Course Title :

Financial Economics
Course code:
Econ 3091

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 Chapter 1:
NATURE AND ROLE OF FINANCIAL SYSTEM IN
ECONOMIC DEVELOPMENT
•1.1 FINANCE AND THE ECONOMY
•In any economy, all economic units can be classified into
one of four groups:
• (1) households, (2) business firms, (3) governments (local, state, and
federal), and (4) foreign investors (nondomestic households, businesses,
and government units).
• Each type of unit has different income sources and spending patterns.
• Every economic unit must operate within a budget constraint imposed
by the unit’s total income for the period. 2
.

•For a budget period such as a year, an economic unit can have

one of three budget positions:
• 1. A balanced budget: Income and expenditures are equal.
• 2. A surplus budget: Income for the period exceeds expenses; these
economic units have money to lend and are called surplus spending units
(SSUs).
• 3. A deficit budget: Expenditures for the period exceed revenues; these
economic units need to borrow money and are called deficit spending
units (DSUs).

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• Households are the principal SSUs in the economy,

• But some businesses, state and local governments, and
foreign investors and their governments periodically run
surplus budgets.
• Taken as a group, businesses are the principal DSUs in the
economy
• Financial claims are claims against someone else’s money at a
future date.
• Financial claims also go by different names, such as securities
or financial instruments; the names are interchangeable.
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•Financial claims (IOUs) are

• liabilities for borrowers (DSUs)
Simultaneously
• assets for lenders (SSUs)
• These are the two faces of debt.
Thus,
•Total financial liabilities outstanding in the
economy must equal total financial assets.
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 1.2 THE ROLE OF THE FINANCIAL SYSTEM
• is to facilitate the flow and efficient allocation of funds throughout
the economy.
• The greater the flow of funds, the greater the accommodation of
individuals’ preferences for spending and saving.
• An efficient and sound financial system is a necessary condition to
having a highly advanced economy.
• The financial system Transfers funds from surplus to deficit spending
units through financial markets and financial institutions
• Thus, the financial system consists of:
• financial markets and
• financial institutions.
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1.3: Financial Markets and financial institutions
• Financial markets
• Financial markets are platforms where people buy and sell financial instruments
such as stocks, bonds, and futures contracts which is distinctly different from
goods markets where people buy and sell different types of goods and haggle
over prices.
• Financial Institutions
• Financial institutions are intermediaries, converting financial securities with one
set of characteristics into securities with another set of characteristics with a
process called financial intermediation.

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• Transfer of funds from surplus to deficit spending units takes place

through direct financing mechanism and indirect financing
mechanisms.

• Direct financing goes through financial markets while indirect

financing goes through financial intermediaries

• Financial intermediaries either transfer funds from SSUs to DSUs by

intermediation or using financial markets

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 TRANSFER OF FUNDS FROM SURPLUS TO DEFICIT SPENDING UNITS

•-

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 Chapter 2:
DIRECT FINANCING MARKETS

• DSUs borrow money directly from SSUs in financial markets by selling them securities in
exchange for money.
• Typical financial instruments bought and sold in the direct financial markets are stocks
and bonds.
• The major buyers and sellers of securities in the direct financial markets are commercial
banks, other financial institutions, large corporations, the federal government, and some
wealthy individuals.
• Two important players that deliver critical services in the direct credit markets are
• investment banking firms and
• large money center banks.
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2.1 INVESTMENT BANKS
• Firms that specialize in helping businesses sell new debt or equity in
the financial markets.
Once the securities are sold,
• They provide a variety of broker dealer services (buying and selling
securities) for securities that have already been issued.

• Investment Banking Services

• Bring New Securities to Market
• Trading and Brokerage Services

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 2.1.1 Bring New Securities to Market

•When management decides to expand a firm, it has a specific capital project in mind,
such as building a new manufacturing facility.
•At this moment investment banks offer to help firms bring their new debt or equity
securities to market.
•In this regard the three distinct tasks involved may be:
• origination, preparing a security issue for sale.
• underwriting, the process selling the new security issue in the direct financial
markets. The most common type of underwriting arrangement is called a firm
commitment
• distribution occurs immediately after the securities are bought from the issuer and
is the marketing and sales of securities to institutional and individual investors.
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2.1.2 Trading and Brokerage Services
• Once financial claims have been issued, they may be resold to other investors in an
aftermarket or a secondary market
•There are two types of market participants that facilitate these transactions.
• Brokers help bring buyers and sellers together, acting as “matchmakers”
• Dealers “make markets” for securities by carrying an inventory of securities from
which they stand ready to either buy or sell at quoted prices.
•Except for the wealthy, individuals do not participate in the direct financial markets
because of their wholesale nature.
•Individuals gain access to the financial markets indirectly by transacting with financial
intermediaries, such as commercial banks or mutual funds, or through retail channels
with investment banking firms.
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2.2 LARGE MONEY CENTER BANKS
• Money center banks are large commercial banks usually located in
major financial centers who are major participants in the money
markets.
• These powerful firms are the flagship banks for the economy and
provide funds and business loans to large multinational corporations.
• In US Money center banks are highly regulated by the Federal
Reserve Bank to ensure that they take prudent risks with both their
investment and loan portfolios.
• Money center banks may also have a large retail banking presence,
providing consumers with personal and mortgage loans, checking and
savings accounts, and credit cards.

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 2.3 TYPES OF FINANCIAL MARKETS
•2.3.1 PRIMARY AND SECONDARY MARKETS
• Financial claims are initially sold by DSUs in primary markets.
• All financial claims have primary markets.
• People are more likely to purchase a primary financial claim if they
believe they will not have to hold it
• forever (in the case of most common stock) or
• until its maturity date (in the case of bonds).

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•Secondary markets are like used-car markets;
• they let people exchange “used” or previously issued financial claims for cash at
will.
•Secondary markets provide liquidity for investors who own primary
claims.
• Securities can be sold only once in a primary market; all subsequent
transactions take place in secondary markets.
• The desirable characteristics of securities in secondary markets are:
• Marketability
• Liquidity

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•Marketability
• An important characteristic of a security to investors is its
marketability.
• Marketability is the ease with which a security can be sold and
converted into cash.
• A security’s marketability depends in part on the cost of trading and
the search for information.
• The lower these costs, the greater a security’s marketability.
• Because secondary markets make it easier to sell securities, their
presence increases a security’s marketability.
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• Liquidity.
• A term closely related to marketability is liquidity.
• Liquidity is the ability to convert an asset into cash quickly without
loss of value.
• In common usage, the two terms are often used interchangeably,
but they are different.
• Liquidity implies that when a security is sold, its value will be
preserved.
• Marketability does not carry this implication.

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2.3.2 EXCHANGE AND OVER-THE-COUNTER MARKETS
•Once issued, a financial claim (security) can be traded in the secondary
market on an organized security exchange.
•Trades made through an exchange are usually made on the floor of the
exchange or through its computer system.
•Organized security exchanges provide a physical meeting place and
communication facilities for members to conduct their transactions
under a specific set of rules and regulations.
•Only members of the exchange may use the facilities, and only
securities listed on the exchange may be traded.

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• Securities not listed on an exchange are bought and sold in the over
the counter (OTC) market.
• The OTC market differs from organized exchanges because the market
has no central trading place.
• Instead, investors can execute OTC transactions by visiting or
telephoning an OTC dealer or by using a computer-based electronic
trading system linked to the OTC dealer.
• Traditional stocks traded over the counter have been those of small
and relatively unknown firms, most of which would not qualify to be
listed on a major exchange.
• However, electronic trading has become much more important in
recent years, and many OTC stocks are issued by high-profile fi rms,
especially technology fi rms.
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 2.3.3 PUBLIC AND PRIVATE MARKETS
•Public markets
• are organized financial markets where securities registered with the
Securities and Exchange Commission (SEC) are bought and sold.
• Public markets are highly regulated by the SEC to ensure that investors
are treated fairly and that issuers fully disclose an investment’s risk.
• The SEC has broad responsibility for overseeing the securities industry
and it regulates all primary and secondary markets where securities are
traded.
• Its primary regulatory responsibility is to protect investors of modest
means from unscrupulous investment practices.
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• A private
.
market
• involves direct transactions between two parties.
• There is very little regulation in the private markets compared to public market
transactions.
• Transactions in private markets are called private placements.
• Investors in the private markets are considered sophisticated investors and require little
protection or have the means to hire adequate investment counsel.
• In private markets, a company contacts investors directly and negotiates a deal to sell
them the entire security issue.
• Larger firms may be equipped to handle these transactions themselves.
• Smaller fi rms are more likely to use the services of an investment bank, which helps to
locate investors, negotiate the deal, and handle the legal aspects of the transaction.
• Major advantages of a private placement are the speed at which funds can be raised and
the low transaction costs.
• The disadvantage is that privately placed securities cannot legally be sold in the public
markets because they lack SEC registration.
• As a result, private placement securities are less marketable than a comparable registered
security. 22
 2.3.4 FUTURES AND OPTIONS MARKETS
•Markets also exist for trading in futures and options.
• Futures and options are often called derivative securities because they derive
their value from some underlying asset.
•Futures contracts are contracts for the future delivery of assets such as securities,
foreign currencies, interest rates, and commodities.
• Corporations use these contracts to reduce (hedge) risk exposure caused by
fluctuation in interest rates, foreign exchange rates, or commodity prices.
•Options contracts call for one party (the option writer) to perform a specific act if
called on to do so by the option buyer or owner.
•Options contracts, like futures contracts, can be used to hedge risk.
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 2.3.5 FOREIGN EXCHANGE MARKETS

•The foreign exchange market is the market in which foreign currencies are
bought and sold.
• Foreign currencies are traded either for spot or forward delivery over the
counter at large commercial banks or investment banking firms.
•Futures contracts for foreign currencies are traded on organized exchanges.
•The spot market is where currency, commodities, or financial instruments
are sold for cash and delivered immediately.
• In contrast, forward markets are where dealers agree to deliver these
financial claims at a fixed price at a future date.
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2.3.6 INTERNATIONAL AND DOMESTIC MARKETS

•Financial markets can be classified as either domestic or

international markets depending on where they are located.
• Important international financial markets for firms are the
short-term Eurodollar market and the long-term Eurobond
market.
•In these markets, domestic or overseas firms can borrow or lend
large amounts of U.S. dollars that have been deposited in
overseas banks.
•These markets are closely linked to money and capital markets.
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 2.3.7 MONEY MARKETS
•Money markets are markets in which commercial banks and other businesses
adjust their liquidity position by borrowing, lending, or investing for short
periods of time.
•The National Bank conducts monetary policy in the money markets, and
Government Treasury uses them to finance its day-to-day operations.
•Also, in the money markets, businesses, governments, and sometimes
individuals borrow or lend funds for short periods of time—from 1 to 120
days.
•The money market consists of a collection of markets, each trading a
distinctly different financial instrument.
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•In the simplest terms, the money markets are a wholesale market ($1
million) for financial claims that have characteristics very similar to money.
•Money market instruments typically have short maturities (usually 90 days
or less), are highly liquid (active secondary markets), and have low risk of
default.
•There is no formal organized exchange, such as the New York Stock
Exchange, for the money markets.
•Central to the activity of the money markets are the dealers and brokers
who specialize in one or more money market instruments.

