chapter 1: finance and the firm
TRANSCRIPT
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Finance and the Firm
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Learning Objectives
The field of finance The duties of financial managers The basic goal of a business firm Legal and ethical challenges for
financial managers Forms of business organization
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The Field of Finance
Financial Management– Analyze and forecast a firm’s
performance– Evaluate investment opportunities
Financial Markets and Institutions– The flow of funds through institutions– Markets in which financial assets are sold– Impact of interest rates on that flow of
funds Investments
– Locate, select, and manage moneyproducing assets. 3
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Liabilities and equity represent sources of funds.
Assets represent uses of funds. Liabilities represent a debt claim. Equity represents an ownership claim. 4
Balance Sheet
Assets Liabilities
Equity
Financial Statements
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Financial ManagementCapital BudgetingCapital Structure PolicyWorking Capital Management
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Financial Management
ST Assets
LT Assets
ST Liabilities
LT LiabilitiesEquity
LT Assets
Deals with the firm’s investment in long-term real assets
e.g., in what projects should the firm invest?
Capital Budgeting
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Financial Management
ST Assets
LT Assets
ST Liabilities
Deals with long-term financing of the firm’s activities
e.g., what mix of long term debt and equity will the firm use?
Capital Structure Policy
LT LiabilitiesEquity
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Deals with management of short-term (current) assets.
e.g., will the firm purchase supplies on credit or pay cash?
Financial Management
ST Assets
LT Assets
ST Liabilities
LT LiabilitiesEquity
ST Assets
Working Capital Management
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Investments
Stockholders are owners of the firm Bondholders are creditors of the firm
Looks at financial analysis from perspective of investor
Risk-return tradeoff: Investors prefer high returns to low returns and low risk to high risk.
From the firm’s perspective this rate of return represents a cost of funds.
From investor’s perspective, what matters is the rate of return on a security
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Financial Markets and Institutions
Financial markets and institutions facilitate the flow of funds in the economy
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This makes society more productive, thus increasing social welfare
Topics include:
How interest rate levels are determinedHow the Fed controls the money supplyRelationships between macroeconomic
variables such as inflation, interest rates, money supply and GDP.
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Duties of Financial Managers
Measure a firm’s performance Forecast financial consequences Recommend new investment Locate external financing Recommend best financing mix Determine financial expectations of
owners
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Basic Goal of the Business Firm
The primary financial goal of the business firm is to maximize the wealth of the firm’s owners (or the value of the firm).
This is not necessarily the same as “maximizing profits”.
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Maximizing the "value” of a firm?
The value of a firm is determined by the discounted value of all future expected cash flows derived from the firms business activities.
The financial manager should make decisions that cause this value to be maximized.
Value depends on future prospects and risk.
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Factors that affect the value of a firm’s stock price:
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Cash flows– Necessary to pay the bills– Not the same as sales or profits
Timing of cash flows– Cash received sooner is better than cash
received later Risk
– Definite cash inflows are generally preferred to uncertain cash inflows
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Legal and Ethical Challenges
Managers are agents for the firm’s owners but they may have interests that conflict with those owners.
These agency conflicts impose costs (such as the cost of accounting audits).
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Agency issues
Interests of non-owner stakeholders Workers, creditors, suppliers,
customers, and others are not owners, but may have a stake in the business.
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Legal and Ethical ChallengesLegal and Ethical Challenges The interests of society as a whole may
not coincide with the interests of owners of a firm. Costs of disposing of toxic waste reduce
owners’ profits. There may be goodwill generated by
voluntary actions that benefit society. Sometimes the right thing must be done in
spite of the cost to the company Government often imposes rules that
force companies to respond to the best interests of society.
