copyright ©2004 pearson education, inc. all rights reserved. chapter 5 banking and interest rates

Copyright ©2004 Pearson Education, Inc. All rights reserved.

Chapter 5

Banking and Interest Rates

Copyright ©2004 Pearson Education, Inc. All rights reserved. 5-2

Chapter Objectives

• Describe the functions of financial institutions

• Identify the components of interest rates

• Clarify the relationship between the maturity and interest rate of an investment


Types of Financial Institutions

• Depository institutions: Financial institutions that accept deposits from individuals and provide loans– Commercial banks: financial institutions

that accept deposits and use the funds to provide commercial and personal loans

• Deposits insured by Federal Deposit Insurance Corporation (FDIC) up to $100,000 per depositor



– Savings institutions (or thrift institutions): financial institutions that accept deposits and provide mortgage and personal loans to individuals

– Credit unions: nonprofit depository institutions that serve members who have a common affiliation



• Focus on Ethics: Special Rates on Deposits– Check the fine print before making any

deposit

– Ask important questions • How long is an advertised rate good for?

• What will it be lowered to?

• How long must your maintain the deposit?



• Nondepository institutions: financial institutions that do not offer federally insured deposit accounts, but provide various other financial services– Finance companies: nondepository

institutions that specialize in providing personal loans



– Securities firms: nondepository institutions that facilitate the purchase or sale of securities by providing investment banking and brokerage services

– Insurance companies: nondepository institutions that provide insurance to protect individuals or firms against possible

adverse events



– Investment companies: nondepository institutions that sell shares to individuals and use the proceeds to invest in securities to create mutual funds

• Financial conglomerates: financial institutions that offer a diverse set of financial services to individuals or firms– Examples include Bank of America, Merrill

Lynch, and Citigroup


Banking Services Offered by Financial Institutions

• Checking services– Checking accounts allow you to draw on

funds by writing checks

– Monitor your account balance by recording checks as you write them

• Banks charge fees for bounced checks

– You should reconcile your account balance with your monthly statement



• You can often access your account balance by calling an automated phone service or online

• Electronic checking reduces fraud by clearing checks immediately


Banking Services Offered by Financial Institutions• Credit card financing such as Visa

and Mastercard

• Debit card: a card that is used to make purchases that are charged against an existing checking account

• Safety deposit box: a box at a financial institution where a customer stores valuables such as documents or jewelry


Additional Services Financial Institutions Offer

• Automated teller machines (ATMs): machines where individuals can deposit

and withdraw funds any time of the day

• Money order: a check that is written on behalf of a person and will be charged against a nonfinancial institution’s account


Additional Services Financial Institutions Offer• Traveler’s check: a check that is written

on behalf of an individual and will be charged against a large well-known financial institution or credit card sponsor’s account

• Cashier’s check: a check that is written on behalf of a person to a specific payee and will be charged against a financial institution’s account


Selecting a Financial Institution

• Convenience– Close to where you live or work, convenient

ATM locations, Internet banking

• Deposit rates and insurance– Comparison shop for best interest rates

• Fees– Comparison shop for best fees on the

services you need


Financial Planning Online:Internet Banking

• Go to: http://www.chicagofed.org

• Click on: Project Money $mart, then “What You Should Know About Internet Banking”

• This Web site provides information that can help you decide whether an Internet bank suits your needs.

http://www.chicagofed.org/




Financial Planning Online: Financial Institutions That Can Serve Your Needs

• Go to: http://dir.yahoo.com/business_and_economy/finance_and_investment/banking/

• This Web site provides information about individual financial institutions such as the services they offer and the interest rates they pay on deposits or charge on loans.

http://dir.yahoo.com/business_and_economy/finance_and_investment/banking/

http://dir.yahoo.com/business_and_economy/finance_and_investment/banking/


Interest Rates on Deposits and Loans• Interest rates on deposits and loans affect

your cash inflows and outflows

• Certificate of deposit: an instrument that is issued by a depository institution and specifies a minimum investment, an interest rate, and a maturity

