investment, financial intermediation & financial markets lecture 7

INVESTMENT, FINANCIAL INTERMEDIATION

& FINANCIAL MARKETS

Lecture 7

INVESTMENTINVESTMENTINVESTMENTINVESTMENT

An action taken today that has costs An action taken today that has costs today but provides benefits in the future.today but provides benefits in the future.

• Firm building plant today incurs costs today but Firm building plant today incurs costs today but earns revenue in the futureearns revenue in the future

• Student incurs costs to attend university now for the Student incurs costs to attend university now for the sake of higher earnings in the futuresake of higher earnings in the future

• Government spends money today to build a dam to Government spends money today to build a dam to have a source of hydroelectric power in the futurehave a source of hydroelectric power in the future

An action taken today that has costs An action taken today that has costs today but provides benefits in the future.today but provides benefits in the future.

• Firm building plant today incurs costs today but Firm building plant today incurs costs today but earns revenue in the futureearns revenue in the future

• Student incurs costs to attend university now for the Student incurs costs to attend university now for the sake of higher earnings in the futuresake of higher earnings in the future

• Government spends money today to build a dam to Government spends money today to build a dam to have a source of hydroelectric power in the futurehave a source of hydroelectric power in the future

$$$$$$

NOMINAL INTEREST RATESNOMINAL INTEREST RATESNOMINAL INTEREST RATESNOMINAL INTEREST RATES

Interest rates actually charged Interest rates actually charged in the market.in the market.

REAL INTEREST RATESREAL INTEREST RATES

Nominal interest rates adjusted Nominal interest rates adjusted for inflation.for inflation.

Interest rates actually charged Interest rates actually charged in the market.in the market.

REAL INTEREST RATESREAL INTEREST RATES

Nominal interest rates adjusted Nominal interest rates adjusted for inflation.for inflation.

FINANCIAL INTERMEDIARIESFINANCIAL INTERMEDIARIESFINANCIAL INTERMEDIARIESFINANCIAL INTERMEDIARIES

Organizations that receive Organizations that receive funds from savers and channel funds from savers and channel them to investors.them to investors.

• financial institutions such as financial institutions such as banks, savings and loans, and banks, savings and loans, and insurance companiesinsurance companies

Organizations that receive Organizations that receive funds from savers and channel funds from savers and channel them to investors.them to investors.

• financial institutions such as financial institutions such as banks, savings and loans, and banks, savings and loans, and insurance companiesinsurance companies

ANIMAL SPIRITSANIMAL SPIRITSANIMAL SPIRITSANIMAL SPIRITS

John Maynard Keynes emphasized that John Maynard Keynes emphasized that sharp swings in moods of investors were sharp swings in moods of investors were often irrational and perhaps reflected our often irrational and perhaps reflected our most basic, primal instincts.most basic, primal instincts.

John Maynard Keynes emphasized that John Maynard Keynes emphasized that sharp swings in moods of investors were sharp swings in moods of investors were often irrational and perhaps reflected our often irrational and perhaps reflected our most basic, primal instincts.most basic, primal instincts.

ACCELERATOR THEORYACCELERATOR THEORYACCELERATOR THEORYACCELERATOR THEORY One theory of investment spending that One theory of investment spending that

emphasizes the role of expected growth in emphasizes the role of expected growth in real GDP on investment spending.real GDP on investment spending.

When real GDP growth is expected to be When real GDP growth is expected to be high, firms anticipate that their investments high, firms anticipate that their investments in plant and equipment will be profitable in plant and equipment will be profitable and therefore increase their total and therefore increase their total investment spending.investment spending.

One theory of investment spending that One theory of investment spending that emphasizes the role of expected growth in emphasizes the role of expected growth in real GDP on investment spending.real GDP on investment spending.

When real GDP growth is expected to be When real GDP growth is expected to be high, firms anticipate that their investments high, firms anticipate that their investments in plant and equipment will be profitable in plant and equipment will be profitable and therefore increase their total and therefore increase their total investment spending.investment spending.

