Module 8 Loanable Funds Market

Module 8: Loanable Funds Market

Financial Market

A Financial Market is the interaction between borrowers and lenders through a variety of financial instruments. This market plays a crucial role in the economy by facilitating the flow of funds from savers to those who need capital, such as businesses and governments.

Key Financial Securities:

  • Stocks: Represent ownership in a company and come with voting rights for shareholders. They can pay dividends and are traded on stock exchanges.

  • Bonds: Debt instruments that entities use to raise capital, promising to pay back the principal plus interest.

  • Commercial Paper: A short-term unsecured promissory note issued by companies to raise funds for working capital needs.

  • Exchange Rates: The value of one currency for the purpose of conversion to another, influencing trade and investments.

  • Commodities: Basic goods used in commerce that are interchangeable with other goods of the same type, such as precious metals, agricultural products, and energy resources.

Financial Intermediary

Definition:

Financial Intermediaries are institutions that facilitate the exchange of financial securities between borrowers and lenders, streamlining access to capital and liquidity.

Examples:

  • Banks: Accept deposits and provide loans; they are the primary financial intermediaries in the economy.

  • Loan Companies: Provide personal loans and financing, often at higher interest rates than banks.

  • Mutual Funds: Pool funds from multiple investors to purchase a diversified portfolio of stocks and bonds, offering liquidity and diversification.

  • Insurance Companies: Collect premiums and invest them to cover future claims, also acting as financial intermediaries.

Types of Financial Intermediaries

  • Mutual Fund: Aggregates funds from investors to create a diverse range of investments, enabling smaller investors to benefit from collective resource pooling.

  • Bank: Uses deposited funds to purchase securities or provide loans, acting as a bridge between savers and those needing capital.

Firm Financing

Methods for Firms to Raise Funds:

  1. Retained Earnings: Profit reinvestment for capital projects rather than distribution as dividends.

  2. Equity Financing: Issuing shares to investors, providing them with partial ownership of the firm.

  3. Debt Financing: Borrowing money from individuals or institutions, promising repayment with interest.

Types of Funding:

  • Direct Funding: Firms borrow money directly from lenders without intermediaries.

  • Indirect Funding: Firms obtain funding through financial intermediaries, such as banks, which can streamline access to capital and offer better terms.

Bond Basics

Definition:

A bond is a financial instrument that represents a loan made by an investor to a borrower (typically corporate or governmental).

Key Characteristics:

  • Principal/Face Value: The amount borrowed, which must be repaid at maturity.

  • Coupon Payment: The interest paid to bondholders, typically at fixed intervals.

  • Maturity: The date on which the bond's principal must be repaid.

Bonds Structures and Payments

  • Bondholders are considered creditors and do not have ownership stakes in the issuing firm.

  • In bankruptcy, bondholders are prioritized over shareholders in claims on assets.

Example Calculation:

A $1,000 bond with a $60 annual interest showcases:

  • Principal = $1,000

  • Coupon Payment = $60

  • Maturity = 20 years.

Bonds Interest Rate Calculation

  • Formula: Interest Rate (%) = (Interest Payment / Principal) * 100.

  • Example calculation for a $1,000 bond with a $60 payment:Interest Rate = (60 / 1000) * 100 = 6%.

Stocks Overview

Definition:

Stocks represent equity financing, providing investors partial ownership in a firm.

Payments:

  • Dividends: Profits paid out to shareholders; not guaranteed and depend on the firm's profitability.

Risks and Returns:

  • Shareholders are generally the last in line to be compensated in bankruptcy situations.

  • Stocks are riskier than bonds, but tend to offer higher potential returns due to the higher risk associated with equity.

Savings and Investment Relationship

  • Equation: Investment = Savings (I = S)

  • For closed economies (NX = 0): Y = C + I + GRearranged: S = Y - C - GThis highlights how national income is allocated among consumption, investment, and government spending.

Private and Public Savings

  • Equation Split:S = Private Savings + Public Savings(Y - C) + (-G)This can be useful in understanding how savings can be influenced by both individual preferences and government policies.

Loanable Funds Market

Supply and Demand:

  • Supply Curve: Lenders (Savers) supply funds; higher real interest rates generally incentivize more saving.

  • Demand Curve: Borrowers (firms) demand funds; higher borrowing costs (interest rates) tend to discourage borrowing.

Factors Shifting Supply

  • Current Income/Wealth: Increases lead to a higher supply of loanable funds as savers feel more secure in setting aside money.

  • Future Income Expectations: If savers expect their future income to rise, they might save less now, reducing current supply.

  • Consumer Behavior: Increased tendency to consume rather than save can decrease supply.

  • Retirement Plans: Tax benefits associated with retirement savings can incentivize saving, increasing the loanable funds supply.

Factors Shifting Demand

  • Future Profitability Expectations: Anticipating higher profits in the future tends to increase current demand for funds.

  • Productive Technology: Advances that improve efficiency raise the prospective returns on capital, therefore heightening demand for funds for investment.

Scenarios of Shifts in Supply/Demand

  • Single Shift Example: If household income increases and saving rises:Supply increases, Interest rates decrease, loanable funds increase.

  • Double Shift Example: Increased spending during holiday seasons combined with higher business cash flow creates a complex scenario where supply may decrease due to more spending while demand rises concurrently, resulting in indeterminate effects on total loanable funds and interest rates.

Growth Rate Formula

Formula:

A = P × (1 + r)^tWhere:A = Future ValueP = Principalr = Growth Ratet = TimeThis formula can be used to calculate the future worth of investments over time at a compounded interest rate.

Compounding Interest

Formula:

A = P × (1 + r/n)^(nt)

Example Calculation:

Using $600 at 6% interest compounded monthly over 5 years illustrates the power of compounding in growing investments.

Rule of 70

Concept:

A method for estimating the time required to double an investment, providing a quick reference instead of complex calculations.

Formula:

Number of years to double = 70 / Growth Rate.This rule illustrates how growth rates impact how quickly investments can multiply.

Present Value Calculations

Definition:

The present value represents the current worth of future cash flows adjusted for interest, significant for evaluating investment opportunities.

Formula:

PV = FV / (1 + r)^n

Example:

Calculating the present value for $300 due in 2 years at an interest rate of 5% allows individuals to assess the true value of future cash.

Annuity Payments

Definition:

An annuity consists of a series of payments made over time rather than a single lump sum, relevant for retirement planning and structured settlements.

Calculations Involved:

  • Different methodologies apply depending on whether payments start immediately or at a future date, impacting their present value.Example calculations for both scenarios are provided to illustrate this concept clearly.

Lottery Financial Decision

Summary:

When faced with lottery winnings, individuals often choose between present value and annuity options. Evaluating these options relative to interest rates can guide decision-making for maximizing financial benefit, emphasizing the importance of understanding time value of money concepts.