1. Managerial Economics1 Managerial Economics, Session 11: SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM & THE BASIC TOOLS OF FINANCE

2. Managerial Economics2 SAVING, INVESTMENT, AND THE FIN. SYSTEM The people who save are not always the same as the people who invest The financial system mediates between the two to allow investors to borrow from savers to finance their projects Financial institutions comprise financial markets and financial intermediaries The Bond Market Bonds are essentially IOUs which specify that a borrower must repay the borrowed amount at a certain date in future and pay interest on the loan at given intervals (illustration on board)

3. Managerial Economics3 SAVING, INVESTMENT, AND THE FIN. SYSTEM Coupon Bond:

4. Managerial Economics4 SAVING, INVESTMENT, AND THE FIN. SYSTEM Yield to Maturity: Price of One-Year 5 percent Coupon Bond = The value of i that solves this equation is the yield to maturity

5. Managerial Economics5 SAVING, INVESTMENT, AND THE FIN. SYSTEM Yield To Maturity: If the price of the bond is $100, then the yield to maturity equals the coupon rate Since the price rises as the yield falls, when the price is above $100, the yield to maturity must be below the coupon rate Since the price falls as the yield rises, when the price is below $100, the yield to maturity must be above the coupon rate.

6. Managerial Economics6 The Bond Market Important features of a bond include: - its rate of interest - its term to maturity - its level of credit risk (risk of default) - its tax treatment SAVING, INVESTMENT, AND THE FIN. SYSTEM

7. Managerial Economics7 The Stock Market While bonds represent debt finance, stocks represent equity financing The person or company providing the financing becomes an owner of the company who is entitled to a share of the profit of the company In contrast, a bond holder will receive the same amount of pay, irrespective of how well the company does – unless it defaults on its debt SAVING, INVESTMENT, AND THE FIN. SYSTEM

8. Managerial Economics8 Banks Financial intermediaries whose function it is to take deposits from the public and loan part of them to others who want to borrow (to invest or consume) Banks in principle live off the difference between borrowing rates and lending rates Mutual Funds Collective investment vehicles which provide diversification, access to markets unavailable to the small individual investor and professional investment management (including risk management) SAVING, INVESTMENT, AND THE FIN. SYSTEM

9. Managerial Economics9 Saving We’ve discussed that the resources necessary to produce new capital must necessarily come from a nation’s collective saving (leaving out foreign saving for the moment) Both businesses, households, and the public sector engage in saving. Saving by any economic unit = Current income less Spending on current needs SAVING, INVESTMENT, AND THE FIN. SYSTEM

10. Managerial Economics10 Wealth Increases through saving but also changes through increases or decreases in the values of real of financial assets, ie. Change in wealth = Saving + Capital gains – Capital losses Business Saving Businesses use the revenues from their sales to pay workers’ salaries and other operating costs, to pay taxes and to provide dividends to their shareholders. The funds remaining represent business saving SAVING, INVESTMENT, AND THE FIN. SYSTEM

11. Managerial Economics11 Household Saving Life-cycle saving (planning for retirement, college education for children, new homes etc) Precautionary saving (protection against sudden illness, loss of income etc.) Bequest saving (saving in order to leave to children, charity and suchlike) Government Saving Equal to budget surplus (more below) SAVING, INVESTMENT, AND THE FIN. SYSTEM

12. Managerial Economics12 SAVING IN THE NATIONAL ACCOUNTS: Identies: Y = C + I + G + NX If the economy is completely closed, NX=0. Hence Y = C + I + G Subtracting C and G from both sides: Y – C – G = I But Y- C – G is also equal to a nation’s total saving, ie its income less its spending on currrent needs, hence S = Y – C – G = I

13. Managerial Economics13 Saving in the National Income Accounts To distinguish private sector income from public sector income, we incorporate taxes paid by the private sector to the public sector and transfers made by the government to the private sector. Define T as taxes paid by the private sector less transfers payment received from the public sector (= “net taxes”). We had: Adding and subtracting T on the right side of the equation, we get:

14. Managerial Economics14 SAVING IN THE NATIONAL INCOME ACCOUNTS: We now have:

15. Managerial Economics15 THE MARKET FOR LONABLE FUNDS: Supply of loanable funds is provided by national saving Demand for loanable funds derives from private sector investment

16. Managerial Economics16 THE MARKET FOR LONABLE FUNDS: Saving Incentives:

17. Managerial Economics17 THE MARKET FOR LONABLE FUNDS: Investment Incentives:

18. Managerial Economics18 THE MARKET FOR LONABLE FUNDS: Government Deficit and Crowding Out:

19. Managerial Economics19 THE BASIC TOOLS OF FINANCE: Two elements characterise all financial decisions: Time and Risk The Time Value of Money Calculating Future Value of a given capital X=capital N=number of periods r=rate of interest This process is called compounding

20. Managerial Economics20 THE BASIC TOOLS OF FINANCE: The Time Value of Money Calculating Present Value of a given capital in received in the future: This process is called discounting

21. Managerial Economics21 THE BASIC TOOLS OF FINANCE: The higher the rate of interest, the greater the FV of a given amount invested a given period The longer the investment period, the greater the FV of a given amount invested today (if r>0) The higher the rate of interest, the smaller the PV of a given amount received in future The more distant the amount received in future, the smaller its PV (if r>0)

22. Managerial Economics22 THE BASIC TOOLS OF FINANCE: Investment Decisions: Discount future cash flow from investment project at relevant rate of interest to compute PV of cash flows Subtract required investment to get Net Present Value (NPV) of project: NPV = PV – required investment if NPV > 0, accept project Rate of interest: opportunity cost of capital = return on best available alternative investment

23. Managerial Economics23 THE BASIC TOOLS OF FINANCE: Managing Risk: risk aversion

24. Managerial Economics24 THE BASIC TOOLS OF FINANCE: Managing Risk: the market for insurance Spreading Risk Adverse Selection Moral Hazard

25. Managerial Economics25 THE BASIC TOOLS OF FINANCE: Managing Risk: diversification of portfolio

26. Managerial Economics26 THE BASIC TOOLS OF FINANCE: Managing Risk: the risk-return trade-off

27. Managerial Economics27 THE BASIC TOOLS OF FINANCE: Asset Valuation: fundamental analysis The value of stocks:

28. Managerial Economics28 THE BASIC TOOLS OF FINANCE: The Efficient Markets Hypothesis: Informational efficiency Random Walk Index Funds Market Irrationality What do you think? Are financial markets predictable?