PROCYCLICALPROCYCLICALPROCYCLICALPROCYCLICAL

Increases during booms and falls Increases during booms and falls during recessionsduring recessions

• Investment spending is highly Investment spending is highly procyclicalprocyclical

Increases during booms and falls Increases during booms and falls during recessionsduring recessions

• Investment spending is highly Investment spending is highly procyclicalprocyclical

210 210

200 200

190 190

180 180

170 170

89 89 90 90 91 91 92 92 93 93 94 94 95 95 89 89 90 90 91 91 92 92 93 93 94 94 95 95

350 350

400 400

450 450

500 500

550 550

Billions ofBillions of1992 dollars1992 dollars

Billions ofBillions of1990 dollars1990 dollars

YearYear YearYearNon-residential structuresNon-residential structures Producers’ durable EquipmentProducers’ durable Equipment

160 160

INVESTMENT IN STRUCTURES AND EQUIPMENT IN THEINVESTMENT IN STRUCTURES AND EQUIPMENT IN THEEARLY 1990s EARLY 1990s

Source: Data from Economic Report of the President, Washington, DC:Source: Data from Economic Report of the President, Washington, DC:U.S. Government Printing Office, yearlyU.S. Government Printing Office, yearly

MULTIPLIER-ACCELERATOR MULTIPLIER-ACCELERATOR MODELMODEL

MULTIPLIER-ACCELERATOR MULTIPLIER-ACCELERATOR MODELMODEL

• In this model a downturn in real GDP would In this model a downturn in real GDP would lead to a sharp fall in investment, which, in lead to a sharp fall in investment, which, in turn, would entail further reductions in GDP turn, would entail further reductions in GDP through the multiplier for investment through the multiplier for investment spending.spending.

• In this model a downturn in real GDP would In this model a downturn in real GDP would lead to a sharp fall in investment, which, in lead to a sharp fall in investment, which, in turn, would entail further reductions in GDP turn, would entail further reductions in GDP through the multiplier for investment through the multiplier for investment spending.spending.

BONDBONDBONDBOND

A promise to pay money in A promise to pay money in the futurethe future

A promise to pay money in A promise to pay money in the futurethe future

NOMINAL INTEREST RATES NOMINAL INTEREST RATES NOMINAL INTEREST RATES NOMINAL INTEREST RATES

• Interest rates quoted in the market at Interest rates quoted in the market at savings and loans or banks or for savings and loans or banks or for bondsbonds

• These are actual rates that These are actual rates that individuals or firms pay or receive individuals or firms pay or receive when they borrow money or lend when they borrow money or lend moneymoney

• Interest rates quoted in the market at Interest rates quoted in the market at savings and loans or banks or for savings and loans or banks or for bondsbonds

• These are actual rates that These are actual rates that individuals or firms pay or receive individuals or firms pay or receive when they borrow money or lend when they borrow money or lend moneymoney

REALITY PRINCIPLEREALITY PRINCIPLEREALITY PRINCIPLEREALITY PRINCIPLE

What matters to people is What matters to people is the real value or the real value or purchasing power of purchasing power of money or income, not its money or income, not its face value.face value.

What matters to people is What matters to people is the real value or the real value or purchasing power of purchasing power of money or income, not its money or income, not its face value.face value.

REAL RATE OF INTERESTREAL RATE OF INTERESTREAL RATE OF INTERESTREAL RATE OF INTEREST

• Nominal rate of interest minus Nominal rate of interest minus the inflation ratethe inflation rateReal rate = Nominal rate - inflation rateReal rate = Nominal rate - inflation rate

• Nominal rate of interest minus Nominal rate of interest minus the inflation ratethe inflation rateReal rate = Nominal rate - inflation rateReal rate = Nominal rate - inflation rate

EXPECTED REAL INTEREST RATEEXPECTED REAL INTEREST RATEEXPECTED REAL INTEREST RATEEXPECTED REAL INTEREST RATE The nominal rate minus the expected inflation rate.The nominal rate minus the expected inflation rate.CountryCountry 3-Month Interest3-Month Interest Inflation RateInflation Rate Expected Expected

RateRate over last 3over last 3 real rate real rate monthsmonths of interestof interest

AustraliaAustralia 8.128.12 3.33.3 4.824.82

BelgiumBelgium 5.135.13 2.42.4 2.732.73

CanadaCanada 7.867.86 4.24.2 3.663.66

DenmarkDenmark 6.956.95 2.12.1 4.854.85

FranceFrance 7.807.80 2.32.3 5.505.50

GermanyGermany 4.654.65 3.9 3.9 0.750.75

ItalyItaly 11.00 11.00 6.3 6.3 4.70 4.70

JapanJapan 1.36 1.36 -1.7-1.7 3.06 3.06

SpainSpain 9.28 9.28 7.9 7.9 1.38 1.38

United StatesUnited States 6.08 6.08 3.33.3 2.782.78

Source : The Economist, April 29, 1995, pp122-23 Source : The Economist, April 29, 1995, pp122-23

