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Chapter 4
The Financial System
and Interest
© 2000 South-Western College Publishing
THE "EVERYDAY" FINANCIAL SYSTEM
Goods and Services
Purchase $
Production
Consumption
Wages
Labor Services
Figure 4-1
Everyday Money Flows Between Sectors
TM 4-1
SAVINGS AND INVESTMENT
Consumers save some of their incomes
Companies need funds for large
projects
These needs are "happily
coincidental"
Financial markets channel
consumer savings to companies for
major projects through the sale of financial assets
TM 4-2 Slide 1 of 2
Goods and Services
Purchase $
Production
Consumption
Wages
Labor Services
Purch $
Securities
Purch $
Financial
Markets
Securities
Interest and Dividends
Figure 4-1 Money Flows Between Sectors
TM 4-2 Slide 2 of 2
The Term INVEST
To use a resource to better one's position in the
future rather than for current consumption. To
earn a "return."
Individuals invest by putting savings in financial assets:
stocks, bonds, bank accounts.
Companies invest by purchasing or building assets used
in business.
The funds available for business investment come from
savings put into financial assets by individuals.
Hence, in the economy, Savings Equals Investment
More precisely, (Consumer) Savings Equals (Business) Investment
TM-4-3
FINANCIAL MARKETS
MONEY MARKET: Short term debt < one year
CAPITAL MARKET: Long term funds > one year
Stocks and long term debt
PRIMARY MARKET: The first sale of a security
Issuing company gets proceeds
SECONDARY MARKET:
Subsequent sales of the security
Between investors
Company not involved
TM-4-4
PRIMARY MARKET TRANSFERS
$$$
Security
Investor
Company
(a) Direct Transfer
$$$
Investor
Investment
Company
Security
Bank
(b) Direct Transfer Through Investment Banker
$$$
Investor
Security
of FI
Financial
Intermediary
$$$
Security
Company
of Co.
(c) Direct Transfer Through Financial Intermediary
Figure 4-3
TRANSFER OF FUNDS FROM INVESTORS TO BUSINESSES
TM 4-5 Slide 1 of 2
FINANCIAL INTERMEDIARY
Pools the invested money of individuals
-Invests it in securities
-Issues its own security to
individual investors
Types of Financial Intermediary:
*Mutual funds *Pension funds
*Insurance companies *Banks
Financial Intermediaries are institutional investors
Have great influence in the financial markets
TM 4-5 Slide 2 of 2
THE STOCK MARKET
A network of investors, brokers and exchanges
Broker (house): licensed to trade in securities
for a commission
Exchange: Administrative marketplace
Exchange
Seller
Local
Broker
Floor Broker
Specialist
(trade made)
Floor Broker
Figure 4-4
Local
Broker
Buyer
Schematic Representation of a Stock Market Transaction
TM 4-6 Slide 1 of 2
EXCHANGES
The New York Stock Exchange
(NYSE)
The American Stock Exchange
(AMEX)
Regional Exchanges
TM 4-6 Slide 2 of 2
READING STOCK MARKET
QUOTATIONS
1
2
3
52 Weeks
Hi Lo Stock
4
5
6
7
8
9
10
11
12
Yld
Vol
Net
Sym Div % PE 100s Hi Lo Close Chg
891/2 471/16 GenMotor GM 2.00 2.2 23 52058 92 887/8 8815/16 + 15/16
TM 4-7
Trading in Stocks
Privately (closely) Held: Not generally available
Securities Newly Offered to the Public
Initial Public Offering (IPO)
Prospectus - Red Herring
SEC Approval
SEC Regulation aimed at Disclosure
Public (but unlisted): Available on the Over The
Counter (OTC) Market (NASDAQ)
Listed: Available on one or more exchanges
T-4-8
INTEREST
The Return on a Debt Investment.
Interest Drives the Price of Securities
A lower price => a higher return given a
stream of cash flows
Security prices (both stocks and bonds)
adjust to changing interest rates by changing
their prices in the opposite direction
Hence: Interest (among other things)
drives the stock market
Interest Also Drives the Economy
Determines the feasibility of doing projects
on borrowed money
T-4-9
COMPARING SUPPLY AND DEMAND FOR A
PRODUCT WITH SUPPLY AND DEMAND
FOR MONEY (DEBT)
Interest
Rate
k%
Price
S
p*
S
Lenders
Buy bonds
k*
D
D
Q*
Figure 4-6
Quantity
Supply and Demand Curves
for a Product
Borrowers
Sell bonds
$$$
$*
Figure 4-7
Supply and Demand Curves
for Money (Debt)
TM 4-10
THE COMPONENTS OF AN INTEREST RATE
Base Rate
k = kPR
+
kPR =
INFL =
DR =
LR =
MR =
INFL +
Risk Premium
DR
+
LR
+ MR
Pure Interest Rate
Inflation Adjustment*
Default Risk Premium
Liquidity Risk Premium
Maturity Risk Premium
* Average planned inflation rate over life of the loan.
TM 4-11 Slide 1 of 3
THE COMPONENTS OF AN INTEREST RATE
Default risk - Chance of not receiving full
payment of principal and interest
Liquidity risk - Chance of not being able to
sell at full price
Maturity risk - Chance of loss on price
changes due to interest rate
movements -greater with longer
maturities
Essentially zero for short-term debt
TM 4-11 Slide 2 of 3
FEDERAL GOVERNMENT DEBT
DR = 0: Federal government can print money
LR effectively zero: Ready market exists
RISK FREE RATE
Base Rate
Rate on short term government debt - 90 day T-bills
REAL RATE
Without inflation adjustment
TM 4-11 Slide 3 of 3
THE TERM STRUCTURE OF INTEREST RATE
THE YIELD CURVE
A graph of interest rates vs the term of debt for borrowers of similar quality
Interest
Rate
(k%)
or
Inverted
YIELD
Normal
90 days
Thirty years
Figure 4-8
Yield Curves
TM 4-12 Slide 1 of 2
THEORIES OF THE SHAPE OF THE
YIELD CURVE
Expectations: Shape depends on expectations of future
interest (or inflation) rates
Liquidity Preference:
Lenders prefer more liquid short term
loans because: 1. Less exposure to price changes due to interest rate
movements
2. Can wait out maturity if need money
An extra incentive is required to lend long so curve slopes up
Segmentation:
Market segmented into many sub-markets by term
Supply and demand independent in each
Equilibrium rates can be anything relative to one another
so curve can slope up or down
TM 4-12 Slide 2 of 2