Ch 14 The Basics of Finance 2023

Introduction

• Title: PowerPoint Presentations for Macroeconomics Third Canadian Edition

• Authors: Karlan, Morduch, Alam, Wong

• Adapted by: Andrew Wong, University of Alberta

Chapter Overview

• Chapter Title: The Basics of Finance

Basics of Finance

• Traditional markets match buyers and sellers of goods and services.

• The financial system connects savers and borrowers in interconnected markets trading diverse financial products.

• Institutions within the financial system focus on financing capital investments, providing liquidity, and diversifying risk.

Financial Market Characteristics

• Financial markets allow the trade of future claims on funds or goods.

• Potential issues in financial markets:

  • Information Asymmetry: When one party has more information than another.

  • Adverse Selection: Differing information on quality or risk between buyers and sellers.

  • Moral Hazard: Riskier behavior or breach of contracts due to not facing full consequences.

Market for Loanable Funds

• Real-world financial markets accommodate various products and prices.

• Market for Loanable Funds: Integrates savers supplying funds and borrowers demanding funds for investment.

• Real Interest Rate (r): Represents the price of money.

• Saving is the source of supply; investment is the source of demand for loanable funds.

Savings-Investment Identity

• Equation: Y = C + I + G + NX

  • NX = net exports; in a closed economy, NX = 0, so Y = C + I + G

• National Saving (S): Total income after consumption and government purchases.

National Saving Formula

• Types of national saving calculation:

  • S = Y - C - G

  • S = (Y - T - C) + (T - G)

• T: Taxes collected minus transfer payments.

Private and Public Saving

• Private Saving: Income remaining after taxes and consumption: Y - T - C

• Public Saving: Tax revenue after government spending: T - G

• Budget conditions: T > G indicates a surplus; T < G indicates a deficit.

Market Dynamics

• Equilibrium in Loanable Funds: National savings intersect investment to determine interest rates (r*) and traded quantity (Q*).

• Factors Affecting Savings and Investment:

  • Wealth, economic conditions, future expectations, uncertainty, borrowing constraints, social welfare policies, culture.

Interest Rate Variations

• Interest rates are not uniform across borrowers.

• Influencing factors include loan term and transaction riskiness (credit risk).

• Credit Risk: The risk a borrower may default.

• Risk-Free Rate: Theoretical interest rate with no default risk; Risk Premium: Difference between risk-free and actual interest rate.

Functions of the Financial System

• Financial institutions play three crucial roles:

  • Match Buyers and Sellers: Intermediaries channel available funds.

  • Provide Liquidity: Measure of how easily assets convert to cash with minimal loss.

  • Diversify Risk: Sharing risks across various assets or individuals.

Major Financial Assets

Equity

• Represents partial ownership in a company; stockholders receive dividends.

Debt

• Loans and bonds: lenders receive future repayment plus interest; bonds have scheduled coupon payments.

Derivatives

• Financial assets based on other asset values; futures contracts transfer risks of future prices.

Key Players in Financial System

• Banks and Financial Intermediaries: Facilitate matching of savers and borrowers.

• Savers: Mutual funds and pension funds for managed portfolios.

• Entrepreneurs and Businesses: Seek financing for ventures.

• Speculators: Buy/sell assets purely for financial gain.

Valuing Assets

• Classifying risk:

  • Market/Systemic Risk: Affects the whole market.

  • Idiosyncratic Risk: Unique to individual companies/assets.

• Standard Deviation: Commonly used measure of risk.

The Efficient-Market Hypothesis (EMH)

• EMH states market prices integrate all available information, reflecting true asset value.

• Evaluation approaches:

  • Fundamental Analysis: Future earnings estimation.

  • Technical Analysis: Evaluation of price movements.

  • Arbitrage: Seizing profit from market inefficiencies.

Conclusion

• Understanding these finance fundamentals is crucial for analyzing economic systems and investment decisions.