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Forms of Business Organization
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Sole Proprietorship Advantages
• Easily Established• Minimal Organizational Costs• Keep all Generated Profits
Disadvantages• Unlimited Liability• Losses absorbed by owner• Limited Capital• Limited Life
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Forms of Business Organization
• Minimal Organizational Requirements• Negligible Government Regulations
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General PartnershipGeneral Partnership Advantages
• Unlimited Liability• Must be Dissolved or Reorganized if a
Partner Leaves or Dies
Disadvantages
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Forms of Business Organization
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Limited Partnership (LP) Two classes of partners
• General Partners• Limited Partners
Every partnership must have at least one general partner
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Forms of Business Organization
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Limited Partnership (LP)General Partners
Advantages•Participate actively in management•More favorable allocation of ownership/profit/losses
Disadvantages•Unlimited Liability
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Forms of Business Organization
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Limited Partnership (LP)Limited Partners
Advantages•Limited liability
Disadvantages•not active in management•less favorable allocation of ownership/profit/losses
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Forms of Business Organization
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Limited Liability Partnership (LLP)
Similar to General Partnership
•operates like a corporation
•limited liability
•partnership not taxed
•income passed through to partners and partners are taxed
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Forms of Business Organization
– Double Taxation– Time and Cost of Incorporation 23
Corporation
• Advantages
• Disadvantages
A legal “person” separate and distinct from its owners
– Limited Liability– Permanency– Transferability of Ownership– Better Access to Capital
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Forms of Business Organization
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Limited Liability Company (LLC)
• Advantages
• Disadvantages
A form of business organization that is a state-approved, unincorporated association.
– Limited Liability– No Double Taxation
– Relatively New - Some Legal Issues Not Yet Defined
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Homework Questions
1. What is the fiduciary responsibility of an agent?
2. What is meant by double taxation?
3. Explain which type of business organization form affords the most control to the owner?
4. Why would someone choose a limited partnership share over a sole proprietorship?
5. How do agency problems arise? What are some examples of agency problems? What can corporations do to monitor these costs?
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Financial Marketsand Interest Rates
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Learning Objectives
• Operation of U.S. financial system.• Financial securities.• Function of financial intermediaries.• Financial markets.• Securities traded in the money and capital
markets.
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The Financial System
The purpose of the financial system is to bring together individuals, businesses, and government entities (economic units) that generate and spend funds.
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Surplus economic units have funds left over after spending all they wish to spend.
Deficit economic units need to acquire additional funds to sustain their operations.
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The Financial System
• To enable funds to move through the financial system, funds are exchanged for securities.
• Securities are documents that represent the right to receive funds in the future.
• Financial intermediaries discussed in Chapter 3 often help to facilitate this process.
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Financial Markets
• Classified according to the characteristics of participants and securities involved.
• The primary market is where deficit economic units sell new securities to raise needed funds.
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Financial Markets
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Securities
Funds
PrimaryMarket
Primary Market handles IPO’s (new public offerings)
The Circular Flow of The Circular Flow of IncomeIncome
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Financial Markets
• Classified according to the characteristics of participants and securities involved.
• The primary market is where deficit economic units sell new securities.
• The secondary market is where investors trade previously issued securities with each other.
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Financial Markets
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Securities
Funds
SecondarySecondaryMarketMarket
The Circular Flow of IncomeThe Circular Flow of Income
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Financial Markets
• Money Market vs. Capital Market
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Financial Markets
• Money Market– Trade short term (1 year or less) debt instruments (e.g.
T-Bills, Commercial Paper)– Major money centers in Tokyo, London and New York
• Capital Market– Trades long term securities (Bonds, Stocks)– NYSE, ASE, over-the-counter (Nasdaq and other OTC)
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Financial Markets
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Securities
Securities$$
$$
Intermediaries such as commercial banks andinsurance companies help to facilitate theflow of funds in the financial marketplace.
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Market Efficiency
• Market efficiency refers to the ease, speed, and cost of trading securities.– The market for the securities of large companies is
generally efficient: Trades can be executed in a matter of seconds and commissions are very low.
– The real estate market is not generally efficient: It can take months to sell a house and the commission is 6-7% of the price.
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Market Efficiency
– The more efficient the market, the easier it is to transfer idle funds to those parties that need the funds.
– If funds remain idle, this results in lower growth for the economy and higher unemployment.
– Investors can adjust their portfolios easily and at low cost as their needs and preferences change.
