Download savings

The Economic “Big Picture”
Part 2: Financial Instruments
Dr. Katie Sauer
Metropolitan State College of Denver
([email protected])
Colorado Council for Economic Education
4/28/2012
Session Overview:
I.
II.
III.
IV.
V.
Intro to Financial Instruments
Borrowing
Saving and Investing
Interest Rates
Insurance
I. Intro to Financial Instruments
Financial instruments, like every other good or service
in a market economy, must create some value.
- stocks, bonds, loans, credit
Financial instruments fulfill three basic functions:
1. Raise Capital (borrowing)
2. Deal with Excess Capital
- Store It
- Protect It Against Inflation
- Make Profitable Use of It
3. Insure Against Risk
II. Borrowing
Credit refers to the amount of money that a third party
is willing to advance to you (or on your behalf).
Once you have spent that money, it is debt that you owe
to the third party.
You can have credit without debt.
You can have credit and debt.
Your debt results from you first having credit.
Common examples of credit:
- car loan approval
- mortgage approval
- credit card
- overdraft line of credit on checking account
There are 2 types of credit accounts:
- fixed loans
- revolving credit
A. Creditworthiness
In order for you to borrow money for a purchase,
someone has to be willing to lend it to you.
Often times you ask complete strangers to lend you
thousands of dollars.
- car loan
- home loan
- credit card
How do they know you will pay them back?
They don’t. So, they’ll check your financial history
and make a decision based on your past actions.
Whenever you apply for credit or a loan, you give the
lender permission to check your financial history.
A Credit Report is a record of your credit history.
- how much and type of debt you have
- if you have made payments on time
- if you have failed to pay back a loan
Credit reports are compiled by 3 agencies.
Equifax
Experian
TransUnion
Individuals are entitled to one free credit report per year
from each of the three credit bureaus.
annualcreditreport.com
You are not entitled to receive a free credit score.
All the items on your credit report are compiled into a
credit score. (aka FICO score)
Credit scores are used to predict the likelihood that a
person will go 90 days past due (or worse) in the next 24
months.
- higher score = less likely to go past due
Credit scores can range from 300 to 850.
- the higher the number, the better
In general:
750 and above means you have excellent credit and
will qualify for the best interest rates
700 – 749 means you have good credit and will
likely be approved for loans you apply for, but you
might not get the best interest rate possible
650 – 700 means you may or may not be approved
and you definitely will have a higher interest rate
649 and below means you are “subprime” and will
generally not be approved
What affects my credit score?
- paying bills on time (very important!!!!)
- available credit vs how much you owe
- length of time you have had credit
- recent applications for new credit
- number of credit accounts do you have
- type of credit accounts do you have
Credit scores may not consider your race, color, religion,
national origin, sex or marital status.
The reason that people apply for credit is so they can pay
for things now, even though they don’t have the money.
B. Consumption smoothing is the term used to describe
the spending, saving and borrowing that people do in
order to maintain a more constant standard of living
throughout their lifetimes.
Early on in adulthood, people may borrow against future
earnings.
In the “working years” people tend to put aside some
money for the future.
By the middle to end of the working years, people should
have paid back any debt before retirement.
In the “retirement years” people spend the money that
they previously saved.
http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
Sometimes borrowing in order to smooth consumption
is financially responsible, sometimes it is not.
Be sure that the benefits of borrowing truly outweigh
the costs.
C. Benefits of Borrowing to Pay for Purchases
- allows people to buy things that would otherwise
take many years to save up for (house, car)
- allows people to attend college and improve their
future earnings
- allows people to pay for things in an emergency
- allows people to have the things they want,
immediately
D. Cost of Borrowing
When you borrow money to pay for something, you end
up paying back more than the purchase price.
- pay interest
Most people know they have to pay interest on a loan.
However, they are often unaware just how much they are
paying.
III. Saving and Investing
A. Basic Terminology
savings = income – taxes – spending on goods & services
investment = something acquired for future income or
benefit
- investments can generate income
(e.g. interest, dividends)
- investments can appreciate in value
(e.g. house, gold)
By itself, savings is just what is left over from your
income after taxes and your spending.
When you take your savings and put it in an account
that earns interest or buy a stock or a house, you are
investing.
Why do people save?
According to the Federal Reserve’s triennial Survey of
Consumer Finances:
http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
How much do people save?
The savings rate is the percent of after-tax income that is
saved.
The Bureau of Economic Analysis (www.bea.gov) has
been tracking US household saving rates since 1959.
Year
Average Savings Rate
1960s
8.21%
1970s
9.6%
1980s
8.61%
1990s
5.5%
2000- Oct 2008
2.82%
Since Oct 2008
5.77%
http://research.stlouisfed.org/fred2/data/PSAVERT.txt
The saving rate has been trending down since the early
1980s. In recessions, people tend to save more.
B. Turning Savings into Investment
The Financial System is the group of institutions in an
economy that help to match savers with borrowers
The US economy has two basic types of financial
institutions:
- financial markets
- financial intermediaries
1. Financial Intermediaries are institutions where funds
are transferred indirectly from savers to investors.
Examples:
Banks accept savings deposits and make loans.
- pay interest to depositors, charge interest to
borrowers
Mutual Funds are institutions that sell shares to the public
and use the proceeds to buy a portfolio of stocks and
bonds.
- allows individuals with a small amount of money to
diversify
2. Financial Markets are institutions where funds are
transferred directly from savers to investors.
Examples: stocks and bonds
Bonds
A bond is a certificate of indebtedness.
“IOU”
When a firm or government issues a bond, they are
borrowing money from anyone who buys the bond.
They are promising to pay you back a certain value in the
future.
