Chapter 13 : The Basics of Finance

the slope of the supply curve

(loanable funds, interest rate) an increase in interest rate makes saving more attractive which increases the quantity of loanable funds supplied and is reflected in a movement along the supply curve.

The general formula for the after-tax purchasing power of $1 over time

(1 + r)^n = [1 + i (1 - t) - pie]^n

Policy Scenarios

We can also use our simple model of financial markets to examine how government policies can affect saving and investment decisions. --> How policies affect the supply or demand curves for loanable funds. --> How shifts in those curves affect the interest rate and the equilibrium quantity of loans.

what is the national income accounting identify for an open economy?

Y = C + I + G + NX

government budget deficit

a budget deficit reduces national saving and the supply of loanable funds which increases the equilibrium interest rate and decreases the equilibrium quantity of loanable funds.

debt

a loan to a borrower in exchange for the future repayment of the amount loaned plus interest. Examples: bonds, debentures, certificates, mortgages.

Standard deviation

a measure of how spread out a set of numbers are.

Defined Contribution

a pension benefit based on the amount that has accumulated in the account, including contributions plus any gains or losses from investments, expenses, or forfeitures; a savings account with certain tax advantages

defined benefit

a pension plan in which the benefit level is based on years of service and prior earnings; a specified amount that is guaranteed when a worker reaches a given age

pension funds

a professionally managed portfolio that provides income to retirees, two types: defined benefit and defined contribution.

budget deficit

a shortfall of tax revenue (net of transfers) from government spending. T - G < 0 public dissaving competing with the private sector simply a negative budget surplus

the market for loanable funds

a simple demand-supply model of the financial system. Saving is the supply of funds, both public and private, investment is the demand for funds for private investment.

futures contract

an agreement to buy or sell at a specific date in the future at a predetermined price

Mutual Funds

an entity that buys stocks and bonds, puts these stocks and bonds together and then an investor buys a portion of the fund. "sell shares in the fund to the public and use the proceeds to buy portfolios of stocks and bonds of other companies." Provide asset diversification and access to professional money managers who make decisions on behalf of clients for a fee.

budget surplus

an excess of tax revenue (net of transfers) over government spending. T - G > 0 Public saving

investment incentives

an investment tax credit increases the demand for loanable funds which raises he equilibrium interest rate and increases the equilibrium quantity of loanable funds

Shifts in supply

any factor that affects saving will shift the supply curve for loanable funds. Factors that affect saving include: Culture Social welfare policies Wealth Current economic conditions Expectations about future economic conditions

shifts in demand

as the interest rate increases, there will be fewer investments that can generate returns high enough to make the cost of paying back a loan worthwhile, this is why the demand curve slopes downwards. Any factor that affects investment will shift the demand for loanable funds. Investment decisions are based on the trade-off between potential profits and the cost of borrowing. Expectations about the future profitability of investments made today change the level of investment.

in the market for loanable funds, the intersection of the supply and demand curves produces,

equilibrium interest rates and quantity of loanable funds.

efficient-market hypothesis

market prices incorporate all available information. Therefore accurately predicting stock prices is impossible

financial markets principle

markets often organize economic activity in a way that maximizes economic well-being.

financial markets

stock and bond markets, people trade future claims on funds or goods in financial markets.

throw a dart

studies suggest this approach is affective as the two others.

arbitrage

taking advantage of market inefficient to turn a profit.

impacts of tax cuts on savings

tax cut reduces investment and in the long run causes the standard of living to fall

valuing assets

the basic trade off is between risk and return. There is a strong correlation between the expected risk and expected return in financial assets. Cash and fixed income bonds carry very low risk and reward. Assets in emerging countries carry a high but very risky return.

the slope of the demand curve

the curve slopes down

low standard deviation

the data points tend to be close to the mean (or expected value).

the supply for loanable funds: demand

the demand for loanable funds comes from private investment

risk premium

the difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities.

provide liquidity

the ease at which an asset can be converted into cash.

how tax cuts effect savings and investment

the effect of a tax cut on national saving and investment depend on the behaviour of consumers. if there is no change in consumption then there will be no change in either national saving or investment.

real interest rate (r)

the interest rate corrected for inflation (pie), the rate of growth in the purchasing power of a deposit or debt

nominal interest rate (i)

the interest rate not correct for inflation (pie), the rate of growth int the dollar value of a deposit or debt

the supply curve will be further to the left...

the more consumer oriented people are. the more generous polices relation to unemployment, poverty, health and retirement. if households are richer. if there is a recession. if expectations about the future are optimistic.

crowding out

the reduction in private borrowing caused by an increase in government borrowing.

