Chapter Two

1. Chapter Two The Financial System and the Economy

2. Chapter Outline Who participates in the financial system? • Financial Securities • Debt and equity • Financial Intermediaries • Financial Markets • The Financial System What do investors care about?

3. Neither a Borrower Nor a Lender Be? • For what purposes do we sometimes need more money than we have? • When we borrow, two functions are served: • Borrowers have money they desire to spend • Lenders have an opportunity to earn a return on their savings • The financial system matches these two groups of people.

4. The Financial System Figure 2.1

5. Financial Securities Financial securities are a tool used in financial markets to match savers seeking an investment opportunity with borrowers in need of capital.

6. Financial Securities (cont’d) • A financial security is a contract between borrower and lender. Securities are owned by the lender/investor. • Each security specifies future compensation to lender (return) and consequences if the borrower does not pay.

7. Debt and Equity There are two major types of securities. • Debt securities promise to pay the owner according to a prearranged schedule. • Equity securities make the owner also an owner in the firm, with payment related to the firm’s performance. • Over ½ of U.S. households invest in/own securities.

8. U.S. Debt and Equity Securities Fourth Quarter 2004 Figure 2.2 The total amount of debt and equity held is over four times U.S. output.

9. Who Issues Securities? Figure 2.3 Debt and Equity, By Issuer Fourth Quarter 2004 Debt and Equity, By User Fourth Quarter 2004

10. Debt and Equity (cont’d) • Two features distinguish debt from equity: • Maturity (length of time until the borrowed funds are repaid) • Debt instruments specify a maturity date; equity owners may (seek to) liquidate at any time. • Type of Periodic Payments Made • Debt securities pay a specified amount of interest (payments made in exchange for the use of money in addition to the repayment of principal). • Equities (may) pay a dividend (payment made from the company’s earnings which is dependent on the level of said earnings).

11. Who Owns Securities? Figure 2.4 Debt and Equity, By Investor Fourth Quarter 2004

12. Pros principal is repaid and interest earned as terms of contract fixed schedule of payments to borrower debt owners repaid before equity owners in bankruptcy Cons payments do not increase if company does better than anticipated; potential return is limited May be a short term cash need on part of (borrowing) company Pros and Cons of Debt Securities

13. Pros Equity = ownership; owners have input into operations and are entitled to dividends when paid If firm performs well, returns are nearly unlimited Cons Dividends subject to firm’s performance; not all pay dividends Equity owners last to be repaid in bankruptcy cases Pros and Cons of Equity Securities

14. Matching Borrowers with Lenders • Two channels exist to match borrowers with savers • Direct Finance = direct contact between borrowers and lenders • Indirect Finance = through a financial intermediary (those who buy securities and resell them)

15. Matching Borrowers & Lenders Figure 2.5 Direct and Indirect Finance

16. What Do Financial Intermediaries Do? • Match borrowers to savers • Reduce the costs of getting involved in financial markets; make transactions easier • Include banks, credit unions, mutual funds, etc.

17. Financial Intermediaries (cont’d) Functions • Help savers diversify their investments • Pool funds of many people • Turn short-term deposits into long-term loans • Gather information for both borrowers and lenders • Reduce costs of transacting

18. Financial Markets • Financial Market a place or mechanism by which borrowers, savers, and financial intermediaries trade securities • Financial markets can be physical or virtual, local and/or international.

19. Financial Markets (cont’d) • There are markets for new issues of securities, and for reselling securities. • The primary market is where new securities are traded • The secondary market is for trades of existing securities between investors • Firms issuing securities only receive proceeds from sales in the primary market • Without the secondary market’s function in transmitting information, the primary market would not have much value; buyers need to know they have the ability to sell later

20. Primary & Secondary Markets Figure 2.6

21. Prices of Securities • Securities prices are determined by supply and demand, no matter which market they are traded in • Savers will want to purchase more securities the greater the return; borrowers are interested in borrowing more at lower interest rates • Equilibrium prices and quantities vary as market conditions change

22. Supply & Demand • Quantity demanded depends on price: lower price today implies higher quantity of securities demanded • Quantity supplied also depends on price: lower price today implies lower quantity of securities supplied

23. Supply & Demand (cont’d) Figure 2.7 Supply and Demand for a Security

24. Shifts in Supply & Demand • Shifts in supply and/or demand affect the equilibrium price & quantity • Businesses wanting to expand capacity in anticipation of growth may borrow more, increasing supply of their securities (a shift to the right) • Businesses fearful of a downturn may borrow less, decreasing the supply of their securities (a shift to the left)