The nominal rate minus the expected inflation rate.The nominal rate minus the expected inflation rate.CountryCountry 3-Month Interest3-Month Interest Inflation RateInflation Rate Expected Expected

RateRate over last 3over last 3 real rate real rate monthsmonths of interestof interest

AustraliaAustralia 8.128.12 3.33.3 4.824.82

BelgiumBelgium 5.135.13 2.42.4 2.732.73

CanadaCanada 7.867.86 4.24.2 3.663.66

DenmarkDenmark 6.956.95 2.12.1 4.854.85

FranceFrance 7.807.80 2.32.3 5.505.50

GermanyGermany 4.654.65 3.9 3.9 0.750.75

ItalyItaly 11.00 11.00 6.3 6.3 4.70 4.70

JapanJapan 1.36 1.36 -1.7-1.7 3.06 3.06

SpainSpain 9.28 9.28 7.9 7.9 1.38 1.38

United StatesUnited States 6.08 6.08 3.33.3 2.782.78

Source : The Economist, April 29, 1995, pp122-23 Source : The Economist, April 29, 1995, pp122-23

0 0

-$100 -$100

CostCost

TYPICAL INVESTMENTTYPICAL INVESTMENT

0 0

-$100 -$100

CostCost

ReturnReturn


$104$104

0 0

-$100 -$100

CostCost

ReturnReturn


A typical investment, in which a cost of $100 incurred today yields a A typical investment, in which a cost of $100 incurred today yields a return of $104 next year.return of $104 next year.

PRINCIPLE OF PRINCIPLE OF OPPORTUNITY COSTOPPORTUNITY COST

PRINCIPLE OF PRINCIPLE OF OPPORTUNITY COSTOPPORTUNITY COST

The opportunity cost of something is what you The opportunity cost of something is what you sacrifice to get it.sacrifice to get it.

• Used to help decide whether to undertake Used to help decide whether to undertake investmentinvestment

• If the firm undertakes the investment, it must If the firm undertakes the investment, it must give up $100 today to get $104 the following give up $100 today to get $104 the following yearyear

• The interest rate provides a measure of the The interest rate provides a measure of the opportunity cost of the investmentopportunity cost of the investment

The opportunity cost of something is what you The opportunity cost of something is what you sacrifice to get it.sacrifice to get it.

• Used to help decide whether to undertake Used to help decide whether to undertake investmentinvestment

• If the firm undertakes the investment, it must If the firm undertakes the investment, it must give up $100 today to get $104 the following give up $100 today to get $104 the following yearyear

• The interest rate provides a measure of the The interest rate provides a measure of the opportunity cost of the investmentopportunity cost of the investment

INTEREST RATES AND INVESTMENTINTEREST RATES AND INVESTMENT

Re

al R

ate

of

Inte

res

tR

ea

l Ra

te o

f In

tere

st

Investment SpendingInvestment Spending

As the real interest rate declines, investment spending in theAs the real interest rate declines, investment spending in theeconomy increases.economy increases.

REAL INVESTMENT SPENDINGREAL INVESTMENT SPENDINGREAL INVESTMENT SPENDINGREAL INVESTMENT SPENDING• Inversely related to the real interest rateInversely related to the real interest rate

• Nominal interest rates are not necessarily a Nominal interest rates are not necessarily a good indicator of the true cost of investinggood indicator of the true cost of investing

• Inflation would increase the nominal rate of Inflation would increase the nominal rate of return and nominal interest rate equallyreturn and nominal interest rate equally

• A firm makes its investment decisions by A firm makes its investment decisions by comparing its expected real net return from comparing its expected real net return from investment projects to the real rate of investment projects to the real rate of interestinterest

• Inversely related to the real interest rateInversely related to the real interest rate

• Nominal interest rates are not necessarily a Nominal interest rates are not necessarily a good indicator of the true cost of investinggood indicator of the true cost of investing

• Inflation would increase the nominal rate of Inflation would increase the nominal rate of return and nominal interest rate equallyreturn and nominal interest rate equally

• A firm makes its investment decisions by A firm makes its investment decisions by comparing its expected real net return from comparing its expected real net return from investment projects to the real rate of investment projects to the real rate of interestinterest