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 The major money market instruments are:
• Treasury Bills
• Negotiable Certificates Of Deposit
• Commercial Paper
• Federal Funds
• TREASURY BILLS
• Treasury bills are direct obligations of the U.S. government and thus are considered to have no default risk.
• They are sold weekly and have maturities that range from 3 months to 1 year.
• Financial institutions, corporations, and individuals buy these securities for their liquidity and safety of
principal.
• NEGOTIABLE CERTIFICATES OF DEPOSIT
• Negotiable certificates of deposit (NCDs) are large-denomination time deposits of the nation’s largest
commercial banks.
• Unlike other time deposits of most commercial banks, NCDs may be sold in the secondary market before
their maturity.
• Only a handful of banks sell NCDs.
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 .
• COMMERCIAL PAPER
• Commercial paper is the unsecured promissory note (IOU) of a large business.
• Commercial paper typically has maturities ranging from a few days to 120 days and does not have an active
secondary market.
• Corporations and finance companies are the major issuers of commercial paper.
• FEDERAL FUNDS
• Technically, federal funds are bank deposits held with the Federal Reserve bank.
• Banks with deposits in excess of required reserves may lend those excess reserves— called fed funds—to
other banks.
• The bank that acquires the fed funds may use them to cover a deficit reserve position or can use the funds
to make consumer or business loans.
• Fed funds loans are typically for 1 day or for over a weekend.
• At a more practical level, you may think of the fed funds market as the market in which banks make short-
term unsecured loans to one another, and the fed funds interest rate is the interbank lending rate.
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 2.3.8 CAPITAL MARKETS
•Individuals own real assets to produce income and wealth.
•Thus, the owner of a machine shop hopes to profit from the sale of products from the shop,
and the owner of a factory hopes to earn a return from the goods produced there.
•Similarly, owners of apartments, office buildings, warehouses, and other tangible assets hope
to earn a stream of future income by using their resources to provide services directly to
consumers or to other businesses.
•These assets are called capital goods; they are the stock of assets used in production.
• Capital markets are where capital goods are financed with stock or long-term debt
instruments.
•Compared to money market instruments, capital market instruments are less marketable;
default risk levels vary widely between issuers and have maturities ranging from 5 to 30 years.
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•Financial institutions are the connecting link between the short-term money
markets and the longer-term capital markets.
•These institutions, especially those that accept deposits, typically borrow
short term and then invest in longer-term capital projects either indirectly
through business loans or directly into capital market instruments.
• We will now briefly describe the major capital instruments.
• Selected capital market instruments:
• Common stock
• Corporate bonds
• Municipal bonds
• Mortgages

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• COMMON STOCK
• Common stock represents an ownership claim on a firm’s assets.
• Also referred to as equity securities, stock differs from debt obligations
in that equity holders have the right to share in the firm’s profits.
• The higher the fi rm’s net income, the higher the return to stockholders.
• On the other hand, stockholders must share in any of the losses that the
company may incur.
• And in the event of bankruptcy, creditors and debt holders have first
claim on the firm’s assets.
• Most stock market transactions take place in the secondary markets.

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CORPORATE BONDS
• When large corporations need money for capital expenditures, they may issue
bonds.
• Corporate bonds are thus long-term IOUs that represent a claim against the firm’s
assets.
• Unlike equity holders’ returns, bondholders’ returns are fixed; they receive only
the amount of interest that is promised plus the repayment of the principal at the
end of the loan contract.
• Even if the corporation turns in an unexpectedly phenomenal performance, the
bondholders receive only the fixed amount of interest agreed to at the bonds’
issue.
• Corporate bonds typically have maturities from 5 to 30 years, and their secondary
market is not as active as for equity securities.
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MUNICIPAL BONDS
• Municipal bonds are the long-term debt obligations of state and local
governments.
• They are used to finance capital expenditures for things such as schools,
highways, and airports.
• The most distinguishing feature of municipal bonds is that their coupon
income is exempt from federal income taxes.
• As a result, individuals or companies that are in the highest income tax
brackets purchase municipal bonds.
• Although the bonds of large municipalities have secondary markets, most
municipal bonds have limited secondary markets and thus are not considered
liquid investments.
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MORTGAGES

•Mortgages are long-term loans secured by real estate.

•They are the largest segment in the capital markets in terms of the
amount outstanding.
•More than half of the mortgage funds go into financing family
homes, with the remainder financing business property,
apartments, buildings, and farm construction.
• Mortgages by themselves do not have good secondary markets.
• However, a large number of mortgages can be pooled together to
form new securities called mortgage-backed securities, which have
an active secondary market.
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 Chapter 3:
FINANCIAL INTERMEDIARIES AND INDIRECT FINANCING

• Many business firms are too small to sell their debt or equity directly to
investors.
• They have neither the expert knowledge nor the money it takes ($1
million or more) to transact in wholesale markets.
• When these companies need funds for capital investments or for liquidity
adjustments, their only choice may be to borrow in the indirect market
from a financial institution.
• These financial institutions act as intermediaries, converting financial
securities with one set of characteristics into securities with another set
of characteristics with a process is called financial intermediation.

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•For direct financing to take place, the DSU must be willing to issue a
security with a denomination, maturity, and other security characteristics
that match exactly the desires of the SSU.
• Unless both the SSU and the DSU are satisfied simultaneously, the
transfer of money will not take place.
•When this is not so, indirect financing comes into the picture.
•In indirect financing, a financial institution—an intermediary—stands
between the SSU and the DSU.
•The hallmark of indirect financing is that the financial intermediary
transforms financial claims in a way that makes them attractive to both the
SSUs and the DSUs.
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• Banks are a critical player in the financial system. Banks provide a
place where individuals and businesses can invest their money to earn
interest at low risk.
• Banks take these funds and redeploy them by making loans to
individuals and businesses.
• Banks are singled out for special treatment by regulators and
economists because most of what we call money in the economy is
represented by deposits and checking accounts issued by banks.
• Thus, banks are the principal caretaker of the payment system
because most purchases are paid by writing a check or making an
online payment against a bank account.

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• The bank raises money by selling services such as checking accounts, savings accounts, and
consumer CDs(certificates of deposits), and then uses the money to make loans to
businesses or consumers.
• On a larger scale, insurance companies provide much of the long-term financing in the
economy through the indirect credit market.
• Insurance companies invest heavily in corporate bonds and equity securities using funds
they receive when they sell insurance policies to individuals and businesses.
Small Business Loans

Loan request Certificate of Deposit

Commercial
Bank Investors and
Small restaurant Intermediary depositors
Cash
Cash

Large scale loans

Issues debt or
equity Insurance Sells business policies
company Investors and
Business firm Intermediary Policy holders
Cash
Cash
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• An important difference between the indirect and direct financial markets is

that,
• in the direct financing, as securities flow between SSUs and DSUs, the
form of the securities remains unchanged,
• while in the indirect market, however, as securities flow between SSUs
and DSUs, they are repackaged and thus their form is changed.

• Money from the sale of insurance policies becomes investments in

corporate debt or equity.
• By repackaging securities, financial intermediaries tailor a wide range of
financial products and services to meet the needs of consumers, small
businesses, and large corporations.
• Their products and services are particularly important for smaller
businesses that do not have access to direct financial markets.
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3.1THE ECONOMICS OF FINANCIAL INTERMEDIATION
•Financial intermediaries are firms that operate to make a profit.
•They buy financial claims (held as assets), such as business loans,
consumer installment loans, and corporate bonds from DSUs.
• These claims have characteristics designed to meet the needs of the
DSUs that buy them.
•Financial intermediaries finance the purchase of these financial claims
by selling financial claims (IOUs) on themselves that are held as assets
by others, assets such as checking and saving accounts, life insurance
policies, and mutual fund shares to SSUs.
•These financial claims have characteristics that are attractive to SSUs.
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 .
• To earn profits, financial intermediaries buy financial claims from DSUs
whenever the income generated by the financial claims covers all of their
borrowing and production costs.
• The local bank charges the small business owner 9 percent for the business loan,
and the bank’s cost of money for the CDs averages 5 percent.
• Thus, the bank’s gross interest rate margin is 4 percent (9 – 5) from which the
bank has to cover the cost of manufacturing the loan, its overhead expenses,
and the risk of not being paid back (default risk).
• Question we might ask to understand why financial intermediaries exist
• why don’t consumers or businesses “manufacture” their own banking services and
pocket the profits?
• Banks and other financial intermediaries are middlemen, and who needs a middleman?
• We need to understand the role of two important market imperfections—
• transaction costs and
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• information costs.
 TRANSACTION COSTS

•By transaction costs we mean all fees and commissions paid when buying or selling
securities, such as
• search costs,
• cost of distributing securities to investors,
• cost of SEC registration, and
• the time and hassle of the financial transaction.
• In general, the greater the transaction cost, the more likely it is that a financial
intermediary will provide the financial service.
•Banks and other financial intermediaries are experts in reducing transaction costs.
•Much of the cost savings come from economies of scale and from the use of
sophisticated digital technology. 43
 .
• Transaction costs are particularly high when dealing with consumers and
small businesses because the dollar amount of the transactions is small.
• Thus, the transaction costs of selling securities in small dollar amounts are
often prohibitively expensive.
• As a result, financial intermediaries are almost always able to produce
financial services at a lower cost than can individuals or small businesses.
• This is not always true for larger firms that have sufficient size to capture
economies of scale and access to sophisticated technology.
• These large firms transact primarily in the direct credit markets for most of
their financial service needs.
• Regardless of their size, however, almost every firm maintains some
banking relationship, at a minimum, a transaction account to have access to
the national payment system.
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 Basic transactions needed to make the loan, and the bank’s
costs and individual costs
• Loan contract.
• You hire a lawyer to draw up a loan agreement: cost $600.
• The bank hires a topflight lawyer who draws up an airtight contract that is used at all the bank’s
branches: cost $3.00 per contract.

