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The Financial System, Money, and Prices: Part II. Chapter 9. Banking System. Financial intermediaries are firms that extend credit to borrowers using funds raised from savers Banks have lower cost of evaluating opportunities than an individual would
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Banking System • Financial intermediaries are firms that extend credit to borrowers using funds raised from savers • Banks have lower cost of evaluating opportunities than an individual would • Banks pool the savings of many individuals to make large loans
Banking System • Banks gather and evaluate potential investments to direct savings to higher-return, more productive investments • Service provided to depositors • Banks provide access to credit for small businesses and homeowners • May be the only source of credit for some investments • When banks make loans, they earn interest which, in turn, is paid to the bank's depositors
The Banking System • Having bank deposits makes payments easier • Checks • ATMs • Debit card • Checks and debit cards are safer than cash • Banks provide a record of your transactions
Bonds • A bond is a legal promise to repay a debt • Each bond specifies • Principal amount, the amount originally lent • Maturation date, the date when the principal amount will be repaid • The term of a bond is the length of time from issue to maturation • Coupon payments, the periodic interest payments to the bondholder • Coupon rate, the interest rate that is applied to the principal to determine the coupon payments
Bonds • Corporations and governments issue bonds • The coupon rate depends on • The bond's term • 30 days to 30 years; longer term, higher coupon rate • The issuer's credit risk • Probability the issuer will default on repayment • Higher risk, higher coupon rate • Tax treatment for the coupon payments • Municipal bonds are free from federal taxes • Lower taxes, lower coupon rates
Bond Market • Bonds can be sold before their maturation date • Market value at any time is the price of the bond • Price depends on the relationship between the coupon rate and the interest rate in financial markets • A two-year government bond with principal $1,000 is sold for $1,000, 1/1/09 • Coupon rate is 5% • $50 will be paid 1/1/10 • $1,050 will be paid 1/1/11 • Bond's price on 1/1/10 depends on the prevailing interest rate
Selling a Bond • Offer for sale: one government bond with payment of $1,050 due in one year • The competition: a new one-year bond with principal of $1,000 and coupon rate of 6% • Pays $1,060 in one year • Year-old bond with 5% coupon rate is less valuable than the new bond • Price of the used bond will be less than $1,000 (Bond price) (1.06) = $1,050 Bond price = $991 • Bond prices and interest rates are inversely related
Stocks • A share of stock is a claim to partial ownership of a firm • Receive dividends, a periodic payment determined by management • Receive capital gains if the price of the stock increases • Prices are determined in the stock market • Reflect supply and demand
FortuneCookie.com Example • New company with estimated dividend of $1 in 1 year • Selling price of stock will be $80 in 1 year • Interest rate on safe asset (government bond) is 6% • Value of the new stock is $81 in 1 year (Stock price) (1.06) = $81 Stock price = $76.42 • Value would be higher if • Dividend were higher • Price of stock in one year were higher • Interest rate were lower
Risk Premium • Risk premium is the rate of return investors require of risky asset minus the rate of return on a safe asset • Suppose interest on a safe investment is 6% • FortuneCookie.com is risky, so 10% return is required • Stock will sell for $80 in 1 year; dividend will be $1 (Stock price) (1.10) = $81 Stock price = $73.64 • Risk aversion increases the return required of a risky stock and lowers the selling price
Bond Markets and Stock Markets • Channel funds from savers to borrowers with productive investment opportunities • Sale of new bonds or new stock can finance capital investment • Like banks, bond and stock markets allocate savings • Provision of information on investment projects and their risks • Provide risk sharing and diversification across projects • Diversification is spreading one's wealth over a variety of investments to reduce risk
Benefits of Diversification • Vikram has $200 to invest in stocks, each $100 • Buy 2 shares of either stock • 50% chance of $20 gain and 50% chance of $0 • Diversify and buy 1 share of each • One stock will be worth $100 and the other will be worth $110 • Return is $10 with no risk
Rise and Fall of the US Stock Market • Standard & Poor's 500 index rose 60% between 1990 and 1995 • More than doubled 1995 – 2000 • Lost 40% of its value Jan 2001 – Jan 2003 • Returned to Jan 2000 level by Jan 2008 • And then….. • Increase (boom) in stock prices can be due to • Increased optimism about future value • A fall in required return
Rise and Fall of the US Stock Market • In the 1990s, optimism was high • Strong dividends • Promise of new technologies • Risk premium declined • Increased diversification through mutual funds • Investors may have underestimated risk • Optimism and risk premium trends reversed in 2000 • Many high-tech firms less profitable than expected • Corporate accounting scandals of 2002 • Terrorist attack in US
Key Points • Thus a bond is like a loan: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor).
Bond Vs Stock • Bonds and stocksare both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders).
Bond Vs Stock • Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.