NEOCLASSICAL THEORY NEOCLASSICAL THEORY OF INVESTMENTOF INVESTMENT

NEOCLASSICAL THEORY NEOCLASSICAL THEORY OF INVESTMENTOF INVESTMENT

• Pioneered by Dale Jorgenson of HarvardPioneered by Dale Jorgenson of Harvard

• Real interest rates and taxes play a key Real interest rates and taxes play a key role in determining investment spendingrole in determining investment spending

• Jorgenson used his theory to analyze the Jorgenson used his theory to analyze the responsiveness of investment to a variety responsiveness of investment to a variety of tax incentives, including investment tax of tax incentives, including investment tax credits that are subsidies to investmentcredits that are subsidies to investment

• Pioneered by Dale Jorgenson of HarvardPioneered by Dale Jorgenson of Harvard

• Real interest rates and taxes play a key Real interest rates and taxes play a key role in determining investment spendingrole in determining investment spending

• Jorgenson used his theory to analyze the Jorgenson used his theory to analyze the responsiveness of investment to a variety responsiveness of investment to a variety of tax incentives, including investment tax of tax incentives, including investment tax credits that are subsidies to investmentcredits that are subsidies to investment

Q-THEORY OF INVESTMENTQ-THEORY OF INVESTMENTQ-THEORY OF INVESTMENTQ-THEORY OF INVESTMENT• Originally developed by Nobel laureate, James Originally developed by Nobel laureate, James

Tobin of Yale UniversityTobin of Yale University• Theory states that investment spending increases Theory states that investment spending increases

when stock prices are highwhen stock prices are high• If stock prices are high, it can issue new shares of If stock prices are high, it can issue new shares of

its stock at an advantageous price and use the its stock at an advantageous price and use the proceeds to undertake new investmentproceeds to undertake new investment

• Recent research has shown a close connection Recent research has shown a close connection between Q-theory and neoclassical theory and between Q-theory and neoclassical theory and highlighted the key role that real interest rates and highlighted the key role that real interest rates and taxes play in the Q-theory as welltaxes play in the Q-theory as well

• Originally developed by Nobel laureate, James Originally developed by Nobel laureate, James Tobin of Yale UniversityTobin of Yale University

• Theory states that investment spending increases Theory states that investment spending increases when stock prices are highwhen stock prices are high

• If stock prices are high, it can issue new shares of If stock prices are high, it can issue new shares of its stock at an advantageous price and use the its stock at an advantageous price and use the proceeds to undertake new investmentproceeds to undertake new investment

• Recent research has shown a close connection Recent research has shown a close connection between Q-theory and neoclassical theory and between Q-theory and neoclassical theory and highlighted the key role that real interest rates and highlighted the key role that real interest rates and taxes play in the Q-theory as welltaxes play in the Q-theory as well

SOURCE OF INVESTMENT SOURCE OF INVESTMENT SPENDINGSPENDING

SOURCE OF INVESTMENT SOURCE OF INVESTMENT SPENDINGSPENDING

• Investment spending in an economy Investment spending in an economy must ultimately come from savingsmust ultimately come from savings

• When households earn income, they When households earn income, they consume part and save the restconsume part and save the rest

• These savings become the source of These savings become the source of funds for investment in the economyfunds for investment in the economy

• Investment spending in an economy Investment spending in an economy must ultimately come from savingsmust ultimately come from savings

• When households earn income, they When households earn income, they consume part and save the restconsume part and save the rest

• These savings become the source of These savings become the source of funds for investment in the economyfunds for investment in the economy

LIQUIDITYLIQUIDITYLIQUIDITYLIQUIDITY

• Households want savings to be Households want savings to be readily accessible in case of readily accessible in case of emergenciesemergencies

• Funds deposited in a bank account Funds deposited in a bank account provide a source of liquidity for provide a source of liquidity for households, since these funds can households, since these funds can be obtained at anytimebe obtained at anytime

• Households want savings to be Households want savings to be readily accessible in case of readily accessible in case of emergenciesemergencies

• Funds deposited in a bank account Funds deposited in a bank account provide a source of liquidity for provide a source of liquidity for households, since these funds can households, since these funds can be obtained at anytimebe obtained at anytime

