Transcript PPT

Investment and
Financial Markets
PREPARED BY:
FERNANDO QUIJANO, YVONN QUIJANO,
KYLE THIEL & APARNA SUBRAMANIAN
© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez
chapter
1 How do fluctuations in energy prices affect investment decisions by firms?
Energy Price Uncertainty Reduces Investment Spending
2 How can understanding the concept of present value help a lucky lottery winner?
Options for a Lottery Winner
3 Why are there different types of interest rates in the economy?
Interest Rates Vary by Risk and Length of Loan
4 How does the government affect the home mortgage market today?
Fannie Mae and Freddie Mac Facilitate Homeownership: But Do They
Increase Risk?
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12.1
AN INVESTMENT: A PLUNGE INTO THE UNKNOWN
• accelerator theory
The theory of investment that says that current
investment spending depends positively on the
expected future growth of real GDP.
 FIGURE 12.1
Investment Spending as a
Share of U.S. GDP, 1970–2005
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12.1
AN INVESTMENT: A PLUNGE INTO THE UNKNOWN
• procyclical
Moving in the same direction as real GDP.
• multiplier-accelerator model
A model in which a downturn in real GDP
leads to a sharp fall in investment, which
triggers further reductions in GDP through
the multiplier.
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ENERGY PRICE UNCERTAINTY REDUCES INVESTMENT SPENDING
APPLYING THE CONCEPTS #1: How do fluctuations in energy prices affect investment
decisions by firms?
One important channel by which volatility of oil prices can hurt the
economy is by creating uncertainty for firms making investment decisions.
Consider whether a firm should invest in an energy-saving technology for
a new plant:
• If energy prices remain high, it may be profitable to
invest in new energy-saving technology for the plant.
• If prices fall, these investments would be unwise.
• If future oil prices are uncertain, a firm may simply delay
building the plant until the path of oil prices are clear.
When firms are faced with an increasingly uncertain future, they will
delay their investment decisions until the uncertainty is resolved.
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12.2
EVALUATING THE FUTURE
Understanding Present Value
• present value
The maximum amount a person is willing to
pay today to receive a payment in the future.
PRESENT VALUE AND INTEREST RATES
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12.2
EVALUATING THE FUTURE
Understanding Present Value
PRESENT VALUE AND INTEREST RATES
Let’s summarize our discussion of present value:
1 The present value—the value today—of a given payment in the future
is the maximum amount a person is willing to pay today for that payment.
2 As the interest rate increases, the opportunity cost of your funds also
increases, so the present value of a given payment in the future falls.
3 As the interest rate decreases, the opportunity cost of your funds also
decreases, so the present value of a given payment in the future rises.
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OPTIONS FOR A LOTTERY WINNER
APPLYING THE CONCEPTS #2: How can understanding the concept of present value help a
lucky lottery winner?
The lucky winner of a lottery was given an option:
• Receive $1 million a year for 20 years
• Receive $10 million today
Why would anyone take the $10 million today?
To determine which payment option is best, our
lottery winner would first need to:
• Calculate the present value of $1 million for each of
the 20 years
• Add up the result
• Compare it to the $10 million being offered to her today
Example: With an 8 percent interest rate, the present value of an
annual payment of $1 million every year for 20 years is $9.8 million.
Best option: If interest rates exceed 8 percent, it is better to take the $10 million dollars.
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Extra Application 8
DEFENSE COMPANIES CASH IN ON CLIMATE OF FEAR
Terrorism and global conflicts have escalated government spending on military and
defense items to the point where many defense stocks have doubled in value since 9/11.
Some stocks have increased as much as fivefold in price over the same period.
• Many analysts continue to recommend smaller defense stocks believing the
continued trend still holds the potential for increased stock prices.
• A number of technology companies are developing “biometrical scanning devices,
face or behavior recognition systems, detection systems for explosives,” and a host
of other defense related products.
• Research and development spending in this industry is also up with British defense
companies increasing R & D spending by 61 percent last year alone.
As long as the political climate continues to favor defense spending, companies are more
than happy to provide them with new and better products.
Defense companies can cash in on fear since the increased threat of terrorism stimulates
demand for their products. As projected cash flows increase then so does the stock price
since the true value of these companies should be the present value of their future
expected cash flows.
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12.2
EVALUATING THE FUTURE
Real and Nominal Interest Rates
• nominal interest rate
Interest rates quoted in the market.
• real interest rate
The nominal interest rate minus the inflation rate.
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12.2
EVALUATING THE FUTURE
Real and Nominal Interest Rates
• expected real interest rate
The nominal interest rate minus
the expected inflation rate.
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INTEREST RATES VARY BY RISK AND LENGTH OF LOAN
APPLYING THE CONCEPTS #3: Why are there different types of interest rates in the economy?
 FIGURE 12.2
Interest Rates on Corporate
and Government Investments,
2002-2005
Riskier loans and loans for
longer maturities typically
have higher interest rates.
Notice that rates for corporate
bonds are higher than the rates
for 10-year Treasury bonds.
Reason: Corporations are less
likely to pay back their loans
than the U.S. government.
