Microeconomics Chapter 18 Financial Markets

Two possibilities for entrepreneurs who don’t have great personal wealth to get startup funds:

Borrow the money

Invite other people to invest in the new venture

Financial intermediary

An institution that makes savings available to dissavers. They reduce search and information cost in the financial markets.

Crowdfunding

The financing of a project through individual contributors from a large number of people, typically via an Internet platform

The factors that influence savings decisions are:

Time preferences

Interest rates

Risk

Risk management

Risk premiums

Time preferences

People saved now to spend later

Interest rates

Higher interest rate rates increase the quantity of available savings (loanable funds)

risk

People do not want to risk losing a lot of money

Risk management

Diversifying their portfolios to attain whatever degree of average risk they preferred

Risk premiums

Lenders want to be compensated for any above average risks they take

We discount future dollars by the opportunity cost of money or…

The market rate of interest

The present discounted value of a future payment declines with:

Higher interest rates

Longer delay delays in future payment

Higher interest rates reduce…

The present value of future payments

How much loanable funds are demanded depends on:

The expected rate of return

The cost of funds

Entrepreneurs’ perspective:

The Interest rate represents the cost of funds

Savers’ perspective:

the interest rate represents the payoff to savings

When interest rates rise…

The quantity of funds supplied goes up and the quantity demanded goes down

The market rate of interest is determined by…

The intersection of the curves representing supply of and demand for loanable funds

Three legal forms of business entities are:

Corporations

Partnerships

Proprietorships

Proprietorship

Business owned by a single individual

Corporation

A business organization having a continuous existence independent of its members and power and liabilities distinct from those of its members

Corporate stock

Refers to shares of ownership in a corporation

Dividend

The amount of corporate profits paid out for each share of stock

Capital gain

An increase in the market value of an asset

People who own stocks can get two distinct payoffs:

Dividends

Capital gains

The higher the expected total return (future dividends and capital gains)…

The greater the desire to buy and hold stocks

Initial public offering (IPO)

The first issuance (sale) to the general public of stock in a corporation

Exaggerated movements in the stock market are caused by:

Sudden and widespread Changes In expectations

Bond

A certificate acknowledging a debt and the amount of interest to be paid each year until repayment

A bond is first issued when:

An institution wants to borrow money

After issuance, bonds are traded in the:

Aftermarket or secondary market

Par value or face value of a bond

The amount to be repaid when the bond is due

Coupon rate

The interest rate set for a bond at time of issuance

Default

Failure to make scheduled payments of interest or principal on a bond

Current yield

The rate of return on a bond. Calculated by the annual interest price divided by the bond’s price

As bond prices rise…

Their effective interest rate (current yield) falls

Charging bond prices change the yield, but…

Not the bond’s coupon rate (interest rate fixed at issuance.)

Venture capitalists provide:

Financial support for the entrepreneurial ideas and share in the risks and rewards