SAVERS AND INVESTORSSAVERS AND INVESTORS

SaversSavers


SaversSaverswho face riskwho face risk

RiskRiskLoss of LiquidityLoss of Liquidity

costs of negotiationcosts of negotiation


SaversSaverswho face riskwho face risk



DemandDemandHigh InterestHigh Interest

RatesRates


SaversSaverswho face riskwho face risk InvestorsInvestors



DemandDemandHigh InterestHigh InterestRates fromRates from

FINANCIAL INTERMEDIARIESFINANCIAL INTERMEDIARIESFINANCIAL INTERMEDIARIESFINANCIAL INTERMEDIARIES• Institutions such as banks, savings and loans, Institutions such as banks, savings and loans,

insurance companies, money market mutual insurance companies, money market mutual funds, and many other financial institutionsfunds, and many other financial institutions

• Accept funds from savers and make loans to Accept funds from savers and make loans to businesses and individualsbusinesses and individuals

• Pool funds of savers, reducing costs of Pool funds of savers, reducing costs of negotiationnegotiation

• Acquire expertise in evaluating and monitoring Acquire expertise in evaluating and monitoring investmentsinvestments

• Some financial intermediaries, such as banks, Some financial intermediaries, such as banks, provide liquidity to householdsprovide liquidity to households

• Institutions such as banks, savings and loans, Institutions such as banks, savings and loans, insurance companies, money market mutual insurance companies, money market mutual funds, and many other financial institutionsfunds, and many other financial institutions

• Accept funds from savers and make loans to Accept funds from savers and make loans to businesses and individualsbusinesses and individuals

• Pool funds of savers, reducing costs of Pool funds of savers, reducing costs of negotiationnegotiation

• Acquire expertise in evaluating and monitoring Acquire expertise in evaluating and monitoring investmentsinvestments

• Some financial intermediaries, such as banks, Some financial intermediaries, such as banks, provide liquidity to householdsprovide liquidity to households

DIVERSIFICATIONDIVERSIFICATIONDIVERSIFICATIONDIVERSIFICATION

• Investing in a large number of Investing in a large number of projects whose returns, although projects whose returns, although uncertain, are independent of one uncertain, are independent of one another another

• How financial intermediaries reduce How financial intermediaries reduce riskrisk

• Investing in a large number of Investing in a large number of projects whose returns, although projects whose returns, although uncertain, are independent of one uncertain, are independent of one another another

• How financial intermediaries reduce How financial intermediaries reduce riskrisk

SaversSavers InvestorsInvestors

Financial IntermediariesFinancial Intermediaries



BankBank

FinancialFinancialIntermediaryIntermediary

banksbankssavings and loanssavings and loans

insurance companiesinsurance companies



BankBankmakemake

deposits todeposits to






BankBankmakemake

deposits todeposits tomakemake

loans toloans to




FINANCIAL INTERMEDIATION MALFUNCTIONSFINANCIAL INTERMEDIATION MALFUNCTIONSFINANCIAL INTERMEDIATION MALFUNCTIONSFINANCIAL INTERMEDIATION MALFUNCTIONS

• Financial intermediation failures occurred for Financial intermediation failures occurred for banks in the USA during the Great Depression banks in the USA during the Great Depression and for savings and loans during the savings and and for savings and loans during the savings and loan crises of the 1980sloan crises of the 1980s

• During the 1930s worried depositors and rumors During the 1930s worried depositors and rumors triggered runs on bankstriggered runs on banks

• Since banks, as financial intermediaries, never Since banks, as financial intermediaries, never keep 100% of funds on hand, the runs closed keep 100% of funds on hand, the runs closed down thousands of healthy banksdown thousands of healthy banks

• To prevent this from happening again, the U.S. To prevent this from happening again, the U.S. government began to provide deposit insurance government began to provide deposit insurance for banks and savings and loansfor banks and savings and loans

• Financial intermediation failures occurred for Financial intermediation failures occurred for banks in the USA during the Great Depression banks in the USA during the Great Depression and for savings and loans during the savings and and for savings and loans during the savings and loan crises of the 1980sloan crises of the 1980s

• During the 1930s worried depositors and rumors During the 1930s worried depositors and rumors triggered runs on bankstriggered runs on banks

• Since banks, as financial intermediaries, never Since banks, as financial intermediaries, never keep 100% of funds on hand, the runs closed keep 100% of funds on hand, the runs closed down thousands of healthy banksdown thousands of healthy banks

• To prevent this from happening again, the U.S. To prevent this from happening again, the U.S. government began to provide deposit insurance government began to provide deposit insurance for banks and savings and loansfor banks and savings and loans

