12-1 copyright © 2012 pearson prentice hall. all rights reserved. c h a p t e r 12 investment and...

12-1Copyright © 2012 Pearson Prentice Hall. All rights reserved.

C H A P T E R 12Investment and Financial Markets

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Investment and Financial Markets

Brock Williams

P R E P A R E D B Y

The housing market is a perfect example of the close links between investment and finance.

CHAPTER

12

Copyright © 2012 Pearson Prentice Hall. All rights reserved.



1

2

3

4

How do fluctuations in energy prices affect investment decisions by firms?

Energy Price Uncertainty Reduces Investment Spending

How can understanding the concept of present value help a lucky lottery winner?

Options for a Lottery Winner

Why did many homeowners in 2010 owe more to banks than their home was worth?

Underwater Homes: Bets Gone Wrong

How have recent financial innovations created new risks for the economy?

Securitization: The Good, the Bad, and the Ugly

A P P L Y I N G T H E C O N C E P T S


C H A P T E R 12Investment and Financial Markets 12.1 AN INVESTMENT: A PLUNGE

INTO THE UNKNOWN

• accelerator theoryThe theory of investment that says that current investment spending depends positively on the expected future growth of real GDP.

FIGURE 12.1Investment Spending as a Share of U.S. GDP, 1970–2009

The share of investment as a component of GDP ranged from a low of about 10 percent in 1975 to a high of over 18 percent in 2000.

The shaded areas represent U.S. recessions.


C H A P T E R 12Investment and Financial Markets 12.1 AN INVESTMENT: A PLUNGE

INTO THE UNKNOWN (cont’d)

• procyclicalMoving in the same direction as real GDP.

• multiplier-accelerator modelA model in which a downturn in real GDP leads to a sharp fall in investment, which triggers further reductions in GDP through the multiplier.



ENERGY PRICE UNCERTAINTY REDUCES INVESTMENT SPENDING

APPLYING THE CONCEPTS #1: How do fluctuations in energy prices affect investment decisions by firms?

One important way 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 energy-saving technology.

• 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.

A P P L I C A T I O N 1


C H A P T E R 12Investment and Financial Markets 12.2 EVALUATING THE FUTURE

• present valueThe maximum amount a person is willing to pay today to receive a payment in the future.

P R I N C I P L E O F O P P O R T U N I T Y C O S T

The opportunity cost of something is what you sacrifice to get it.

Understanding Present Value

present value = (1 )tK

i+

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. In other words, you need less money today to get to your future “money goal.”

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. In other words, you need more money today to get to your money goal.

PRESENT VALUE AND INTEREST RATES



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.



C H A P T E R 12Investment and Financial Markets 12.2 EVALUATING THE FUTURE (cont’d)

Real and Nominal Interest RatesR E A L - N O M I N A L P R I N C I P L E

What matters to people is the real value of money or income—the purchasing

power—not the face value of money.

• nominal interest rateInterest rates quoted in the market.

• real interest rateThe nominal interest rate minus the inflation rate.

real rate =nominal rate−inflation rate



• There are different types of interest investments.

• Corporate bonds are considered more risky than federal government bonds, so pay a higher interest rate.

• Long term investments are more risky than short term investments, so again pay a higher interest rate.

12.2 EVALUATING THE FUTURE (cont’d)

FIGURE 12.2Interest Rates on Corporate andGovernment Investments,2002–2008


C H A P T E R 12Investment and Financial Markets 12.3 UNDERSTANDING INVESTMENT DECISIONS

As the real interest rate declines, investment spending in the economy increases.

FIGURE 12.3The Relationship between Real Interest Rates and Investment Spending

• neoclassical theory of investmentA theory of investment that says both real interest rates and taxes are important determinants of investment.



(cont’d)

Investment and the Stock Market

• retained earningsCorporate earnings that are not paid out as dividends to their owners.

• corporate bondA bond sold by a corporation to the public in order to borrow money.

• Q-theory of investmentThe theory of investment that links investment spending to stock prices.

price of a stock = present value of expected future dividend payments



(cont’d)

Both the stock market and investment spending rose sharply from 1997, peaking in mid-2000.

FIGURE 12.4The Stock Market and Investment Levels, 1997–2003


C H A P T E R 12Investment and Financial Markets 12.4 HOW FINANCIAL INTERMEDIARIES

FACILITATE INVESTMENT

FIGURE 12.5

Savers and Investors

• liquidEasily convertible into money on short notice.



FACILITATE INVESTMENT (cont’d)

• financial intermediariesOrganizations that receive funds from savers and channel them to investors.

FIGURE 12.6Financial Intermediaries



•In early 2010 one quarter of all U.S. homes were “underwater”, that is, the homeowners owed more than their home was worth.

•Homes are highly leveraged; even if you put down 10 percent, that leaves 90 percent borrowed.

•If the home value falls 20 percent, the homeowner is 10 percent underwater. In the Las Vegas area, approximately 70 percent of all homes were underwater.

UNDERWATER HOMES: BETS GONE WRONG

APPLYING THE CONCEPTS #3: Why Did Many Homeowners in 2010 Owe More to Banks Than Their Home Was Worth?





• securitizationThe practice of purchasing loans, re-packaging them, and selling them to the financial markets.

• leverageUsing borrowed funds to purchase assets.




• bank runPanicky investors simultaneously trying to withdraw their funds froma bank they believe may fail.

When Financial Intermediaries Malfunction

• deposit insuranceFederal government insurance on deposits in banks and savings and loans.



•As securitization developed, it allowed financial intermediaries to provide new funds for borrowers to enter the housing market.

•As the housing boom began in 2002, lenders and home purchasers began to take increasing risks. Lenders made “subprime” loans to borrowers with limited ability to actually repay their mortgages.

•Some households were willing to take on considerable debt because they were confident they could make money in a rising housing market. Lenders securitized the subprime loans and financial firms offered exotic investment securities to investors based on these loans. Many financial institutions purchased these securities without really knowing what was inside them.

•When the housing boom stopped and borrowers stopped making payments on subprime loans, it created panic in the financial market. Effectively, through securitization the damage from the subprime loans spread to the entire financial market, causing a major crisis.

SECURITIZATION: THE GOOD, THE BAD, ANDTHE UGLY

APPLYING THE CONCEPTS #4: How have recent financial innovations created new risks for the economy?



C H A P T E R 12Investment and Financial Markets K E Y T E R M S

accelerator theory

bank run

corporate bond

deposit insurance

expected real interest rate

financial intermediaries

leverage

liquid

multiplier-accelerator model

neoclassical theory of investment

nominal interest rate

present value

procyclical

Q-theory of investment

real interest rate

retained earnings

securitization

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