The Financial System. Sherif Khalifa. Sherif Khalifa () The Financial System 1 / 29

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1 The Financial System Sherif Khalifa Sherif Khalifa () The Financial System 1 / 29

2 Investment in physical capital and human capital are essential for productivity. Saving and investment are key ingredients to long run economic growth. When a country saves a large portion of its income, more funds are available to finance investment in capital. Higher human capital and physical capital increases a country s productivity and living standards. Sherif Khalifa () The Financial System 2 / 29

3 The financial system consists of those institutions in the economy that matches saving with investment. The financial system channels the economy s scarce resources from savers to investors. Savers supply their money to the financial system with the expectation that they will get it back with interest at a later date. Investors demand money from the financial system with the knowledge that they will pay it back with interest at a later date. The financial system is comprised of the financial market and the financial intermediaries. Sherif Khalifa () The Financial System 3 / 29

4 Financial Markets are the institutions through which savers can directly provide funds to borrowers. Financial markets are markets in which people and entities buy and sell securities such as stocks and bonds. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Sherif Khalifa () The Financial System 4 / 29

5 A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. A government issues a bond to cover a budget deficit, and a firm issues a bond to finance investment. The buyer of the bond pays money in exchange for a promise of interest and repayment of the principal. The buyer can hold the bond until maturity or can sell it at an earlier date to someone else. Default likelihood is the probability that the issuer will fail to pay some of the interest or principal. When the probability of default is high, the bond promises a higher interest rate to compensate for the risk. Sherif Khalifa () The Financial System 5 / 29

6 A stock is an ownership in a firm and is a claim to the profits that the firm makes. The shareholder is part owner of the company and is entitled to a portion of its profits. Stocks offer the holder higher risk and potentially higher return compared to bonds. After a corporation issues stock by selling shares to the public, these shares trade on stock exchanges. The price at which shares trade on stock exchanges are determined by the supply of and demand for the stock. The demand for the stock reflects people s perception of and optimism about a company s future profitability. Sherif Khalifa () The Financial System 6 / 29

7 A bank is an institution that takes in deposits from those who want to save and use these deposits to make loans to those 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 profits to the owners. Banks channel funds from savers to investors indirectly, and act as an intermediary between them. Banks analyse the creditworthiness of the borrower to ensure their ability to repay the loan. Sherif Khalifa () The Financial System 7 / 29

8 A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks, bonds or both. The shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the value of the portfolio increases, the shareholders benefit. If the value of the portfolio decreases, the shareholders suffer a loss. Allow people with small amounts of money to diversify and face less risk. Allow ordinary people access to the skills of professional financial experts. Sherif Khalifa () The Financial System 8 / 29

9 The financial system coordinates the economy s saving and investment. It concerns decisions that we make today that will affect our lives in the future. Participants in the financial system make decisionson the allocation of resources over time and the handling of risk. Sherif Khalifa () The Financial System 9 / 29

10 Time Value The present value is the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money. The future value is the amount of money in the future that an amount of money today will yield, given prevailing interest rates. Sherif Khalifa () The Financial System 10 / 29

11 Time Value If you deposit $100 in a bank account today, how much will it be worth in N years, if the interest rate is r? FV 1 = 100 (1 + r) FV 2 = 100 (1 + r) (1 + r) = 100 (1 + r) 2 FV 3 = 100 (1 + r) (1 + r) (1 + r) = 100 (1 + r) 3.. FV N = 100 (1 + r) N FV = PV (1 + r) N Sherif Khalifa () The Financial System 11 / 29

12 Time Value If someone proposes a project that costs you $100 today, and will wield $200 in 10 years. Should you accept the proposal if the interest rate is 5%? FV = 100 ( ) 10 = 163 You spend $100 in the project that yields $200 in 10 years. You deposit $100 in the bank and earn $163 in 10 years. You accept the project proposal. Sherif Khalifa () The Financial System 12 / 29

13 Time Value How much you would have to deposit in a bank right now to yield $200 in N years if the interest rate is r? FV = PV (1 + r) N PV = FV (1 + r) N PV = 200 (1 + r) N Sherif Khalifa () The Financial System 13 / 29

