Download Investment and Financial Markets

C H A P T E R 12
Investment and Financial
Markets
Copyright © 2012 Pearson
Prentice
Hall.
All rights
reserved.
Copyright
© 2012
Pearson
Prentice
Hall. All rights reserved.
12-1
CHAPTER
Investment and Financial
Markets
12
The housing market is a perfect example of the close links between
investment and finance.
PREPARED BY
Brock Williams
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
C H A P T E R 12
Investment and Financial
Markets
APPLYING THE CONCEPTS
1
How do fluctuations in energy prices affect investment decisions
by firms?
Energy Price Uncertainty Reduces Investment Spending
2
How can understanding the concept of present value help a lucky
lottery winner?
Options for a Lottery Winner
3
Why did many homeowners in 2010 owe more to banks than their
home was worth?
Underwater Homes: Bets Gone Wrong
4
How have recent financial innovations created new risks for the
economy?
Securitization: The Good, the Bad, and the Ugly
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
12-3
C H A P T E R 12
Investment and Financial
Markets
12.1
AN INVESTMENT: A PLUNGE
INTO THE UNKNOWN
• accelerator theory
The theory of investment that says that current
investment spending depends positively on the
expected future growth of real GDP.
 FIGURE 12.1
Investment Spending as a
Share of U.S. GDP, 1970–2009
The share of investment
as a component of GDP
ranged from a low of
about 10 percent in 1975
to a high of over 18
percent in 2000.
The shaded areas
represent U.S. recessions.
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12-4
C H A P T E R 12
Investment and Financial
Markets
12.1
AN INVESTMENT: A PLUNGE
INTO THE UNKNOWN (cont’d)
• procyclical
Moving in the same direction as real
GDP.
• multiplier-accelerator model
A model in which a downturn in real
GDP leads to a sharp fall in
investment, which triggers further
reductions in GDP through the
multiplier.
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12-5
C H A P T E R 12
Investment and Financial
Markets
APPLICATION
1
ENERGY PRICE UNCERTAINTY REDUCES
INVESTMENT SPENDING
APPLYING THE CONCEPTS #1: How do fluctuations in energy
prices affect investment decisions by firms?
One important way volatility of oil prices can hurt the economy is by
creating uncertainty for firms making investment decisions.
Consider whether a firm should invest in an energy-saving technology
for a new plant:
• If energy prices remain high, it may be profitable to
invest in energy-saving technology.
• If prices fall, these investments would be unwise.
• If future oil prices are uncertain, a firm may simply delay
building the plant until the path of oil prices are clear.
When firms are faced with an increasingly uncertain future, they will
delay their investment decisions until the uncertainty is resolved.
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12-6
C H A P T E R 12
Investment and Financial
Markets
12.2
EVALUATING THE FUTURE
Understanding Present Value
PRESENT VALUE AND INTEREST RATES
• present value
The maximum amount a person is willing to pay today to receive a
payment in the future.
K
present value =
(1  i )t
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
1
2
3
The present value—the value today—of a given payment in the future is
the maximum amount a person is willing to pay today for that payment.
As the interest rate increases, the opportunity cost of your funds also
increases, so the present value of a given payment in the future falls. In
other words, you need less money today to get to your future “money goal.”
As the interest rate decreases, the opportunity cost of your funds also
decreases, so the present value of a given payment in the future rises. In
other words, you need more money today to get to your money goal.
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12-7
C H A P T E R 12
Investment and Financial
Markets
APPLICATION
2
OPTIONS FOR A LOTTERY WINNER
APPLYING THE CONCEPTS #2: How can understanding the concept of
present value help a lucky lottery winner?
The lucky winner of a lottery was given an option:
• Receive $1 million a year for 20 years
• Receive $10 million today
Why would anyone take the $10 million today?
To determine which payment option is best, our lottery winner would first need to:
• Calculate the present value of $1 million for each of the 20 years
• Add up the result
• Compare it to the $10 million being offered to her today
Example: With an 8 percent interest rate, the present value of an annual payment
of $1 million every year for 20 years is $9.8 million.
Best option: If interest rates exceed 8 percent, it is better to take the $10 million
dollars.
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12-8
C H A P T E R 12
Investment and Financial
Markets
12.2
EVALUATING THE FUTURE (cont’d)
Real and Nominal Interest Rates
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—the purchasing
power—not the face value of money.
• nominal interest rate
Interest rates quoted in the market.
