Macroeconomics Midterm #2

dont have study guide yet so just guessing based on practice exam

Financial System

• Brings savers and borrowers together

• The system of financial markets and financial intermediaries through which borrowers (firms) acquire funds from savers (households)

• Financial Markets and financial intermediaries together comprise the financial system

Financial markets

Financial institutions through which savers can directly provide funds to borrowers

The bond market

• A bond is a form of loan

The stock market

• A stock is a claim to partial ownership in a firm

The bond market

• A bond is a form of loan

  • which specifies the amount borrowed, interest/coupon rate, maturity, etc.

• Issuers of bonds: debtors, people who take out loans

• Buyers of bonds: bond holders, creditors, money lenders

• Bonds can be issued not only by firms, but also state, local, and sovereign governments

• A bondholder (person who lends the money) can hold the bond until maturity, or can sell the bond at an earlier date to someone else

• Debt finance: sale of bonds to raise money

Parts of a bond

• Principal/face value/par value: the amount borrowed

  • a bond with $10,000 face value represents a $10,000 loan to the issuer ($10,000 of principal)

  • Face value/principal is the amount that bondholder expects to receive on the bond’s maturity date

• Date of maturity: The time at which the principal/loan will be repaid

• Rate of interest/coupon rate: that the borrower will pay periodically until the loan matures

• Bond issuer:

  • Issued by the federal government: U.S treasuries

  • Issued by the state and local government: municipal bonds

  • Issued by corporations: corporate bonds

Coupon rate (Bonds)

The borrower will pay periodically until the loan matures

Annual coupon rate=annual coupon rate/principal ($ borrowed) X100

U.S Treasuries (bonds)

Treasury bills: <1 year (also called T-bills) (lowest risk)

Treasury notes: 3-10 years

Treasury bonds: >10 years (highest risk)

bonds have higher interest rates to help compensate for higher risk

How to read a bond

Four characteristics of bonds

1. Term/term to maturity

2. Credit risk

3. Liquidity

4. tax treatment

Term/Term to Maturity (Bond characteristics)

Length of time until the bond matures

• Short terms or long terms

• If we look at U.S treasuries

  • Treasury bills: <1 year (also called T-bills) (lowest risk)

  • Treasury notes: 3-10 years

  • Treasury bonds: >10 years (highest risk)

  • Treasury bonds are riskier than T-bills because a lot can happen in 10-30 years (inflation, government changes, economic collapse potential, etc).

    • Bonds have higher interest rates to help compensate for higher risk

Credit risk (bond charecteristics)

Probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

• Such a failure to pay is called default

  • U.S. Treasuries are considered default-free

  • Risk premium: the spread between the interest rates on bonds with default risk and interest rates on (same maturity) Treasury bonds

• How to determine credit risk?

  • Credit rating agencies

Credit risk cont. (bonds charecteristics)

• Investment grade bonds: bonds with ratings of at least Baa (or BBB)

• Junk bonds (issued by financially shaky corporations) pay very high interest rates

  • ratings are below BBB or Baa

Liquidity (bond characteristics)

The relative ease with which an asset can be converted into cash

• U.S. Treasuries are more liquid than corporate bonds

  • Most bondholders are risk-averse

  • Number of buyers/sellers in a bond market

  • Corporate bondholders require higher compensation→ higher interest rates

Tax treatment (bond characteristics)

way the tax laws treat the interest earned on the bond

• interest on most bonds is taxable income

• Municipal bonds (issued by state and local government): are exempt from federal income tax

  • that’s why municipal bonds are popular with the rich

  • Holding everything else constant, municipal bonds have lower interest rates than U.S. Treasury bonds

The stock market

Another way to borrow money is issuing stocks

• Equity finance: sale of stock to raise money

• A share of stock: ownership in a firm

  • Therefore, it is a claim to some of the profits that the firm makes

  • Stocks pay dividends, not periodic interest payments

  • Stockholders are residual claimants

    • After firms earn revenue, bondholders get paid the predetermined interest payment first

    • Stockholders get paid after bondholders are paid

Financial intermediaries

Institutions through which savers can indirectly provide funds to borrowers

• Banks

Banks

Primary role for banks

• Take in deposits from savers (small interest rate)

• Use these deposits to make loans to borrowers (charge a higher interest rate)

• banks earn profit from interest rate margin

• for banks to make profit, they must make more than they give

interest rate margins= i₁-i₂