Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 13 The Financial Markets

13-2 Chapter Objectives Market for loans Reasons for borrowing Demand and supply for loans Factors affecting interest rates Financial intermediaries Risk and return Stock market

13-3 Market for Loans Some definitions in the lending market: The lender gives the borrower a sum of money called the principal. The price of the loan is the interest rate, which defines how much the borrower has to pay the lender in exchange for the use of the money. The length of the loan is called its term.

13-4 Reasons for Borrowing Households borrow to finance purchases of goods such as cars and homes. A business typically needs to borrow to fund the expansion of the business. Ability to borrow is important for growth in the economy. –Without borrowing, fewer goods would be sold and less investment would be made by businesses.

13-5 Demand Curve for Loans The amount of borrowing by households, business, and state and local government depends on interest rates. –Federal Government borrowing is not sensitive to interest rates. In general, the willingness to borrow will fall as the interest rate rises. –This is law of demand for loans. The demand curve is downward-sloping.

13-6 How High Interest Rates Discourage Borrowing Low-rate scenario Medium-rate scenario High-rate scenario Purchase cost of land $1,000,000 Construction cost $2,000,000 Total loans needed $3,000,000 Interest rate1%5%10% Interest cost$30,000$150,000$300,000 Total cost$3,030,000$3,150,000$3,300,000 Revenues from selling homes $3,200,000 Profits$170,000$50,000-$100,000

13-7 Supply Curve Lenders make a profit when loaning money by charging an interest rate. The interest rate has to be high enough to compensate the lender, both for sacrificing the time value of money and for bearing the risk of default. –If you lend out money, there is a risk the borrower may default, or fail to pay you back. The possibility of not getting paid back on a loan is known as the risk of default.

13-8 Supply Curve –The opportunity cost of not having your money available to you is known as the time value of money. You charge interest on the loan as compensation for the fact that you don’t have that money available for other uses. As the interest rate rises, lenders are willing to supply more loans, all other things being equal. –As a result, there is an upward- sloping supply schedule for lending.

13-9 Basic Market for Loans Demand curve for loans Q r Interest rate Quantity borrowed/lent Supply curve for loans

13-10 Factors Affecting Interest Rates Besides monetary and fiscal policy, interest rates are affected by two factors: –The first factor is the strength of the economy. An expanding economy will cause the demand curve for loans to shift to the right. Because of the strength of the economy, interest rates will rise. Alternatively, during periods of economic weakness, interest rates will fall.

13-11 Impact of a Stronger Economy on the Loan Market Original demand curve for loans Q r New demand curve for loans Interest rate Q1Q1 Quantity borrowed/lent Supply curve for loans r1r1

13-12 Impact of a Weaker Economy on the Loan Market Original demand curve for loans Q r New demand curve for loans Interest rate Q1Q1 Quantity borrowed/lent Supply curve for loans r1r1

13-13 Factors Affecting Interest Rates –The second factor is the risk of default. Lenders are less willing to advance money to borrowers who are more likely to default. As a result, at the same interest rate, the quantity of loans made to high-risk borrowers is less than to safer borrowers. This is equivalent to an upward shift in the supply curve. This results in higher interest rates for high-risk borrowers.

13-14 Why High-Risk Borrowers Pay a Higher Interest Rate Demand curve for loans Q r Supply curve for loans to low-risk borrowers Interest rate Q1Q1 Quantity borrowed/lent Supply curve for loans to high-risk borrowers r1r1

13-15 Financial Intermediaries A financial intermediary is any institution or business that collects money from suppliers of capital (the depositors), and then funnels the funds out to users of capital (the businesses that borrow from the financial institution). The whole flow – from suppliers of capital, through the financial intermediary, to the users of capital – is called a bank credit channel.

13-16 Bank Credit Channel

13-17 Venture Capital Credit Channel Besides the bank credit channel, companies can borrow through the venture capital credit channel. Venture capital firms are financial intermediaries that provide funds to risky start-ups. –Most of today’s high technology firms are funded through venture capital.

13-18 Venture Capital Credit Channel

13-19 Risk and Return Risk is defined as the possibility that something unexpected, either good or bad, will happen to your investment. Return is the gain you can expect on your investment over the long run. The risk-return principle says that the only way to get consistently higher returns over the long run is to take more risks.

13-20 Different Types of Risk There are different types of risk: Default risk – also known as credit risk – is the possibility that a borrower won’t pay back the loan on time, or at all. Event risk measures the odds that a major event, such as a terrorist attack or a big earthquake, will reduce the return on the investment. Inflation risk is the danger that inflation will increase, so the lender would be paid back in dollars that are worth less.

13-21 Stock Market A share of stock in a company is a piece of ownership in that business. A stock market, as the name implies, is a market where shares of stocks are bought and sold. The price of a stock is determined by how well the company is doing. Companies can raise money by issuing new stocks. Shareholders may also receive a dividend from a stock.

13-22 Stock Market The return on a share of stock is equal to the change in the stock price, plus the dividend, divided by the original price. The key financial intermediaries in the stock market are the investment banks and stock brokers. –Initial public offerings (IPOs) are the first time a stock is sold to the public and are handled by the investment banks. –Brokers handle the buying and selling of shares between investors.

13-23 Diversification Principle Diversification means splitting your money across different investments; it is a central principle of financial economics. Diversification can help you reduce risk without reducing return. But even the best diversification cannot completely eliminate risk from the stock market.

13-24 Performance of the Stock Market

13-25 Diversity of Financial Intermediaries There are other credit channels in the economy besides the bank, venture capital, and equity credit channels. Each channel has its own set of suppliers of capital, its own financial intermediaries, and its own capital users. Multiple credit channels lead to more competition, and make it easier for businesses to raise money.

13-26 Bond Market Credit Channel A bond is a loan that entitles the lender – the bondholder – to get regular interest payments over time, and then to get back the principal at the end of the loan period. Bonds are sold in the bond market. This is the main way corporations and governments raise money. Borrowing by issuing bonds is typically cheaper than borrowing from a bank.

13-27 How a Bond Works

13-28 Government Borrowing The Federal Government borrows to fund the budget deficit. To fund the deficit and raise money, the Treasury Department sells: –Treasury bonds with terms of 10 and 30 years. –Treasury bills, which are short-term securities, that mature in less than one year.