ECO 103 Chp. 11

Banking system

Banking system

consists of commercial banks (privately owned firms that accept deposits from individuals and businesses and use those deposits to make loans

1. Banks are important financial intermediaries

Financial intermediaries- firms that extend credit to borrowers using funds raised from savers

Bonds

a legal promise to repay a debt usually including both the principal amount (the amount originally lent) and regular interest payments

Bond prices and interest rates are inversely related

Coupon rate

the interest rate promised when a bond is issued; the annual coupon payments are equal to the coupon rate times the principal amount of the bond

Coupon payments

regular interest payments made to the bond holder

1. Ex. if the principal amount of a bond is $1,000,0000 and its coupon rate is 5%, then the annual coupon payment made to the holder of the bond is (0.05)($1,000,000)= $50,000

Municipal bonds

issued from local governments- are exempt from federal taxes

1. Lower interest rates on municipal bonds

Stock

1. a claim to partial ownership of  a firm

   1. Dividend- a regular payment received by stockholders for each share that they own

      1. Determined by the firm’s management and usually depend on the firm’s recent profits

      2. Stockholders receive returns in the form of capital gains when the price of their stock increases

   2. A stock’s price rises and falls as the demand for the stock changes

      1. Demand for stocks depends on factors such as news about the prospects of the company

         1. Ex. stock price of a pharmaceutical company that annpunces the discorvery of an important new drug is likley to rise on the announcement, even if actual production and marketing of the drug is some time away, because financial investors expect the company to become more profitable in the future

Risk premium- the rate of return that financial investors require to hold risky assets minus the rate of return on safe assets

Dividend

a regular payment received by stockholders for each share that they own

1. Determined by the firm’s management and usually depend on the firm’s recent profits

2. Stockholders receive returns in the form of capital gains when the price of their stock increases

Risk premium

the rate of return that financial investors require to hold risky assets minus the rate of return on safe assets

Diversification

the practice of spreading one’s wealth over a variety of different financial investments to reduce overall risk

Mutual Fund

a financial intermediary that sells shares in itself to the public and then uses the funds raised to buy a wide variety of financial assets

International financial markets

financial markets in which borrowers and lenders are residents of different countries

• Unlike a domestic financial transaction, an international financial transaction is subject to the laws and regulaations of at least two countries

International capital flows

purchases or sales of real and financial assets across international borders

Capital inflows

purchases of domestic assets by foreign households and firms

• Net capital inflows = capital inflows - capital outflows

Capital outflows

purchases of foreign assets by domestic households and firms

• Net capital outflows= capital outflows - capital inflows

Trade balance + net capital inflows = 0

Financial system

the group of institutions that helps match the saving of one person with the investment of another

• Financial intermediaries- institutions through which savers can indirectly provide funds to borrowers

  • Firms that extend credit to borrowers using funds raised from savers

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

  • Ex. banks, mutual funds (instiutitons that sell shares to the public and use proceeds to buy portfolios of stocks and bonds)

• Financial markets- institutions through which savers can directly provide funds to borrowed

  • Ex. the bond market, the stock marke

Bond

a legal promise too repay a debt, usually including both the principal amount and regular interest, or coupon payments

• Principal amount- the amount originally lent

• Maturation date- the date when the principal amount will be repaid

• Term- the length of time from issue to the bond’s maturation

• Coupon payments- the periodic interest payments to the bondholder

• Coupon rate- the interest rate that ia applied to the principal to determine the coupon payments

  • The coupon rate depends on:

    • The bond’s term- longer term bonds have higher coupon rates

    • The issuer’s credit risk

      • Probability the issuer will default on repayment

      • Higher risk→ higher coupon rate

    • Tax treatment for the coupon payments

      • Municipal bonds are free from federal taxes

      • Lower taxes, lower coupon rates

• Bondholders are not required to hold bonds until maturity, the time at which they’re supposed to be repaid by the issuer

  • They are free to sell their bonds in the bond market, an organizedmarket run by professional bond traders

  • Price of the bond- the market value of a particular bond at any given point in time

Current bond price

= future value / (1 + interest rate)

Stock

a claim to partial ownership of a firm

Stockholders a part owners of the corporation and as such receive returns on their investment in two ways:

1. Receive dividends- a regular payment received by stockholders for each share they owned

2. Receive capital gains- if the price of the stock increases

The price of a stock depends on

1. An increase in expected future dividends or in expected future market price of a stock raises the current price of the stock

2. An increase in interest rates, implying an increase in the required rate of return ot hold stocks, lowers the current price of stocks

3. An increase in perceived riskiness, as reflected in an increase in the risk premium, lowers the current price of stocks

Risk premium

the rate of return investors require to hold risky assets minus the rate of return on safe assets

Risk aversion

increases the return required of a risky stock and lowers the selling price

• The tendency of investors to prefer outcomes with low uncertainty to those outcomes with high uncertainty

Closed economy

does not interact with other economies in the world

Open economy

interacts with other economies around the world

• Economies interact through the flow of goods and services and the flow of capital

International capital flows

purchases or sales of real and financial assets across international borders

• Capital inflows- purchases of domestic assets by foreign households and firms

• Capital outflows- purchases of foreign assets by domestic households and firms

Net capital inflows (KI)- capital inflows - capital outflows