Financial Markets Chapter 31 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Financial Intermediaries By reducing search and information costs, financial intermediaries facilitate raising funds They reduce the cost to borrowers of locating loanable funds They reduce the cost to savers of finding suitable lending or investment opportunities

The Supply of Loanable Funds The supply of loanable funds comes from savings Savings decisions are influenced by Time preferences: In deciding to save, people effectively reallocate spending over time Interest rates: Higher interest rates increase the quantity of available savings (loanable funds)

Risk Premiums Lenders want to be compensated for any above-average risks they take Risk premium: The difference in rates of return on risky (uncertain) and safe (certain) investments

Time Value of Money Present discounted value (PDV): The value today of future payments, adjusted for interest accrual where N refers to the number of years in the future a payment is to be made

Time Value of Money The PDV of a future payment declines with: Higher interest rates Longer delays in future payments (higher N)

Expected Value Expected value: The probable value of a future payment, including the risk of nonpayment

The Demand for Loanable Funds How much loanable funds are demanded depends on: The expected rate of return The cost of funds The higher the expected return, or the lower the cost, the greater demand will be

Shared Ownership Corporate stock: Shares of ownership in a corporation Each share of corporate stock represents partial ownership of the business Shareholders select a board of directors to monitor corporate activity and protect their interests

Stock Returns Dividend: Amount of corporate profits paid out for each share of stock An increase in the value of a stock represents a capital gain for shareholders Capital gain: An increase in the market value of an asset

Total Return There are two motivations for buying and holding stocks: The expectation of dividends The anticipation of capital gains The higher the expected return, the greater the desire to buy and hold stocks

Worsening Expectations Initial demand for stock Initial supply of stock New supply of stock Price A B New demand for stock Quantity of Stock (shares per day)

Bond Trading Once a bond has been issued, the initial lenders can sell their bonds to someone else Liquidity is an important consideration for prospective bondholders Liquidity: The ability to convert an asset into cash

Financial Markets End of Chapter 31 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.