Financial Markets and International Capital Flows

BSE2701

Daolu Cai

NUS Business School

September 7, 2023
Outline

Frank-et-Bernanke 8e, Chapter 11

Savings and Investments

Bonds
Stocks
International Capital Flows

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Learning Objectives

At the end of this lecture, you will be able to:

• Describe the role of financial intermediaries, such as commercial banks in the financial
system, and differentiate between bonds and stocks.
• Analyze the factors that determine international capital flows to understand how domestic
saving, the trade balance, and net capital flows are related.

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Savings and Investments

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The Allocation of Saving

• A successful economy allocates its saving to the most productive investments.

• The banking system improves the allocation of saving:
• Provides information to savers about the possible uses of their funds.
• Help savers share the risks of individual investment projects.

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Banking System

• Banks and other intermediaries specialize in evaluating the quality of borrowers.

• Banks have a lower cost of evaluating opportunities than an individual would.
• Banks pool the saving of many individuals to make large loans, spreading out risk.

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Bonds

• A bond is a legal promise to repay a debt, usually including both the principal amount
and regular interest, or coupon payments. Each bond specifies.
• Principal amount, the amount originally lent.
• Maturation date, the date when the principal amount will be repaid. (The term of a bond is
the length of time from issue to maturation.)
• Coupon payments, the periodic interest payments to the bondholder.
• Coupon rate, the interest rate that is applied to the principal to determine the coupon
payments.

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Bonds

• Corporations and governments issue bonds. The coupon rate depends on.
• The bond’s term; longer term, higher coupon rate.
• The issuer’s credit risk.
• Tax treatment for the coupon payments

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Bond Market

• Bonds can be sold before their maturation date. Market value at any time is the
price of the bond.
Example:
• A two-year government bond with principal $1,000 is sold for $1,000 (price), 1/1/20.
• Coupon rate is 5 percent.
• $50 will be paid 1/1/21.
• $1,050 will be paid 1/1/22.
• Bond’s price when sold depends on the prevailing interest rate.

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Selling a Bond (Example)

• Offer for sale: one government bond with a payment of $1,050 due in one year. (At
what price?)
• Competition: a new one-year bond with principal of $1,000 and coupon rate of 6
percent. (Pays $1,060 in one year.)
• Year-old bond with 5 percent coupon rate is less valuable than the new bond.
• Price of the used bond will be less than $1,000.
•

Bond Price(1 + 6%) = 1050 (1)

Bond Price = 991 (2)

• Used bond prices and interest rates are inversely related.

• Higher interest rates.
• the new bond pays more
• the old bond is worse by comparison
• the old bond sells for less

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Stocks

• A share of stock (or equity): is a claim to partial ownership of a firm.

• Receive dividends, a regular payment received by stockholders for each share they own.
• Receive capital gains if the price of the stock increases.
• Prices are determined in the stock market.

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Example
• BSP2701 Company: New company with estimated dividend of $1 in 1 year.
• Estimated selling price of stock will be $80 in 1 year.
• Current Interest rate is 6 percent.
• Value of the new stock will be $81 (80 +1) in 1 year.
•

Stock Price(1 + 6%) = (80 + 1) (3)

Stock Price = $76.42 (4)
• Value would be higher if:
• Dividends were higher
• Price of stock in one year were higher.
• Interest rate were lower.
• If any of these changes, the current price of the stock will adjust.
• If the company’s outlook improves and anticipated sale price jumps to $84, then

Stock Price(1 + 6%) = (84 + 1) (5)

Stock Price = $80.19 (6)

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Risk Premium

• Risk premium is the rate of return investors require to hold risky assets minus the rate of
return on safe assets.
• BSP2701 Company (NOT NUS): New company with estimated dividend of $1 in 1
year.
• Estimated selling price of stock will be $80 in 1 year.
• Current Interest rate is 6 percent, but this is a risky business (4 percent premium)
• Value of the new stock will be $81 (80 +1) in 1 year.
•

Stock Price(1 + 6% + 4%) = (80 + 1) (7)

Stock Price = $73.64 (8)

• Risk aversion increases the return required of a risky stock and lowers the selling price.

