Econ 102 1st Edition Lecture 15Outline of Last Lecture I. Corporate Income TaxesII. Federal Deficits 1974-2013III. Automatic Stabilizers- Keynesian ViewIV.Are Deficits Bad?V. The Clinton, George W. Bush, and Obama AdministrationsVI.Financial Markets: Borrowing and LendingVII. Financial IntermediaryOutline of Current LectureI. Financial IntermediariesCurrent LectureI. Financial Intermediariesa. Real expected return from lending = {the nominal interest rate}- { the expected inflation rate} - expected risk - transaction costsand taxesb. they diversify risk of lendingi. the more diverse of people being lending to1. samsung & applea. one will do well in smartphone market, maybe both do wellb. odds are they wont BOTH failc. spread your money aroundThese 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.c. Banksi. Under perfect competition, spread between the lending rate and the deposit rate equals the costs of financial in-termediation:1. lending rate is what a BORROWER paysa. competition between banks makes this as smallas they can (by diversifying risk) otherwise borrowers would go to bankii. Credit assessmentiii. Loan Assessment iv. Monitoring 1. make sure borrower pays back, send letters, send repo man to take thingsv. Risk 1. pay a higher interest rate to compensatevi.Deposit rate or “inter-bank rate” if they borrow from other banks instead of households1. (after second exam)2. The spread is counter-cyclicala. spread goes up when GDP goes downb. because risk goes up when GDP goes downi. risk increases during recessionsc. daily information on interest rate spreads3. The spread shrinks as efficiency increasesa. reduces cost of banks because you enter SSN and can find out all the information they need about youd. Direct Lendingi. The individual saver earns the lending rateii. the individual saver assumes all the intermediation costs and risk1. Venture capitalists a. borrow from the bank at one rate and then lend at another one and make moneyiii. Under perfect competition, the net return equals thedeposit rate (if such lending takes place at all, that is!)e. Bond Marketsi. IOU- I owe you ii. specifies1. annual return “coupon”a. $10 each yearb. sometimes no coupon along the wayi. for tax reasons or company personal rea-son may be preferredii. start up company needs a few years to get going before they can payout 2. the date of full repayment “the term”a. January 1, 20163. the repayment price4. the contract can be sold to anybody at any time5. The resale market price is known as the “secondary market price”a. when trading contracts that have already been madeiii. opportunity cost is putting money in the bank1. as alternatives look more attractive bond is worth less2. if deal gets riskier less chance of paying3. if inflation goes up need a higher rate of return to compensatea. By paying less for it you are actually get-ting the higher rate for it without renego-tiating the contractiv. Bond ratings1. are professional assessments of bond riska. AAA is the highesti. US was AAA, now AA1. risk the US wont pay off debt, comevery close (twice in last 18 months)to not meeting obligations right at the brink of paymentb. BB and lower in the alphabet are called “junk bonds”2. A CDS (Credit Default Swap) is an insurance con-tract on a risky bonda. can hold on to bond rather than sell it, person who bought the bond takes out the insurancei. if borrower pays back good to goii. If not, insurance will pay a minimum1. insurance company lends to many firms so they have more diversified risk than one individual3. The value of the CDS is derived from the value of an asset (bond). Tools like this for dealing with asset risk are known as financial derivativesa. its value depends on something elsef. Stock Marketsi. a way to sell parts (shares) of a firm 1. the firm sells shares of itself rather than taking out aloana. no repayment is necessaryii. Stocks can be traded or sold to third parties1. first party stock issuer2. second party buyer3. third party tradersiii. The stock market values the stock given its expecta-tions about the firm’s future value (profits, inflation, pro-ductivity)1. sell firm at a higher price in the futurea. everything will cost more because of inflationiv. There are two sources of expected return from stocks:1. Dividends (shares of profits paid out periodically)a. some people like this to help make their monthly payments2. The future resale price of the stocka. retained earnings make the firm more valuableb. no dividends, saves tax burden3. one is not better than the other just depends on whatyou wantg. Risk in Stock and Bond Marketsi. Stocks and Bonds are both risky because their current value depends on expectations about the future.ii. Efficient Markets Hypothesis: You can’t do better than us-ing the market valuation of stocks and bonds1. You can’t beat the stock/bond market (on average)2. Motivated self-interest will self-regulate the stock and bond markets, or at any rate do as well as any regulatory authority would doiii. Ownership of firm stock is riskier than ownership of a bond issued by the same firm1. Bondholders have legal first claim to a firm’s assetsa. If ever in financial trouble must pay the bond-holders firstb. therefore stock market returns are higher be-cause higher riskh. Risk and Market pricesii. GOOD STUDY SHEET!**1. As risk increases, lenders demand a higher rate of returna. Banks charge higher interest ratesb. Current stock prices fallc. Currently-issued bonds offer a combination of ahigher coupon rate and a higher repayment priced. Secondary-market bond prices falle. Credit Default Swaps (CDS’s) get more expen-sivei. Sovereign debti. “Sovereign” debt is debt issued by a government, rather than by a firm.1. Generally bond debt2. There is no collateral; the government can’t legally be forced to sell the country’s assets in order to pay off the debt so long as the government remains sov-ereign.3. Sovereign debt valuation depends on expectations of future tax revenue (related to aggregate productivityforecast, but also to popular willingness to accept taxincreases)j. International Capital Mobilityi. Financial markets are internationalii. Money flows across borders to get highest expected re-turniii. Risk varies across countries as it does across firms within countries1. Gross return compensates for expected
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