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Why is market efficiency important?
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Securities in the Financial Market
• Money Market Securities– Highly liquid, low risk– Treasury Bills (T-Bills)– Certificates of Deposit (CDs)– Commercial Paper– Eurodollars– Banker’s Acceptances
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Securities in the Financial Market
• Money Market Securities– Highly liquid, low risk– Treasury Bills (T-Bills)– Certificates of Deposit (CDs)– Commercial Paper– Eurodollars– Banker’s Acceptances
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• T-Bills: are short-term securities issued by the Federal government.
•After initial sale, they have an active secondary market.
•They are bought at a discount and at maturity the investor receives the full face value.
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Securities in the Financial Market
• Money Market Securities– Highly liquid, low risk– Treasury Bills (T-Bills)– Certificates of Deposit (CDs)– Commercial Paper– Eurodollar– Banker’s Acceptances
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• Negotiable CDs:Negotiable CDs: are interest-bearing securities issued by financial institutions.
•They have maturities of one year or less.
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Securities in the Financial Market
• Money Market Securities– Highly liquid, low risk– Treasury Bills (T-Bills)– Certificates of Deposit (CDs)– Commercial Paper– Eurodollars– Banker’s Acceptances
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•Commercial paper: is unsecured debt issued by corporations with good credit ratings.
•Most buyers are large institutions.
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Securities in the Financial Market
• Money Market Securities– Highly liquid, low risk– Treasury Bills (T-Bills)– Certificates of Deposit (CDs)– Commercial Paper– Eurodollars– Banker’s Acceptances
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• Eurodollars: are dollar denominated, deposits, located in non-US banks.
•Buyers and sellers are large institutions.
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Securities in the Financial Market
• Money Market Securities– Highly liquid, low risk– Treasury Bills (T-Bills)– Certificates of Deposit (CDs)– Commercial Paper– Eurodollars– Banker’s Acceptances
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•Banker’s Acceptances: are debt securities that have been guaranteed by a bank. They are used to facilitate international transactions.
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Securities in the Financial Market
• Money Market Securities– Highly liquid, low risk– Treasury Bills (T-Bills)– Certificates of Deposit (CDs)– Commercial Paper– Eurodollars– Banker’s Acceptances
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Securities in the Financial Market
• Capital Market Securities– Bonds
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•Bonds: are “IOUs” issued by the borrower and sold to investors.
•The issuer promises to repay the face amount on the maturity date and to pay interest each year in the amount of the coupon rate times the face value.
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Securities in the Financial Market
– BondsTreasury BondsMunicipal BondsCorporate Bonds
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• Treasury Bonds:: are issued by the federal government.
• Municipal Bonds:: are issued by state and local governments.
• Corporate Bonds: are issued by corporations.
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Securities in the Financial Market
– Stock
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•Companies can also raise funds by selling shares of stock
Capital Market Securities
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Securities in the Financial Market
– StockCommon Stock
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• Common stockholders: own a portion of the company and can vote on major decisions.
•They receive a return on their investment in the form of dividends and capital gains.
Capital Market Securities
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Securities in the Financial Market
– StockCommon StockPreferred Stock
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• Preferred stockholders do not generally have voting rights, but have priority in receiving dividends and are paid dividends at a pre-set rate.
Capital Market Securities
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Interest Rates
– Real Rate of Interest– Expected Inflation– Default Risk– Maturity Risk– Illiquidity Risk
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Interest Rates Determined by
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Interest Rates
– Compensates for the lender’s lost opportunity to consume.
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Real Rate of Interest
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Interest Rates
– For most securities, there is some risk that the borrower will not repay the interest and/or principal on time, or at all.
– The greater the chance of default, the greater the interest rate the investor demands and the issuer must pay.
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Default Risk
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Interest Rates• Expected Inflation
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Inflation erodes the purchasing power of money.
Example: If you loan someone $1,000 and they pay it back one year later with 10% interest, you will have $1,100. But if prices have increased by 5%, then something that would have cost $1,000 at the outset of the loan will now cost $1,000(1.05) = $1,050.
