Lesson Summary

What if you woke up one day and discovered you won $10,000\$10{,}000? What are you going to do with this new-found wealth? Spend it? Save it? If you decide to save it, then you are participating in the financial system.
The purpose of the financial system is to connect savers and borrowers. Savers store their wealth in ways that let them earn a return. Borrowers want to pursue projects, but they need money (from savers) to fund those projects. For example, if a firm wants to build a new factory, they might issue bonds and stocks to savers as a way to raise financial assets and get real assets. When borrowers buy those stocks and bonds, they are effectively lending money to these firms.

Key terms

Key termdefinition
financial systemthe set of institutions that connect savers with borrowers
financial intermediaryan institution that transforms the savings from individuals into financial assets (for the saver) and liabilities (for the borrower); the financial intermediary that people have the most experience with is a bank, which converts the savings and other deposits of many depositors into loans for borrowers.
assetsome item of value that is expected to provide the holder some future benefit; factories are an asset because they can be used to produce goods that provide income to a firm in the future, and a bond is an asset to a bondholder because it will provide income in the future.
liabilitiesrequirements to pay money in the future; a loan is a liability for the person who takes out a loan, but an asset to the person who loaned money out.
real asset(sometimes called a physical asset) a claim on a tangible object that gives the owner the right to use it as they wish. A house is a real asset that its owner can sell or rent out, and a factory is a real asset that a business can use to earn profits.
financial asseta contractual claim to something of value; modern economies have four main types of financial assets: bank deposits, stocks, bonds, and loans. In reality, there are many more types of financial assets (like derivatives, calls, puts, and so on), but you only need to know the basics of these four types for this course.
financial riskwhen there is any uncertainty about the future value of an asset; for example, if you don't know how many lime smoothies you can buy with the money in your savings account next week, the value of your savings account has risk, because inflation can reduce its value.
bank deposits(also called demand deposits) money kept in a bank, like checking accounts; we call these "demand deposits" because banks are usually required to provide access to the money in those accounts immediately on request (in other words, on demand).
liquidityhow easily an asset converts to cash without loss of purchasing power; a house might be a store of value, but it's not a very liquid asset because you can't immediately buy a bowl of ice cream with it very easily. Cash is the most liquid asset because you can use it immediately.
returnthe profit made on an asset, usually expressed as a percentage; for example, a stock that is purchased for $100\$100 and sold for $110\$110 has a return of 10%10\%.
bondsbonds are a form of an IOUs (a promise to pay back some amount in the future); bonds have three key features: the bond’s par, the bond’s maturity, and the bond’s coupon payments.
stocka slice of ownership in a company; if you own one share of a company that has a total of 100 shares, you own 1/100th1/100^\text{th} of that company. Stocks derive their value from their ability to appreciate and the payment of dividends.

Key takeaways

Cash and demand deposits are the most liquid forms of money

When it comes to financial assets, liquidity refers to how easily we can convert that asset into purchasing power. A good analogy for liquidity is liquids! Think of money in a checking account as water, wealth you have stored in a savings bond as cooking oil, and a house as honey. They will each pour out of their “container” at different speeds, and the one that is most liquid (the water/money) will pour out the quickest - you can spend money right away!
It takes a while to sell a house, however, which makes it similar to honey: it’s going to be a while before you have access to its purchasing power. We call assets like this illiquid because they are either hard to convert to spending power, or spending power is lost in the process. For instance, to sell your house this week you might have to sell it at a loss (less than you paid for it), and so some of its spending power will be lost in the process.
This is why cash and demand deposits are the most liquid assets: you can use them immediately to buy things without any loss of value. If you want to buy a $10\$10 lime smoothie, you can pull a $10\$10 bill out of your pocket and do that easily. But the $10\$10 savings bond your grandmother tucked in your birthday card is going to take more time and effort before you can spend it.

There are many kinds of financial assets

A modern economy has many ways to store value besides money, such as stocks, bonds, derivatives, and commodities like gold. Each kind of financial asset has a different goal for the agent that issues it, and they each have a different amount of risk and return for the person who purchases it. For instance:
A car factory owner might not know how much they can sell cars for once they are made. The value of stocks might increase, decrease, or even lose all of their value. Bond issuers may fail to pay back the par value of a bond. Even cash and savings accounts have risk because inflation may cause their purchasing power to decrease.

