The Loanable Funds Theory
The interest rate is the price of loanable funds; It is determined by the Demand and Supply for loanable funds
Treasuries notes and bonds
are issued by the federal government to finance the national debt and other government expenditures
Interest Rate Risk
because of their long maturity, T-notes and T-bonds experience wider price fluctuations than money market securities when interest rates change
older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes
are loans to individuals or businesses to purchase homes, land or other real state property
the principal value of TIPS is adjusted by
the percentage change in the Consumer Price Index(CPI) every six months
Munis are used to
fund imbalances between expenditures and receipts and finance long-term capital outlays
Muni bonds are attractive to household investors because
interest is exempt from federal and most local income taxes
The primary market
part of the capital markets that deals with the issuance of new securities; Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue
The secondary market
the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold
Classify the following transactions as taking place in the primary or secondary markets; IBM issues $200 million of new common stock
Classify the following transactions as taking place in the primary or secondary markets; The New Company issues $50 million of common stock in an IPO
Classify the following transactions as taking place in the primary or secondary markets; IBM sells $5 million of GM preferred stock out of its marketable securities portfolio
Classify the following transactions as taking place in the primary or secondary markets; The Magellan Fund buys $100 million of previously issued IBM bonds
Classify the following transactions as taking place in the primary or secondary markets; Prudential Insurance Co. Sells $10 million of GM common stock
How does the location of the money market differ from that of the capital market?
Money market deals with maturities one year or shorter, the capital market deals with securities longer than one year
The money market
deals with maturities one year or shorter while capital markets deal with securities longer than one year
The capital market
is a market for securities, where business enterprises and governments can raise long-term funds; It is defined as a market in which money is provided for periods longer than a year
commercial and savings banks, credit unions, insurance companies, mutual funds.
A commercial bank (or business bank) is a type of financial institution and intermediary; It is a bank that provides transactional, savings, and money market accounts and that accepts time deposits.
Depository institutions in the form of savings associations, savings banks, and credit unions.
Financial institutions that protect individuals and corporations (policyholders) from adverse events; Life insurance companies provide protection from untimely death, illness, and retirement; Property casualty insurance protects against personal injury and liability due to accidents, theft, fire, etc.
Securities firms and investment banks
The principal businesses of most large investment banks include, investment banking business managed by the Investment Banking Division, which focuses on capital raising and M&A transactions for corporate clients and capital raising for government clients
financial intermediaries that makes loans to both individuals and businesses; Unlike depository institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding.
financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of asset.
offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years; Funds originally invested in and accumulated in a pension fund are exempt from current taxation.
Why would a world limited to the direct transfer of funds from suppliers of funds to user of funds likely result in quite low levels of funds flows?
Because, it reduces liquidity risk for investors; A financial institution that knows what they are doing will provide a reasonable rate of return; The ability to purchase a share of the financial institution will reduce the liquidity risk since they are (or should be) diversified.
How do FIs alleviate the problem of liquidity risk faced by investors wishing to invest in securities of corporations?
Because financial institutions are diversified, a loss in any market sector does not signify a collapse in the value of the financial institution; Allowing for investors to trade the security or asset quickly and prevent loss (or make the required profit).
What is meant by maturity intermediation?
Making long-term loans on funds borrowed at short-term interest rates; It is a vulnerable position for a bank.
When interest is added to the principal, so that from that moment on, the interest that has been added also itself earns interest; This addition of interest to the principal is called compounding; A bank account, for example, may have its interest compounded every year.
Calculate the future value in five years of $5,000 received today if your investments pay 6% compounded annually
Calculate the future value in five years of $5,000 received today if your investments pay 8% compounded annually
Calculate the future value in five years of $5,000 received today if your investments pay 10% compounded annually
Calculate the future value in five years of $5,000 received today if your investments pay 10% compounded semi-annually
Calculate the future value in five years of $5,000 received today if your investments pay 10% compounded quarterly
What factors cause the demand for funds to shift?
The increase or decrease in cost of loanable funds. (Interest)
If we observe a one-year Treasury security rate higher than the two-year Treasury security rate, what can we infer about the one-year rate expected one year from now?
You can, one year hence, expect that the interest rate will be lower.