• real interest rate
The nominal interest rate minus the inflation rate.
real rate  nominal rate  inflation rate
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12-9
C H A P T E R 12
Investment and Financial
Markets
12.2
EVALUATING THE FUTURE (cont’d)
• There are different types of interest investments.
• Corporate bonds are considered more risky than federal government
bonds, so pay a higher interest rate.
• Long term investments are more risky than short term investments, so
again pay a higher interest rate.
 FIGURE 12.2
Interest Rates on
Corporate and
Government
Investments,
2002–2008
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12-10
C H A P T E R 12
Investment and Financial
Markets
12.3
UNDERSTANDING INVESTMENT DECISIONS
 FIGURE 12.3
The Relationship between Real Interest
Rates and Investment Spending
As the real interest rate declines,
investment spending in the economy
increases.
• neoclassical theory of investment
A theory of investment that says
both real interest rates and taxes
are important determinants of
investment.
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12-11
C H A P T E R 12
Investment and Financial
Markets
12.3
UNDERSTANDING INVESTMENT DECISIONS
(cont’d)
Investment and the Stock Market
• retained earnings
Corporate earnings that are not paid
out as dividends to their owners.
• corporate bond
A bond sold by a corporation to the
public in order to borrow money.
• Q-theory of investment
The theory of investment that links
investment spending to stock prices.
price of a stock = present value of expected future dividend payments
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12-12
C H A P T E R 12
Investment and Financial
Markets
12.3
UNDERSTANDING INVESTMENT DECISIONS
(cont’d)
 FIGURE 12.4
The Stock Market and Investment
Levels, 1997–2003
Both the stock market and
investment spending rose
sharply from 1997, peaking in
mid-2000.
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12-13
C H A P T E R 12
Investment and Financial
Markets
12.4
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
• liquid
Easily convertible into money on short notice.
 FIGURE 12.5
Savers and Investors
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12-14
C H A P T E R 12
Investment and Financial
Markets
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT (cont’d)
12.4
• financial intermediaries
Organizations that receive funds from
savers and channel them to investors.
 FIGURE 12.6
Financial Intermediaries
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12-15
C H A P T E R 12
Investment and Financial
Markets
APPLICATION
3
UNDERWATER HOMES: BETS GONE WRONG
APPLYING THE CONCEPTS #3: Why Did Many Homeowners in 2010
Owe More to Banks Than Their Home Was Worth?
•In early 2010 one quarter of all U.S. homes were “underwater”, that is, the
homeowners owed more than their home was worth.
•Homes are highly leveraged; even if you put down 10 percent, that leaves
90 percent borrowed.
•If the home value falls 20 percent, the homeowner is 10 percent
underwater. In the Las Vegas area, approximately 70 percent of all homes
were underwater.
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12-16
C H A P T E R 12
Investment and Financial
Markets
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT (cont’d)
12.4
• securitization
The practice of purchasing loans,
re-packaging them, and selling
them to the financial markets.
• leverage
Using borrowed funds to
purchase assets.
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12-17
C H A P T E R 12
Investment and Financial
Markets
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT (cont’d)
12.4
When Financial Intermediaries Malfunction
• bank run
Panicky investors simultaneously
trying to withdraw their funds from
a bank they believe may fail.
• deposit insurance
Federal government insurance on
deposits in banks and savings
and loans.
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12-18
C H A P T E R 12
Investment and Financial
Markets
APPLICATION
4
SECURITIZATION: THE GOOD, THE BAD, AND
THE UGLY
APPLYING THE CONCEPTS #4: How have recent financial
innovations created new risks for the economy?
•As securitization developed, it allowed financial intermediaries to provide new
funds for borrowers to enter the housing market.
•As the housing boom began in 2002, lenders and home purchasers began to
take increasing risks. Lenders made “subprime” loans to borrowers with
limited ability to actually repay their mortgages.
•Some households were willing to take on considerable debt because they
were confident they could make money in a rising housing market. Lenders
securitized the subprime loans and financial firms offered exotic investment
securities to investors based on these loans. Many financial institutions
purchased these securities without really knowing what was inside them.
•When the housing boom stopped and borrowers stopped making payments
on subprime loans, it created panic in the financial market. Effectively, through
securitization the damage from the subprime loans spread to the entire
financial market, causing a major crisis.
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12-19
C H A P T E R 12
Investment and Financial
Markets
KEY TERMS
accelerator theory
neoclassical theory of investment
bank run
nominal interest rate
corporate bond
present value
deposit insurance
procyclical
expected real interest rate
Q-theory of investment
financial intermediaries
real interest rate
leverage
retained earnings
liquid
securitization
multiplier-accelerator model
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12-20