•Credit reports.
• You purchase an “economy” credit report to help you evaluate the firm’s creditworthiness: cost
$550.
• To ensure that your analysis is correct, you hire a neighbor who is the credit manager of a
small manufacturing firm for $200: cost $750 ($500 + $250).
• The bank uses an expensive and sophisticated credit scoring model that generates a45 credit
 .

•Monitoring the loan.

• You gather the data and your neighbor reviews the quarterly financials for $200.
• The bank has a computer automated system for monitoring monthly loan
payments and quarterly financials: the bank’s cost for the year $25.

The total cost for the loan transaction score card looks like this:
Transaction Task Bank Cost ($) Your Cost ($)

Loan contract $3.00 $600.00

Credit report $10.00 $750.00

Monitoring loan $25.00 $200.00

Total cost $38.00 $1,550.00

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 .
• Thus, the bank’s transaction costs, through a combination of scale
economies, technology, and expertise, are much lower than you can
generate as an individual.
• The bank’s profit is $1,512 (i.e., $1,550 - $38).
• Therefore,
• financial intermediaries can reduce transaction costs substantially,
• they can provide loans and other financial services for people at
favorable prices.

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 ASYMMETRIC INFORMATION
•The presence of transaction costs explains some of the reasons why
financial intermediaries play such an important role in financial markets.
• Financial intermediaries are major contributors to information production.
•They are especially good at selling information about a borrower’s credit
standing.
•The need for information about financial transactions occurs because of
asymmetric information.
• Asymmetric information occurs when buyers and sellers do not have access
to the same information;
• sellers usually have more information than buyers.
• This is especially true when the seller owns or has produced the asset to be sold to the buyer. 48
.

• For financial transactions, asymmetric information

refers to the fact that issuers of securities (the
borrowers) know more than investors (the lenders)
about the credit quality of the securities being issued.
• Informational asymmetry is larger for loans to
consumers and small businesses because little
information is publicly available.
• Informational asymmetry is much less of a problem
for large public corporations because so much
information is readily available.
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 .

•Asymmetric information problems occur in two forms:

• adverse selection and
• moral hazard.

•Adverse selection problems occur before a financial

transaction takes place.
• For example, Let's Say
“an owner of a woodworking shop goes to a local bank for a business loan.
The company is in financial trouble and may fold unless the owner is able to
secure a loan for working capital. What is the owner to say when asked if he
can repay the loan? He needs the money and divulging the truth may
jeopardize his chances to get the loan.
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• Moral hazard problems occur after the transaction (loan) takes place.
• They occur if borrowers engage in activities that increase the probability
that the borrower will default.
• In other words, the loan’s default risk is much higher than the lender was
led to believe at the time the loan was made.
Let’s say that
“the woodworking shop owner who requested a loan for additional working capital
got loan from the bank . Rather than using the money for working capital, however, the
owner takes half the money and puts 10 percent down to buy a new high-tech machine
that will increase his shop’s operating efficiency, design capability, and (he hopes) sales.
But it’s a lot of money for one machine, and the monthly payments are large given
current sales. Clearly, the large monthly payment, which is a fixed cost, increases the
loan’s default risk above the original deal.”

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 PROTECTION AGAINST MARKET FAILURES

•If good solutions are not available for adverse selection and
moral hazard problems, lenders will decrease the number of
loans they make in a particular market.
•In the extreme case, the market will fail. To protect
themselves against market failures, financial institutions
become specialists in the production of additional
information.
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With respect to adverse selection

•Banks are specialists in the origination of loans and determining a borrower’s

creditworthiness.
• for consumer credit and small-business loans, banks have developed sophisticated
credit-scoring models to determine prospective borrowers’ creditworthiness.
• The customer fills out the credit application; the information is then scanned into a
data bank, and in a matter of seconds the credit risk profile is displayed along with a
credit recommendation.
• If the recommendation is to grant credit, the bank then verifies critical data; most of
the verification can be automated by computer search.
• Thus, through the use of technology, banks have dramatically reduced adverse
selection costs and have achieved significant economies of scale. 53
 With Respect Moral hazard problems
• Moral hazard problems occur after the money is lent.
• Business loan contracts are detailed documents designed to provide incentives
for borrowers to behave in a manner consistent with the intent of the loan
contract.
Example,
• the contract may spell out a series of performance measures with rewards
and/or penalties, depending on the fi rm’s performance over time.
• The performance measures are typically financial ratios.
• For example, if the fi rm’s current ratio declines below 1.5, the loan rate
increases 0.5 percent.
• Loan contracts can also be very restrictive: They can prohibit certain asset
purchases or require
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 3.2 TYPES OF INTERMEDIATION SERVICES
•In “transforming” direct financial claims into indirect ones, financial intermediaries perform five
basic intermediation services.
•Financial intermediaries, therefore, tailor the characteristics of the indirect securities they issue
to the desires of SSUs. They engage in one or more distinct types of intermediation:
• (1) denomination intermediation,
• (2) currency intermediation,
• (3) risk intermediation,
• (4) maturity intermediation, and
• (5) liquidity intermediation.
•They provide these and other services to earn a profit.
•SSUs and DSUs use these services as long as the cost of doing so is less than providing the
services for themselves through the direct credit markets.
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 Denomination Divisibility

• Financial intermediaries are able to produce a wide range of

denominations—from $1 to many millions.
• They can do this by pooling the funds of many individuals and investing
them in direct securities of varying sizes.
• Of particular importance is their acceptance of deposits from individuals
who typically do not have money balances large enough to engage in the
wholesale transactions ($1 million or more) found in direct financial
markets.

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Currency Transformation

•Many companies export goods and services to other countries, but

few individuals living in this country are able to finance the overseas
activities of these companies by buying direct financial claims
denominated in a foreign currency.
•Financial intermediaries help to finance the global expansion of
companies by buying financial claims denominated in one currency and
selling financial claims denominated in other currencies.

57
 Maturity Flexibility
• Financial intermediaries are able to create securities with a wide
range of maturities—from 1 day to more than 30 years.
• Thus, they are able to buy direct claims issued by DSUs and issue
indirect securities with precisely the maturities (usually shorter)
desired by SSUs.
• For example, savings and loan associations obtain funds by issuing
passbook accounts and savings certificates and investing the funds
in long-term consumer mortgages.
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Credit Risk Diversification

•By purchasing a wide variety of securities, financial intermediaries are

able to spread risk.
• If the securities purchased are less than perfectly correlated with each
other, the intermediary is able to reduce the fluctuation in the principal
value of the portfolio.

59
 Liquidity

• For most consumers, the timing of revenues and expenses rarely

coincides.
• Because of this, most economic units prefer to hold some assets
that have low transaction costs associated with converting them
into money.
• Many of the financial commodities produced by intermediaries
are highly liquid.
• For example, a checking account permits consumers to purchase
an asset or repay a debt with minimal transaction cost
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 3.3 TYPES OF FINANCIAL INTERMEDIARIES

•Although different, financial intermediaries all have one function in

common: they purchase financial claims with one set of
characteristics from DSUs and sell financial claims with different
characteristics to SSUs.
•Financial intermediaries are classified as:
(1) deposit-type institutions,
(2) contractual savings institutions,
(3) investment funds, or
(4) other types of intermediaries.
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 Primary Assets and Liabilities of Financial Intermediaries
Assets Liabilities

Type of Intermediary Direct Securities Purchased Indirect Securities Sold

DEPOSIT-TYPE INSTITUTIONS
Commercial banks Business loans Checkable deposits
Consumer loans Time and savings deposits Mortgages
Mortgages Borrowed funds
Thrift institutions Mortgages NOW accounts and savings deposits
Credit unions Consumer loans Share accounts
Time and savings deposits
CONTRACTUAL SAVINGS INSTITUTIONS
Life insurance companies Corporate bonds Life insurance policies
Corporate stock
Casualty insurance companies Municipal bonds Casualty insurance policies
Corporate bonds
Corporate stock

62
 Private pension funds Corporate stock Pension fund reserves
Government securities
Corporate bonds
State and local government
pension funds Corporate stock Pension fund reserves
Government securities
Corporate bonds
INVESTMENT FUNDS
Mutual funds Corporate stock Shares in fund
Government securities
Corporate bonds
Money market funds Money market securities Shares in fund
OTHER FINANCIAL INSTITUTIONS
Finance companies Consumer loans Commercial paper
Business loans Bonds
Federal agencies Government loans Agency securities

63
 DEPOSIT-TYPE INSTITUTIONS
• Deposit-type financial institutions are the most commonly recognized
intermediaries because most people use their services on a daily basis.
• Typically, deposit institutions issue a variety of checking or savings accounts and
time deposits, and they use the funds to make consumer, business, and real estate
loans.
• The interest paid on deposit accounts is usually insured by one of several federally
sponsored insurance agencies.
• Thus, for practical purposes, the deposits are devoid of any risk of loss of principal.
• Also, these deposits are highly liquid because they can be withdrawn on very short
notice, usually on demand.
• Deposit-type institutions hold liability accounts that are payable upon demand
• This makes liquidity management a high priority for these firms.
64
 Commercial Banks.

