Ch 17: Capital and Financial Markets

Secondary market

A market in which existing bonds or shares of stock can be bought and sold.

Expected rate of return

Expected annual dividends and annual appreciation of the price of the stock divided by the current price.

Financial capital

Funds used for physical capital

Explain why changes in interest rates on bonds might influence equity prices.

If bonds are an alternative to stocks, a fall in interest rates makes stock more attractive and will result in more buyers and a rise in prices.

Risk-return trade off

The fact that riskier assets will generally offer a higher expected return than safer assets.

Face value

The principal that the firm will pay back at the bond's maturity.

Risk

The volatility of the price or return of a financial instrument.

If rate of return is greater in Japan than US?

The yen will appreciate, dollar will (supply shift to the right, demand shift to the left)

Interest over time Equation

Value in t years=(value in year 0) x (1+i)^t

Primary market

he market in which firms raise funds by selling newly created stocks or bonds to the public.

Suppose that lenders become more confident about future economic conditions and decide to increase their loans now. What will happen in the market for loans?

Supply of loans increases

Suppose that the expected dividends and capital gains for Apple stock increase by 10%. At the same time, the expected rate of return on all other stocks increases by 15%. What will happen to the price of Apple stock?

The price of Apple stock will fall by 5% The expected return for Apple is now 5% lower than other stocks. The price will have to fall by 5% to bring returns in line with other stocks.

Suppose the interest rate goes up from 5% to 8%. What is the new future value of receiving $1000 today and earning interest for one year?

$1080 If you invest $1000 at 8% for a year, at the end you will have $1000 x (1.08) = $1080

Suppose the interest rate (earned every year) is 7%, and you invest $10,000 at that interest rate today. What will that money be worth in 5 years?

$14025.52 The formula for $10,000 in 5 years at 7% is $10,000 x (1.07)^5 = $14,025.52

Suppose we have the option to receive $2000 one year from now, and the interest rate is 8%. What is the present value of this future payment of $2000?

$1851.85 The present value of $2000 in one year at 8% is $2000 / (1.08) = $1851.85

Suppose that someone offers you a choice: you can have $495 in a year or you can have $450 today. The interest rate on savings accounts is currently 8%. Which should you choose?

$495 in one year; If you save $450 at 8% for a year, at the end of that year you will have $450 x (1.08) = $486, which is less than the $495 you could have had.

Consider a bond that has a face value of $1000, 10 years to maturity, and interest payments of $60. If the current interest rate for assets with this type of risk is 12%, what is the present value of the bond?

$660.99

Diversification can...

1.) increase return without increasing risk. 2.) depends on the returns of the assets moving independently 3.) eliminate company-specific, industry-specific, or even country-specific risks, but not the risk of the entire global market.

Suppose the exchange rate between the dollar and the yuan is 8 yuan per dollar. Compare a car in the U.S. with the same car in China. The car in the U.S. costs $5,000, while it costs 50,000 yuan in China. If the exchange rate responds to eliminate this arbitrage opportunity, what will the new exchange rate be in terms of yuan per dollar?

10 At an exchange rate of 8 yuan per dollar, the car is relatively more expensive in China than in the U.S. Thus, buying the car in the U.S., shipping it to China and selling it there provides a profit. Thus, the exchange rate will rise until $5000 is equivalent to 50,000 yuan, or an exchange rate of 10 yuan per dollar. At this exchange rate, there is no more opportunity for arbitrage.

What happens to the value of the marginal product of capital if the price of the good or service being produced falls?

A fall in the price of the goods or services produced will decrease the value of the marginal product of capital at each level of capital. (Thus, the demand curve for capital will decrease.)

bonds

Agreements to repay a principal that has been borrowed at some time in the future and to make interest payments on a regular basis in the meantime.

An increase in the price of the good produced with capital will cause which of the following?

An increase in demand for that capital

*Consider the currency market for U.S. dollars and Brazilian real. Suppose that U.S. coffee drinkers begin to want more Brazilian coffee.

An increase in the popularity of Brazilian coffee in the U.S. means that the demand for Brazilian coffee by Americans has increased. Americans need more Brazilian real in order to purchase more coffee. Demand for real will increase. Therefore, Americans will supply more dollars. The price of dollars as measured in real (the exchange rate) will decrease. (The quantity of dollars bought and sold in the dollar/Euro currency markets will increase.)

An increase in interest rates will cause which of the following?

Decrease the use of capital

Derived Demand

Demand that is derived from the demand for something else. The demand for an input into a production process is derived from the demand for the goods and services that it produces.

Which is a better financial investment - a slow-growing company that will be profitable for a long time to come or a fast-growing company that will be increasingly profitable for a long time to come?

Either one could be the better financial investment. Assuming that the risk is similar, it depends upon the price of the stock. It is likely that the fast-growing company will have a high stock price so that the rate of return is closer to that of the slow growing company.

Efficient markets

Financial markets that adjust quickly to new information. In fact, so quickly that the current price reflects all that is known about economic conditions and the present conditions and future prospects of the company.

Where does demand come from in US dollar exchange?