Argument against EMH

the same asset can trade at different prices in different markets, this suggests the market isn't using all available information, some traders engage in arbitrage to try to buy an asset in one market and sell it higher on another price market.

Diversify Risk

the sharing of risk across assets or people.

adding realism

theres is not a single interest rate paid by all prospective borrowers.

buyers/investors/borrowers

those who have productive ways to spend those funds; want to spend on productive inputs such as factories, machinery and equipment.

the market for loanable funds: equilibrium

when quantity of dollars demand by investors = quantity of dollars supplied by savers

Capital inflow

when savings from another country finance domestic investment.

the financial system

- the institutions that bring savers, borrowers and investors together - financial markets and financial intermediaries, help people manage both money and risk. - It fulfills its rolls by creating financial assets. - acts as an intermediary between savers and borrowers - provides the benefits of liquidity, - helps savers and borrowers diversify risk.

2 ways banks solve mistiming issues

1. loan out money to people who would like to spend more than they earn. 2. collect money from people who earn more than they currently spend.

two basic factors driving differences in interest rates

1. the term of the loan: the opportunity cost of lending money. Lending money for a longer term ties up the money so it cannot be used for other investment opportunities. Longer the term, higher the interest rate. 2. The riskiness of the transaction: a default occurs when a borrower fails to pay back a loan according to the loan terms. Credit risk is the risk of a borrower defaulting on a loan. The risk free interest rate the tousle prevail if there were no risk of default, usually attached to government bonds.

Equity/Stock

A claim to partial ownership of a firm (with voting rights) and its future profits. Compared to bonds, stocks offer higher risk and higher return in the form of dividends and capital gains. Stock prices reflect expected profitability. Stock indexes are watched closely as indicators of future economic conditions.

Derivatives

A kind of equity where financial assets are based on the value of some other asset. Example: a futures contract

The Bond Market

Debt finance;

The Stock Market

Equity finance;

National Income Accounting

GDP is both the total income in an economy and also the total expenditure on the economy's output of goods and services.

bonds

Loans that are standardized into a more easily tradable asset. Certificates of indebtedness in which the buyer lends money in return for regular interest payments over a period of time and the future repayment of the money borrowed. The higher the interest rate, the higher is the borrowers credit risk.

The Efficient Market Hypothesis (EMH)

Market prices will always incorporate all available information, and therefore represent stock value as correctly as possible. As soon as information becomes available people react and prices adjust in a way which should reflect profitability of the company. Suggests finding incorrectly priced stocks is impossible.

S & I in a closed economy

National Saving = Investment

Public Saving

Net tax revenue (total minus transfers) minus government spending = T - G

commercial banks and trust companies

Pay depositors interest and charge borrowers higher interest on loans (to maximize profits). They act as a medium of exchange (cheque writing facilitates transactions).

National Savings (S)

Private Saving + Public Saving S = (Y - C - T) + (T - G) = Y - C - G The proportion of national income that is not used for consumption or by the government, excess funds made available for investment.

asset valuation

Savers decide on which assets to purchase based on this principle. The value of any financial asset sis the present value of its expected future cash flows.

private savings

The proportion of households' income including transfers that is not used for consumption or paying taxes. Y - C - T [or] (Y-T) - C = PS examples of uses: bonds or equities, deposits, mutual funds

closed economy

There are neither exports nor imports therefore; Y = C + I + G

financial markets

They are markets in which people trade financial assets and are governed by the forces of supply and demand. They match buyers and sellers, who can both gain from trade. Allowing funding to throw to the places where it is most highly valued to allocate the economy's scarce resources to their most efficient uses. The link the present to the future by enabling lenders to convert current income into future purchasing power. They enable borrowers to acquire capital to produce goods and services in the future.