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Bond Markets and Stock Markets

• Channel funds from savers to borrowers with productive investment opportunities.

• Like banks, bond and stock markets allocate saving.

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International Capital Flows

• Stock and bond markets are not only domestic.

• Many good investments are outside of the country.
• Investments flow between countries on international financial markets.
• International capital flows are purchases or sales of real and financial assets across
international borders.
• Capital inflows are purchases of domestic assets by foreign households and firms.
• Capital outflows are purchases of foreign assets by domestic households and firms.
• Net capital inflows (KI) are capital inflows minus capital outflows.

Net capital inflows (KI) = Capital inflows - Capital outflows (9)

• Capital flows are not counted as imports or exports since they refer to the purchase of
existing assets rather than currently produced goods and services.

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Two Roles of International Capital Flows

• Trade Imbalances. International capital flows compensate for trade imbalances.

• Trade surplus means net capital outflows. NX > 0 → KI < 0
• Trade deficit means net capital inflows. NX < 0 → KI > 0
• Net capital inflows (KI) are capital inflows minus capital outflows.

Net capital inflows (KI) = Capital inflows - Capital outflows (10)

• Efficient Allocation of Savings

• International capital flows allow savers to invest in the most profitable opportunities.
• Fills savings gap in destination country.

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International Capital Flows

1 Capital inflows to the U.S. include foreign

purchases of Stocks and bonds of U.S.
companies, real assets such as land and
buildings owned by U.S. residents, and
U.S. government bonds
2 Capital flows respond to real interest rates
3 Higher interest rate. Higher level of
savings and investment
4 Higher domestic interest rates mean
greater capital inflows

Figure:

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Risk and Capital Inflows

1 For a given real interest rate, increase in

riskiness of domestic assets decreases
capital inflows
2 Shifts the capital inflow curve to the left
3 Foreigners are less willing to buy domestic
assets
4 Domestic savers are more willing to buy
foreign assets

Figure:

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Trade Balance (NX) and Net Capital Inflows (KI)

• Always True → NX + KI = 0
• Why? Suppose U.S. resident purchases Singapore car (EV) for $20,000 → Imports = 20K .
The Singapore Resident can do a couple of things with the $20,000 USD.
• Option 1: purchase $20,000 of U.S. goods and services so exports = $20,000
→ NX = 0, KI = 0
• Option 2: purchase U.S. bonds or U.S. real estate → NX = −20, 000, KI = 20, 000
• Option 3: sell USD for SGD → Follow the dollars and see what the purchaser does with
them to determine NX and KI

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Savings, Investment, Capital Inflows in an Open Economy

• In a closed economy NX ≡ 0, in an open economy NX 6= 0

Y = C + I + G + NX (11)

• National savings (S) is current income (GDP or Y) less spending on current needs.

Y − C − G − NX = I (12)
S − NX = I (13)

• But we know know NX + KI = 0

S + KI = I (14)

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Saving, Investment and Capital Inflow

1 Savings plus net capital inflows equals

investment in new capital goods. Foreign
savings can supplement domestic savings
to create capital goods to support
economic growth
2 In a closed economy, S = I ; in an open
economy, S + KI = I
3 Capital inflows mean more investment and
lower interest rates

Figure:

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The Saving Rate and the Trade Deficit

• What causes trade deficits?

• Not the production of inferior goods
• Not the result of unfair trade restrictions
• A low rate of national saving is the primary cause
• Recall S − I = NX .
• Hold I fixed
• High level of S implies a high level of NX
• Low level of S implies a low level of NX

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Example of a Balance Sheet

Figure: Balance Sheet

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The U.S. Trade Deficit

• U.S. trade balanced until the mid 1970s

• Large deficits since the mid-1970s
• National saving has been less than investment since the mid 1970s
• Large government budget deficits
• Decline in private saving in the 1990s as consumption spending surged → more spending
on imports
• Large government budget deficits in the 2000s

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Write Down a Few Takeaways from Today’s Lecture

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