Foreign individuals that demand more $ if want to buy more US goods/invest in US

Present value Equation

Future value/(1+ interest rate)

Future value Equation

Future value=present value + (present value x interest rate) Future Value= Present value x (1+ interest rate)

*Suppose you have two choices for a financial investment. One is a company that expects to earn $10 per share per year - the Atlanta Bread Company. The other, the Chicago Bakery Company, has a 50 percent chance of earning no profit and a 50 change of earning $20 per share per year. If they were the same price, which one would you prefer? Why? Which one do you expect most persons to prefer?

Most people would prefer the first, as there is less risk. Both will pay the same amount over time.

Interest payment

Payment by borrowers to lenders. Interest rates are normally expressed as a annual percentage of the value of a loan or bond. Payments are made monthly, quarterly, or annually.

Present value of Bond Equation

Present Value= (interest payment/(1+i)^t) + (original loan/ (1+i)^t)

An increase in the marginal product of capital does what to the price and quantity of capital? Why?

Price and quantity will increase. The demand for capital will increase. As a result, the price and quantity of capital will increase.

*Demand for coal decreases. If nothing else changes, what will happen to the price of the machines used to extract coal and the quantity of machines bought and sold?

Price will decrease, quantity will decrease. The demand for the machines is derived from the demand for coal. As the demand for coal falls, the demand for the machines will fall, leading to a lower equilibrium price and quantity.

An increase in the cost of producing capital will do what to the price and quantity of capital produced? Why?

Price will increase and quantity will decrease. An increase in the cost of producing capital will decrease the supply of capital and increase the price and decrease the quantity used.

Suppose that you graduate from college with student debt totaling $10,000. The interest rate on your loan is 7%. You attend graduate school for 5 years after college, which allows you to defer payments on your loans (not make any payments while you are in school). Using the formula for future value, what will be the size of your debt after 5 years of graduate school?

The future value is Future Value = $10,000 x 1.07^5 = $14,025.52

Return

The income earned on a stock. The dividend plus the capital gain. A rate of return is expressed as percentage of the price of the stock.

value of the marginal product of capital

The increase in revenue resulting from the use of one additional unit of capital.

Capital gain

The increase in the market price of a share of stock. Usually expressed as a percentage of the purchase price.

*Consider the market for loans. Suppose that the government institutes a new program to incentivize people to save more. What will be the impact on the interest rate and the quantity of loans borrowed?

The interest rate will fall and the amount borrowed will rise. If saving increases, interest rates on savings accounts should decrease. If those interest rates decrease, banks should be willing to make more loans at lower interest rates.

If interest rates increase, what is likely to happen to the marginal product of capital?

The marginal product of capital will rise.

Suppose you have several choices for placing your savings in insured bank certificates of deposit. They all pay 5 percent per year - the going interest rate for bank deposits. Most observers expect interest rates to remain at 5 percent for some time to come. One is for 1 year, the second is for 5 years, and the third is for 10 years. Which of the following is the best financial investment?

The one-year certificate. The shortest maturity certificate of deposit should have the lowest interest rate and the longest maturity should have the highest interest rate. Because the one-year certificate is more flexible, investors will increase their demand for it and the return on it will be bid down relative to the five and ten-year certificates.

Coupon rate

The percentage of the bond's face value which the company pays to the bond owner every year prior to maturity.

Where does supply come from in US dollar exchange?

U.S individuals/businesses that want to make purchases/investments in other countries(supply shift right)

What happens to the value of the dollar when prices in the U.S. rise faster than the Thai prices?

Value for dollar decrease; If prices in Thailand increase by less than U.S.prices, demand for U.S. goods by Thailand will decrease and the international demand for the dollar will decrease. A decrease in the value of the dollar results.

*Consider the currency market for U.S. dollars and Brazilian real. Suppose that interest rates in Brazil rise.

With higher interest rates in Brazil, more Brazilians would want to invest in their own financial assets as opposed to foreign assets (like those of the U.S.). They will decrease their demand for other currencies, including the U.S. dollar. Simultaneously, U.S. investors also want to invest in Brazilian assets. In order to purchase these assets, they increase their demand for the Brazilian real and therefore their supply of dollars to the international market. Thus, the demand for dollars falls and the supply of dollars increases.

Consider a bond that was issued 5 years ago for $1000. The price of that bond is now $600. If nothing else about the issuer changed in the meantime, it is likely that interest rates have ______________ since the bond was issued.

increased The price of the bond has fallen. Because bond prices and interest rates move in opposite directions, this means that interest rates must have risen. If nothing else changed, then a rise in overall interest rates will have made these bonds less attractive and their prices would have fallen.

Describe events that can change average prices in bond markets and stock markets.

n bond markets, changes in risk and changes in interest rates will affect bond prices. Stock prices will be affected by risk, profits, expectations, and opportunity costs.

Equity

shares of ownership

supply dollars to the international currency market

the U.S. demand for other countries' goods and services, for investment in other countries, and for other countries' financial assets.

If rate of return is greater for US than Japan?

the dollar will appreciate and yen will depreciate. (supply shift to left, demand shift to right)

Demand for U.S dollars

the international demand for U.S. goods and services, for U.S. investments, and for U.S. financial assets.