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Interest Rates
• Maturity Risk
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If interest rates rise, lenders may find that their loans are earning rates that are lower than what they could get on new loans.
The risk of this occurring is higher for longer maturity loans.
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Interest Rates
• Maturity Risk
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Lenders will adjust the premium they charge for this risk depending on whether they believe rates will go up or down.
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Interest Rates
• Illiquidity
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Investments that are easy to sell without losing value are more liquid.
Illiquid securities have a higher interest rate to compensate the lender for the inconvenience of being “stuck.”
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k = the nominal, or observed rate on security
k* = real rate of interestIRP = Inflation Risk PremiumDRP = Default Risk PremiumMP = Maturity PremiumIlP = Illiquidity Premium
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Determination of Rates
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Interest Rates
• Term Structure
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Relationship between long and short term interest rates
Yield curve
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Treasury Yield Curve8.00%
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Jan 10, 2006
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Jan 10, 2006
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Jan 10, 2006
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Jan 10, 2006
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Jan 10, 2006
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6.00%
5.00%
5.50%
4.50%
4.00%
3.50%3 6 1 2 3 5 7 2010
mos. yr.
maturities
Treasury Yield Curve
Jan 10, 2006
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8.00%
7.50%
7.00%
6.50%
6.00%
5.00%
5.50%
4.50%
4.00%
3.50%3 6 1 2 3 5 7 2010
mos. yr.
maturities
Treasury Yield Curve
Jan 10, 2006March 22,1995August 1, 2008
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Homework Questions1. Would the default premium on an investment grade corporate bond be higher or lower than that on a junk bond? Explain.
2. Explain the difference between a dealer and a broker.
3. The more liquid the financial instrument, the wider the spread between the bid and ask price. Explain why you agree or disagree with this statement.
4. The economy is suffering from a recession, explain what will happen to the yield spread between a Treasury bond and a BBB rated corporate bond.
5. Explain how you earn a return on a Treasury bill. How is this different from the manner in which you earn a return on a Treasury note or bond?
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FinancialInstitutions
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Learning Objectives• The role of financial intermediaries.• Commercial banks and the impact of reserve
requirements.• Federal Reserve regulation of financial
institutions.• The difference between savings and loans and
commercial banks.• Operation of credit unions.• Distinguish among finance companies, insurance
companies, and pension funds.
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The Role of Financial Institutionsas Intermediaries (“Middle Persons”)
• A household with surplus funds can “purchase” a savings account at a financial institution. The bank, S&L, or credit union channels those surplus funds to a firm, government entity, or a household that needs them.
• In this way, small surplus units can be packaged together to meet the needs of large deficit economic units.
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Services offered by Financial Institutions
• Denomination matching
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Services offered by Financial Institutions
• Denomination matching– Households generally have small amounts of
surplus funds to invest. They can put small amounts into savings at a time.
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Services offered by Financial Institutions
• Denomination matching– Households generally have small amounts of
surplus funds to invest. They can put small amounts into savings at a time.
– Those who need loans usually require larger amounts of funds. They can borrow for business purposes, or to buy a home or automobile.
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Services offered by Financial Institutions
• Maturity Matching– Household and business savers generally want
to lend for only a short time. Savings and checking accounts are usually available for immediate withdrawal.
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Services offered by Financial Institutions
• Maturity Matching– Household and business savers generally
want to lend for only a short time. Savings and checking accounts are usually available for immediate withdrawal.
– Borrowers often want long-term financing. Institutions can give 30 year mortgages and long-term loans to businesses and government entities.
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Services offered by Financial Institutions
• Absorbing Credit Risk– Individual lenders cannot easily evaluate the
credit risk of borrowers. They also cannot generally afford to take the risk of losing their limited savings.
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Services offered by Financial Institutions
• Absorbing Credit Risk– Individual lenders cannot easily evaluate the
credit risk of borrowers. They also cannot generally afford to take the risk of losing their limited savings.
– Institutions have the necessary expertise and also are in a better position to absorb an occasional loss.
