Savings, Investment, and Borrowing

Simple Interest Rate for Bonds Equation

Fv = Pv(1 + r)

∆r

movement along the curve

Determinants of savings (supply)

• Income

• Demographics/age of population

• Consumption smoothing

• Economic conditions (uncertainty, prospects of UE)

• Tax incentives for savings (ex: IRA)

Determinants of borrowing (demand)

• consumption smoothing

• expected inflation

• Investor confidence (perceived business opportunities.)

• Government borrowing

• Tax incentives for investment

• Productivity of capital

Arbitrage

buying + selling of equally risky assets to take advantage of profit opportunities caused by differences in prices of interest rates

Default risk

borrower could not repay

Inflation risk

inflation can erode yields

Liquidity risk

may sometimes be difficult to find buyers if you need to sell

Interest rate risk

if bond yields on new, equally risky bonds rise, then old bond prices fall, your bond would then be worth less than what you paid for it

Surplus

At r>r*, Qs > Qd, savers drive r down as they compete to lend

Shortage

At r<r*, Qd > Qs, borrowers drive r up as they compete to borrow

Equilibrium

• Every $ borrowed requires a $ saved

• Savings allocated to most valuable uses

  • (Best-case scenario)

Crowding out

• Reduction of private spending

• Decr. in private investment spending

• Decr. in private consumption (inducing more savings on part of consumers)

Intermediaries

banks, stock markets: where savers go to save and borrowers go to borrow

Banks

• Receive funds from savers + lend to borrowers

• Spread risk among savers: pool savings + distribute funds

• Evaluate investors’ credit worthiness and investment projects

• Facilitate payments across accounts

• Reduce transaction costs

How do banks profit?

Charge borrowers higher price on loans than they pay savers for these funds

Bond markets

• Large companies can issue bonds and borrow directly from the public rather than go to a bank

• Governments can do the same

Bond

• Promises to repay a fixed amount (face value)...

• On a specified date (maturity date)...

• Sometimes with additional periodic payments that occur before the maturity date (coupon payments)

• A bond’s price (or present value) is the amount initially paid by buyers to obtain bond

Corporate bond

issued by firms/companies

Municipal + state bond

issued by local/state governments

T-bonds

• issued by federal gov.

• 20 or 30 year maturity with coupon payments

T-notes

• issued by federal gov.

• 2-10 year maturity with coupon payments

Why do interest rates vary across different bonds?

• Bonds with greater default risk require higher rate of return to attract borrowers

• Long-term bonds more susceptible to interest rate risk, thus require a higher rate of return

Stock markets

where shares of stock are bought and sold

Share

• A certificate of ownership in a corporation

• Stock represents firm ownership: divided into shares

Corporation

A business that is owned by shareholderse that have limited liability for the company’s debt but share in its profits and losses

Public companies

Corporations that sell stock

How do savers earn a rate of return on a share of stock?

1. Dividends paid as periodic payments

2. Capital gains: increase in value of stock over time (sale price - purchase price)

IPO (initial public offering)

first time a corporation sells stock to public in order to raise financial capital