Chapter 3: Savings and Investment

2. information costs

- banks specialize in knowing credit risk, if loan is a good deal, etc - lower costs for savers AND borrowers.

if the issuer fails to pay the bond:

- bond in default - "credit risk" - bonds are usually issued by governments and large corporations - smaller firms usually borrow from banks - "junk bonds" bought by large investors

How is the Coupon Determined?

- coupon is set so bond will sell at face value, "at par" - the less reputable the borrower, the higher is the coupon required - coupon is determined by the market. - bond owner never received more than promised. - coupon cannot, and will not, change.

4. diversification

- each depositor participates in all loans

Treasury Bonds are not free of risk.

- future interest rates are uncertain!

Mutual Funds

- it is a firm that owns the stocks and bonds of other firms. Each mutual fund share participates in a portfolio of stocks and bonds (they pool together the savings of many individuals and invest in stocks and bonds). - many types: growth, income, small/large cap, bond, international, Asia, technology, etc.

Securities and Exchange Commission (SEC)

- it is the umpire on Wall Street. Regulates financial markets in US - all securities must be cleared by SEC. - all public companies must file regular audited reports w/ the SEC. - guiding principles is "full disclosure" - give investors all the relevant information and let markets decide value.

What do Mutual Funds Provide?

- liquidity - low transaction cost (bc saver is making one investment instead of many) - low information cost - diversified holdings of many stocks and other financial instruments... Mutual funds still carry risk however.

1. transaction costs

- lower costs for savers AND borrowers. - banks are convenient.

life insurance

- offers savings plans which protect against the possibility that the saver may not live long enough to meet an objective - not highly liquid - income earned free of tax - "whole life" is insurance and savings

What do investors get for $ per share?

- right to cast one vote per share - participation in profits and dividends - limited liability - BUT you can lose your $.

Pension Funds

- they accumulate the contributions employers and employees make to retirement plans - not liquid. They engage in highly sophisticated investment strategies that would not be available to the individual employee.

Price-Yield Relationship for Long Term Bonds

- yield to maturity on bonds with maturity greater than one year is more complicated to calculate. - if a bond sells at par, then the only component of yield is the coupon yield and that is just the coupon rate. - if the bond is selling at a discount form par, then there is a positive price appreciation component that will be averaged over the life of the bond - discount earned over years - yield is one a per year basis. Good approximation: - divide discount by maturity - add coupon, then divide by price.

how can investors reduce risk?

... by diversifying, owning shares in many companies. - easily done in a mutual fund

a Bond is:

... like a loan, it is a promise to repay with interest, but issuer pays whomever owns the bond. - like stocks, bonds are "negotiable securities" and more liquid than loans. They are marketable securities that are purchased by financial intermediaries like mutual funds and pension funds as well as by individuals - a bond is a standardized product with a market in which the owner can sell it.

The Stock Market

... where share of ownership in corporations are bought and sold. - the total stock market value of a firm = the present value of the stream of profits that the firm is expected to generate

2 Forms of Interest Rate Risk:

1. Price Risk 2. Income Risk

The Bank Provides 4 Services:

1. lower transaction costs 2. lower information costs 3. liquidity 4. diversification

Q Suppose that a treasury note maturing one year from today has a coupon rate of 1.125 and a price of 99.25. What is the yield on this T note?

1.89

3. Liquidity

= convertible into cash quickly at low cost. liquid -> saver's deposit illiquid -> bank's loan - banks convert illiquid assets (loans) into liquid assets (savers' deposits)

Yield to Maturity =

= price appreciated yield + coupon yield - at a price of $100, price appreciation is zero, so the yield is just coupon yield, 5%, and price fall $1. - when rates rise 1 % point, price falls to $99, adding 1% price appreciation yield. By "price appreciation" we mean the increase (or decrease if negative) in value of a bond or note from today until maturity.

the price of a share =

= the present value of the stream of dividends that people expect to receive from the corporation. - is determined by supply and demand. The price is where the supply of shares just equals the demand.

the total stock market value of a firm =

= the present value of the stream of profits that the firm is expected to generate.