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The Role of Financial Institutions
79Securities
Securities$$
$$
Intermediaries help to facilitate theflow of funds in the financial marketplace.
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Financial Intermediation
Commercial loans
$$
Businesses Households
$$ Checking accounts
CommercialBank
Example 1
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Financial Intermediation
Stocks,Bonds
BusinessesInsuranceCompany Households
$$ Insurancepolicies
$$
Example 2
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Types of Financial Institutions
• Commercial Banks
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Types of Financial Institutions
• Commercial Banks
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The primary purpose of commercial banksis to take in business deposits and to lend funds to businesses.
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Types of Financial Institutions
• Commercial Banks• Savings and Loans
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Types of Financial Institutions
• Commercial Banks• Savings and Loans
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Savings and loans’ primary purpose is to take in deposits from households and to lend funds for home mortgages.
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Types of Financial Institutions
• Commercial Banks• Savings and Loans• Credit Unions
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Types of Financial Institutions
• Commercial Banks• Savings and Loans• Credit Unions
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Types of Financial Institutions
• Commercial Banks• Savings and Loans• Credit Unions
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} Depository Institutions
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Types of Financial Institutions
• Commercial Banks• Savings and Loans• Credit Unions
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} Depository Institutions
•Take in deposits•Make loans
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Types of Financial Institutions
• Finance Companies
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Types of Financial Institutions
• Finance Companies
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Types of Financial Institutions
• Finance Companies• Insurance Companies
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Types of Financial Institutions
• Finance Companies• Insurance Companies
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Receive premiums for insurance policies.This pool of funds is used to reimburse policyholders who incur losses that are covered under the policy .
Life Insurers: Insure against financial hardship caused by death.Property and Casualty: Insure againstdamage to person and property (health, autos,homes, theft, earthquake, etc.)
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Types of Financial Institutions
Finance CompaniesInsurance CompaniesPension Funds
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Types of Financial Institutions
• Finance Companies• Insurance Companies• Pension Funds
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Workers and/or employers contribute funds. Defined Benefit Plans (DBP) versus Defined Contribution Plans (DCP).
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Types of Financial Institutions
• Finance Companies• Insurance Companies• Pension Funds
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} Non-Depository Institutions
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Types of Financial Institutions
• Finance Companies• Insurance Companies• Pension Funds
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•Funds come from borrowing, selling insurance policies, and other claims.•Funds used to buy securities and make loans.
} Non-Depository Institutions
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Reserve Requirement of Depository Institutions
• A specified percentage of deposits must be held as non-earning reserves.
• Required by the Fed.• Insures that institutions have some liquidity
to meet demand for withdrawals and helps to control the money supply.
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Simplified Balance Sheet of Commercial Bank
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Reserves
Investments
Loans
Deposits
Borrowed Funds
Bank Capital (Equity)
Fixed Assets
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The Federal Reserve System
• The Fed is the central bank of the United States
• Created in 1913
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Purpose of the FedPurpose of the Fed
Monetary authorityi.e., control the money supply
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Purpose of the Fed
Monetary authorityi.e., control the money supply
Lender of last resortFed makes “discount loans” to depository
institutions
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Purpose of the FedMonetary authority
i.e., control the money supplyLender of last resort
Fed makes “discount loans” to depository institutions
Check clearing
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Purpose of the FedPurpose of the Fed
Monetary authorityi.e., control the money supply
Lender of last resortFed makes “discount loans” to
depository institutionsCheck clearingBank Supervision
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Structure of the Fed• Board of Governors
– Seven members– Located in Washington, DC
• Federal Open Market Committee (FOMC)– Board of Governors plus five district Federal
Reserve Bank presidents– Located in Washington, DC
• Twelve Federal Reserve Banks– Corresponding to twelve districts
• Member Banks
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How the Fed Influences Interest Rates
• Open Market Operations• Discount Rate Policy• Reserve Requirements
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Open Market Operations
• The Fed buys and sells government securities in the open market.
• Buying securities increases the money supply which tends to decrease interest rates.
• Selling securities decreases the money supply which tends to increase interest rates.