FINANCIAL INTERMEDIATION FINANCIAL INTERMEDIATION MALFUNCTIONSMALFUNCTIONS

FINANCIAL INTERMEDIATION FINANCIAL INTERMEDIATION MALFUNCTIONSMALFUNCTIONS

• Deposit insurance indirectly helped create Deposit insurance indirectly helped create savings and loan crisis during the 1980ssavings and loan crisis during the 1980s

• The government tried to assist the The government tried to assist the (struggling) saving and loan industry by (struggling) saving and loan industry by reducing regulationsreducing regulations

• Many investment projects collapsed and the Many investment projects collapsed and the government was forced to bail out many government was forced to bail out many savings and loans at a cost of nearly $100 savings and loans at a cost of nearly $100 billion to the U.S. economybillion to the U.S. economy

• Deposit insurance indirectly helped create Deposit insurance indirectly helped create savings and loan crisis during the 1980ssavings and loan crisis during the 1980s

• The government tried to assist the The government tried to assist the (struggling) saving and loan industry by (struggling) saving and loan industry by reducing regulationsreducing regulations

• Many investment projects collapsed and the Many investment projects collapsed and the government was forced to bail out many government was forced to bail out many savings and loans at a cost of nearly $100 savings and loans at a cost of nearly $100 billion to the U.S. economybillion to the U.S. economy

Financial MarketsFinancial MarketsFinancial MarketsFinancial Markets

• Financial markets are financial institutions Financial markets are financial institutions through which savers can directly provide through which savers can directly provide funds to borrowers. In financial markets, funds to borrowers. In financial markets, there is no “middle man”. The two most there is no “middle man”. The two most important financial markets in the economy important financial markets in the economy are bond and stock markets. are bond and stock markets.

• Financial markets are financial institutions Financial markets are financial institutions through which savers can directly provide through which savers can directly provide funds to borrowers. In financial markets, funds to borrowers. In financial markets, there is no “middle man”. The two most there is no “middle man”. The two most important financial markets in the economy important financial markets in the economy are bond and stock markets. are bond and stock markets.

Bond Market - 1Bond Market - 1Bond Market - 1Bond Market - 1

• Bonds are nothing more than an IOU. All Bonds are nothing more than an IOU. All bonds contain specific information about bonds contain specific information about how much is being borrowed (the how much is being borrowed (the principal), when the bond must be repaid principal), when the bond must be repaid (the maturity date), and the rate of (the maturity date), and the rate of interest that must be paid periodically interest that must be paid periodically until the bond is repaid.until the bond is repaid.

• Bonds are nothing more than an IOU. All Bonds are nothing more than an IOU. All bonds contain specific information about bonds contain specific information about how much is being borrowed (the how much is being borrowed (the principal), when the bond must be repaid principal), when the bond must be repaid (the maturity date), and the rate of (the maturity date), and the rate of interest that must be paid periodically interest that must be paid periodically until the bond is repaid.until the bond is repaid.


• Bonds are issued by companies, as Bonds are issued by companies, as well as the federal, state and local well as the federal, state and local governments, to raise money. When governments, to raise money. When a company or government issues a a company or government issues a bond, they are borrowing money. bond, they are borrowing money. When a person buys a bond, and When a person buys a bond, and becomes a bondholder, that person becomes a bondholder, that person is the lender (or creditor).is the lender (or creditor).

• Bonds are issued by companies, as Bonds are issued by companies, as well as the federal, state and local well as the federal, state and local governments, to raise money. When governments, to raise money. When a company or government issues a a company or government issues a bond, they are borrowing money. bond, they are borrowing money. When a person buys a bond, and When a person buys a bond, and becomes a bondholder, that person becomes a bondholder, that person is the lender (or creditor).is the lender (or creditor).


• Bonds are traded in markets where the Bonds are traded in markets where the interaction of the demand and supply for each interaction of the demand and supply for each type of bond determines that bonds price. There type of bond determines that bonds price. There are three important characteristics that affect the are three important characteristics that affect the value of all bonds: value of all bonds: – the term (how long until the bond is due?);the term (how long until the bond is due?);– the credit risk (what is the probability that the firm the credit risk (what is the probability that the firm

borrowing money will default?); andborrowing money will default?); and– the tax treatment (is the interest paid on the bond the tax treatment (is the interest paid on the bond

taxable by the federal government?). taxable by the federal government?).

