The Economic “Big Picture”Part 2: Financial Instruments

Dr. Katie Sauer

Metropolitan State College of Denver (ksauer5@mscd.edu)

Colorado Council for Economic Education4/28/2012

Session Overview:

I. Intro to Financial InstrumentsII. BorrowingIII. Saving and InvestingIV. Interest RatesV. Insurance

I. Intro to Financial Instruments

Financial instruments, like every other good or service in a market economy, must create some value.

- stocks, bonds, loans, credit

Financial instruments fulfill three basic functions:

1. Raise Capital (borrowing)

2. Deal with Excess Capital- Store It- Protect It Against Inflation- Make Profitable Use of It

3. Insure Against Risk

II. Borrowing

Credit refers to the amount of money that a third party is willing to advance to you (or on your behalf).

Once you have spent that money, it is debt that you owe to the third party.

You can have credit without debt. You can have credit and debt.Your debt results from you first having credit.

Common examples of credit:- car loan approval- mortgage approval- credit card- overdraft line of credit on checking account

There are 2 types of credit accounts:- fixed loans- revolving credit

A. Creditworthiness

In order for you to borrow money for a purchase, someone has to be willing to lend it to you.

Often times you ask complete strangers to lend you thousands of dollars.- car loan- home loan- credit card

How do they know you will pay them back?

They don’t. So, they’ll check your financial history and make a decision based on your past actions.

Whenever you apply for credit or a loan, you give the lender permission to check your financial history.

A Credit Report is a record of your credit history. - how much and type of debt you have- if you have made payments on time- if you have failed to pay back a loan

Credit reports are compiled by 3 agencies. EquifaxExperianTransUnion

Individuals are entitled to one free credit report per year from each of the three credit bureaus.

annualcreditreport.com

You are not entitled to receive a free credit score.

All the items on your credit report are compiled into a credit score. (aka FICO score)

Credit scores are used to predict the likelihood that a person will go 90 days past due (or worse) in the next 24 months.

- higher score = less likely to go past due

Credit scores can range from 300 to 850.- the higher the number, the better

In general:750 and above means you have excellent credit andwill qualify for the best interest rates

700 – 749 means you have good credit and will likely be approved for loans you apply for, but youmight not get the best interest rate possible

650 – 700 means you may or may not be approvedand you definitely will have a higher interest rate

649 and below means you are “subprime” and willgenerally not be approved

What affects my credit score?

- paying bills on time (very important!!!!)- available credit vs how much you owe- length of time you have had credit- recent applications for new credit- number of credit accounts do you have- type of credit accounts do you have

Credit scores may not consider your race, color, religion, national origin, sex or marital status.

The reason that people apply for credit is so they can pay for things now, even though they don’t have the money.

B. Consumption smoothing is the term used to describe the spending, saving and borrowing that people do in order to maintain a more constant standard of living throughout their lifetimes.

Early on in adulthood, people may borrow against future earnings.

In the “working years” people tend to put aside some money for the future.

By the middle to end of the working years, people should have paid back any debt before retirement.

In the “retirement years” people spend the money that they previously saved.

http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf

Sometimes borrowing in order to smooth consumption is financially responsible, sometimes it is not.

Be sure that the benefits of borrowing truly outweigh the costs.

C. Benefits of Borrowing to Pay for Purchases

- allows people to buy things that would otherwise take many years to save up for (house, car)

- allows people to attend college and improve their future earnings

- allows people to pay for things in an emergency

- allows people to have the things they want, immediately

D. Cost of Borrowing

When you borrow money to pay for something, you end up paying back more than the purchase price.

- pay interest

Most people know they have to pay interest on a loan. However, they are often unaware just how much they are paying.

III. Saving and Investing

A. Basic Terminology

savings = income – taxes – spending on goods & services

investment = something acquired for future income or benefit

- investments can generate income (e.g. interest, dividends)

- investments can appreciate in value(e.g. house, gold)

By itself, savings is just what is left over from your income after taxes and your spending.

When you take your savings and put it in an account that earns interest or buy a stock or a house, you are investing.

Why do people save?

According to the Federal Reserve’s triennial Survey of Consumer Finances:

http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf

How much do people save?

The savings rate is the percent of after-tax income that is saved.

The Bureau of Economic Analysis (www.bea.gov) has been tracking US household saving rates since 1959.

Year Average Savings Rate1960s 8.21%1970s 9.6%1980s 8.61%1990s 5.5%2000- Oct 2008 2.82%Since Oct 2008 5.77%

http://research.stlouisfed.org/fred2/data/PSAVERT.txt

The saving rate has been trending down since the early 1980s. In recessions, people tend to save more.

B. Turning Savings into Investment

The Financial System is the group of institutions in an economy that help to match savers with borrowers

The US economy has two basic types of financial institutions:

- financial markets- financial intermediaries

1. Financial Intermediaries are institutions where funds are transferred indirectly from savers to investors.

Examples:

Banks accept savings deposits and make loans. - pay interest to depositors, charge interest to borrowers

Mutual Funds are institutions that sell shares to the public and use the proceeds to buy a portfolio of stocks and bonds.- allows individuals with a small amount of money to diversify

2. Financial Markets are institutions where funds are transferred directly from savers to investors.

Examples: stocks and bonds

Bonds

A bond is a certificate of indebtedness. “IOU”

When a firm or government issues a bond, they are borrowing money from anyone who buys the bond.

They are promising to pay you back a certain value in the future.