• Commercial banks are the largest and most diversified intermediaries on the basis of range of assets
held and liabilities issued.
• commercial banks hold financial assets.
• Their liabilities are in the form of checking accounts, savings accounts, and various time deposits.
• Notice that deposit-type institutions hold liability accounts that are payable upon demand.
• This makes liquidity management a high priority for these firms.
• The Federal Deposit Insurance Corporation (FDIC) insures bank deposits up to a maximum of
$250,000.
• On the asset side, commercial banks make a wide variety of loans in all denominations to
consumers, businesses, and state and local governments.
• In addition, many commercial banks have trust departments and leasing operations.
• Because of their vital role in the nation’s monetary system and the effect they have on the economic
well-being of the communities in which they are located, commercial banks are among the most
highly regulated of all financial institutions
65
Thrift Institutions
• Savings and loan associations and mutual savings banks are commonly
called thrift institutions.
• They obtain most of their funds by issuing checking accounts or
negotiable order of withdrawal (NOW )accounts, savings accounts, and
a variety of consumer time deposits.
• They use these funds to purchase real estate loans consisting primarily of
long-term mortgages.
• They are the largest providers of residential mortgage loans to consumers.
• In effect, thrifts specialize in maturity and denomination intermediation
because they borrow small amounts of money short term with checking
and savings accounts and lend long term on real estate collateral.
• The FDIC insures deposits in thrifts in amounts up to $250,000.
66
Credit Unions
• Credit unions are small, nonprofit, cooperative, consumer organized institutions owned
entirely by their member-customers.
• The primary liabilities of credit unions are checking accounts (called share drafts) and
savings accounts (called share accounts);
• their investments are primarily devoted to short term installment consumer loans.
• Credit union share accounts are federally insured to a maximum of $250,000.
• Credit unions are organized by consumers having a common bond, such as employees
of a given firm or union.
• To use any service of a credit union, an individual must be a member.
• The major regulatory differences between credit unions and other depository
institutions are
• the common bond requirement,
• the restriction that most loans are to consumers, and
• their exemption from federal income tax because of their cooperative nature.
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CONTRACTUAL SAVINGS INSTITUTIONS
• Contractual savings institutions obtain funds under long-term
contractual arrangements and invest the funds in the capital markets.
• Firms in this category are insurance companies and pension funds.
• These institutions are characterized by a relatively steady inflow of
funds from contractual commitments with their insurance
policyholders and pension fund participants.
• Thus, liquidity is usually not a problem in the management of these
institutions.
• They are able to invest in long-term securities, such as bonds, and in
some cases in common stock.

68
Life Insurance Companies
• Life insurance companies obtain funds by selling insurance policies that
protect against loss of income from premature death or retirement.
• In the event of death, the policyholder’s beneficiaries receive the insurance
benefits, and with retirement the policyholder receives the benefits.
• In addition to risk protection, many life insurance policies provide some
savings.
• Because life insurance companies have a predictable inflow of funds and
their outflows are actuarially predictable, they are able to invest primarily in
higher yielding, long-term assets, such as corporate bonds and stocks.
• Life insurance companies are regulated by the states in which they operate
and, compared to deposit-type institutions, their regulation is less strict.

69
Casualty Insurance Companies
• Casualty insurance companies sell protection against loss of property from fire,
theft, accident, negligence, and other causes that can be actuarially predicted.
• Their major source of funds is premiums charged on insurance policies.
• Casualty insurance policies are pure risk-protection policies; as a result, they
have no cash surrender value and thus provide no liquidity to the policyholders.
• As might be expected, the cash outflows from claims on policies are not as
predictable as those of life insurance companies.
• Consequently, a greater proportion of these companies’ assets are in short-term,
highly marketable securities.
• To offset the lower return typically generated by these investments, casualty
companies have substantial holdings of equity securities.
• Casualty insurance companies also hold municipal bonds to reduce their taxes.

70
Pension Funds.
• Pension funds obtain their funds from employer and employee contributions
during the employees’ working years and provide monthly payments upon
retirement.
• Pension funds invest these monies in corporate bonds and equity obligations.
• The purpose of pension funds is to help workers plan for their retirement
years in an orderly and systematic manner.
• The need for retirement income, combined with the success of organized
labor in negotiating for increased pension benefits, has led to a remarkable
growth of both private pensions and state and local government pension
funds since World War II.
• Because the inflow into pension funds is long term, and the outflow is highly
predictable, pension funds are able to invest in higher-yielding, long-term
securities
71
INVESTMENT FUNDS
• Investment funds sell shares to investors and use these funds to
purchase direct financial claims.
• They offer investors the benefit of both denomination flexibility and
default-risk intermediation.

72
Mutual Funds
• Mutual funds sell equity shares to investors and use these funds to
purchase stocks or bonds.
• The advantage of a mutual fund over direct investment is that it
provides small investors access to reduced investment risk that results
from diversification, economies of scale in transaction costs, and
professional financial managers.
• The value of a share of a mutual fund is not fixed; it fluctuates as the
prices of the stocks in its investment portfolio change.
• Most mutual funds specialize within particular sectors of the market.
• For example, some invest only in equities or debt, others in a
particular industry (such as energy or electronics), others in growth or
income stocks, and still others in foreign investments
73
Money Market Mutual Funds.
• A money market mutual fund (MMMF) is simply a mutual fund that invests in
money market securities, which are short-term securities with low default risk.
• These securities sell in denominations of $1 million or more, so most investors
are unable to purchase them.
• Thus, MMMFs provide investors with small money balances the opportunity
to earn the market rate of interest without incurring a great deal of financial
risk.
• Most MMMFs offer check writing privileges, which make them close
substitutes for the interest-bearing checking accounts and savings accounts
offered at most depository institutions.
• This advantage is limited, however, in that most MMMFs restrict the amount
or frequency of withdrawals, and the federal government does not insure the
funds.

74
.

• During the 2008 financial crisis, the federal government took steps to restore confidence in the
financial integrity of money market mutual funds and their ability to absorb losses.
• Many consumers have long considered the funds to be the near equivalent of a bank savings
account.
• However, the recent financial crisis has put money market funds under increasing financial
stress, which could lead to the failure and bankruptcy of some funds.
• As a result, the Treasury Department announced that, as of September 18, 2009, it would
temporarily guarantee losses up to $50 billion. The federal guarantee was removed a year later.
• Money market funds invest in short-term securities, such as Treasury and agency securities,
bank certificates of deposit (CDs), asset-backed commercial paper, and other highly liquid
securities with low default risk.
• Money market mutual funds differ from money market deposit accounts, which are offered by
banks, thrifts, and credit unions.
• These are interest-bearing “bank accounts” insured up to $250,000 by the federal government
and, as a practical matter, are free of risk.
• Money market fund shares carry the default risk of the individual securities that comprise the
fund portfolio or trading loss the fund may incur

75
 OTHER TYPES OF FINANCIAL INTERMEDIARIES
• Several other types of financial intermediaries purchase direct securities from
DSUs and sell indirect claims to SSUs.

• Finance Companies
• Finance companies make loans to consumers and small businesses.
• Unlike commercial banks, they do not accept savings deposits from consumers.
• They obtain the majority of their funds by selling short-term IOUs, called
commercial paper, to investors.
• The balance of their funds comes from the sale of equity capital and long-term
debt obligations.

76
.
• There are three basic types of finance companies:
• (1) consumer finance companies specializing in installment loans to
households,
• (2) business finance companies focused on loans and leases to
businesses, and
• (3) sales finance companies that finance the products sold by retail
dealers.
• Finance companies are regulated by the states in which they operate and
are also subject to many federal regulations.
• These regulations focus primarily on consumer transactions and deal with
loan terms, conditions, rates charged, and collection practices

77
Federal Agencies
• The U.S. government acts as a major financial intermediary through the
borrowing and lending activities of its agencies.
• Since the 1960s, federal agencies have been among the most rapidly growing of
all financial institutions.
• The primary purposes of federal agencies are to reduce the cost of funds and
increase the availability of funds to targeted sectors of the economy.
• The agencies do this by selling debt instruments (called agency securities) in the
direct credit markets at or near the government borrowing rate, then lending those
funds to economic participants in the sectors they serve.
• Most of the funds provided by the federal agencies support agriculture and
housing because of the importance of these sectors to the nation’s well-being.
• It is argued that these and other target sectors in the economy would not receive
adequate credit at reasonable cost without direct intervention by the federal
government
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 3.4THE RISKS FINANCIAL INSTITUTIONS MANAGE
•Financial institutions intermediate between SSUs and DSUs in the hope of earning a
profit by acquiring funds at interest rates that are lower than they charge when they sell
their financial products.
•The differences in the characteristics of the financial claims financial institutions buy and
sell expose them to a variety of risks in the financial markets.
•In their search for higher long-term earnings and stock values, financial institutions must
manage and balance five basic risks:
• credit risk,
• interest rate risk,
• liquidity risk,
• foreign exchange risk, and
• political risk.
• Managing these risks does not mean eliminating them
• There is a trade-off between risk and higher profits.
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CREDIT RISK

•When a financial institution makes a loan or invests in a bond or other debt security,
the institution bears credit risk (or default risk)
•This means it is accepting the possibility that the borrower will fail to make either
interest or principal payments in the amount and at the time promised.
•To manage the credit risk of loans or investments in debt securities, financial
institutions should
• (1) diversify their portfolios,
• (2) conduct a careful credit analysis of the borrower to measure default risk
exposure, and
• (3) monitor the borrower over the life of the loan or investment to detect any critical
changes in financial health, which is just another way of expressing the borrower’s
ability to repay the loan.
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INTEREST RATE RISK

•Interest rate risk is the risk of fluctuations in a security’s price or

reinvestment income caused by changes in market interest rates.
•The concept of interest rate risk is applicable not only to bonds but also to
a financial institution’s balance sheet.
•The savings and loan association industry is the prime example of how
interest rate risk adversely affects a financial institution’s earnings.
• In the volatile interest rate environment of the late 1970s and early 1980s,
many savings and loan associations (S&Ls) failed because the interest rates
they paid on deposits (liabilities) increased faster than the yields they
earned on their mortgage loans (assets), causing earnings to decline.
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LIQUIDITY RISK

•Liquidity risk is the risk that a financial institution will be unable to generate
sufficient cash inflow to meet required cash out flows.
•Liquidity is critical to financial institutions:
• Banks and thrifts need liquidity to meet deposit withdrawals and pay off other liabilities as they come due,
• pension funds need liquidity to meet contractual pension payments, and life insurance companies need
liquidity to pay death benefits.

• Liquidity also means that an institution need not pass up a profitable loan or
investment opportunity because of a lack of cash.
• If a financial institution is unable to meet its short-term obligations because of
inadequate liquidity, the firm will fail even though the firm may be profitable over
the long run.

