Chapter 5

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Chapter 5

  1. 1. Chapter 5 Banking and Interest Rates
  2. 2. Chapter Objectives <ul><li>Describe the functions of financial institutions </li></ul><ul><li>Identify the components of interest rates </li></ul><ul><li>Clarify the relationship between the maturity and interest rate of an investment </li></ul>
  3. 3. Types of Financial Institutions <ul><li>Depository institutions: Financial institutions that accept deposits from individuals and provide loans </li></ul><ul><ul><li>Commercial banks: financial institutions that accept deposits and use the funds to provide commercial and personal loans </li></ul></ul><ul><ul><ul><li>Deposits insured by Federal Deposit Insurance Corporation (FDIC) up to $100,000 per depositor </li></ul></ul></ul>
  4. 4. Types of Financial Institutions <ul><ul><li>Savings institutions (or thrift institutions): financial institutions that accept deposits and provide mortgage and personal loans to individuals </li></ul></ul><ul><ul><li>Credit unions: nonprofit depository institutions that serve members who have a common affiliation </li></ul></ul>
  5. 5. Types of Financial Institutions <ul><li>Focus on Ethics: Special Rates on Deposits </li></ul><ul><ul><li>Check the fine print before making any deposit </li></ul></ul><ul><ul><li>Ask important questions </li></ul></ul><ul><ul><ul><li>How long is an advertised rate good for? </li></ul></ul></ul><ul><ul><ul><li>What will it be lowered to? </li></ul></ul></ul><ul><ul><ul><li>How long must your maintain the deposit? </li></ul></ul></ul>
  6. 6. Types of Financial Institutions <ul><li>Nondepository institutions: financial institutions that do not offer federally insured deposit accounts, but provide various other financial services </li></ul><ul><ul><li>Finance companies: nondepository institutions that specialize in providing personal loans </li></ul></ul>
  7. 7. Types of Financial Institutions <ul><ul><li>Securities firms: nondepository institutions that facilitate the purchase or sale of securities by providing investment banking and brokerage services </li></ul></ul><ul><ul><li>Insurance companies: nondepository institutions that provide insurance to protect individuals or firms against possible adverse events </li></ul></ul>
  8. 8. Types of Financial Institutions <ul><ul><li>Investment companies: nondepository institutions that sell shares to individuals and use the proceeds to invest in securities to create mutual funds </li></ul></ul><ul><li>Financial conglomerates: financial institutions that offer a diverse set of financial services to individuals or firms </li></ul><ul><ul><li>Examples include Bank of America, Merrill Lynch, and Citigroup </li></ul></ul>
  9. 9. Types of Financial Institutions
  10. 10. Banking Services Offered by Financial Institutions <ul><li>Checking services </li></ul><ul><ul><li>Checking accounts allow you to draw on funds by writing checks </li></ul></ul><ul><ul><li>Monitor your account balance by recording checks as you write them </li></ul></ul><ul><ul><ul><li>Banks charge fees for bounced checks </li></ul></ul></ul><ul><ul><li>You should reconcile your account balance with your monthly statement </li></ul></ul>
  11. 11. Banking Services Offered by Financial Institutions
  12. 12. Banking Services Offered by Financial Institutions <ul><li>You can often access your account balance by calling an automated phone service or online </li></ul><ul><li>Electronic checking reduces fraud by clearing checks immediately </li></ul>
  13. 13. Banking Services Offered by Financial Institutions <ul><li>Credit card financing such as Visa and Mastercard </li></ul><ul><li>Debit card: a card that is used to make purchases that are charged against an existing checking account </li></ul><ul><li>Safety deposit box: a box at a financial institution where a customer stores valuables such as documents or jewelry </li></ul>
  14. 14. Additional Services Financial Institutions Offer <ul><li>Automated teller machines (ATMs): machines where individuals can deposit and withdraw funds any time of the day </li></ul><ul><li>Money order: a check that is written on behalf of a person and will be charged against a nonfinancial institution’s account </li></ul>
  15. 15. Additional Services Financial Institutions Offer <ul><li>Traveler’s check: a check that is written on behalf of an individual and will be charged against a large well-known financial institution or credit card sponsor’s account </li></ul><ul><li>Cashier’s check: a check that is written on behalf of a person to a specific payee and will be charged against a financial institution’s account </li></ul>
  16. 16. Selecting a Financial Institution <ul><li>Convenience </li></ul><ul><ul><li>Close to where you live or work, convenient ATM locations, Internet banking </li></ul></ul><ul><li>Deposit rates and insurance </li></ul><ul><ul><li>Comparison shop for best interest rates </li></ul></ul><ul><li>Fees </li></ul><ul><ul><li>Comparison shop for best fees on the services you need </li></ul></ul>