A bond has a date of maturity and a rate of interest associated with it.

Suppose you buy a $1,000 bond that matures in 5 years and pays 6% interest.

- Today, you give up $1,000 and receive the bond.

- You will receive annual interest payments of 6% for the next 5 years.

1,000 x 0.06 = $60 per year

- At the end of the 5 years, you receive $1,000.

Bonds can be sold at par value (face value)a discounta premium

Issue price: $18.75

Face value: $25This bond sold at a discount.

What determines the price of a bond?

term: length of time until the bond matures- longer maturity time … riskier

credit risk: the probability that the borrower will fail to pay the interest or the principal

tax treatment: some bonds have interest that is tax free

Stocks

A stock is a claim of partial ownership of a firm.- shareholder

If you buy a stock, you are not guaranteed to get yourmoney back.

The price of a stock generally reflects the perception of a firm’s future profitability.

What determines the price of a stock?

1. Fundamental analysis is the study of a company’s accounting statements and future prospects.

It includes doing an economic analysis, industry analysis, and company analysis.

- P/E ratio (stock price / net income per share)- competitors- the market for its product- management- credit risk

2. The Efficient Markets Hypothesis is the theory that asset prices reflect all publicly available information about the value of the asset.

- equilibrium of supply and demand sets the price

According to this theory, at the market price, the number of people wanting to sell exactly equals the number wanting to buy.

Any stock that you think is “hot” and about to increase in value, someone else thought it was not hot and was willing to sell it.

3. Market IrrationalityStock prices sometimes seem to be driven by psychological reasons.

Following a StockGoogle Finance 2/21/12

current price per share, the last price a share was traded at

company namename of stock exchange and stock symbol

change: compared to most recent closing price

percent change: change x 100 close price

Range: daily high and low price

52 Week: high and low price for the last 52 weeks

Open: the price at the beginning of trading today

Vol/Avg: Volume = number of shares traded today Average = average number of shares traded daily

Mkt cap: Market Capitalization is a measure of the total value of the company

Mkt Cap= Total Shares Outstanding x Current Price

P/E: Price-to-Earnings Ratio is the price of a share divided by last year’s earnings per share

Div/Yield: a Dividend is the amount of money the firm will pay you (typ. each quarter) for each share you own. The Yield = dividend / price

- not all firms pay dividends

EPS: Earnings Per Share is the amount of earnings per each outstanding share

Shares: the number of shares outstanding

Beta: A statistical estimate of how closely the stock’s performance matches the stock market in general. The higher the beta, the closer the stock matches the general market.

Inst. Own: Institutional Ownership is percent of the shares that the firm owns

savings

business investment

physical capital

capital per worker

productivity

standard of living

C. The Importance of Savings in the Economy

IV. Interest Rates

A. The Market for Loanable Funds

The supply of funds comes from savings. The demand for funds comes from borrowers.

The “price” of funds is the real interest rate.

r

Quantity of Funds

SF

DF

The supply of funds slopes up because as r rises, people will save a higher quantity.

The demand for funds slopes down because as r rises, firms and individuals will borrow a lower quantity.

(Savings)

(Borrowing)

r

Quantity of Funds

SF

DF

Q*

r*

The equilibrium occurs where the supply of funds equals the demand for funds.

If r > r*, the supply would exceed the demand and there would be a surplus, pushing the interest rate down.

If r < r*, the demand would exceed the supply and there would be a shortage, pushing the interest rate up.

(Savings)

(Borrowing)

The interest rate you actually pay on a loan or credit card is the nominal interest rate.

It is comprised of:- the real interest rate the lender wants to earn- the expected inflation rate- a risk premium

B. Another factor influencing interest rates is actions by the Federal Reserve.

The Fed controls the federal funds rate.

Banks charge each other the federal funds rate on short term loans.

Banks charge their best customers the “prime rate”, which is based on the federal funds rate.

The interest rate on consumer loans is often “prime + X”.

V. Insurance

Risk Aversion is a dislike of uncertainty.

One way to deal with risk is to buy insurance. - a person facing a risk pays a fee to an insurance firm

- the firm agrees to take on all or a part of the risk

From the standpoint of the economy as a whole, the role of insurance is to spread around the risk.

- can’t eliminate it completely

Model of Insurance Pricing

Suppose that 1 in 5 drivers age 21 to 24 get in an accident each year. The average amount of damage is calculated to be $4500 per incident.

If an insurance company insures 5 drivers age 21 to 24, it faces this situation:

20% chance of paying out $450080% chance of paying out $0

Expected payout per individual:(0.20)(4500) + (0.80)(0) = $900

The company will need to charge $900 to each driver.

- actuarially fair policy

What if in one year 2 people have accidents. One costs $2000 and the other costs $7000.

The insurance company will have paid out $9000 but will have only received 5 x $900 = $4500 in premiums.

Small groups of insured can have a lot of volatility!

In order to stay in business, insurance companies need to insure many people.

- spread around the risk

In general, the lower the probability of an “event”, the less you will pay in premiums.

In general, the larger the number of people in the risk pool, the less you will pay in premiums.

Insurance markets suffer from two problems not faced by most other markets:

- people likely to use the insurance are the ones who most want to buy it (adverse selection )

- once a person has insurance, they may change their behavior (moral hazard)

To deal with these problems, the insurance firm rarely agrees to take on all of the risk.

They will only accept the financial responsibility after you have accepted some of it.

- deductibles

In general, the higher the deductible, the lower the premiums.

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Questions?