Stocks

Stocks are ownership claims. When a company initially issues stock, the company is exchanging cash for an equal ownership stake in the company (stocks are sometimes called “equities” because they represent equal shares). That ownership stake entitles the person who owns that stock to a portion of the profit the company makes, called dividends.
Another source of value to someone who owns stock is the ability to sell it to someone else, which will yield a return to the stock owner if the stock has appreciated.
You bet! Instead of issuing bonds, Fields Follies decides to raise money for their project by issuing shares of ownership in the company. They sell 100 shares of stock at $100\$100 per share (the initial sale of stocks is called an "initial public offering").
Jacob buys one share of stock for $100\$100. After one year, the company makes a profit of $999\$999, and issues dividends of $9.99\$9.99, so Jacob gets a check for $9.99\$9.99. He then sells the stock (on the New York Stock Exchange, under the ticker REF) for $120\$120. His return is both the amount that the stock has appreciated ($20\$20) and the dividends he earned while he held the stock ($9.99\$9.99). Jacob made a total of $29.99\$29.99 on his investment. Nicely done, Jacob!

Bonds

Companies and governments issue bonds to get cash today in exchange for money in the future. Unlike stocks, bonds do not give the owner of the bond any ownership claim—it is only a loan.
The value of a bond to the person who buys it is based on its maturity, par value, and coupon payments. Maturity is the length of time until you are paid a fixed amount of money. That fixed amount of money is the par value (sometimes called face value). Sometimes bonds give the owner an occasional payment called a coupon payment. For example, Joe buys a bond for $100\$100 that has a one-year maturity. Its face value is $110\$110 and pays a $1\$1 coupon every six months.
Sure! Fields Follies is a company that creates traveling carnival rides. They want to build a new factory to build their new ride, the Ultra-mega-slide 5000. Instead of borrowing money from a bank to do that, they decide to issue 400 bonds with a face value of $1000\$1000 each. The bonds have an annual coupon payment of 5%5\% and mature in 3 years.
Jacob buys one of these bonds in January 2014 for its face value ($1000\$1000). At the end of 2014, 2015, and 2016 he gets a 5% coupon payment ($1000×.05=$50\$1000 \times .05 = \$50 for each payment). At the end of 2016, he also gets paid back the face value of the bond. In total, then, Jacob has earned $150\$150 on his investment. However, Jacob's initial purchase price of $1000\$1000 is at risk if Fields Follies doesn't pay the bond back.

When interest rates increase, bond prices decrease

When interest rates go up, the price of previously issued bonds goes down. Let’s walk through the logic of why this relationship exists. Suppose you buy a bond that has a par of $110\$110 and you pay $100\$100 for that bond. For simplicity, let’s assume that this bond doesn’t pay any coupons (in other words, it is a “zero coupon bond”). We can calculate the rate of return on this bond the same way we calculate any rate of return:
rate of return=NewOldOld×100%=par valueprice of bondprice of bond×100%=$110$100$100×100%=$10$100×100%=10%\begin{aligned}\text{rate of return}&=\dfrac{\text{New}-\text{Old}}{\text{Old}}\times 100\%\\\\ &=\dfrac{\text{par value}-\text{price of bond}}{\text{price of bond}}\times 100\%\\\\ &=\dfrac{\$110 - \$100}{\$100}\times 100\%\\\\ &=\dfrac{\$10}{\$100}\times 100\%\\\\ &=10\%\end{aligned}
When you bought the bond, you were expecting a 10%10\% return. You were willing to do this because this return was at least as good as any other return you could get for your money, such as a savings account that also paid 10%10\% interest. In fact, if your bank's interest rate is 9%9\%, the bond is even more appealing.
Now, suppose the interest rate on your bank’s savings accounts increases to 12%12\%. Suddenly, that bond doesn’t look like such a great deal anymore! The opportunity cost of buying the bond is the interest you would have earned on a savings account. You would need to be able to buy the bond for less than $100\$100 to have a return comparable to the bank account. Would you be willing to buy it for only $99\$99? Let’s check:
$110$99$99=11.11%\dfrac{\$110 - \$99}{\$99}=11.11\%
Nope! The bond still isn’t as good of a deal, even though the price went down by $1\$1. In fact, the price of the bond would need to go down by almost two dollars before we would even consider it as an alternative to the bank account. All other bond buyers would have the same reaction, so the market price of the bond would go down.
You are absolutely correct! Recall that one of the determinants of demand is a related good: if a substitute is more attractive, the demand for a good will decrease.
In this case, when the return on a savings account increases because the interest rate has gone up, this will lead to a decrease in the demand for bonds. As in any other market, when demand decreases, the price decreases, as shown in the market here.
Figure 1: A bond market

The interest rate is the opportunity cost of money

If you hold onto cash (such as keeping it in your pocket or buried in your backyard) it's going to cost you. For example, if you have a $100\$100 bill in your pocket instead of in a savings account that pays 5%5\%, it costs you $5\$5 to have that money in cash instead of in an interest-bearing account.
That is what an interest rate is—the opportunity cost of holding money. When a bank pays you interest on your savings account, the bank is paying you for letting them use your money. You are willing to give up using that money yourself today in exchange for an ability to use more in the future.

