Saving and Investment Part 1

Saving and Investment in the Financial System

Overview of the Financial System

• The financial system facilitates the movement of funds from savers to borrowers.

• Comprises two main components: financial markets and financial intermediaries.

Financial Markets

• Defined as systems where funds are directly lent to borrowers.

• Allow lenders to choose who to lend their money to, which can be crucial for those wishing to support specific organizations.

• The two major types of financial markets:
    - Stock Market
    - Bond Market

Bond Market

• Understanding Bonds:
    - Definition of a Bond: A bond is defined as a "certificate of indebtedness."
      - Represents that the issuer owes the holder a debt that must be paid back, often with interest.
    - Bonds can be purchased from various entities such as governments (e.g., U.S. government) or corporations (e.g., Ford).

Characteristics of Bonds

• There are three main characteristics that influence the interest rates of bonds:
    1. Term:
       - Definition: The duration until the bond matures, meaning the time until all principal is paid back.
       - Example: A bond might have a term of thirty years but can be bought and sold before maturity.
       - Interest Relationship: Generally, longer-term bonds pay higher interest rates compared to shorter-term bonds.
    2. Credit Risk:
       - Definition: The probability of the borrower failing to pay part or all of the interest or principal.
       - Example: Higher credit risk results in higher interest rates due to the increased risk to the lender.
       - Safe bonds such as U.S. government securities typically offer lower interest rates, while riskier bonds must promise higher returns.
    3. Tax Treatment:
       - Some bonds, like municipal bonds (state and local), offer tax-exempt interest income at the federal level.
       - Because of this tax exemption, municipal bonds generally pay lower interest rates than taxable bonds.

Introduction to Finance

• Finance Definition: The study of how people allocate resources and deal with risk over time.

• In finance, two critical formulas help to understand the value of money over time:
    - Time Value of Money (TVM) formulas.

Present Value Formula

• Definition: Present value is the current worth of a future sum of money given a specified rate of return.

• Formula:
    $PV = rac{FV}{(1 + r)^n}$
    where:
    - $PV$ = Present Value
    - $FV$ = Future Value
    - $r$ = interest rate
    - $n$ = number of years until maturity

• 

• Example Scenario:
    - Present value of a bond worth $7,000 maturing in three years with a coupon of $50 annually at a desired interest rate of 2%:
       - Calculate present value for each cash flow:
          - Year 1: $rac{50}{(1+0.02)^1} <br>ightarrow 49.02$
          - Year 2: $rac{50}{(1+0.02)^2} <br>ightarrow 48.06$
          - Year 3: $rac{50}{(1+0.02)^3} <br>ightarrow 47.12$
          - Total Future Value: $rac{7000}{(1+0.02)^3} <br>ightarrow 6,005.96$
       - Adding these values gives the maximum price to pay for the bond:
       - Total Present Value: $PV <br>ightarrow 6,740.46$

Future Value Formula

• Definition: Future value is the amount of money an investment will grow to over a period of time at a given interest rate.

• Formula:
    $FV = PV imes (1 + r)^n$
    where:
    - $FV$ = Future Value
    - $PV$ = Present Value
    - $r$ = interest rate
    - $n$ = number of years

  

• Example Scenario:
    - Future value of $10,000 earning 3% interest for twenty years:
       - Calculation:
       $FV = 10000 imes (1 + 0.03)^{20}$
       - Result: $FV <br>ightarrow 18,061.11$

Stock Market

• Definition of a Stock: Represents a claim of partial ownership in a firm. Stocks are intended to reflect the expected future value of a company.

• Stocks can be volatile and vary significantly based on market sentiment and company performance.

Dividends vs. Retained Earnings

• Dividends: Portion of profits distributed to shareholders.
    - Example: Companies like AT&T or Microsoft pay dividends, allowing shareholders periodic income.

• Retained Earnings: Profits that are reinvested into the company instead of distributed as dividends.
    - Example: Companies like Amazon or Netflix often retain earnings for future growth and expansion.

Financing Methods

• Equity Finance: Involves raising money through the sale of stocks.

• Debt Finance: Involves raising money through the sale of bonds.

• Stocks generally offer higher potential returns but come with higher risk compared to bonds, which provide steady but lower returns.

Financial Intermediaries

• Defined as institutions that facilitate indirect lending between savers and borrowers.

• Common types of financial intermediaries include:
    1. Banks: Receive deposits, pay lower interest to depositors, and lend money at higher rates.
    2. Credit Unions: Similar to banks but typically focused on serving specific groups and offering additional benefits to members.
    3. Mutual Funds: Pool resources from multiple investors to invest in diversified portfolios, giving investors shares in the fund without direct control over underlying assets.
      - Index Funds: A type of mutual fund that aims to track the performance of a specific index, known for low costs and consistent returns.

Conclusion and Future Topics

• Financial knowledge is essential for individual decision-making and market understanding.

• The next topic will cover savings and investment definitions, focusing on loanable funds in macroeconomics.