Chapter 2 The Financial System and The Economy

2
The FINANCIAL SYSTEM

and the ECONOMY
PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed
with a certain product or service or otherwise on a password-protected website for classroom use.
1
The Financial System
• Financial system
– Matching those who have savings with
those who want to borrow
• With or without the use of financial
intermediaries
– The securities, intermediaries, and
markets that exist to match savers and
borrowers
– Essential part of a well- functioning
economy
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website for classroom use.
2
2.1
3
Financial Securities
• Financial security
– A contract in which a borrower
• Who seeks to obtain money from someone
• Promises to compensate the lender in the
future
– Debt security
– Equity security [stock]
• Investor
– Owner of a financial security
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
4
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
• Debt security
– A contract that promises to pay
• A given amount of money to the owner of the
security
• At specific dates in the future
• Equity security [stock]
– A contract that makes the owner of a
security a part owner of the company that
issued the security
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2.2
U.S. Debt and Equity Securities, Fourth Quarter 2010
6
• Who borrows using debt and equity?
– Debt: households, business firms,
foreigners, governments, and financial
intermediaries
– Equity: domestic and foreign business
firms and financial intermediaries
7
2.3
Debt and Equity, by Issuer, Fourth Quarter 2010
8
• Households
– Mortgage debt
• To buy homes
– Consumer credit
• Credit cards
• Loans for large purchases
• Business firms (domestic and foreign)
– Borrow using both debt and equity
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• Financial intermediaries
– Borrow using both debt and equity
• Governments
– Borrow substantial amounts by issuing
debt securities
• Who owns these securities?
– Households, business firms
– Foreigners
– Governments, and financial intermediaries
10
2.4
Debt and Equity, by Investor, Fourth Quarter 2010
11
• Differences between debt and equity
– Maturity
– Type of periodic payment being made
– In case of bankruptcy
• Maturity
– The time until borrowed funds are repaid
– Debt security - specifies a particular
maturity date
– Equity security – no maturity
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• Types of periodic payments
– Debt securities - pay a specific amount of
interest
• Periodically until the debt matures
– Equity securities – pay dividends
• Not specified by the equity security
• Higher when earnings are high
• Lower in bad times
13
• Principal
– The original amount invested in a security
• Interest
– A payment (or series of payments)
– Made by the borrower to the investor in a
debt security
• In addition to repayment of the principal
• Dividend
– The periodic payment made on an equity
14
• In case of bankruptcy
– Employees are paid any wages they are
owed
– Other companies to which the bankrupt
firm owed money also are paid off
– Debt owners are paid off
– If anything is left, it goes to the equity
owners
15
2.1
Characteristics of Financial Securities
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Matching Borrowers with Lenders
• Financial system
– Match borrowers who issue debt and
equity securities
– With savers who are willing to lend
• Matches are facilitated through
– Direct finance
– Indirect finance
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• Direct finance
– Savers buy securities directly from
borrowers
• Indirect finance
– Savers invest through financial
intermediaries, which buy securities from
borrowers
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• Financial intermediary
– Company that transfers funds from savers
to borrowers
– By receiving funds from savers
– And investing in securities issued by
borrowers
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2.5
Direct and Indirect Finance
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• Direct versus indirect finance
– Both use financial securities
– Both types of transactions are conducted
in financial markets
– Young financial system – indirect finance
– Over time, larger economy – direct finance
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• Financial intermediaries
– Issue and own a large percentage of all
the securities in the United States
– Are major participants in the financial
system
– Commercial banks, savings institutions
– Credit unions, life insurance companies
– Mutual funds, pension funds
– Finance companies
22