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12.3
UNDERSTANDING INVESTMENT DECISIONS
 FIGURE 12.3
The Relationship Between Real Interest
Rates, Spending, and Investment
• neoclassical theory of investment
A theory of investment that says both real
interest rates and taxes are important
determinants of investment.
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12.3
UNDERSTANDING INVESTMENT DECISIONS
Investment and the Stock Market
• retained earnings
Corporate earnings that are not
paid out as dividends to its owners.
• corporate bond
A bond sold by a corporation to the
public in order to borrow money.
• Q-theory of investment
The theory of investment that links
investment spending to stock prices.
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12.3
UNDERSTANDING INVESTMENT DECISIONS
Investment and the Stock Market
 FIGURE 12.4
The Stock Market and Investment Levels, 1997–2003
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Extra Application 5
DOW PLUNGES
The U.S. Labor Department indicated that inflation was higher than anticipated. The
consumer price index (CPI) increased by 0.6 percent during the month of April. However,
more alarming was the 0.3 percent increase in the core CPI, the measure that excludes
the usually volatile food and energy components. The higher inflation overshadowed the
slight drop in crude oil prices and sent the stock market tumbling.
• The Dow Jones Industrial Average fell by more than 150 points.
• This index measures only 30 stocks but it is typically indicative of the overall market.
• Other broader market measures such as the NASDAQ and the S & P 500 fell as well.
Why is the stock market so sensitive to inflation data?
• Financial markets are extremely sensitive to interest rate changes and billions of
dollars (and other currencies) move around the world based on minor changes in
interest rates and other variables.
• The higher than expected inflation caused many investors to reevaluate their financial
positions and adjust their portfolios accordingly.
• This portfolio rebalancing led to the large drop in the DJIA.
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Extra Application 7
STOCKS STRUGGLE AFTER FED CHIEF’S ECONOMIC VIEW
New Fed chairman Ben Bernanke’s first congressional testimony on monetary policy kept
the stock market jittery. Investors listened for any indication of future interest rate
movement and responded negatively when Bernanke indicated that more rate hikes may
be in the Fed’s future. Bernanke’s concern over budget deficits made investors jittery as
well. However, Bernanke reassured the committee that economic growth appeared on
track and inflation was currently under control.
• Market analysts have a better understanding of Bernanke’s position on the economy.
• Most believe that Bernanke will establish the Fed as hawkish on inflation.
• Investors will pay close attention to economic indicators for signs of inflation.
Since the true value of a stock should be a function of the present
value of the expected cash flows the company will generate, an
increase in interest rates will decrease that present value.
Investors will revalue stocks given the new expected higher (or
lower) interest rates. The expectation of higher interest rates will
cause fewer potential investors to demand stocks and also cause
existing investors to supply more stocks at a given price. These
two shifts result in a new equilibrium at a lower price.
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12.4
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
• liquid
Easily convertible into money on short notice.
 FIGURE 12.5
Savers and Investors
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12.4
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
• financial intermediaries
Organizations that receive funds from
savers and channel them to investors.
 FIGURE 12.5
Financial Intermediaries
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12.4
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
When Financial Intermediaries Malfunction
• bank run
Panicky investors simultaneously
trying to withdraw their funds from
a bank they believe may fail.
• deposit insurance
Federal government insurance on
deposits in banks and savings
and loans.
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FANNIE MAE AND FREDDIE MAC FACILITATE HOMEOWNERSHIP: BUT DO THEY
INCREASE RISK?
APPLYING THE CONCEPTS #4: How does the government affect the home mortgage
market today?
Fannie Mae and Freddie Mac are financial intermediaries that facilitate
home ownership in the United States. Here is how they operate:
• They purchase home mortgages from S&Ls and banks that have made
loans to homeowners.
• They package together the mortgages they purchase and then sell
guaranteed, mortgage-backed securities to investors.
• They borrow money from other investors in the market in order to buy
the mortgages from banks and S&Ls.
Economists and investors have begun to worry whether Fannie Mae and
Freddie Mac are fully safe. Reasons:
• Interest rates can rise and fall sharply.
• Homeowners can refinance or pay off their mortgages when rates fall.
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Extra Application 6
TEENS LACK FINANCIAL LITERACY
The Federal Reserve released the results of a recent survey about the financial and
economic literacy of U.S. high school seniors. This latest survey showed that high school
seniors correctly answered only 52.4 percent of questions, a very slight improvement over
last year’s results where seniors answered 52.3 percent of the questions correctly. Both
years represent improvement over the 2002 survey results of 50.2 percent.
• Only 14.2 percent of students correctly identified stocks as offering higher growth
potential than U.S. savings bonds.
• Sixty-two percent incorrectly identified retirement income from a company pension
plan as Social Security.
• Demographic differences also exist with seniors from higher income households
being more financially literate than those from the lowest income groups and white
students scoring higher than black and Hispanic students.
Why is this lack of financial acumen considered to be problematic?
• Lack of financial acumen probably contributes further to income disparities.
• While many may increase their earning potential through education, many will not
retain and grow wealth without financial knowledge.
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accelerator theory
neoclassical theory of investment
bank run
nominal interest rates
corporate bond
present value
deposit insurance
procylical
expected real interest rate
Q-theory of investment
financial intermediaries
real interest rate
liquid
retained earnings
multiplier-accelerator model
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