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When the Fed buys T-Bills
The public
T-bills
$The Fed
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When the Fed When the Fed buysbuys T-Bills T-Bills
Reserves are injected into the economy
The public
T-bills
$The Fed
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When the Fed buys T-bills
Bank reserves increase.
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When the Fed When the Fed buysbuys T-bills T-bills
Bank reserves increase.This makes banks more willing to
lend, increasing the supply of loanable funds.
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When the Fed When the Fed buysbuys T-bills T-bills
Bank reserves increase.This makes banks more willing to
lend, increasing the supply of loanable funds.
{Supply of LF } { i }
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When the Fed buys T-bills• Bank reserves increase.• This makes banks more willing to lend,
increasing the supply of loanable funds.• {Supply of LF } { i }• Fed decreases rates when it wants to
stimulate the economy.
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When the Fed sells T-Bills
The public
T-bills
The Fed $
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When the Fed sells T-Bills
Reserves are extracted from the economy
The public
T-bills
$The Fed
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When the Fed sells T-bills
Bank reserves decrease
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When the Fed When the Fed sellssells T-bills T-bills
Bank reserves decreaseThis makes banks less willing to
lend, decreasing the supply of loanable funds.
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When the Fed When the Fed sellssells T-billsT-bills
Bank reserves decreaseThis makes banks less willing to
lend, decreasing the supply of loanable funds.
{Supply of LF } { i }
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When the Fed sells T-bills
• Bank reserves decrease• This makes banks less willing to lend,
decreasing the supply of loanable funds.
• Fed raises rates when it wants to slow the economy down.
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{Supply of LF } { i }
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Discount Rate PolicyDiscount Rate Policy
When the Fed increases the discount rateThis increases the cost of funds to
borrowing depository institutions, causing them to increase the rates they charge.
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Discount Rate Policy• When the Fed increases the discount rate
– This increases the cost of funds to borrowing depository institutions, causing them to increase the rates they charge.
• When the Fed decreases the discount rate– This decreases the cost of funds to
borrowing depository institutions, causing them to decrease the rates they charge.
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Reserve Requirements
When the Fed increases reserve requirements
– This decreases the amount of funds available for lending
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Reserve Requirements
When the Fed increases reserve requirements– This decreases the amount of funds
available for lending– {Supply of LF } { i }
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Reserve Requirements When the Fed When the Fed increasesincreases reserve reserve
requirementsrequirements– This This decreasesdecreases the amount of the amount of
funds available for lendingfunds available for lending– {{Supply of LF Supply of LF }} {{ i i }}
When the Fed When the Fed decreasesdecreases reserve reserve requirementsrequirements– This increases the amount of funds This increases the amount of funds
available for lendingavailable for lending
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Reserve Requirements• When the Fed increases reserve requirements
– This decreases the amount of funds available for lending
– {Supply of LF } { i}
• When the Fed decreases reserve requirements– This increases the amount of funds available
for lending– {Supply of LF } { i}
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The Federal Reserve• As the central bank of the United States,
“The Fed” regulates the financial system, the nation’s money supply, and makes loans to financial institutions.
• The Fed consists of twelve district banks, the Federal Open Market Committee, and the Board of Governors. The latter two are located in Washington DC.
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The Fed Influences Interest Rates by:
• Buying and selling federal securities (“open market operations”).– Selling (buying) securities reduces (increases) the money supply
which tends to increase (decrease) interest rates.• Discount rate
– Increasing the cost of funds to financial institutions tends to increase the rates they charge.
• Reserve Requirements– Increasing (decreasing) the amount of non-earning reserves that
must be held makes funds less (more) available and generally more (less) costly.
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Homework QuestionsHomework Questions
1. Explain how the Fed lowers and raises the federal funds rate.
2. What is the discount window?
3. The Federal Reserve is concerned about a continuing recession; what will they most likely do and how will they accomplish this?
4. What would happen to the standard of living if financial institutions did not exist? Why?
5. Interest rates are about to rise in the near future. Explain how this would impact a negative interest-rate spread of a financial institution.