ECON 2203 1st Edition Lecture 15EquationsExamplesDefinitionsImportant InformationFill in the blankOutlineFinancial Institutions in U.S. Economyo Financial Markets: The bond market, the stock market o Financial Intermediaries: Banks, mutual funds Financial Institutions in the U.S. Economy o Financial system - the group of institutions that helps match the saving of one person with the investment of anotherHouseholds ($30) BANK  ($30) Firms- Savers/lenders: people who spend less than they earn- Borrowers: people who spend more than they earnFinancial Institutions in the U.S. Economy:Financial Systems1. Financial Marketsa) Bond Marketb) Stock Market2. Financial Intermediaries a) Banksb) Mutual FundsFinancial Marketso Financial Markets- the institutions through which a person who wants to save can directly supply funds to a person who wants to borrowThe Bond Market o Bond - a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bondo Date of maturity – identified by bond, the time at which the loan will be repaid[A Bond is an IOU (I oweyou)]These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.o Bondholders – receive a fixed interest payment regardless of profitabilityo Principal – the buyer gives his money to Intel in exchange for this promise of interest and the repayment of the amount borrowedSaversHouseholds**(Save for various reasons)BorrowersLarge corporations, Federal government, orstate and local governments**(Borrow for various reasons)Buy Bonds ----------> Issue bonds & sell to the publicGet interests payment <--------- Pay interests to bondholdersGet borrowed money back when bondsmature<--------- Repay the principal when bondsmatureo The bondholder can sell the bond at an earlier day to someone elseo Then, borrowers will continue pay interests and the principal finally to the person holding this bondThree Significant Characteristics of Bonds1. Term - the length of time until the bond matureso Short-term bond- 3-month Treasury Billso Long-term bond- 10-year government bondo Perpetuity - a bond never maturesThe Interest rate on a bond depends, in part, on its termo Long-term bonds are riskier than short-term bonds o Long-term bonds usually pay higher interest rates than short-term bondso The interest rate depends on its term2. Credit Risk- the probability that the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a defaulto Government bonds- tend to pay lowinterest rates**(Less politically stable governments pay higher interest rates)o Corporation bonds- tend to pay high interest rateso Junk bonds- pay very high interest rateso Default can be done by declaring bankruptcy3. Tax treatment - the interest on most bonds is taxable income, that is, the bond owner has to pay a portion of the interest in income taxeso Owners of the bonds (issued by state or local government) are not required to pay federal income taxo Municipal bonds tend to paylow interest rates than bonds issued by federal government or corporationsQuestion 1: Which bond would you expect to pay a higher interest rate? Explain. 1. A bond of the U.S. government or a bond of an East European government. 2. A bond that repays the principal in year 2015 or a bond that repays the principal in year 2040. 3. Abondissuedbythe federalgovernmentor a bond issue by New York State. The Stock Market o Stock- represents ownership in a firm and is, therefore, a claim to the profits that the firm makeso Stockholders - share in the profits of a corporation offering both higher risk and higher reward than bondsSavers(Households)Borrowers (Large Corporations)Buy stocks ----------> Issue stocks & sell to the publicGet partial ownership <---------- Sell partial ownershipGet dividends <------------ Pay dividendsExample:If Intel sells a total of 1 million shares of stock, then each share represents ownership of 1/1 millionth of the business (have claim on the future profits)Stock exchangeso Stock exchanges - issued stocks trade among stockholders on organized stock exchangeso The corporation itself receiveno moneywhen its stock changes handsThe most important stock exchanges in United Stateso The Dow Jones Industrial Average: thirty major U.S. companieso The Standard & Poor’s 500 Index: 500 major companiesStock prices o Stock prices - determined by the supply of and demandfor the stock in these companieso The demand for a stock reflects people’s perception of the corporation’s future profitabilityo When people become optimistic about a company’s future, they raise their demand for its stock and thereby bid up the price of a share of stockStock Index o Stock index - in average of a group of stock prices**(It monitors the overall level of stock prices and economic conditions)Most famous stock index:o The Dow Jones Industrial Average: thirty major U.S. companieso The Standard & Poor’s 500 Index: 500 major companiesDifference between Bond and Stock o Equity finance - the sale of stock to raise money o Debt finance - the sale of bond to raise money If the company is very profitable ,o The stockholders enjoy the benefits of these profitso The bond holders get only the interest on their bondsIf the company runs into financial difficulty , o The bondholders are paid what they are due before stockholders receive anything at allStocks offer the holder both highrisk and potentially high returnFinancial Intermediaries o Financial Intermediaries- financial institutions through which savers can indirectly provide funds to borrowers; reflects the role of these institutions in standing between savers & borrowersBankso Banks – an institution that ___________ and __________o Pay depositors interest on their deposits and charge borrowers slightly higher interest ontheir loanso Medium of exchange– an item that people can easily use to engage in transactionsMutual Fundso Mutual funds – an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bondsAdvantages: 1. Theyallowpeoplewithsmallamountsofmoney to diversify their holdings2. Theygiveordinarypeopleaccesstotheskillsof professional