TAMU ECON 311 - Ch. 2 - The Financial System

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Ch. 2 - The Financial System!investment - purchase of physical capital!!Structure of the financial system!!Financial system!"Financial Markets!! ! ! ! ! ! Financial intermediaries!Direct Finance!!!!!!!!Indirect finance!equity (stock) markets!! ! ! ! ! ! banks***!debt (bond) markets! ! ! ! ! ! ! S&L’s!foreign exchange markets! ! ! ! ! ! insurance companies!! ! ! ! ! ! ! ! ! mutual funds!!Monetary theory!-examines role of money in economy!!Monetary policy!-use of money and interest rates to minimize inflation and unemployment!!Function and structure of financial markets!function and types of financial intermediaries!regulation of financial system!!Role of financial system!1. provide individuals, firms, governments funds to do things today they couldn’t otherwise afford — at a price!2. storing, protecting, providing profitable uses for excess capital!3. insuring against risk!4. speculation!!Structure of financial markets!1. debt & equity markets!2. primary and secondary markets!3. exchange and over-the-counter markets!4. money and capital markets!!Debt and equity markets!-debt securities = promises to repay principal and interest at specified date. (primary source of direct finance) **BONDS**!-debt security maturity describes length of time until final payment is made!! -short-term = < 1 year!! -intermediate term = 1 year < maturity < 10 years!! -long term = > 10 years!-equity securities represent ownership of corporation and entitle stockholder to firm’s earnings/assets!!Primary and secondary markets!-primary = newly issued debt/equity securities sold to initial buyers!-secondary = previously issued securities are bought/sold!!Types of secondary markets!1. exchanges - buying/selling takes place in centralized location!2. OTC - buying/selling takes place through computerized trading!!Money and capital markets!-short-term securities traded in money markets!-equity securities and longer term securities traded in capital markets!!Example of money market instruments!1. commercial paper - unsecured corporate debt issued to finance short-term working capital needs!2. repurchase agreements (repos) - sale of securities with simultaneous agreement to repurchase securities at agreed upon future date at an agreed upon future price!!Functions of financial intermediaries!-financial intermediation is process of indirect finance using financial intermediaries!-financial intermediaries provide route for moving funds for savers/lenders to investors/borrowers because they reduce transaction costs/information costs!-Transaction costs - time/money spent carrying out transaction!-economies of scale!-average cost of transactions falls as number of transactions increases!-information cost - arise from asymmetric information problems!-adverse selection and moral hazard#Ch. 3 - Understanding Interest Rates!!interest and interest rates!-interest = amount lenders receive for extending credit, or amount borrowers pay for obtaining credit!-interest rates reflect amount of interest paid in relation to amount lent/borrowed!-interest rates reflect trade-off between present/future consumption!-interest rates reflect “price” of capital!!ex. !!Calculating interest rates!-concepts!-present value!-yield to maturity!!ex. Principal = $10,000 ; Repay = $15,000 ; Interest = $5,000!! 10 years —> $5,000/10 = 5% per year!!Present value!Yield to maturity!-interest rate that requires price of an asset today with the present value of all future payments associated with that asset!YTM is the interest rate (i) that equates the 2 sides of the equations!!4 credit market instruments!1. simple loan - commercial bank loan!2. discount bond - US T-bill, zero coupon bond!3. coupon bond - U.S. Treasury Bond, corporate bond!4. fixed payment loan - car loan, mortgage!!Simple loan!-borrower receives principal and repays principal plus interest at maturity!!YTM on a simple loan = interest rate!Discount bond!-borrower repays face value of bond at maturity, but initially receives less than face value!Coupon bond!-borrower initially receives face value of bond, then makes payments of interest at regular intervals and repays face value at maturity!** if coupon issued at Par(face value) then coupon rate = YTM **!!!!Fixed payment loan!-borrower makes regular period payments of equal size. Each payment includes both principal and interest!Calculating YTM!** bond prices and interest rates are negatively related **!!YTM vs. ROR!-if bond is held until it matures, then ROR = YTM!!For a bond held t to t+1!!!!!If bond is held to maturity, then ROR always equals YTM!** if interest rate goes up, then price of bond goes down **!** longer term bonds are affected more by change in interest rates **!** long term bonds = higher interest rate risk **!** if interest rate goes up tomorrow, buy long term today**!** if interest rate goes down tomorrow, buy short term today **!!Real vs. nominal interest rates!-real interest rate = nominal minus rate of inflation!!Ex post vs ex ante real interest rates!-ex post = nominal minus actual rate of inflation (for the past)!-ex ante = nominal minus expected inflation rate (to predict future real interest rate)#Ch. 4 - Behavior of Interest Rates!!2 approaches to determination of interest rates!! 1. bond market framework!! 2. liquidity preference framework!!*both rely on theory of asset demand*!!Theory of asset demand!-other things equal, how will change in any of the following affect one’s decision to buy particular asset!-wealth!-asset’s expected return relative to other assets!-asset’s risk relative to other assets!-asset’s liquidity relative to other assets!!Demand for asset X will increase, other things equal, as result of:!-increase in wealth of buyers!-increase in expected return of asset x relative to expected return on other assets!-a decrease in riskiness of asset x relative to riskiness of other assets!-increase in liquidity of asset x relative to liquidity of other assets!!A model: market for bonds!-assume only type of kind and only one interest rate in the economy!!!Bond supply!-positive relationship between bond prices and quantity of bonds supplied!!Equilibrium!-quantity supplied = quantity demanded at the going price —>!!!!Factors that increase demand for bonds!-increase in wealth!-decrease in expected future interest rates!-***if expected future interest rates fall, expected future bond price will rise***!-decrease in expected future inflation!-decrease in riskiness of bond relative to

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