82
FOREIGN EXCHANGE RISK
•Foreign exchange risk is the fluctuation in the earnings or value of a financial
institution that arises from fluctuations in exchange rates.
•Many financial institutions deal in foreign currencies for their own account, or they
buy or sell currencies for their customers.
•Financial institutions invest in the direct credit markets of other countries, or they may
sell indirect financial claims overseas.
•Because of changing international economic conditions and the relative supply and
demand of U.S. and foreign currencies, the rate at which foreign currencies can be
converted into U.S. dollars fluctuates.
•These fluctuations can cause gains or losses in the currency positions of financial
institutions, and they cause the U.S. dollar values of non-U.S. financial investments to
change.
83
POLITICAL RISK

•Political risk is the fluctuation in value of a financial institution

resulting from the actions of the domestic or foreign governments.
•Domestically, if the government changes the regulations faced by
financial institutions, their earnings or values are affected.
•It is important for managers of financial institutions to monitor and
predict as best as possible changes in the regulatory environment.
• Managers must be prepared to react quickly when regulatory
changes occur.

84
Read about the nature of financial instruments
•Money Market Instruments
• Treasury bills
• Short-term municipal securities
• Large, negotiable CDs
• Commercial paper
• Federal funds and security repurchase agreements
•Capital market instruments
• Bond Markets instruments
• Equity Market instruments
• Mortgage Market instruments
•Derivatives
85
.

•Internationally, the concerns are much more dramatic, especially when

institutions consider lending in developing countries without stable
governments or well-developed legal systems.
• Governments can repudiate (i.e., cancel) foreign debt obligations.
•Repudiations are rare, but less rare are debt rescheduling in which foreign
governments declare a moratorium on debt payments and then attempt to
renegotiate more favorable terms with the foreign lenders.
•In either case, the lending institution is left “holding the bag.”
•To grow and be successful in the international arena, managers of financial
institutions must understand how to measure and manage these risks
•
86
4. INTEREST RATES DETERMINATIUON
•People have been lending goods to other people, and on occasions they have
asked for some compensation for this service.
•This compensation is called rent—the price of borrowing another person’s
property.
•Similarly, money is often loaned, or rented, for its purchasing power.
• The rental price of money is called the interest rate and is usually expressed
as an annual percentage of the nominal amount of money borrowed.
•Thus, an interest rate is the price of borrowing money for the use of its
purchasing power

87
.

• To a person borrowing money, interest is the penalty paid for

consuming income before it is earned.
• To a lender, interest is the reward for postponing current consumption
until the maturity of the loan.
• During the life of a loan contract, borrowers typically make periodic
interest payments to the lender.
• On maturity of the loan, the borrower repays the same amount of
money borrowed (the principal) to the lender.

88
.

• Like other prices, interest rates serve an allocative function in our

economy.
• They allocate funds between surplus spending units (SSUs) and deficit
spending units (DSUs) and among financial markets.
• For SSUs, the higher the rate of interest, the greater the reward for
postponing current consumption and the greater the amount of saving
in the economy.
• For DSUs, the higher the yield paid on a particular security, the
greater the demand for that security by SSUs but the less willing they
are to supply the security.
• Therefore, SSUs want to buy financial claims with the highest yield,
whereas DSUs want to sell financial claims at the lowest possible
interest rate
89
4.1 Why are Interest rates considered such an important economic
variable?

• They’re important because they directly affect consumer and business

spending.
• Interest rates are the cost of borrowing someone else’s money to
purchase goods and services, which must be paid back at a later date.
• The total cost of any credit purchase is the price of the product plus
the interest payments.

90
.

• Thus, when interest rates are high,

• purchases become more expensive,
• business and consumer spending slows down,
• inflation is typically curbed, and
• economic expansion and job creation are choked off.
• In contrast, lower interest rates tend to encourage
• spending by consumers and businesses and to
• stimulate business expansion and job creation;
• however, under certain conditions, lower interest can overstimulate
demand, which in turn can lead to inflation.

91
4.2 TIME PREFERENCE FOR CONSUMPTION
• People have different preferences for consumption over time.
• All things being equal, however, people prefer to consume goods
today rather than tomorrow.
• This is called a positive time preference for consumption.
• For example, most people who want to buy a new car prefer to have it
now rather than wait until they have earned enough cash to make the
purchase.
• When people consume today, however, they realize that their future
consumption may be less because they have forgone the opportunity to
save and earn interest on their savings

92
.

• Given people’s positive time preference for consumption,

the interest rate offered on financial instruments determines
whether they will save or spend.
• At low interest rates, most people postpone very little
consumption for the sake of saving—the reward for saving
is low so they continue to buy TVs and video games.
• To coax people to postpone current spending, interest rates
must be raised.
• At higher interest rates, people save more and spend less

93
4.3 REAL INTEREST RATE
•The interest rate that we observe in the marketplace at any given time is called the
nominal rate of interest.
•Real interest rate is the rate of interest determined by the returns earned on
investments in productive assets (capital investment) in the economy and by
individuals’ time preference for consumption.
•The real rate of interest is one of the most important economic variables in the
economy.
•The factors that determine the real rate of interest are the underlying determinants
of all interest rates observed in the economy.

94
.

•For this reason, an understanding of the real rate of interest is important.

•The real interest rate is determined in the absence of inflation and, as a
result, it more accurately reflects the true cost of borrowing.
•The real rate of interest is rarely observable because most industrial
economies operate with some degree of inflation, and periods of zero
inflation are rare.
•Its value reflects the factors that determine the real rate of interest plus
the market’s estimate of the degree of inflation in the economy. Inflation is
the amount that aggregate price levels rise over time

95
4.4 RETURN ON INVESTMENT
• Businesses invest in capital projects that are expected to generate positive cash
flows by producing additional real output.
• By more real output, we mean more automobiles, houses, high-definition
TVs, and so on.
• The output generated by a capital project constitutes its return on investment,
which is usually measured as a percentage.
• For example, if a firm has a capital project that costs $1,000 and it produces $200 in
cash flows each year, the project’s return on investment is 20 percent ($200/$1,000).
• For a capital project to be approved by management, its return on investment
must exceed the firm’s cost of funds (debt and equity)—often called the cost
of capital.
• Intuitively, this makes sense because if an investment earns a return greater
than the firm’s cost of funding, it should be profitable and thus increase the
value of the firm. 96
.

• Continuing the example above, if the firm’s cost of capital is 15 percent, the
$1,000 capital project would be accepted by management because the project’s
return on investment exceeds the firm’s cost of capital (20 percent - 15 percent).
• If the capital project earned only 12 percent, the project would be rejected because
its rate of return is less than the firm’s cost of capital (12 percent - 15 percent).
• Thus, a firm’s cost of capital is the minimum acceptable rate of return on capital
projects.
• Also notice that the level of interest rates affects the number of projects that can be
funded in the economy.
• As interest rates increase, fewer capital projects are funded because fewer projects
can earn an expected return that exceeds the firm’s cost of capital.
• As interest rates increase, fewer capital projects are funded because fewer projects
can earn an expected return that exceeds the firm’s cost of capital.

97
4.5 The Level of Interest Rates: EQUILIBRIUM CONDITION

• The real rate of interest is determined in a supply and demand framework.

• Surplus spending units (SSUs) are willing to supply more funds to
borrowers as interest rates go up because lending is more profitable.
• As interest rates go up, however, deficit spending units (DSUs) pull back
on spending because it becomes too expensive to borrow.
• Thus, when interest rates are higher, people spend less and save more,
and business investment is choked off by the higher cost of funds.
• The equilibrium rate of interest (r*) is the point where the desired level of
borrowing (B) by deficit spending units (DSUs) equals the desired level
of lending (L) by surplus spending units (SSUs).

98
 Determinants of the Real Interest Rate

Desired lending:
the amount SSUs
want to lend
•.
r*
Real interest rate (%)

Desired borrowing:
the amount DSUs
want to borrow

L=B

Quantity of lending/borrowing in the economy ($

99
.

• At this point, funds are allocated in the economy in a manner that fits
• people’s preference between current and future consumption, and
• all capital projects whose return on investment exceed the firm’s cost of capital.
• The equilibrium rate of interest is called the real rate of interest.
• The real rate of interest is the fundamental long-run interest rate in the
economy.
• The real rate is closely tied to the rate of return on capital investments
and people’s time preference for consumption.
• It is called the real rate of interest because it is determined by real output
factors in the economy

100
4.6 FLUCTUATION IN THE REAL RATE

• Using the supply and demand framework in the figure you can see
how economic factors that cause a shift in the desired lending or
desired borrowing curves will change the equilibrium rate of interest.
• Demand Factors.
• A major breakthrough in technology will shift the desired
borrowing schedule to the right, thus increasing the real rate of
interest.
• New technology spawns an increase in investment
opportunities, increasing the desired level of borrowing.
• Breakthrough in Technology increases the productivity of
existing capital or labor

101
.

• A reduction in the corporate tax rate

• provides business firms with more money to spend on
investments, which increases the desired borrowing schedule
and causes the real rate of interest to increase.
• An increase in expected business product demand such as
• a big jump in the demand for efficient electric cars; or
• a demographic change such as a younger population, who
tend to be heavy borrower spenders (DSUs).

102
Supply Factors.
• A supply factor could shift the desired level of lending to the right, and
hence lead to a decrease in the real rate of interest
• a decrease in the tax rate for individuals.
( Lower individual tax rates would leave lender-savers with more money to
lend and hence a lower real rate of interest)

• monetary policy actions by the Central Bank.

( An increase in the money supply increases the funds available for lending,
which should decrease the real interest rate.)

• a shift in consumer attitudes about saving,

(The real rate of interest has historically been around 3 percent for the U.S.
economy and has varied between 2 and 4 percent)

103
 4.7 LOANABLE FUNDS THEORY OF INTEREST
• Although the trade-off between productivity and thrift ( returns and saving) is the
underlying force that determines interest rates, it is difficult to use this framework to
explain short-run changes in the level of interest rates observed in a monetary economy
(where money is the medium of exchange).

• Interest rates can be viewed as being determined by the demand for and supply of direct
and indirect financial claims during a particular time period.

• Thus, in the short run, interest rates depend on the supply of and the demand for
loanable funds, which in turn depend on productivity and thrift.