25. Example: Supply Shift Figure 2.8 Shift for a Security

26. Calculating the Price of a Security • P = price of security paying $1,500 in one year • Demand: QD = 250 – 0.15 P • Supply: QS = 100 + 0.05 P • Solution: P = 750, Q = 137.5

27. Changes in Securities Prices • Suppose demand increases… QD = 300 – 0.15 P Solution: P = 1000, Q = 150 • Suppose supply increases… QS = 150 + 0.05 P Solution: P = 500, Q = 175

28. The Financial System & Economic Growth • Businesses need funds to be able to invest in capital goods in order to offer more and more goods and services • Retained earnings (past profits) • New funds via borrowing (selling securities) • Countries with efficient financial systems grow faster than others • Savers and borrowers are efficiently matched • The costs of saving and investing are relatively low

29. Broken Systems: The Asian Crisis • October 1997 marked a rush of investors out of Asia, a once-thriving area • Few accounting standards to convey information to investors about their investments • Government involvement in the financial sector • Weak banking systems & debt management • Inconsistent plans for monetary policy & exchange rates

30. What Do Investors Care About? Five Determinants of Investors’ Decisions • Expected return (the gain the investor anticipates making via the investment) • Risk (the degree of uncertainty regarding an investment’s return) • Liquidity (the ease of converting an investment into cash) • Taxes (How much will capital gains be taxed?) • Maturity (How long must the investor wait for to earn a return?)

31. Expected Return Return = current yield + capital-gains yield • Current yield = income/initial value • Capital-gains yield = capital gain/initial value (note: capital gains yield may be negative, or a capital loss)

32. Risk • Return is ALWAYS unknown; risk measures the degree of uncertainty about future returns Sources of risk • Default (when the borrower fails to make payment) • Unexpected change in dividend • Change in price of security • Unexpected change in inflation rate

33. Quantifying Risk • How far are possible returns from expected return, and how likely are they? • Tool for Measuring: standard deviation • Standard deviation is the square root of the average of squared deviations from the expected return • Standard deviation = [p1 (X1 - E)2 + p2 (X2 - E)2 + . . . + PN (XN - E)2]1/2

34. Quantifying Risk (cont’d) Interpreting standard deviations • Higher standard deviation means a riskier security • The likelihood of a security with a high standard deviation meeting its expected return is lower

35. Liquidity Liquidity: how easy it is to convert a security (by buying or selling) into cash • May also be thought of as ease of transferring in the secondary market • Only marketable securities are liquid • The time and cost it takes to sell or buy are a measure of liquidity Why a concern? Investors may want or need to sell a security prior to its maturity.

36. Taxes • Interest and dividends earned are subject to taxation; after-tax expected return is what investors are ultimately concerned with After-tax expected return = (1 – tax rate) × pre-tax expected return • Tax rate affects investment decisions; tax avoidance and tax evasion may result • Tax rates affect equilibrium security prices…tax-exempt securities have lower pre-tax expected returns

37. Maturity • When does the investor get the principal back? • People have different preferences as a result of different goals, stages of life, etc

38. Choosing an Investment Portfolio • Portfolio = your collection of securities • Investors care about return, risk, etc. of whole portfolio, not each security individually • Diversify a portfolio to reduce idiosyncratic risk (also called unsystematic risk) if the cost to do so is low • It is not possible to diversify market risk (also called systematic risk); a diversified stock portfolio reflects risk of entire stock market

39. Choosing an Investment Portfolio (cont’d) • The main trade-off when assembling a portfolio is between expected return and risk • Portfolios with higher expected returns also have higher risk • What should you do? The answer depends on your preferences

40. Data Bank: Default Risk on Debt • Corporations rated on financial strength by Moody’s, Standard & Poors, and others • Example: S&P • AAA >AA>A>BBB>BB>B > CCC>CC>C>R>SD>D • Could have a + or – to grade • Investment grade is a rating of BBB or better; ratings of BB and below have “significant speculative characteristics” • Investors trade off risk and expected return, so interest rates reflect risk

41. Data Bank: Default Risk on Debt (cont’d) Figure 2.A Interest Rates on Aaa versus Baa bonds

42. Default Risk on Debt (cont.) Figure 2.B Risk Spread (Aaa vs. Baa) • The risk spread on debt (the amount by which interest rate is higher because of risk) varies over time • Risk spread is strongly affected by the business cycle

43. Risk from Inflation Figure 2.C Actual and Expected Inflation • One of the most difficult tasks for investors is forecasting inflation • Example: In the 1970s, high unexpected inflation destroyed much of investors’ wealth