A bond has a date of maturity and a rate of interest
associated with it.
Suppose you buy a $1,000 bond that matures in 5 years
and pays 6% interest.
- Today, you give up $1,000 and receive the bond.
- You will receive annual interest payments of
6% for the next 5 years.
1,000 x 0.06 = $60 per year
- At the end of the 5 years, you receive $1,000.
Bonds can be sold at
par value (face value)
a discount
a premium
Issue price: $18.75
Face value: $25
This bond sold at a discount.
What determines the price of a bond?
term: length of time until the bond matures
- longer maturity time … riskier
credit risk: the probability that the borrower will fail to
pay the interest or the principal
tax treatment: some bonds have interest that is tax free
Stocks
A stock is a claim of partial ownership of a firm.
- shareholder
If you buy a stock, you are not guaranteed to get your
money back.
The price of a stock generally reflects the perception of a
firm’s future profitability.
What determines the price of a stock?
1. Fundamental analysis is the study of a company’s
accounting statements and future prospects.
It includes doing an economic analysis, industry
analysis, and company analysis.
- P/E ratio (stock price / net income per share)
- competitors
- the market for its product
- management
- credit risk
2. The Efficient Markets Hypothesis is the theory that
asset prices reflect all publicly available information
about the value of the asset.
- equilibrium of supply and demand sets the price
According to this theory, at the market price, the
number of people wanting to sell exactly equals the
number wanting to buy.
Any stock that you think is “hot” and about to
increase in value, someone else thought it was not hot
and was willing to sell it.
3. Market Irrationality
Stock prices sometimes seem to be driven by
psychological reasons.
Following a Stock
Google Finance 2/21/12
company name
name of stock exchange and stock symbol
change: compared to most recent closing price
current price per share,
the last price a share
was traded at
percent change: change x
close price
100
Range: daily high and low price
52 Week: high and low price for the last 52 weeks
Open: the price at the beginning of trading today
Vol/Avg: Volume = number of shares traded today
Average = average number of shares traded daily
Mkt cap: Market Capitalization is a measure of the total value of
the company
Mkt Cap= Total Shares Outstanding x Current Price
P/E: Price-to-Earnings Ratio is the price of a share divided by
last year’s earnings per share
Div/Yield: a Dividend is the amount of money the firm will pay
you (typ. each quarter) for each share you own.
The Yield = dividend / price
- not all firms pay dividends
EPS: Earnings Per Share is the amount of earnings per each
outstanding share
Shares: the number of shares outstanding
Beta: A statistical estimate of how closely the stock’s
performance matches the stock market in general. The higher the
beta, the closer the stock matches the general market.
Inst. Own: Institutional Ownership is percent of the shares that
the firm owns
savings
business investment
C. The Importance of
Savings in the Economy
physical capital
capital per worker
productivity
standard of living
IV. Interest Rates
A. The Market for Loanable Funds
The supply of funds comes from savings.
The demand for funds comes from borrowers.
The “price” of funds is the real interest rate.
r
SF (Savings)
The supply of funds
slopes up because as r
rises, people will save a
higher quantity.
The demand for funds
slopes down because as
r rises, firms and
individuals will borrow
a lower quantity.
DF (Borrowing)
Quantity of Funds
r
SF (Savings)
The equilibrium occurs
where the supply of funds
equals the demand for
funds.
If r > r*, the supply would
exceed the demand and
there would be a surplus,
pushing the interest rate
down.
r*
Q*
If r < r*, the demand would
DF (Borrowing) exceed the supply and there
would be a shortage,
Quantity of Funds
pushing the interest rate up.
The interest rate you actually pay on a loan or credit
card is the nominal interest rate.
It is comprised of:
- the real interest rate the lender wants to earn
- the expected inflation rate
- a risk premium
B. Another factor influencing interest rates is actions by
the Federal Reserve.
The Fed controls the federal funds rate.
Banks charge each other the federal funds rate
on short term loans.
Banks charge their best customers the “prime
rate”, which is based on the federal funds rate.
The interest rate on consumer loans is often
“prime + X”.
V. Insurance
Risk Aversion is a dislike of uncertainty.
One way to deal with risk is to buy insurance.
- a person facing a risk pays a fee to an insurance
firm
- the firm agrees to take on all or a part of the
risk
From the standpoint of the economy as a whole, the
role of insurance is to spread around the risk.
- can’t eliminate it completely
Model of Insurance Pricing
Suppose that 1 in 5 drivers age 21 to 24 get in an accident
each year. The average amount of damage is calculated
to be $4500 per incident.
If an insurance company insures 5 drivers age 21 to 24, it
faces this situation:
20% chance of paying out $4500
80% chance of paying out $0
Expected payout per individual:
(0.20)(4500) + (0.80)(0) = $900
The company will need to charge $900 to each
driver.
- actuarially fair policy
What if in one year 2 people have accidents. One costs
$2000 and the other costs $7000.
The insurance company will have paid out $9000 but
will have only received 5 x $900 = $4500 in premiums.
Small groups of insured can have a lot of volatility!
In order to stay in business, insurance companies need
to insure many people.
- spread around the risk
In general, the lower the probability of an “event”, the
less you will pay in premiums.
In general, the larger the number of people in the risk
pool, the less you will pay in premiums.
Insurance markets suffer from two problems not faced
by most other markets:
- people likely to use the insurance are the ones
who most want to buy it (adverse selection )
- once a person has insurance, they may change
their behavior (moral hazard)
To deal with these problems, the insurance firm rarely
agrees to take on all of the risk.
They will only accept the financial responsibility after
you have accepted some of it.
- deductibles
In general, the higher the deductible, the lower the
premiums.
Educationcents.org
Questions?