• The loanable funds framework is widely used by financial analysts and economists
because of its intuitive appeal and because it is easily employed as a basis for interest
rate forecasting models
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 4.8 SUPPLY AND DEMAND FOR LOANABLE FUNDS

• DSUs issue financial claims to finance expenditures in excess of their current

income.

• The need to sell these financial claims constitutes the demand for loanable
funds.

• On the other side of the market, SSUs supply loanable funds to the market.
• SSUs purchase financial claims to earn interest on their excess funds.

• Households, businesses, and governmental units operate on both sides of

the market.
105
• Supply of Loanable Funds (SSU)
• Consumer savings
• Business savings (depreciation and retained earnings)
• State and local government budget surpluses
• Federal government budget surplus (if any)
• Federal Reserve increases in the money supply (∆M)

• Demand for Loanable Funds (DSU)

• Consumer credit purchases
• Business investment
• Federal government budget deficits
• State and local government budget deficits

• Notice that households, businesses, and governmental units are both suppliers and demanders of
loanable funds.

• During most periods, households are net suppliers of funds, whereas the business sector is almost
always a net demander of funds.
106
 Examples
• Households both as suppliers and demanders of loanable funds,
• consumer personal savings are a major source of funds and, simultaneously, most households are
demanders of funds as they engage in a wide variety of consumer credit purchases.
• Businesses both as suppliers and demanders of loanable funds,
• business firms supply loanable funds through depreciation and retained earnings, and they demand
loanable funds to invest in plant, equipment, and inventories.
• State and local governments both as suppliers and demanders of loanable funds,
• State and local governments can run surplus budgets (tax revenues exceed expenditures) that act as a
supply of funds, whereas budget deficits (expenditures exceed tax revenues) create a demand for
loanable funds as governmental units issue debt to cover the shortfall in revenues.
• Federal governments both as suppliers and demanders of loanable funds,
• The federal government historically has been a demander of loanable funds because it typically runs a
deficit budget.
• The National bank is a source of loanable funds.
• The supply of loanable funds is increased whenever the national Bank increases the money supply
(DM is positive) through an open-market purchase of Treasury securities.
• Likewise, an open market sale of Treasury securities decreases the money supply (DM is negative)
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.

• The supply of loanable funds schedule is a composite of all suppliers

of loanable funds in the economy, and it is drawn sloping upward to
the right.
• Hence, at higher interest rates, SSUs are willing to provide greater
amounts of loanable funds.
• Furthermore, at higher interest rates there is a decrease in the
demand to hold money balances because of the greater opportunity
cost of holding non-interest-bearing money.
• Thus, as interest rates rise, the quantity of loanable funds supplied to
the market increases

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.

• However, not all suppliers of loanable funds are

equally sensitive to changes in interest rates.
• In general, consumers save more as interest rates rise.
• Higher interest rates also stimulate business to finance
investments out of internal sources (retained earnings and
depreciation) rather than by issuing new debt or equity.
• This can be accomplished by reducing dividend payments
to increase retained earnings or by switching to an
accelerated depreciation method.

109
.
• The aggregate demand schedule for loanable funds is drawn as a
downward-sloping function of interest rates.
• In general, the higher the interest rate, the smaller the quantity of
loanable funds demanded by DSUs.
• Higher borrowing costs reduce the level of business investments in
plant and equipment, cause state and local governments to postpone
capital expenditures, and reduce consumer installment purchases.
• The federal government’s borrowing is not influenced much by
higher interest rates

110
Interest Rate Determination in a Loanable Funds Framework
 4.9 PRICE EXPECTATIONS AND INTEREST RATES
• So far, the influence of price-level changes—inflation or deflation—on the level of interest rates has not
been discussed.
• The real rate of interest is determined by real factors; thus, changes in price levels were not issues.
• For other interest rates discussed, we assumed that price levels remained constant over the life of the loan
contract.
• In the real world, however, price-level changes are common, and they affect the value of loan contracts, for
that matter, the value of any financial contract.
• To account properly for price-level changes in a loan contract, there are two important relationships that we
need to draw on from basic economics:
• (1) the value of money, which is its purchasing power—that is, what you can buy with it, and
• (2) the inverse relationship between changes in the price level and the value of money.
• As the price level increases (inflation), the value of money decreases( when we have rising prices (inflation),
a dollar buys less)
• Likewise, if prices decrease (deflation), the value of money increases because a dollar buys more.
(Note that deflation is just the reverse of inflation; it should not be confused with disinflation, which is the
slowing down in the rate of price increases (inflation)).
112
 4.10 LOAN CONTRACTS AND INFLATION
• If borrowers and lenders do not adjust the loan contract to address the impact of
expected price-level changes, there can be unexpected transfers of purchasing
power between borrowers and lenders.
• For example,
• if prices rise during the life of a loan contract, the purchasing power of money decreases
and the borrower repays the lender in inflated dollars—dollars with less purchasing power.
• Thus, borrowers receive a windfall gain at the expense of lenders.
• If prices decrease, the purchasing power of the money increases and lenders receive a
windfall of more purchasing at the expense of borrowers.
• Protection against changes in purchasing power can be incorporated into the
interest rate on a loan contract.
• Suppose that you decided to loan a friend $1,000 for 1 year. After some discussion, you both
agree that the fair rental price for loaning money is 5 percent and you both anticipate 7
percent inflation for the year. In the spirit of fair play, a contract fair to both you and the
borrower would be as follows:
113
.

• For the use of $1,000 for 1 year, the loan contract calls for the payment of
three items at maturity:
• (1) $1,000, which is the repayment of the amount borrowed;
• (2) $50, which is the interest, or rent, for the use of the money’s purchasing
power for 1 year; and
• (3) $70, which is the compensation to the lender for the loss of purchasing
because of the 7 percent inflation expected during the 1-year period.
• It is clear from the example that the actual “interest” charged is not 7
percent, but 12 percent ($120):
• 5 percent ($50) compensation for forgoing current consumption and
• 7 percent ($70) for the anticipated loss of purchasing power due to inflation

114
 .

Items to Be Paid Calculation Amount

1. Principal $1,000.00
2. Rent for 1 year on money loaned $1,000 x 5% 50.00
3. Compensation for expected loss of $1,000 x7% 70.00
purchasing power on the loan amount

Total Compensation to Lender $1,120.00

115
 THE FISHER EQUATION

• The preceding example suggests that protection against price-level changes is achieved
when the nominal rate of interest is divided into two parts:
• (1) the real rate of interest, which is the rate of interest that exists in the absence of price-level
changes; and
• (2) the anticipated percentage change in price levels over the life of the loan contract. This can be
written as follows:

• i the nominal rate of interest (the contract rate) i  r  pe

• r the real rate of interest
• expected annualized price level change
ΔPe=(Pt+1-Pt)/Pt
In our case 0.05 + 0.07 = 0.12 = 12%
.
THE REALIZED REAL RATE OF RETURN
• The Fisher equation shows that the nominal interest rate is affected by inflationary
expectations in the economy.
• However, the realized rate of return on a loan may differ from the nominal rate
that was agreed on at the time the loan was made.
• The realized real rate of return can be defined as the actual rate of return to the
lender at the conclusion of the loan contract and it can be formally expressed as
follows: rr  i  Pa
• rr is realized real rate of return on a loan contract
• i is observed nominal rate of interest
• Pa = ( Pt 1  Pt ) / Pt is actual rate of inflation during the loan contract,
where P are commodity price
.
• There are three possible outcomes for loan contracts and inflation.
ΔPa > ΔPe, ΔPa = ΔPe, ΔPa < ΔPe
• Who benefits the most, Lender of Borrower in each of the cases?
• If the actual inflation rate at the end of the loan contract turns out to be higher
than the expected inflation rate the lender will earn a lower real rate of return
because of an unintended transfer of purchasing power to the borrower from
the lender.

• if the actual rate of inflation is equal to the expected inflation rate expectations
are realized

• If the actual inflation rate turns out to be less than the expected inflation rate,
the lenders will earn a higher rate of return because of unintended transfer of
purchasing power from the borrower to the lender.
FORECASTING INTEREST RATES
• This is important because changes in the level of interest rates affect
the present value of streams of future payments; that is, they affect the
prices of financial assets—one’s economic wealth !
• In general, economists use a variety of approaches to forecast interest
rates.
• They range from naïve forecasting models based on
• subjective adjustments
to
• extremely complicated financial models of the economy.
.

• There are two most popular forecasting methods used by economists

• ECONOMIC MODELS and
• FLOW-OF-FUNDS ACCOUNT FORECASTING

• ECONOMIC MODELS
• Economic models predict interest rates by estimating the statistical relationships between
measures of the output of goods and services in the economy and the level of interest
rates.

• Some of the larger economic models simultaneously forecast changes in spending on

goods and services, wages and salaries, price levels, the balance of international trade,
credit demand, supply of securities, capital goods, the money supply, the fiscal policy of
the federal government, and interest rates.
• FLOW-OF-FUNDS ACCOUNT FORECASTING

• One of the most widely used interest rate forecasting techniques uses the
flow-of funds framework embedded within the loanable funds theory of
interest rates.
• The flow-of-funds data show the movement of savings—the sources and uses
of funds—through the economy in a structured and comprehensive manner.
• The flow-of-funds accounts are companion data to the national income
accounts, which provide information about the flow of goods and services in
the real economy.
5. Asset Prices and Interest Rate Risk
• THE TIME VALUE OF MONEY
• The time value of money is based on the belief that people have a positive
time preference for consumption; that is, people prefer to consume goods
today rather than consume similar goods in the future.
• FUTURE VALUE
• Future value is the value of a given amount of money invested today (present
value) at a given point in the future (future value) at a given rate of interest.
The formula for calculating future value (compounding) is:
FV  PV (1  i ) n

123
.

• PRESENT VALUE
• Present value is the value today of a given sum of money to be received
at a given point in the future.
• PV = FV /(1+i) n

• For example, suppose that you could buy a financial claim that would pay
$121.67 in 5 years, and there is no doubt the amount will be paid (i.e., a
risk-free cash flow), if the interest rate on our next best alternative
investment(i.e., your opportunity cost) were 4 percent.
PV = $100.00
.

