Financial markets and institation

UNIT II:MARKETS

CLASS OUTLINE

 

1. Interest rates

These are the basis of all financial markets

 

All finance is a series of footnotes to compounding and discounted present value”.

 

1. Basic principles of interest rates & fixed-income markets:
2. Time preference
3. Time value of money
4. Future value (compounding)
5. Present value (discounting)

 

1. Time preference and the time value of money

 

People prefer consumption now to consumption later.

if they defer consumption – if they SAVE – they require something additional in                        future  THAT IS THE RATE OF INTEREST

 

REMEMBER THAT 10% MEANS 0.10 – that’s what we use in calculations.

 

 

 

 

 

1. Future value (compounding)

If you invest $1 for one year at a rate of r percent, the “future value” of that $1 is                          what you get back – the $1 plus interest – after one year.

 

 

 

Same thing for $x:

 

 

e.g.

 

For longer or shorter periods:

 

e.g. FV($100,2 years,5%) =

 

FV($100,6 months = 0.5 year,5%) =

 

 

 

1. Present value (discounting)

This is the INVERSE of future value:  If you know you will receive $1.10 one year                  from now, and the interest rate is 10%, what is that expected amount worth now?

That is “present value”

 

 

 

In general:

 

 

 

 

So, the present value of $x  to be received afterT years discounted r%:

 

 

 

e.g.

 

 

 

 

Present Value is used to compute the price of all bonds, short-term and long-term.

For short-term markets there is only one payment; for long-term markets there are                         many payments of both interest and principal.

 

NOTE: PV and interest rate move inversely:

asi rises, PV declines; as i declines, PV rises.

compare PV of $100 to be received in 2 years, discounted (a) 10% (b) 5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1. Where do interest rates come from?  LOANABLE FUNDS THEORY

 

Basic supply and demand:

1. Demand comes from . . .

 

 

 

2. Supply comes from . . .

 

 

 

 

3. Equilibrium determination of interest rate

 

 

 

NOTE: this is the supply and demand for credit; its price is the interest rate.                            Once that is known, you can calculate the present value of a bond, etc.

 

1. Factors that affect interest rates

 

1. Economic Growth:

 

 

 

 

1. Inflation: if prices are rising

(1) credit demanders (deficit units)

 

 

(2) credit suppliers (surplus units

 

 

— together these increasethe interest rate

 

 

terms:      nominal interest rate :  the actual rate in a transaction

real interest rate :        the interest rate adjusted for inflation

 

if the borrower pays 5% per annum but expected inflation is 4%, the                                    “real” interest    rate is 5% – 4% = 1%

this is the “Fisher Effect”:

 

or

Here, the real interest rate is the difference between the blue and red lines:

 

 

1. Monetary policy:

 

 

 

 

 

1. Fiscal policy:

 

 

 

 

 

 

1. Foreign demand and supply:  the same things but from foreign sources.

 

 

Recent history of U.S. short-term interest rates

 

 

 

 

1. Securities

 

1. Financial markets primarily buy and sell securities

 

 

 

 

 

1. Primary market

 

 

 

1. Secondary market

After a security is issued in the primary market it can be sold to someone else. (This                       is most of what you see in the daily trading of stocks and bonds.)

 

 

 

1. Valuation of securities
2. Information is the key.

 

 

2. Securities regulation tries to be sure all relevant information is public.

 

 

3. Cash flows are crucial to valuation.

 

4. “Efficient markets hypothesis” – that the market price reflects all relevant                                information so no one can reliably earn higher-than-market returns.

HIGHLY CONTROVERSIAL

 

NAME:  ____________________________            ________POINTS _______  PERCENT

 

 

5 problems on FUTURE VALUE and PRESENT VALUE (2 points each) (show work for possible partial credit)

 

1. PRESENT VALUE of $10,000, at 2.3%, 2 years

 

 

 

 

2. FUTURE VALUE of $10,000, at 1.25%, 1 year

 

 

 

 

3. FUTURE VALUE of $1,000, at 3.5%, 4 years

 

 

 

 

4. PRESENT VALUE of $1,000,000, at 0.5%, 6 months

 

 

 

 

5. FUTURE VALUE of $750, at 0.75%, 9 months

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

6. This graph shows an initial equilibrium in the Market for Loanable Funds.
7. Show the changes in the graph if the fiscal authorities (i.e. Congress and the                       President) increase government spending substantially.  (6 points)

 

 

1. In this case the equilibrium interest rate  (choose one) . . .
2. increases
3. decreases

 

1. In this case the equilibrium quantity of loans (choose one) . . .
2. increases
3. decreases

 

 

7. If the Market for Loanable Funds shows a nominal interest rate of 7%, use the           Fisher Equation — i_nominal= E(INF) + r_real — to find the real rate of interest if                      expected inflation is 3%. (2 points)

 

 

 

 

8. For each of the following, indicate whether it takes place in the primary market or the secondary market for securities. (circle the correct answers)  (2 points)

 

1. A successful startup corporation decides to issue shares to the public for the first                          time. (primary/secondary)
2. You buy 100 shares of Apple Inc., which is listed on the NASDAQ exchange                        (primary/secondary)