

33
DIVERSIFICATION

• Investing in a large number of projects whose
  returns, although uncertain, are independent of
  one another
• How financial intermediaries reduce risk

34
Financial Intermediaries
Savers
Investors
35
Financial Intermediaries
Savers
Investors
Financial Intermediary
Bank
banks savings and loans insurance companies
36
Financial Intermediaries
Savers
Investors
Financial Intermediary
Bank
make deposits to
banks savings and loans insurance companies
37
Financial Intermediaries
Savers
Investors
Financial Intermediary
Bank
make deposits to
make loans to
banks savings and loans insurance companies
38
FINANCIAL INTERMEDIATION MALFUNCTIONS

• Financial intermediation failures occurred for
  banks in the USA during the Great Depression and
  for savings and loans during the savings and loan
  crises of the 1980s
• During the 1930s worried depositors and rumors
  triggered runs on banks
• Since banks, as financial intermediaries, never
  keep 100 of funds on hand, the runs closed down
  thousands of healthy banks
• To prevent this from happening again, the U.S.
  government began to provide deposit insurance for
  banks and savings and loans

39
FINANCIAL INTERMEDIATION MALFUNCTIONS

• Deposit insurance indirectly helped create
  savings and loan crisis during the 1980s
• The government tried to assist the (struggling)
  saving and loan industry by reducing regulations
• Many investment projects collapsed and the
  government was forced to bail out many savings
  and loans at a cost of nearly 100 billion to the
  U.S. economy

40
Financial Markets

• Financial markets are financial institutions
  through which savers can directly provide funds
  to borrowers. In financial markets, there is no
  middle man. The two most important financial
  markets in the economy are bond and stock
  markets.

41
Bond Market - 1

• Bonds are nothing more than an IOU. All bonds
  contain specific information about how much is
  being borrowed (the principal), when the bond
  must be repaid (the maturity date), and the rate
  of interest that must be paid periodically until
  the bond is repaid.

42
Bond Market - 2

• Bonds are issued by companies, as well as the
  federal, state and local governments, to raise
  money. When a company or government issues a
  bond, they are borrowing money. When a person
  buys a bond, and becomes a bondholder, that
  person is the lender (or creditor).

43
Bond Market - 3

• Bonds are traded in markets where the interaction
  of the demand and supply for each type of bond
  determines that bonds price. There are three
  important characteristics that affect the value
  of all bonds
• the term (how long until the bond is due?)
• the credit risk (what is the probability that the
  firm borrowing money will default?) and
• the tax treatment (is the interest paid on the
  bond taxable by the federal government?).

44
Bond Market - 4

• Each of these three characteristics determine the
  riskiness and profitability of buying and holding
  a bond, and therefore affect the demand for the
  bond. As bonds become more risky, the demand for
  the bond falls, and the bond issuer must offer to
  pay a higher interest rate to persuade people to
  purchase the bond.

45
Bond Market - 5

• As bonds become more profitable,the demand for
  the bond rises. Because of this, tax free
  municipal bonds pay low rates of interest.

46
Stock Markets - 1

• Issuing stock is another way for firms to raise
  money (the government cannot issue stock).
  Whoever buys a firms stock becomes a part owner
  of that firm.

47
Stock Markets - 2

• The money received by a firm from issuing stock
  never needs to be repaid (so stockholders are NOT
  creditors). Like bonds, stock prices are
  determined in markets by the interaction of the
  demand and supply for each individual stock.

48
Stock Markets - 3

• Stock prices reflect peoples expectations about
  the firms future profitability. When firms are
  expected to be profitable, demand will be high,
  and the stock price will rise. When firms are
  expected to lose money, demand will below, and
  the stock price will fall.