Key equations

The Savings-Investment spending identity

I=SI=S
(II is investment and SS is savings).
When firms engage in investment spending (II), that money has to come from somewhere. Investment spending is on big projects like buying machinery or building new buildings which require firms to borrow money. That borrowed money comes from the savings (SS) of a lot of people. Therefore, all investment spending (II) must equal all savings (SS).
Let’s think about what would happen if savings and investment weren’t equal to each other. Suppose the current interest rate was 4%4\%. Investors know that they have projects that will earn them a return of 7%7\%, and so they want to borrow money to fund those projects because they would profit 3% on the project.
Suppose firms want to borrow a total of $100,000\$100,000 when the interest rate is 4%4\%. However, if people see a 4%4\% interest rate and only want to save a total of $80,000\$80{,}000, there is a problem! Banks can’t loan out money that they don’t have.
So, the bank increases the interest rate to 5%5\%. With the higher interest rate, firms aren’t as eager to do these new projects and will only borrow $90,000\$90{,}000. But some more savers are willing to deposit money, so a total of $90,000\$90{,}000 is now saved. The interest rate adjusted until the market for these funds has achieved an equilibrium.
There are three ways to think about an interest rate: It is the opportunity cost to people with money in their pocket of not putting that money in an interest-bearing account. It is the price of borrowing money. It is the reward for saving money.

Common misperceptions

  • A lot of people think of loans only as a liability, not an asset, because having a loan means you owe something. Butut to the person who is owed that money, the loan is an asset. Banks count loans as assets because they are a store of value for them. If a bank has made a loan for $100\$100, that is $100\$100 it knows will be paid back. In fact, banks frequently sell loans to other banks.
  • Similarly, people tend to only think of their bank accounts as assets. That’s true, but to the bank that has to pay the account holder that money when they want to withdraw it, that deposit is a liability.
  • Money is not just pieces of paper or coins with historical faces it. Money is anything that can serve the three functions of money. That means that anything we believe is performing those functions is money, including printed currency, electronic records, or even the giant stone money on the island of Yap.
  • Some people believe that "financial risk" is when you don't know if the value of something is going to go down or not. In reality, financial risk means uncertainty in any direction, not just down.
  • A common mistake is to mix up the relationship between bond prices and interest rates. Think of bonds and other financial assets (such as savings accounts) as substitute goods. Like other substitutes, when the price of one goes up, the demand for its substitute goes down. When interest increases (which is basically the “price” you are paid for the money in your savings account), the demand for bonds will decrease. As a result, the price of bonds will decrease.

Discussion questions

  • Use the format below to create a table describing the four financial assets that includes
1) the definition of the financial asset
2) the risks that that asset faces
3) the return to holding that form of asset
Assetsource of risksource of return
a)
b)
c)
d)
Assetsource of risksource of return
Stocksuncertainty over resale value, uncertainty about dividendsresale value, dividends
Bondsdefault risk, inflation risk, interest rate riskresale, a par value higher than the purchase price, coupon payments
Bank depositsinflation risk, bank failuresinterest
Loansdefault risk, inflation riskresale of a loan, interest
-The interest rate is currently 5%5\%. The government issued a zero coupon with a par value of $200\$200 bond in 2015 that is currently selling for $190\$190. If the interest rate increases to 7%7\%, what will happen to the price of this bond? Explain.
The price of the bond will decrease. The expected return on the government issued bond is:
200190190=5.26\dfrac{200-190}{190}=5.26
Therefore, the bond is paying a higher return than the current interest rate. However if the interest rate increases, a bond with a return of 5.26%5.26\% is not as attractive anymore, and the demand for that bond will decrease in the bond market. When the demand for something decreases, so does its price.
-What is the opportunity cost of keeping $100\$100 in your pocket, rather than buying a $100\$100 bond?
The interest rate that you could be earning on that money from an interest-bearing account or the return on any other kind of asset.
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