FI 301 1nd Edition Exam 1 Study Guide Lectures 1 8 Chapter 1 Surplus Unit person that has money to give aka an investor Deficit unit borrower needs money Name of a company individual helps deficit units get money from surplus units Intermediary financial institutions help flow of funds do these in financial markets Money market short terms a year or less examples CD derivative security Capital market a year or more long term debt examples bonds stocks mortgages Bonds investment in a debt Stock share equity in a company Mortgage real estate investment Investments and debts Derivative security short term investment with an asset backing speculators and hedger invest in these Speculator uses derivative to bet or gamble if prices are going up and down Hedging foreigners and banks they are trying to reduce risk Difference between primary and secondary market Primary buys investment initially or borrows money initially Secondary 2 investors trade with each other Commercial bank main job is to make short term loans Credit union different than a bank credit unions do business with their members and banks will make a loan with anyone Credit unions make better deals most of the time Finance company makes high interest loans for people with bad credit Securities mutual funds treasuries stocks bills and bonds CDs mortgages Financial asset piece of paper that gives you a claim to its asset that backs it Piece of paper that gives us a return something that gives us a value and a return on your investment Financial institution bank insurance company investment brokerage they transfer capital invest for us facilitate the flow of funds Physical assets farm commodities real estate deals with land and buildings Liquidity financial assets are more liquid Real estate assets generally take longer to sell and transfer Insurance markets guaranteed a certain payback with insurances not guaranteed with bonds and stocks Derivative securities futurist swap contracts short term and long term securities where they have physical asset underlying them and its not always real estate ex Corn soybeans rice contract or it can be an interest rate another form of security that has an asset behind it invented for two type of people farmers and the banks they use derivatives to hedge risk Speculation trying to make big returns Risk management and hedging don t care if they loose as long as they don t loose big Hedge and risk banks and farmers want to avoid disaster so they take out contracts and they note going in that they may loose money futurist contract but they don t care because they are trying to avoid disaster ex if interest rates move too fast they cant pay off their liabilities Chapter 2 5 types of demand household provide by investing in debt largest supplier of money that s demanded federal government interest inelastic interest rates don t affect their demand they will borrow money no matter the interest rates because they can print money to pay it back if they have to municipal government cant print money issue bonds or raise taxes to pay back debt they are tax free businesses corporationsforeign investorswhen do corporations decide to buy money and affect interest rates they want to expand they are expecting to make more profit higher cash flows interest rates change when they expect more cash flow interest rate risk free rate risk premium risk premium default risk liquidity risk inflation return risk tax default risk risk you will not pay it back liquidity risk cant sell the asset quickly to make a profit return risk tax interest makes up the yield curve shows interest rates on vertical size and maturity on horizontal side shows expectations in the economy upward slope economy is going to get better interest rates should rise downward slope expecting recession interest rates should lower flat or hump shaped tells us that there is uncertainty examples in chapter 2 economic conditions economy expected to grow demand is going to INCREASE interest rates are going to RISE If inflation is expected to start rising 2 to 4 inflation demand is going to go UP right now for money because price is going to go up want to buy it now while it is cheaper interest rates are going to go UP Budget surplus demand for money is low interest rates are going to fall because banks need people to borrow money Foreign investors supply goes down interest rates are going to increase The Loanable Funds Theory suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds Lower interest rate the better If we didn t care what the interest rate was it was an absolute emergency there is still gonna be a lot more money at 2 then 6 because there s less interest money to pay back it is more attractive more people can afford the 2 percent than the 6 percent Foreign countries want to borrow money from us or we want to borrow from them We borrow money in a foreign country instead of our own because they have a lower interest rate Each country has different interest rates Risk currency risk our dollar is worth more or less in other places Benchmark interest rates US 0 25 China 6 Brazil 11 Japan 0 Australia 2 5 Mexico 3 Tells you higher percentage the higher likely they are to default foreign investors in that country not government itself They have high inflation high interest rates like brazil and china they are trying to slow down their economy We want foreign investors to borrow from us low interest rates same with Japan Chapter 3 Liquidity how quickly turn investment into cash without loosing value Affects interest rate you pay higher interest rate if less liquid 3 People can control their tax status Different tax brackets Example municipal bond and a corporate bond municipal bonds can pay out less lower interest rate where a corporate is higher municipal bond you don t have to pay taxes on they can give you less for returns Tax effects what interest rates are Equivalent before tax Yield at bt 1 T bt at 1 T Example Questions Suppose our household income is approximately 100 000 Due to few tax deductions we are in the 35 tax bracket What is our after tax yield on our holdings if we made 4 40 before tax yield on dividends on our Public Storage stock holdings Now what is our before tax yield if we made a 1 56 after tax return on our Union Pacific stock holdings Yat ybt 1 T Yat 0 044 1 35 Yat 0 044 65 Yat 2 86 0 0156 0 65 2 4 ybt Yield Curve Return structure of interest rate important