ECON 2 Lecture 26: Chapter 26 - Notes
Chapter 26: Savings and Investments
This chapter looks at how loanable funds (money) can move from savers to borrowers
• Borrowers will be those looking to purchase capital (spending their borrowed money in I)
The market for Loanable Funds is an abstraction
• There are many markets to borrow and lend money
• However, all these markets share common features captured by our abstract market
The price paid for loanable funds is the (real) interest rate
Financial Markets
• Borrowers and lenders can negotiate directly
o If larger companies negotiate deals for financial instruments directly, this is an Over-the-
Counter trade
• Borrowers and lenders can interact through larger marketplaces with many buyers and sellers
o Stock exchanges (NYSE, NASDAQ)
o Bond markets
• Financial intermediaries can connect Lenders and Borrowers
o Banks, mutual funds
Key terms
• Bond - certificate of indebtedness
o Principal - the face value of a bond
o Rate of bond interest - the amount paid periodically until the date of maturity
• Corporate stock - a claim of ownership and thus to the profits a firm makes
• Debt finance - raising money through the sale of bonds
• Equity finance - raising money through the sale of stock
• *stocks have generally higher risk but higher average returns
Suppose given the choice between a) a bond that will default 1% of the time and b) a bond that will
default 50% of the time
• The riskier bond must pay more money --> sale of stock (50%) vs sale of bond (1%)
• If people are risk neutral, the expected payoff will be the same
10(.99) = payoff of safe loan
x(0.5) = payoff of risky loan
9.9 = 0.5x --> x = $19.8
Bond Characteristics:
1. Term - how long until the principal is paid back ("matured")
a. Longer terms are riskier because of unknown inflation and financial stability of lender
b. Assume longer term bonds have higher average payoff
2. Credit Risk - probability of default
a. Increasing probability of default means higher returns necessary to sell the bond
b. Junk bonds have very high interest rates and higher risk…
c. US government is trusted, so they pay low interest rates
3. Tax Treatment - interest earned on bonds are typically treated as taxable income
Document Summary
This chapter looks at how loanable funds (money) can move from savers to borrowers: borrowers will be those looking to purchase capital (spending their borrowed money in i) The market for loanable funds is an abstraction: there are many markets to borrow and lend money, however, all these markets share common features captured by our abstract market. The price paid for loanable funds is the (real) interest rate. Financial markets: borrowers and lenders can negotiate directly. If larger companies negotiate deals for financial instruments directly, this is an over-the- Counter trade: borrowers and lenders can interact through larger marketplaces with many buyers and sellers, stock exchanges (nyse, nasdaq, bond markets. Financial intermediaries can connect lenders and borrowers: banks, mutual funds. If people are risk neutral, the expected payoff will be the same. 10(. 99) = payoff of safe loan x(0. 5) = payoff of risky loan. Banks - take in deposits from savers (pay interest) and make loans to borrowers (charge interest)
