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Banking system
consists of commercial banks (privately owned firms that accept deposits from individuals and businesses and use those deposits to make loans
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
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
Lower interest rates on municipal bonds
Stock
a claim to partial ownership of a firm
Dividend- a regular payment received by stockholders for each share that they own
Determined by the firm’s management and usually depend on the firm’s recent profits
Stockholders receive returns in the form of capital gains when the price of their stock increases
A stock’s price rises and falls as the demand for the stock changes
Demand for stocks depends on factors such as news about the prospects of the company
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
Determined by the firm’s management and usually depend on the firm’s recent profits
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:
Receive dividends- a regular payment received by stockholders for each share they owned
Receive capital gains- if the price of the stock increases
The price of a stock depends on
An increase in expected future dividends or in expected future market price of a stock raises the current price of the stock
An increase in interest rates, implying an increase in the required rate of return ot hold stocks, lowers the current price of stocks
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
Note
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