• Functions of financial intermediaries
– Help savers diversify their financial
investments
– Pool the funds of many people
– Take short-term deposits and make long-
term loans
– Play an important role in the economy by
gathering information
– Reduce the cost of transacting
23
Financial Markets
• Financial market
– Place or mechanism by which borrowers,
savers, and financial intermediaries trade
securities
– New York Stock Exchange, physical
location
– On-line, Local financial markets
– No physical location, NASDAQ stock
market
24
Financial Markets
• Primary market
– Market in which a security is initially sold
to an investor by a borrower
– Generate funds for the issuer of the
security
• Secondary market
– Market in which a security is sold from one
investor to another
25
2.6
Primary and Secondary Markets
26
Financial Markets
• How financial markets determine prices of
securities
– Market supply and demand
• Security, fixed amount to be repaid in one
year
– No periodic interest payments
– Interest = amount repaid – price (of the
security)
27
Financial Markets
• Demand
– Investors buy more securities, the more
interest they receive
• Supply
– Borrowers want to borrow more, the less
interest they must pay
• Lower price = Higher interest
– Higher quantity demanded
– Lower quantity supplied
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2.7
Supply and Demand for a Security
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Financial Markets
• Increase in supply
– Decline in the equilibrium price of the
security
– Higher quantity of securities
– Higher interest
30
2.8
Shift of Supply for a Security
31
Calculating the Price of a Security
• Price of a security: b
• Quantity demanded for a security:
BD = 250 – 0.15b
• Quantity supplied of the security:
BS = 100 + 0.05b
• Equilibrium: BS = BD
100 + 0.05b = 250 – 0.15b
b = 750
32
• The financial system and economic
growth
– Ability to borrow - essential for new firms
to grow
– Efficient financial system
• Is good at matching savers and borrowers,
with low costs of doing so
• County - grows faster than a country that has
a weak financial system
33
• What happens when the financial system
works poorly?
– Less investment, decreasing economic
growth, declining standard of living
• The Asian crisis, October 1997
– Hong Kong, Indonesia, Malaysia,
Singapore, South Korea, Thailand
34
• Causes for the Asian crisis
– Government involvement in the financial
sector
– Inconsistent plans for monetary policy and
exchange rates
– Weak banking systems
– Poor debt management
– Lack of accounting rules
35
• The savings and loan crisis, U.S., 1980s
– Savings and loan institutions (S&Ls)
• Making long-term mortgage loans
– Which they financed with short-term deposit
accounts
• A rise in inflation – sharp rise in interest rates
they had to pay out on their deposit accounts
• Lost huge amounts of money
– Government regulators failed to close the
S&Ls promptly
36
• Mortgages and housing
– Ease of owning a home - directly related
to the efficiency of the financial system
• The financial crisis of 2008
– Mid-2000s, housing prices rose sharply
• Increasing subprime lending
– Home prices began to decline in 2007
• Subprime mortgage loans - packaged
together into mortgage-backed securities
– Panicked investors
37
– Market for mortgage-backed securities
crashed
– Numerous investment firms suffered
billions of dollars
• Many of those firms were highly leveraged
– Small decline in the value of their assets drove
them to insolvency
– Widespread mortgage-backed securities
• Widespread panic
38
– Governments and central banks - forced
to bail out banks and other financial
institutions
• To prevent a complete collapse of the
financial system
– Deep recession
39
• Lessons learned from the financial crisis
– Unregulated financial firms need to be
prevented from growing so large
• That their failure would severely damage the
economy
– Government regulators need to respond
more quickly
– The Dodd–Frank bill, passed in 2010
• Regulators - more power
40
What do investors care about?
• Five determinants of investors’ decisions
– Five major attributes of financial securities
• Expected return
• Risk
• Liquidity
• Taxability
• Maturity
41
1. Expected return
– The gain that an investor anticipates
making, on average, from a financial
security
• Return
– The income from a security
– Plus the change in the value of the
security
• As a percentage of the security’s initial value
42
• Return
= Current yield + Capital-gains yield
• Current yield
– Income the investor receives in some
period
– Divided by the value of the security at the
beginning of that period