What is a Bond?

A contract between the issuer of the bond (the borrower) & the owner of the bond (the lender)/ - pays face value at maturity and interest in form of periodic coupons - at maturity, bond ceases to exist - they are described by issuer, coupon, and maturity. - prices are quoted for face value of $100, determined by supply and demand.

The Interest Rate

It is a key variable in the economy, it affects the cost of capital and durable goods. - Treasuries are default-free; so US Treasury bonds pay the least. **-Treasures are the most liquid of all bonds! - the Yield on Treasures is benchmark rate.

Q investment spending in macroeconomics refers to

adding to physical capital.

Consols Mature in Eternity

another way to approximate relationship between t=price and yield of long term bond focuses on a bond of infinitely long maturity - such bonds are called consols. Never matures, pays coupon forever Yield = coupon/price therefore price = coupon/yield - a useful approximation for long term bonds

Q The term liquidity means that the

asset is readily convertible to cash without much loss of value

Price Risk

bond price changes when rates change.

Q Which of the following assets is the LEAST liquid? a. money in a checking account b. a U.S. government bond c. a 2010 Toyota Camry d. 100 shares of Apple stock

c. a 2010 Toyota Camry

Q Which of the following is (are) source(s) of funds for Facebook's investment spending? a. investors who purchases shares of stock in the company b. borrowing from savers c. both d. neither

c. both

Income Risk

cannot be sure of rate when reinvest. - T bill has very little price risk - income risk argues for matching maturity to time you will need money.

Q Which of the following assets is the MOST liquid? a. a life insurance policy b. a house c. 100 shares of apple stock d. money in a checking account

d. money in a checking account.

Q Owners of stock may receive income in the form of:

dividends and profit from selling the stock for more than its purchase price.

New One-Year Treasury Note: what must the coupon be for investors to be willing to pay "par" or $100 for it?

enough so the new bond yields as much as existing one year notes conclusion: the coupon on the new note must equal the interest rate.

Investment has 2 meanings:

financial investment - 100 shares of Amazon capital investment - Amazon's new warehouse both are part of the process that turns (household) savings into the production and purchase of new capital goods.

how does price change with a change in yield on a consol?

for long term bonds, the % change in price is approximately the negative of the % change in yield, the approximation being more accurate for small changes - long term bonds have the greatest price risk!

Q Suppose that you are faced with a choice between two Treasury notes: 1. Rate - 5.625 Maturity - 1/31/2018 Ask - 101.00 2. Rate - 7.750 Maturity - 1/31/2018 Ask - 103.01 which do you prefer?

indifferent between the two. or neither, the price is too great and the money is better put towards...

Bond prices move _____ with interest rates.

inversely

A Bond Yield

is a percent gain from a purchase to maturity: Yield = amount gained/price paid x 100% gain is what you get minus the price you paid, so: Yield = ((face value + coupon) - price)/price x 100% - a rise of 1% point in the yield results in a 1% loss in market value!

Q Financial markets make borrowing large amounts of money easier because they simplify

reducing transaction costs

Q Transaction costs are

the expenses of negotiating and executing a deal.

coupon and face value are fixed, only the _____ can change!

the market price - yield adjusts through change in price - that is why there is interest rate risk!

What are "Financial Intermediaries"?

they are channels of saving to investment, and banks are only one. Firms which pool the savings of households and invest them in other firms. - they all offer lower transaction and information costs, liquidity, and diversification - many offer tax benefits..... They all commonly serve as a conduit for the flow of household savings to investment in new capital.

The Role of Financial Intermediaries

they specialize in bringing together savers and investors.

when rates fall, bond prices rise. Thus,

when the interest rate falls, the value of existing bonds rises.

when rates rise, bond prices fall. Thus,

when the interest rate rises, the value of existing bonds falls.