Transcript interest rate

Chapter 13
The Financial Markets
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Market for loans
• Reasons for borrowing
• Demand and supply for loans
• Factors affecting interest rates
• Financial intermediaries
• Risk and return
• Stock market
13-2
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
13-3
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
13-4
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
13-5
How High Interest Rates
Discourage Borrowing
Low-rate
scenario
Medium-rate
scenario
High-rate
scenario
Purchase cost
of land
$1,000,000
$1,000,000
$1,000,000
Construction
cost
$2,000,000
$2,000,000
$2,000,000
Total loans
needed
$3,000,000
$3,000,000
$3,000,000
Interest rate
1%
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
$3,200,000
$3,200,000
13-6
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
13-7
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 upwardsloping supply schedule for lending.
13-8
Basic Market for Loans
Interest rate
Supply curve for
loans
r
Demand curve for
loans
Q
Quantity borrowed/lent
13-9
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.
13-10
Impact of a Stronger
Economy on the Loan Market
Supply curve for
loans
Interest rate
r1
r
New demand
curve for loans
Original demand
curve for loans
Q
Q1
Quantity borrowed/lent
13-11
Impact of a Weaker
Economy on the Loan Market
Interest rate
Supply curve for
loans
r
r1
Original demand
curve for loans
New demand
curve for loans
Q1
Q
Quantity borrowed/lent
13-12
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.
13-13
Why High-Risk Borrowers
Pay a Higher Interest Rate
Supply curve for
loans to high-risk
borrowers
Supply curve for
loans to low-risk
borrowers
Interest rate
r1
r
Demand curve for
loans
Q1
Q
Quantity borrowed/lent
13-14
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
13-15
Bank Credit Channel
13-16
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.
13-17
Venture Capital Credit
Channel
13-18
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
13-19
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
13-20
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
13-21
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
13-22
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.
13-23
Performance of the Stock
Market
13-24
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
13-25
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
13-26
How a Bond Works
13-27
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.
13-28