• Bond pricing

• A bond is a contractual obligation of a borrower to make periodic cash

payments to a lender over a given number of years. A bond
constitutes debt, so there is a borrower and a lender.
• In the parlance of Wall Street, the borrower is referred to as the bond
issuer.
• The lender is referred to as the investor, or the bondholder.
• The bond consists of two types of contractual cash flows.
• First, on maturity, the lender is paid the original sum borrowed,
which is called the principal, face value, or par value, of the bond.
• Note that these three terms are interchangeable.
125
 .
• Second, the borrower or issuer must make periodic interest payments to
the bondholders.
• These interest payments are called the coupon payments (C).
• The magnitude of the coupon payments is determined by the coupon rate
(c), which is the amount of coupon payments received in a year stated as a
percentage of the face value (F).
• For example,
• if a bond pays $80 of coupon interest annually and the face value is $1,000, the
coupon rate is:
c = C/F , = $80/$1,000= 8%
• The coupon rate and the market rate of interest may differ.
• The coupon rate is fixed throughout the life of a bond

126
• Because a bond is a borrower’s contractual promise to make future cash
.

payments, the pricing of a bond is an application of the present value formula.

• The price of a bond is the present value of the future cash flows (coupon
payments and principal amount) discounted by the interest rate, which
represents the time value of money.
• The formula for the present value, or price, of a fixed-coupon-rate bond with n
periods to maturity is:
PB= C/ (1+i)1 + C/ (1+i)2 + …..+ (C+F)/ (1+i)n
where:
• PB =the price of the bond or present value of the stream of cash payments
• C= the periodic coupon payment
• F = par value or face value (principal amount) to be paid at maturity
• i = market interest rate (discount rate or market yield)
• n = number of periods to maturity

127
.

• the formula says that the present value, or market price, of a bond is
the sum of the discounted values of all future cash flows (coupon
payments and principal).

• PAR, PREMIUM, AND DISCOUNT BONDS

• Take different value of market interest rate above and below bond
principal to see which are PAR, PREMIUM, AND DISCOUNT BONDS

128
BOND YIELDS
• Bond yields are bond returns.
• A yield on any investment, such as a bond, is the interest rate that
equates the market price of an investment with the discounted sum
of all cash flows from the investment.
• The ideal yield measure should capture all three potential sources of
cash flow from a bond: (1) coupon payments, (2) interest income from
reinvesting coupon payments, and (3) any capital gain or loss.
• There are four yield measures: yield-to-maturity, expected yield,
realized yield, and total return.

129
YIELD-TO-MATURITY
• If a bond’s purchase price is known, the bond-pricing formulas can be
used to find the yield of a bond.
• A yield calculated in this manner is called the yield-to-maturity or
promised yield.
• It is the yield promised the bondholder on the assumption that the
bond is held to maturity, all coupon and principal payments are made
as promised, and the coupon payments are reinvested at the bond’s
promised yield for the remaining term-to-maturity.
• If the coupon payments are reinvested at a lower rate, the
bondholder’s actual yield is less than the promised yield
(reinvestment risk).

130
A n ex am p leo fay ield -to -m atu rity calu latio n

• If a person purchased a 3-year, 5 percent coupon (semiannual payments) bond

for $951.90, the yield to maturity is found by solving the following equation for
the interest rate (i):
• $951.90 = $25/ (1+i/2)1 + $25/ (1+i/2)2 + $25/ (1+i/2)3 + ….+ $1025/ (1+i/2)6
• Unfortunately, the yield-to-maturity (i) cannot be determined algebraically but
must be found by trial and error.
• That is, the calculation is done by selecting different values of i until the
present value of the cash flows on the right side of the equation equals
$951.90.
• Solving the preceding equation in this manner results in a yield of 3.407
percent semiannually, or 6.814 percent annually.
• The yield-to-maturity tells us what return we will earn on a bond if the
borrower makes all cash payments as promised, if interest rates do not change
over the bond’s maturity, and if the investor holds the bond to maturity
131
 Expected Yield
• An investor may plan to sell a bond before maturity, the bond may be called prior to
maturity, or the bond issuer may default. In any event, the return actually earned on a
bond is likely different from the promised yield.
• Investors and financial institutions that plan to sell their bonds before maturity would
like to know the potential impact of interest rate changes on the returns of their bond
investments ex ante (before the fact).
• They can use various forecasting techniques to estimate future interest rates based on
information about the money supply, inflation rates, economic activity, and the past
behavior of interest rates.
• Once armed with an interest rate forecast, an investor can predict the market price of a
bond at the end of a relevant holding period.
• Given the prediction of the future price, the investor can calculate an expected yield
that reflects the expected sale price.
132
.

• Suppose you purchase a 10-year, 8 percent coupon (annual payments)

bond at par and you plan to sell it at the end of 2 years at the prevailing
market price.
• When you purchase the bond, your investment adviser predicts that
similar bonds with 8 years to maturity will yield 6 percent at the end of 2
years.
• Your interest rate forecast implies that the bond’s expected price is
$1,124.20:

133
.

• PB = $1124.20 = $80/ (1.06) 1 + $80/ (1.06)2 + .….+ $1080/ (1.06)8

• Notice there are eight coupon payments and the principal payment remaining at the
time of the planned sale.
• To calculate the expected yield over your 2-year holding period, you solve for the
interest rate that equates the original purchase price (par, or $1,000, in this example)
with the discounted sum of the cash flows you expect to receive (coupon payments
and the expected sale price):
• $1,000 = $80/( 1+i)1 + ($80+ $1,124.20)/ (1+i) 2
• Solving the preceding equation, the expected yield is 13.81 percent.
• In this case, the difference between the promised yield and the expected yield is
accounted for by the expected capital gain of $124.20 received from selling the bond
before maturity.
• Note that calculating the expected yield this way assumes we will be able to reinvest
the coupon payments we receive at the expected yield of 13.81 percent.
134
REALIZED YIELD

• The realized yield is the return earned on a bond given the cash flows
actually received by the investor and assuming that the coupon payments
are reinvested at the realized yield.
• Suppose you purchased the bond in the previous example, a 10-year, 8
percent coupon (annual payments) bond at par. Rather than selling it in 2
years, however, you hold on to it for 3 years and sell it so that you can take
a vacation.
• At the time you sell the bond, 7-year bonds with similar characteristics
(e.g., default risk) sell at yields of 10 percent.
• In this case, the realized yield is different from the promised yield of 8
percent (or the expected yield of 13.81 percent calculated previously)
because market yields on similar bonds increased to 10 percent.

135
.

• Similar to the calculation of expected yield, we calculate the yield actually

earned on the investment by solving for the interest rate that equates the
price you originally paid for the bond with the discounted sum of the cash
flows you actually received.
• The first step is to calculate the terminal price of the bond (i.e., the market
price of the bond on the date you sell it). In the example, you paid $1,000
for the bond.
• You held the bond for 3 years and received three annual coupon payments
of $80 each.
• The market price of the bond on the day you sell it is equal to the present
value of the remaining seven coupon payments and final principal
repayment

• PB = $902.63 = $80/ (1.10)1 + $80/ (1.10)2 + .….+ $1080/ (1.10)7

136
,
• The next step is to set the original purchase price of $1,000 equal to the
present value of the cash flows actually received (three coupon payments
of $80 and the sale price of $902.63) and solve for the interest rate:
• $1,000 = $80 /(1+i) 1 + $80/( 1+i)2 + ($ 80+ $902.63)/(1+i)3
• Solving the preceding equation by trial and error results in a realized yield
of 4.91 percent annually.
• The difference between the realized yield and the promised yield in this
case is accounted for by the capital loss of $97.37 ($1,000 - $902.63)
suffered when the bond was sold before maturity.
• In sum, realized yield is useful because it allows an individual investor or
financial institution to evaluate the return on a bond ex post (after the
end of the holding period or investment horizon)

137
TOTAL RETURN
• Unfortunately, both the expected yield and realized yield calculations assume
that we will be able to reinvest the coupon payments at the calculated yield.
• Fortunately, if we know (or if we are willing to make an explicit assumption
about) the actual reinvestment rate, we can calculate something called the
total return on a bond.
• It is the return we receive on a bond that considers capital gains or losses
and changes in the reinvestment rate.
• To calculate the total return for a bond, we must first determine two things:
• (1) the terminal value of the bond (the selling price if we sell the bond, the call price
if the bond is called prior to maturity, or the par or face value of the bond if we hold it
until maturity), and
• (2) the accumulated future value of all the coupon payments we received based on a
known (or assumed) reinvestment rate.

138
.

• Once we know these two values, we determine the interest rate that
equates our initial purchase price to the sum of these two values over
the number of periods in our holding period.
• Consider the previous example in which we purchased a 10-year, 8
percent coupon (annual payments) bond at par.
• We sold the bond after 3 years for $902.63 (see the previous
calculations), so we know the bond’s terminal value.
To determine the accumulated future value of the coupon payments, we
must find the reinvestment rate. If we are willing to assume that we
reinvested the coupon payments at the initial promised yield of 8 percent,
we would calculate the accumulated future value as follows:
FV = C [ (1+i)n -1]/i ( derived from the sum of geometric series = Sn= a( r -1)/( r-1) where a is
n

the recurring amount, r is the ratio of increase , n is the number of payments which means Sn=FV, a=C r=1+i )

= $80[1.08-1]3/0.08= $259.71
139
.

This is just an application of the future value of an annuity formula (as

opposed to the future value of a lump sum calculation introduced
earlier in the chapter).

Now, we just determine the interest rate that equates our initial
purchase price, $1,000, to the sum of the $902.63 and $259.71:

$1,000 = ($902.63 + $259.71 )/ (1+i) 3

Solving for i, we learn that the total return for this investment is 5.14
percent. This is higher than the 4.91 percent we calculated earlier
because our assumed reinvestment rate of 8 percent is higher than the
implicitly assumed reinvestment rate of 4.91 percent in the realized
yield calculation
140
BOND PRICES AND YIELDS

• Bond prices and yields vary inversely.

