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Chapter 8

Chapter #8 ECN.doc

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ECN 204
Christopher Gore

Chapter #8 Financial Institutions  The financial system: the group of institutions that helps match the saving of one person with the investment of another  Financial markets: institutions through which savers can directly provide funds to borrowers o The Bond Market: A bond is a certificate of indebtedness  A bond is an IOU  It identifies the time at which the loan will be repaid, called the date of maturity, and the rate of interest that will be paid periodically until the loan matures. The buyer of a bond gives his or her money to Intel in exchange for this promise of interest and eventual repayment of the amount borrowed (called the principal).  The buyer can hold the bond until maturity or can sell the bond at an earlier date to someone else  The first characteristic is a bond’s term —the length of time until the bond matures. Some bonds have short terms, such as a few months, while others have terms as long as 30 years. (The British government has even issued a bond that never matures, called perpetuity - bond pays interest forever, but the principal is never repaid.  Long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal. If a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk, long- term bonds usually pay higher interest rates than short-term bonds.  credit risk —the probability that the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a default  Borrowers can (and sometimes do) default on their loans by declaring bankruptcy. When bond buyers perceive that the probability of default is high, they demand a higher interest rate to compensate them for this credit risk. o The Stock Market: A stock is a claim to partial ownership in a firm  Another way for Intel to raise funds to build a new semi-conductor factory is to sell stock in the company  a claim to the profits that the firm makes  The sale of stock to raise money is called equity finance, whereas the sale of bonds is called debt finance.  The owner of shares of Intel stock is a part-owner of Intel; the owner of an Intel bond is a creditor of the corporation. If Intel is very profitable, the shareholders enjoy the benefits of these profits, whereas the bondholders get only the interest on their bonds. And if Intel runs into financial difficulty, the bondholders are paid what they are due before stockholders receive anything at all. Compared to bonds, stocks offer the holder both higher risk and potentially higher return.  The most important stock exchanges in the U.S. economy are the New York Stock Exchange, the American Stock Exchange, and NASDAQ (National Association of SecuritiesDealers Automated Quotation system).  In Canada, the Toronto Stock Exchange(TSX) is the most important.  A more speculative stock exchange that raises money for junior companies is the TSX Venture Exchange, located in Calgary.  stock index - is computed as an average of a group of stock prices. • The most famous stock index is the Dow Jones Industrial Average, which has been computed regularly since 1896. • It is now based on the prices of the stocks of 30 major competitive companies  Financial intermediaries: institutions through which savers can indirectly provide funds to borrowers o Banks  Small companies will finance their business expansion with a loan from a local bank.  A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow.  Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks’ costs and returns some profit to the owners of the banks.  They facilitate purchases of goods and services by allowing people to write cheques against their deposits. In other words, banks help create a special asset that people can use as a medium of exchange.  A medium of exchange - is an item that people can easily use to engage in transactions. Abank’s role in providing a medium of exchange distinguishes it from many other financial institutions. o Mutual funds – institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds  The shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss.  The primary advantage of mutual funds is that they allow people with small amounts of money to diversify.  people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company.  A second advantage claimed by mutual fund companies is that mutual funds give ordinary people access to the skills of professional money managers.  As a result, it is hard to “beat the market” by buying goodstocks and selling bad ones. In fact, mutual funds called index funds, which buy all the stocks in a given stock index, perform somewhat better on average than mutual funds that take advantage of active management by professional money managers. The explanation for the superior performance of index funds is that they keep costs low Saving and Investment in the National Income Accounts  Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: o Y = C + I + G + NX o In a closed economy: o Y = C + I + G
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