= income/initial value
43
• Capital gain
– Increase in the dollar value of a financial
investment in some period
= final value – initial value
• Capital-gains yield
– Capital gain divided by the value of the
security at the beginning of the period
= capital yield/initial value
44
• Negative capital gain, capital loss
– If the security declines in value
• Expected return
= (probability of high return ˣ high return)
+ (probability of low return ˣ low return)
45
How to Calculate a Security’s Expected Return
• Expected return to a security that has
many different possible returns:
1. Multiply each return by its probability
2. Add up the results from step 1
• E = p1X1 + p2X2 + . . . + pNXN (1)
• Expected return, E
• N possible outcomes
• A given outcome Xi (i 1, 2, . . . , N) occurs
with probability pi
• Sum p1+p2 + . . .+ pN = 1
46
2. Risk
– The amount of uncertainty about the
return on a security
• Main causes of uncertainty
– Default by the issuer of a debt security
– An unexpected change in the dividend
paid on an equity security
– A change in the price of a security
– An unexpected change in the inflation rate
47
• Default
– The issuer fails to make a payment
promised by a debt security
• Upside risk
– Risk of a rise in the market price of a
security
• Downside risk
– Risk of a decline in the market price of a
security
48
• Standard deviation
– A measure of the risk to a security
1. Calculate the difference (or “deviation”) of each
return from the expected return
2. Square each of those differences (that is, multiply
it times itself)
3. Multiply those squared differences by the
probability that the return occurs
4. Add all the numbers from step 3 for all the
possible returns
5. Take the square root of the sum in step 4
49
3. Liquidity
– How easy it is to buy or sell a security in
the secondary market
• When you want to
• Without incurring significant costs
• Nonmarketable security
– Cannot be sold to another investor
• Marketable security
– Can be sold to another investor
50
4. Taxes
– The interest and dividends paid on
securities are subject to taxation
• After-tax expected return
– The expected return after taxes are paid
= pretax expected return - (tax rate ˣ
pretax expected return)
= (1 - tax rate) ˣ pretax expected return
51
5. Maturity
– Many investors favor securities with short
times to maturity
– Borrowers offer higher interest rates on
securities with longer times to maturity
52
• Choosing a Financial Investment Portfolio
• Portfolio
– Collection of securities an investor owns
• Idiosyncratic (unsystematic) risk
– Risk that can be eliminated by
diversification
• Market (systematic) risk
– Risk that cannot be removed by
diversification
53
How to Calculate the Standard Deviation of the
Return to a Security
• Standard deviation
={[probability of outcome 1ˣ (deviation of
outcome 1)2] +
+ [probability of outcome 2 ˣ (deviation of
outcome 2)2] +
. . . + [probability of outcome N ˣ (deviation of
outcome N)2]}1/2
= [p1(X1-E)2+p2(X2-E)2+…+pN(XN-E)2]1/2 (2)
• N possible outcomes
• E comes from Equation (1)
54
Default Risk on Debt
• Rating the financial strength of companies
– By Moody’s Corporation and Standard &
Poor’s Corporation
– An A rating is better than a B rating
– Companies with an A rating:
• Strongest companies: Aaa
• Not quite as strong: Aa
• Slightly worse: A
55
• Rating the financial strength of companies
– Companies with a B rating:
• Baa
• Ba
•B
– Companies with a C rating:
• Caa
• Ca
• C - the lowest grade
56
• The lower the bond rating
– The higher the interest rate paid on bonds
• Risk spread
– Difference in interest rates because of risk
– Changed substantially over time
• Overall state of the economy
– Rises sharply in most recessions
• Declines when the recession is over
57
2.A
Interest Rates on Aaa versus Baa Bonds
58
2.B
Risk Spread (Aaa versus Baa)
59
How Much Risk Do Investors Face
from Inflation?
• Actual inflation rate rose sharply relative
to the expected inflation rate
– Dramatic rises in oil prices
• Mid-1950s, 1973–1975, 1979–1980, 1990,
2003–2005, and 2007–2008
– Expansionary fiscal and monetary policy
• Late 1960s
• Actual inflation rate - lower than expected
– Early 1980s
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2.C
Actual and Expected Inflation
61
How Much Risk Do Investors Face
from Inflation?
• Expected inflation
– Forecast for the inflation rate in consumer
prices
– From the Livingston Survey of economists
• Actual inflation in consumer prices
– Spikes up during oil-price shocks
• Not forecastable
62

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2

The FINANCIAL SYSTEM

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