• Specifically, as the market rate of interest (or yield) rises, a bond’s market price
declines; or as the market rate of interest (or yield) declines, a bond’s market price
rises.
• This inverse relationship exists because the coupon rate or interest rate on a bond is
fixed at the time the bond is issued.
• For example, when market interest rates rise, the only way to increase a bond’s yield
to be equal to the market rate of interest is to reduce the bond’s price because the
rate of interest the bond pays is fixed for the life of the bond contract.
• The investor in such a bond is “paid” the additional interest as a capital gain. \
• Likewise, if market interest rates decline, the only way to reduce a bond’s yield to the
market rate is to increase the bond’s price.
• The inverse relationship, one of the most important concepts discussed in this book,
applies to bonds or any financial contract whose interest rate payments are fixed for
the life of the contract. 141
EQUITY PRICING
• Equity valuation requires us to apply the mathematics of present
value.
• For any security, including common stock or preferred stock, the
valuation process involves three steps.
• First, identify the timing and the size of the cash flows.
• Second, decide on the appropriate discount rate. The discount rate, which is
the interest rate used in the present value calculation, should reflect the
opportunity cost of investing in the security. The opportunity cost is the rate
of return offered by a security with similar characteristics, including risk, that
is trading in the market.
• Third, apply the discount rate to the cash flows in each period to obtain
present values and sum the present values to obtain the price of the security.

142
 COMMON STOCK VALUATION
• For a common stock, the expected cash flows are the dividends you expect to
receive plus what you expect to be able to sell the stock for in the future.
• Let P0 be the current stock price and P1 be the expected stock price 1 year
from now.
• Assume the firm pays a dividend of D1 at the end of the first year. Using the
present value formula, we write:
P0 = D1 /(1+r) + P1 /(1 + r)
P1 = D2 /(1+r) + P2 /(1 + r) , P0 = D1 /(1+r) + D2 /(1+r)2 + P2 /(1 + r)2
P2 = D3 /(1+r) + P3 /(1 + r) , P0 = D1 /(1+r) + D2 /(1+r)2 + D3 /(1+r)3 + P3 /(1 + r)3
P0= D1 /(1+r) + D2 /(1+r)2 + D3 /(1+r)3 +…. =∑ ∞
t=1 Dt /(1 + r)t
143
• We can make some assumptions about the nature of future dividends
.

that simplify our calculations

• Constant Dividend Growth Rate
Dt = D0 x (1+g)t
P0= D1 /(1+r) + D1 ( 1+g) /(1+r)2 + D1( 1+g)2/(1+r)3+…..
Multiplying both sides of the above equation by (1+g)/(1+r)
P0(1+g)/(1+r)= D1 (1+g)/(1+r)2 + D1 ( 1+g)2 /(1+r)3 + D1( 1+g)3/(1+r)4+…..
P0 - P0(1+g)/(1+r)= D1 /(1+r) + D1 ( 1+g) /(1+r)2 + D1( 1+g)2/(1+r)3 ….. - D1
(1+g)/(1+r)2 + D1 ( 1+g)2 /(1+r)3 + D1( 1+g)3/(1+r)4…….
P0 - P0(1+g)/(1+r)= D1 /(1+r)
Multiplying both sides by (1+r) yields:P0 ( 1+r)- P0(1+g)= D1
P0 (r-g)= D1 , P0= D1 / (r-g) , Pt= Dt+1 / (r-g) 144
Example
• If the dividend next year is $2.10, the growth rate is a constant 5
percent and the discount rate is 12 percent, we obtain the price as
P0= $2.1/(0.12-0.05)=$30
If we solve Equation P0= Dt / (r-g) for r, we obtain r = D1/P0 + g
• The first term of the expression is called the dividend yield, which is
the expected dividend expressed as a proportion of the price of the
stock.
• The second term, g, can be interpreted as the capital-gains yield,
which is the rate at which the value of the firm is expected to grow

145
INVESTMENT RISK IN STOCKS
• If you put all your money in a savings account at the bank, you will earn a low
return, but you will be certain not to lose money.
• Alternatively, if you invest in stocks, you may lose money or make money, which
means the return is uncertain.
• Any rational investor will require a higher expected return given greater
uncertainty (risk).
• It is important to recognize that, although investing in stocks should yield a
higher expected return, it does not mean the return you actually make—the
realized return—will be higher (or even positive) than if you put your money in
the bank.
• There is a probability of losing some or all of your investment
• Now, we discuss the types of risk faced in equity markets and how risk is
reflected in the required returns of stocks.
146
.

• Risk is a function of the dispersion of possible future outcomes

• Expected Value:
• probability of a particular outcome times the magnitude
• Risk is measured as the standard deviation of expected outcomes
• Diversification across securities
• As the number of securities in a portfolio increases the portfolio risk
decreases and approaches the risk of the total market
• Diversification works because unsystematic risks (unique or security specific
risks) of different securities tend to partially offset one another in a portfolio.
T
• Market risk is inherent from business cycles, inflation, interest rates, and
economic factors
• Firm-specific risk is tied to the company’s labor contracts, new product
development and other company related factors
147
Portfolios and risks
• Note, however, that no matter how many securities we add, the total risk of the
portfolio can only be reduced to the level of systematic risk. Systematic risk is also
called market risk or nondiversifiable risk. No matter how many securities we add
to a portfolio, we cannot reduce systematic risk because it is the risk that tends to
affect the entire market in a similar fashion.
• The expected return of a portfolio is a weighted average of the expected returns
of each of the securities in the portfolio
E(Rp) = S Xi Ri
• The weights (Xi) are equal to the percentage of the portfolio’s value which is
invested in each security and Ri is the [expected] return for each asset i in the
portfolio.
• The riskiness of a portfolio is is the square root of the sum of the weighted (X2i)
times the variances (s2) of each security and the correlation ri between each pair
of securities
148
.

• In a 2-Asset Portfolio the riskiness is

sp = (X2i s2i + X2j s2j + 2 Xi Xj ri,j si sj)1/2

• The correlation coefficient (ri,j) can be positive (+1), zero, or negative (-1)
• If the average correlation of securities in the portfolio is positive – the riskiness of
the portfolio will be larger.
• If the average correlation of securities in the portfolio is negative – the riskiness of
the portfolio is smaller: the third term will be negative

• Portfolio diversification
• Diversification can increase the risk/return tradeoff if the average correlation
coefficient between individual securities in the portfolio is less than 1.0
• The benefits of diversification increase as the correlation coefficient gets smaller
149
• Most
. investors are primarily concerned with systematic risk, which is usually
measured by how closely a security’s returns are correlated with the returns of
the entire market.
• The extent to which a stock’s returns are related to general market swings is
measured with beta (ϐ).
• Suppose a stock has a beta of 2 relative to the market.
• This means that if the market risk increases 10 percent, you’d expect the stock
to increase by approximately 20 percent.
• And if the market fell by 10 percent, you’d expect the stock to fall by about 20
percent.
• Hence, the stock has twice the systematic risk as the market.
• Thus, if a stock has a beta of 0.5, it will have half the systematic risk of the
market.
• If the market falls 10 percent, you’d expect the stock to fall about 5 percent.
150
STOCK MARKET INDEXES

• PRICE-WEIGHTED INDEXES
• A price-weighted index is first computed by summing the prices of the
individual stocks composing the index. Then the sum of the prices is divided
by a divisor to yield the chosen base index value.

• MARKET VALUE–WEIGHTED INDEXES

• A market value–weighted index is computed by calculating the total market
value of the firms in the index and the total market value of those firms on the
previous trading day.
DOW JONES AVERAGES

• The most widely cited stock market index is the Dow Jones Industrial
Average (DJIA), which was first published in 1896.

• The DJIA is a price-weighted index that originally consisted of 20

stocks with a divisor of 20; thus, the value of the index was simply the
average of the price of the 20 stocks

• In 1928, the DJIA was enlarged to encompass 30 of the largest U.S.

industrial stocks—so-called blue-chip stocks.
Capital asset pricing model (CAPM)
• Theoretically, the required (or expected) return on a stock depends on the amount
of its systematic risk.
• The capital asset pricing model (CAPM) is the most popular model of the relation
between systematic risk and expected return.
• To understand the model, consider the following definition of a risk premium
• Risk premium = required (or expected) return on a risky security minus the return
on a risk-free security
• the risk premium is E(Rj) - RF = ϐj x ([E(RM) - RF]/ϐM).
• E(Rj) = expected return on stock j
• E(RM) = expected return on the market portfolio, which consists of all assets in the market
(Consider the market portfolio as the ultimate in diversified portfolios.)
• RF = rate of return on a risk-free asset, such as a T-bill
• ϐj = the beta of stock j
• ϐM = the beta of the market portfolio
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• If the beta for the market portfolio is 1
• E(Rj) - RF = ϐj x ([E(RM) - RF]) and E(Rj) = RF + ϐj x ([E(RM) - RF])
• This means the required return on a security equals the return on a
risk-free asset plus a premium for bearing systematic risk in the
amount ϐj.

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 PRICING TREASURY BILLS
•.
p f  p0 360
yd    100%
pf n

yd = discount yield on an annualized basis

Pf = face value (amount paid to the investor at maturity)
P0 = purchase price of the T-bill
n = number of days to maturity
.

Arbitrage
• Arbitrage is the simultaneous purchase and sale of the same asset in
different markets in order to profit from tiny differences in the asset's
listed price.
• It exploits short-lived variations in the price of identical or similar
financial instruments in different markets or in different forms.
• Arbitrage exists as a result of market inefficiencies and it both exploits
those inefficiencies and resolves them.

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Arbitrage Pricing Theory (APT)
• APT is a multi-factor asset pricing model
• that an asset's returns can be predicted using the linear relationship between the
asset’s expected return and a number of macroeconomic variables that capture
systematic risk.
• It is a useful tool for analyzing portfolios from a value investing perspective, in
order to identify securities that may be temporarily mispriced.
• Arbitrage Pricing Theory Model:
• E(Ri)=E(Rz)+(E(i)−E(Rz))×βn
• where:
• E(R)i=Expected return on the asset i
• Rz=Risk-Risk-Free rate of return
• βn=Sensitivity of the asset price to macroeconomic factor n
• Ei=Risk premium associated with factor i
Example
• You are an analyst for a money market mutual fund.
• The fund is considering whether to purchase 6-month (182- day) Treasury bills.
• So that you can compare the yield on the T-bills with other securities in the portfolio,
the portfolio manager that you report to has asked you to calculate the yield.
• Here is what you know.
• The T-bills have a face value of $10,000 and are selling at 99 percent of face value.
Basel Accords

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