EQUATIONS YOU NEED TO KNOW Fisher Equation o R r E Expected nominal IR expected real IR expected inflation premium IR YTM DR o IR or YTM par value purchase price x 365 days in a year days to maturity purchase price o DR par value purchase price x 360 par value days to maturity Class Book Notes from Chapter 2 Creation of Financial Assets T account analysis Represents changes in items on the balance sheet of firms households Firm s Balance Sheet A o o o o o o Capital paid in amount raised when the firm issued their stock Retained earnings reinvested earnings Household s Balance Sheet B Add up across ALL households and firms all of the financial assets all of the nonfinancial assets TL of all HH firms NW of all HH firms NW stock and NW RE of all firms Total value of NFA in firms HH NW HH firms NW RE Represents total wealth in the economy The point simply issuing a financial asset doesn t create new wealth Creates an asset for those who have it but it s still a liability for someone else A Assets Financial Assets FA Bank deposits Government bonds MMM Funds Non Fin Assets NFA Buildings Equipment Inventories Total Assets FA NFA B Assets Financial Assets FA Corporate stock Bank deposits MMM Funds Non Fin Assets NFA Housing Durable goods cars furniture etc Total Assets FA NFA Liabilities Total Liabilities TL Bank loans Short term debt Accounts payable Capital account NW Capital paid in NW stock Retained Earnings NE re Assets liabilities Liabilities Total Liabilities TL Mortgage Credit card debt Bank loans Net Worth NW HH TL NW HH Question What happens when a financial asset is created o Example A firm issues 100K bond to purchase computer equipment from Dell HH purchase the bond Step 1 firm issues the bond and receives cash Result no wealth creation by the issuance of the bond but the firm s balance sheet has expanded Step 2 Firm uses the cash to purchase the computer equipment 2 parties involved firm Dell Suppose Dell s cost of equipment is 90K but they sell it for 100K Was any wealth created in this process Yes by Dell 10K step 1 Firm Assets 100K cash Liabilities 100K bond step 2 Firm Liabilities Assets 100K cash 100K equipment Assets 100K cash 90K inventories step 2 Dell Liabilities 10k retained earnings Net Borrowers Net Lenders in the Economy Balance Sheet Items are stock variables Changes in the balance sheet items are flow variables An economic unit can be a lender of funds 1 period a borrower the next or even both in the same period Financial intermediaries banks and insurance companies both lend and borrow Each economic unit in the financial market must conform to the equation R E FA D R current income receipts E expenditures out of current income FA change in holdings of financial assets D change in debt and equity outstanding Example if R exceeds E we ll make up the difference by Reducing our financial assets ie from savings Issuing debt expenditures borrow the money The individual economic unit must always fall into 1 of 3 groups Deficit Budget Unit DBU net borrower of funds E R so D FA Households tend to be net lenders Surplus Budget Unit SBU net lender of funds R E so FA D Business government tend to be net borrowers Balanced Budget Unit BBU neither borrower lender everything is equal o o o o o o o o o o o o o Example R 4000 E 3000 FA 2000 D NOTE o 4000 3000 2000 x x 1000 they re still incurring debt of 1K even though they re a net lender because FA D still In 2007 households and non financial businesses in the US became the big net borrowers In 2008 the federal government and firms were HUGE borrowers not enough for US households to keep up with the lending By 2009 households still net borrowers the big net lenders became the Federal Reserve So foreign investors supplied the funds The big net borrower Federal government Financial Transactions All financial institutions move scarce funds from those who save and lend SBUs to those who wish to borrow and invest DBUs Transfer of funds from savers to borrowers can be accomplished in at least 3 different ways 1 Direct Finance borrower and lender meet each other and exchange funds in return for financial assets without a third party bringing them together a Example buying stocks bonds directly from the company who issues them b These claims primary securities because they flow directly from the borrower to the lender c It s the simplest method of a financial transaction but has limitations i Borrower and lender must want to exchange the same amount of funds ii Lender must be willing to accept borrower s IOU which may be risky iii Lender and borrower may incur information costs trying to find each other 2 Semi direct Finance A business firm individual who is a broker dealer brings the SBU and DBU together reducing information costs a Broker provides information concerning possible purchases and sales of securities i Just brings buyer and seller together reduces information costs b Dealer holds the seller s assets stock and hope to sell it out of their inventory to lenders i They take a position of risk whereas brokers don t ii Good because a dealer can split up a large amount of primary securities so that smaller units can afford the assets buy them instead of having to find a HUGE unit to finance a large amount of the assets iii Dealers play a HUGE role in the market and in the treasury market they ARE the market 3 Indirect Finance Financial Intermediation carried out by financial intermediaries a Banks insurance companies pension mutual hedge funds etc i Serve as both ultimate lenders and borrowers b Issue secondary securities securities of their own i Checking savings accounts life insurance policies mutual fund shares etc ii Relatively low default risk and usually more liquid than primary securities c And accept IOUs primary securities from ultimate borrowers d Makes savings and borrowing easier for everyone improving the financial system s efficiency Pricing of Money Market Assets 2 measures of money market interest rates 1 Yield to Maturity YTM Investment Rate IR Chapter 6 a An annualized interest rate b You can always calculate a YTM IR on ANY investment c Formula i IR or YTM par value purchase price x 365 days in a year days to maturity purchase price 2 Bank Discount Rate DR a The interest rate that traders in the market quote each other b An annualized interest rate c Differs from the YTM IR in 2 ways i Investment base is the face value of the asset not how much you actually invested ii Computed on the base of a 360 day