14 Time Value If someone proposes a project that costs $100 today, and will yield $200 in 10 years. Should you accept the proposal if the interest rate is 5%? 123 = 200 ( ) 10 You spend $100 in the project that yields $200 in 10 years. You have to deposit $123 in the bank to earn $200 in 10 years. You accept the project proposal. Sherif Khalifa () The Financial System 14 / 29

15 Time Value The value of a security to a holder is what the holder gets out of owning it. This includes the present value of the stream of furture payments and the final sale price. Traders buy shares when price < value, sell shares when price > value. When good news about a company s prospects become public, the value of the company increases so traders buy shares until the price increases. When bad news about a company s prospects become public, the value of the company decreases, so traders sell the shares until the price decreases Sherif Khalifa () The Financial System 15 / 29

16 Risk aversion is a dislike of uncertainty. Utility is a person s subjective measure of well-being or satisfaction. Diminishing marginal utility reflects that the more wealth a person has, the less utility he gets from an additional dollar. Sherif Khalifa () The Financial System 16 / 29

17 Risk Utility Current utility Current wealth Wealth Sherif Khalifa () The Financial System 17 / 29

18 Risk Utility Utility gain from winning $1000 Utility loss from losing $ Wealth Sherif Khalifa () The Financial System 18 / 29

19 Risk A person facing a risk pays a fee to an insurance company, which in return agrees to accept all or part of the risk. The role of insurance is not to eliminate the risks but to spread them around more effi ciently. Insurance does not reduce the risk, it merely compensates you in case the risky event occurs. Sherif Khalifa () The Financial System 19 / 29

20 Risk A diversified portfolio contains assets whose returns are not related. Some assets will realize high returns, and otherswill realize low returns. The high and low returns average out, so the portfolio earns an intermediate return. Firm-specific risk is the risk that affects only a single company. Market risk is the uncertainty associated with the entire economy, which affects all companies. Sherif Khalifa () The Financial System 20 / 29

21 Risk Standard dev of portfolio return Increasing the number of stocks reduces firmspecific risk # of stocks in portfolio But market risk remains. Sherif Khalifa () The Financial System 21 / 29

22 Risk Sherif Khalifa () The Financial System 22 / 29

23 Y C G = I Y = C + I + G Y C G + T T = I Y } {{ T C } + T }{{ G } = I Private Saving Public Saving S = I Sherif Khalifa () The Financial System 23 / 29

24 National saving is the total income in the economy that remains after paying for consumption spending and government spending. Private saving is the amount of income that households have left after paying their taxes and their consumption spending. Public saving is the amount of tax revenue that the government has left after paying for government spending. Sherif Khalifa () The Financial System 24 / 29

25 Market for Loanable Funds Loanable funds refers to all incomes that people have chosen to save and lend out rather than use for their own consumption. The market for loanable funds is the market in which those who want to save supply funds and those who want to invest demand funds. The interest rate is the price of a loan, and in this market it is both the return to saving and the cost of borrowing. Because a high interest rate makes borrowing more expensive, the quantity of loanable funds demanded decreases as interest rate increases. Because a high interest rate makes saving more attractive, the quantity of loanable funds supplied increases as the interest rate increases. Sherif Khalifa () The Financial System 25 / 29

26 Market for Loanable Funds i S 1 i 1 D 1 L 1 L Sherif Khalifa () The Financial System 26 / 29

27 Market for Loanable Funds Event: an increase in government budget deficit. i S 2 S 1 i 2 i 1 L 2 L 1 D 1 L Sherif Khalifa () The Financial System 27 / 29

28 Market for Loanable Funds Event: an increase in investment tax credits. i S 1 i 2 i 1 D 2 L 1 L 2 D 1 L Sherif Khalifa () The Financial System 28 / 29

29 Market for Loanable Funds Event: an increase in tax incentives for saving accounts. i S 1 i 1 S 2 i 2 D 1 L 1 L 2 L Sherif Khalifa () The Financial System 29 / 29

Saving, Investment, and the Financial System

7 Saving, Investment, and the Financial System The Financial System The financial system consists of the group of institutions in the economy that help to match one person s saving with another person