chapter 9 atw108 usm tutorial

8/7/2019 Chapter 9 ATW108 USM Tutorial

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Chapter 9The Financial System, Money, and Prices


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Financial Intermediaries

Firms that extended credit to borrowers using

funds raised from savers

Why we need Financial Intermediaries?

Specialization

Safe Earn Returns

Payment Mediator


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Your Savings flow in Firm

A is cash flow in

B is working capital

C is profit

D is interest rate, dividend, cash, and other costs

E is retained earnings


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Risk Ladder


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Bonds

A legal Promise to repay a debt

The repayment is divided into two parts:

Principal Amount

Coupon Payment

Bond Owners are not require to hold their

Bonds until maturation date (The date at

which the principal will be repaid).

The Market Value of particular bond at any

given point in time is the Bond Price


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Problems 1

Understanding bond prices: The principal amount is $1000, the term is three years, the coupon

rate is 6%, and the coupon payment is $60.

At the end of the second year, the only remaining payment is the final

$1060 to be paid in one year. If the interest rate is 3%, the value of

$1060 one year from today is $1060/1.03 = $1029. If the interest rate

is 8%, the value of the bond today is $1060/1.08 = $981. And if the

interest rate is 10%, the value of the bond today is $1060/1.10 = $964.

One possible reason is that bad news arrives about Amalgamated

Corporation, leading financial investors to fear that the firm might go

bankrupt and not pay off its debt in one year. If there is some chance

that the final payment of $1060 will not be made, financial investors

will not be willing to pay $1000 for the bond, as they know they can

earn 6% without risk by holding the debt of the government or very

stable companies.


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Problems 3

A. When interest rates of newly issued government bonds

rise, both bond and stock prices fall. The reason is that

the value of one dollar in the future is now lower than it

was at the original interest rate, so investors are only

willing to purchase existing stocks and bonds if theirprices fall.

B. First, recall the Fisher effect: the nominal interest rate

equals the real interest rate plus the inflation rate. Thus,

for a given real interest rate, a lower inflation implieslower nominal interest rates. The lower nominal interest

rate increases the value of one dollar in the future, so

investors are willing to purchase existing stocks and

bonds at higher prices.


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Problems 3

C. Increased risk premium lowers the stock price because the value ofone dollar received in the future has fallen. There are two

possibilities for bond prices. First, its possible that the bond price

will be unaffected if investors view events in the stock market as

having no effect on the rest of the economy. Second, the bond price

could rise; investors become worried by the stock market swings andare willing to accept lower-than-safe interest rates just to keep their

principle safe. This is sometimes called a flight to quality.

D. The development of a new drug will probably make the firm more

profitable after the drug is introduced five years from now. This will

probably translate into increased future dividends, and an increasein dividends raises the current stock price.

E. If financial investors previously expected the company to pay a

dividend, this news will reduce the stock price.

F. Price controls will probably reduce future profits and dividends and

therefore this lowers the current stock price.


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Stocks

A claim to partial ownership of a firm

The Difference between the required rate of

return to hold risky assets and the rate of

return on safe assets is called Risk Premium

(Rm-Rf)

Benefits from Stocks

Capital Gains: The Difference between Today Stock

prices and Yesterday Stock Prices

Dividend: A regular payment received by

stockholders for each share that they own


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Money and its Uses Money has three principle

uses: a medium of exchange,unit of account, and store of

value

Medium of Exchange: an asset

used in purchasing products

Unit of Account: a basic

measure of economic value

Store of Value: an asset that

serves as a means of holding wealth

If there is no

Money? Barter!

Unit of account

Store of value


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Measuring Money

M1: sum of currency outstanding and

balances held in checking accounts

M2: All the assets in M1 plus some additional

assets that are usable in making payments but

at greater cost or inconvenience than currency

M3: All the assets in M2 plus certificate of

dollars, foreign deposit, and repurchase

agreement


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Creation of Money Bank Reserves: cash or similar assets held by

commercial banks for the purpose of meetingdepositor withdrawals and payments

Reserve-Deposit Ratio: Bank Reserves divided

by deposito Bank Deposits:

Note that not all money is in bank, but youkeep it as currency. So, how to calculate the

money supply?

ratiodepositerveDesiredres

servesBank

Re


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Problems 7

Deposits equal bank reserves/(desired reserve/deposit ratio) =

100/0.25 = 400. The money supply equals currency held by the public

+ deposits = 200 + 400 = 600.

Let X = currency held by the public = bank reserves. Then the money

supply equals X + X/(reserve/deposit ratio); substituting what we

know from the problem,

500 = X + X/0.25

500 = 5X

X = 100

Thus currency and bank reserves both equal 100. Since the money supply equals 1250 and the public holds 250 in

currency, bank deposits must equal 1000. If bank reserves are 100,

the desired reserve/deposit ratio equals 100/1000 = 0.10.

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