6.9 Introducing financial markets

in what two forms can people hold wealth

real or financial assets

real assets

productive assets i.e. capital goods, land, housing

firms own a lot of these but firms are technically owned by households —> households = ultimate owners of aggregate wealth

financial assets

bonds, shares, bank deposits

financial sector

plays an important role in channeling household savings towards investment by companies in the productive assets that increase agg wealth in the ecnoomy

**enables households to borrow long term to buy a real asset

traded securities

bought and sold in financial markets, aka bonds and shares

who does the gov/firm make coupon payments to on a bond?

whoever owns the bond at the time of payment, until it reaches maturity

debt finance

when companies finance their activities by borrowing via bank loans and bonds

initial public offering

when shares are first sold by a company

shareholders are co-owners of the company and legally own any profits the company makes - they’re not entitled to regular payments but the company may decide to pay out some of its profits in the form of dividends

**profits not paid out are reinvested into ongoing operations

retained earnings

main source of funding for investment projects in well-established companies

equity finance

when companies finance activities by selling new shares or through retained earnings

equity finance vs debt finance

equity = finance activities by selling shares or through retained earnings

debt = finance activities through bank loans or by selling bonds

if you’re an investor, what does the choice between different assets depend on?

depends on what you expect to get back in the future aka rate of return

**applies to any asset, real or financial

what is the rate of return in the case of a guaranteed bank deposit?

rate of interest

rate of return formula

1 + rate of return = total amt borrower pays back / loan

1 + rate of return = what you get back / what you put in

rate of return (%) = capital gain or loss (%) + income (%)

what you get back can be separated into two parts:

value of asset when you sell it and any income you receive from it while you own it

rate of return (%) = capital gain or loss (%) + income (%)

capital gain/loss & income

change in value (diff between future and current prices) as a percentage of intiail investment

income = annual income as a percentage of the initial investment

**current price = what you put in

any asset that has a future value which depends on future market prices is a risky investment even if income component is guaranteed - why?

bc market prices are uncertain - volatility changes, etc.

real rate of return

return rate corrected for inflation

real rate of return = nominal rate of return - inflation rate