• Bonds are traded in markets where the Bonds are traded in markets where the interaction of the demand and supply for each interaction of the demand and supply for each type of bond determines that bonds price. There type of bond determines that bonds price. There are three important characteristics that affect the are three important characteristics that affect the value of all bonds: value of all bonds: – the term (how long until the bond is due?);the term (how long until the bond is due?);– the credit risk (what is the probability that the firm the credit risk (what is the probability that the firm

borrowing money will default?); andborrowing money will default?); and– the tax treatment (is the interest paid on the bond the tax treatment (is the interest paid on the bond

taxable by the federal government?). taxable by the federal government?).


• Each of these three characteristics Each of these three characteristics determine the riskiness and profitability of determine the riskiness and profitability of buying and holding a bond, and therefore buying and holding a bond, and therefore affect the demand for the bond. As bonds affect the demand for the bond. As bonds become more risky, the demand for the become more risky, the demand for the bond falls, and the bond issuer must offer bond falls, and the bond issuer must offer to pay a higher interest rate to persuade to pay a higher interest rate to persuade people to purchase the bond.people to purchase the bond.

• Each of these three characteristics Each of these three characteristics determine the riskiness and profitability of determine the riskiness and profitability of buying and holding a bond, and therefore buying and holding a bond, and therefore affect the demand for the bond. As bonds affect the demand for the bond. As bonds become more risky, the demand for the become more risky, the demand for the bond falls, and the bond issuer must offer bond falls, and the bond issuer must offer to pay a higher interest rate to persuade to pay a higher interest rate to persuade people to purchase the bond.people to purchase the bond.


• As bonds become more profitable,As bonds become more profitable,the demand for the bond rises. the demand for the bond rises. Because of this, tax free municipal Because of this, tax free municipal bonds pay low rates of interest.bonds pay low rates of interest.

• As bonds become more profitable,As bonds become more profitable,the demand for the bond rises. the demand for the bond rises. Because of this, tax free municipal Because of this, tax free municipal bonds pay low rates of interest.bonds pay low rates of interest.

Stock Markets - 1Stock Markets - 1Stock Markets - 1Stock Markets - 1

• Issuing stock is another way for Issuing stock is another way for firms to raise money (the firms to raise money (the government cannot issue stock). government cannot issue stock). Whoever buys a firm’s stock Whoever buys a firm’s stock becomes a part owner of that firm.becomes a part owner of that firm.

• Issuing stock is another way for Issuing stock is another way for firms to raise money (the firms to raise money (the government cannot issue stock). government cannot issue stock). Whoever buys a firm’s stock Whoever buys a firm’s stock becomes a part owner of that firm.becomes a part owner of that firm.


• The money received by a firm from The money received by a firm from issuing stock never needs to be repaid issuing stock never needs to be repaid (so stockholders are NOT creditors). Like (so stockholders are NOT creditors). Like bonds, stock prices are determined in bonds, stock prices are determined in markets by the interaction of the demand markets by the interaction of the demand and supply for each individual stock. and supply for each individual stock.

• The money received by a firm from The money received by a firm from issuing stock never needs to be repaid issuing stock never needs to be repaid (so stockholders are NOT creditors). Like (so stockholders are NOT creditors). Like bonds, stock prices are determined in bonds, stock prices are determined in markets by the interaction of the demand markets by the interaction of the demand and supply for each individual stock. and supply for each individual stock.


• Stock prices reflect people’s Stock prices reflect people’s expectations about the firm’s future expectations about the firm’s future profitability. When firms are expected profitability. When firms are expected to be profitable, demand will be high, to be profitable, demand will be high, and the stock price will rise. When and the stock price will rise. When firms are expected to lose money, firms are expected to lose money, demand will below, and the stock demand will below, and the stock price will fallprice will fall..

• Stock prices reflect people’s Stock prices reflect people’s expectations about the firm’s future expectations about the firm’s future profitability. When firms are expected profitability. When firms are expected to be profitable, demand will be high, to be profitable, demand will be high, and the stock price will rise. When and the stock price will rise. When firms are expected to lose money, firms are expected to lose money, demand will below, and the stock demand will below, and the stock price will fallprice will fall..

investment, financial intermediation & financial markets lecture 7

Documents

theory of investment

total investment spending

rates nominal

expected inflation rate

real value

real gdp growth

inflation ratereal rate

actual rates