True or False: Non-price factors affect the demand for loanable funds cause a shift in the demand curve.

True

financial intermediaries

banks and mutual funds

entrepreneurs and businesses

borrow to finance investments

Investment Banks

do not accept deposits and do not make typical loans; instead, they assist companies in issuing stocks and bonds by acting as market makers. They match buyers with sellers.

financial assets

claims on future funds or goods; two types, debt and equity.

market for loanable funds; supply

comes from house hold saving (people with extra income can loan it out and earn interest), public saving (the government budget) + = adds to national saving and supply of loanable funds/- = reduces national saving and the supply of loanable funds.

Technical analysis

computer analysis of movement sin stock prices to predict future movements

Fundamental analysis

conducting research on an individual company to predict future profits. Net Present Value (NPV) a measure of the current value of a stream of expected future cash flows.

financial assets

debt and equity

Y - T

disposable income (Yd)

Financial Intermediaries

financial institutions through which savers can indirectly provide funds to borrowers

financial products are generally exchanged in

financial markets

saving incentive

going to shift the supply curve right, tax incentives for saving increase the supply of loanable funds which reduces equilibrium interest rate and increases the equilibrium quantity of loanable funds

Who relies on financial markets to achieve financial goals?

government, households, businesses, NGOs

Intermediation

helps match one person's saving (sellers) with another person's investment (buyers), saving and investment are both key to long run growth.

nominal after tax return

i(1-t)

Equilibrium adjustment: Surplus

if the interest rate were higher than the equilibrium level then there would be a surplus of loanable funds which would cause the interest rate to fall. The fall in interest rate would make borrowing less costly which would increase demand and encourage households to save less which would decrease interest rate. This process will continue until equilibrium is achieved.

equilibrium adjustment: shortage

if the interest rate were lower than the equilibrium level then there would be a shortage of loanable funds which would cause interest rate to rise because more people want a share of the limited available resources. The rise in interest rate will attract more dollars into the market and increase the cost of borrowing. This process will continue until equilibrium is achieved.

high standard deviation

indicates the data points are spread out over a wider range of values.

the demand for funds comes from

investment

budget deficits and crowding out

investment is important for long run economic growth and standards of living thus, budget deficits reduce the economy's growth rate, this is one reason why many economists believe budget deficits are generally undesirable

implications of income tax and return to saving

it follows that reducing the income tax on saving could be quite effective in stimulating saving and improving future standards of living.

supply of loanable funds come from

saving

Income tax incentives

saving incentives include: TFSAs, RRSPs, RESPs. Investment tax credits reduce the cost of purchasing certain types of machinery in certain industries in certain regions.

T

net of transfers

income tax is levied on

nominal interest income

Savers

people and governments who make funds available.

In the market for loanable funds, the supply curve demonstrates the fact that as the interest rate rises,

people are willing to save more.

speculators

people who buy and sell financial assets purely for financial gain.

sellers/savers/lenders

people with spare funds; let investors borrow funds for a price.

national saving =

private saving + public saving investment in a closed economy

insurance companies

provide protection against possible future losses in exchange for premiums

real after tax return

r = i (1-t) - pie this is also the after-tax real interest rate and your after-tax rate of growth of purchasing power.

define the relationship between real and nominal interest rates

r = i - pie

Companies issue stock in order to

raise capital without borrowing

how does a tax cut cause investment to fall in a closed economy

raising interest rates

Market (systemic) risk

refers to risk that is broadly shared key the entire market or economy; ex. unexpected inflation.

idiosyncratic risk

refers to risk that is unique to a particular company or asset; easiest to mitigate using diversification.

sales taxes versus income taxes

sales taxes only consumption, not saving. income tax greatly reduces the return to saving.

Example: if you save $1,000 for one year at a nominal interest rate of 5% and your marginal tax rate is 20%

your nominal after tax return is $40. = 1,000 x 0.5 - 1,000 x 0.5 x 0.2 = 1,000 x 0.5 (1 - 0.2) = $40 Then - nominal after-tax rate of return ($40/$1,000) = 4% = 5% x (1-0.2)