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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-3 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-4 Types of Financial Institutions –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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-5 Types of Financial Institutions 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?

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-6 Types of Financial Institutions 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-7 Types of Financial Institutions –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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-8 Types of Financial Institutions –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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-9 Types of Financial Institutions

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-10 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-11 Banking Services Offered by Financial Institutions

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-12 Banking Services Offered by Financial Institutions You can often access your account balance by calling an automated phone service or online Electronic checking reduces fraud by clearing checks immediately

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-13 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-14 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-15 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-16 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-17 Financial Planning Online: Internet Banking Go to: 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.

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-18 Financial Planning Online: Financial Institutions That Can Serve Your Needs Go to: nomy/finance_and_investment/banking/ nomy/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.

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-19 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-20 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-21 Financial Planning Online: Current Interest Rate Quotations Go to: This Web site provides updated quotations on key interest rates and charts showing recent movements in these rates.

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-22 Interest Rates on Deposits and Loans

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-23 Interest Rates on Deposits and Loans

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-24 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-25 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-26 Term Structure of Interest Rates Exhibit 5.4: Annualized Deposit Rates Offered on Deposits with Various Maturities

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-27 Term Structure of Interest Rates Exhibit 5.5: Comparison of Interest Rates among Deposits

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-28 Term Structure of Interest Rates 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-29 Term Structure of Interest Rates Exhibit 5.6: Treasury Security Yields

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-30 Financial Planning Online: Updated Treasury Yields Go to: Click on: U.S. Treasuries This Web site provides yields of Treasury securities with various maturities.

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-31 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?

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-32 Integrating the Key Concepts

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-33 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-34 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-35 How the Risk-Free Interest Rate Is Determined Exhibit 5A.1: How an Equilibrium Interest Rate Is Determined

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-36 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-37 Why Interest Rates Change Exhibit 5A.2 Impact of an Inward Shift in the Supply Schedule

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-38 Why Interest Rates Change 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

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-39 Why Interest Rates Change Exhibit 5.A3: Impact of an Outward Shift in the Demand Schedule

Copyright ©2004 Pearson Education, Inc. All rights reserved.5-40 Financial Planning Online: Fed’s Upcoming Meetings Go to: This Web site provides updated information about the Fed’s recent actions and upcoming meetings.