• Risk-free rate: a return on an investment that is guaranteed for a specified period


Interest Rates on Deposits and Loans• Risk premium: an additional return beyond

the risk-free rate that can be earned from a deposit guaranteed by the government

• Loan rate — financial institutions loan money at a rate higher than they pay depositors– Individuals with a poor credit history pay higher

rates


Financial Planning Online:Current Interest Rate Quotations

• Go to: http://www.bloomberg.com/markets/rates.html

• This Web site provides updated quotations on key interest rates and charts showing recent movements in these rates.

http://www.bloomberg.com/markets/rates.html




Interest Rates on Deposits and Loans


Interest Rates on Deposits and Loans• Impact of changes in interest rates

– Rising interest rates increase the amount of interest paid on deposits but also increases the amount of interest charged on loans

• Comparing interest rates and banks– Choice is dependent on your risk tolerance

and your financial situation


Term Structure of Interest Rates

• Term structure of interest rates: the relationship between the maturities of risk-free debt securities and the annualized yields offered on those securities– Often based on rates of return offered by

U.S. Treasury securities with different maturities



Exhibit 5.4: Annualized Deposit Rates Offered on Deposits with Various Maturities



Exhibit 5.5: Comparison of Interest Rates among Deposits



• Shifts in the yield curve

– Graphs such as the one on the previous slide can be found in financial publications such as the Wall Street Journal and illustrate how returns change over time



Exhibit 5.6: Treasury Security Yields


Financial Planning Online:Updated Treasury Yields

• Go to: http://www.bloomberg.com

• Click on: U.S. Treasuries

• This Web site provides yields of Treasury securities with various maturities.

http://www.bloomberg.com/




How Banking Services Fit within Your Financial Plan

• The key banking decisions for your financial plan are:

– What banking service characteristics are most important to you?

– What financial institution provides the best banking service characteristic for you?


Integrating the Key Concepts


Integrating the Key Concepts

• Part 1: Financial Planning Tools

• Part 2: Liquidity Management

– In Chapter 5 we learned about banking and interest rates

– Chapter 6 teaches about managing your money

– Chapter 7 teaches about managing your credit

• Part 3: Financing

• Part 4: Protecting Your Wealth

• Part 5: Investing

• Part 6: Retirement and Estate Planning


How the Risk-Free Interest Rate Is Determined • Determined by total supply of funds

provided by all investors and the total demand for funds by all borrowers

• Interest rate represents cost of debt to borrowers and reward for providing credit to creditors

• Intersection between supply curve and demand curve results in equilibrium rate


How the Risk-Free Interest Rate Is Determined

Exhibit 5A.1: How an Equilibrium Interest Rate Is Determined


Why Interest Rates Change

• Shift in the supply curve– Increase in saving causes supply curve to shift

outward, lowering equilibrium interest rate

– Shift in monetary policy: the actions taken by the Federal Reserve to control the money supply

• Money supply: demand deposits and currency held by the public

• Open market operations: the Fed’s buying and selling of Treasury securities



Exhibit 5A.2 Impact of an Inward Shift in the Supply Schedule



• Shift in the demand curve– Any factors that cause a change in the demand

for funds

– Shift in the government demand for funds

– Shift in the business demand for funds

– Shift in the household demand for funds

• Combining the factors — changes often occur as the result of a combination of factors



Exhibit 5.A3: Impact of an Outward Shift in the Demand Schedule


Financial Planning Online:Fed’s Upcoming Meetings

• Go to: http://www.bloomberg.com/bbn/fedwatch.html

• This Web site provides updated information about the Fed’s recent actions and upcoming meetings.

http://www.bloomberg.com/bbn/fedwatch.html







copyright ©2004 pearson education, inc. all rights reserved. chapter 5 banking and interest rates

Documents

thrift institutions

pearson education

investment slide

personal loans slide

citigroup slide

depositor slide

banking services

common affiliation slide