  17. 17. Financial Planning Online: Internet Banking <ul><li>Go to: http://www. chicagofed .org </li></ul><ul><li>Click on: Project Money $mart, then “What You Should Know About Internet Banking” </li></ul><ul><li>This Web site provides information that can help you decide whether an Internet bank suits your needs. </li></ul>
  18. 18. Financial Planning Online: Financial Institutions That Can Serve Your Needs <ul><li>Go to: http://dir.yahoo.com/business_and_economy/finance_and_investment/banking/ </li></ul><ul><li>This Web site provides information about individual financial institutions such as the services they offer and the interest rates they pay on deposits or charge on loans. </li></ul>
  19. 19. Interest Rates on Deposits and Loans <ul><li>Interest rates on deposits and loans affect your cash inflows and outflows </li></ul><ul><li>Certificate of deposit: an instrument that is issued by a depository institution and specifies a minimum investment, an interest rate, and a maturity </li></ul><ul><li>Risk-free rate: a return on an investment that is guaranteed for a specified period </li></ul>
  20. 20. Interest Rates on Deposits and Loans <ul><li>Risk premium: an additional return beyond the risk-free rate that can be earned from a deposit guaranteed by the government </li></ul><ul><li>Loan rate — financial institutions loan money at a rate higher than they pay depositors </li></ul><ul><ul><li>Individuals with a poor credit history pay higher rates </li></ul></ul>
  21. 21. Financial Planning Online: Current Interest Rate Quotations <ul><li>Go to: http://www. bloomberg .com/markets/rates.html </li></ul><ul><li>This Web site provides updated quotations on key interest rates and charts showing recent movements in these rates. </li></ul>
  22. 22. Interest Rates on Deposits and Loans
  23. 23. Interest Rates on Deposits and Loans
  24. 24. Interest Rates on Deposits and Loans <ul><li>Impact of changes in interest rates </li></ul><ul><ul><li>Rising interest rates increase the amount of interest paid on deposits but also increases the amount of interest charged on loans </li></ul></ul><ul><li>Comparing interest rates and banks </li></ul><ul><ul><li>Choice is dependent on your risk tolerance and your financial situation </li></ul></ul>
  25. 25. Term Structure of Interest Rates <ul><li>Term structure of interest rates: the relationship between the maturities of risk-free debt securities and the annualized yields offered on those securities </li></ul><ul><ul><li>Often based on rates of return offered by U.S. Treasury securities with different maturities </li></ul></ul>
  26. 26. Term Structure of Interest Rates Exhibit 5.4: Annualized Deposit Rates Offered on Deposits with Various Maturities
  27. 27. Term Structure of Interest Rates Exhibit 5.5: Comparison of Interest Rates among Deposits
  28. 28. Term Structure of Interest Rates <ul><li>Shifts in the yield curve </li></ul><ul><ul><li>Graphs such as the one on the previous slide can be found in financial publications such as the Wall Street Journal and illustrate how returns change over time </li></ul></ul>
  29. 29. Term Structure of Interest Rates Exhibit 5.6: Treasury Security Yields
  30. 30. Financial Planning Online: Updated Treasury Yields <ul><li>Go to: http://www. bloomberg .com </li></ul><ul><li>Click on: U.S. Treasuries </li></ul><ul><li>This Web site provides yields of Treasury securities with various maturities. </li></ul>
  31. 31. How Banking Services Fit within Your Financial Plan <ul><li>The key banking decisions for your financial plan are: </li></ul><ul><ul><li>What banking service characteristics are most important to you? </li></ul></ul><ul><ul><li>What financial institution provides the best banking service characteristic for you? </li></ul></ul>
  32. 32. Integrating the Key Concepts
  33. 33. Integrating the Key Concepts <ul><li>Part 1: Financial Planning Tools </li></ul><ul><li>Part 2: Liquidity Management </li></ul><ul><ul><li>In Chapter 5 we learned about banking and interest rates </li></ul></ul><ul><ul><li>Chapter 6 teaches about managing your money </li></ul></ul><ul><ul><li>Chapter 7 teaches about managing your credit </li></ul></ul><ul><li>Part 3: Financing </li></ul><ul><li>Part 4: Protecting Your Wealth </li></ul><ul><li>Part 5: Investing </li></ul><ul><li>Part 6: Retirement and Estate Planning </li></ul>
  34. 34. How the Risk-Free Interest Rate Is Determined <ul><li>Determined by total supply of funds provided by all investors and the total demand for funds by all borrowers </li></ul><ul><li>Interest rate represents cost of debt to borrowers and reward for providing credit to creditors </li></ul><ul><li>Intersection between supply curve and demand curve results in equilibrium rate </li></ul>
  35. 35. How the Risk-Free Interest Rate Is Determined Exhibit 5A.1: How an Equilibrium Interest Rate Is Determined
  36. 36. Why Interest Rates Change <ul><li>Shift in the supply curve </li></ul><ul><ul><li>Increase in saving causes supply curve to shift outward, lowering equilibrium interest rate </li></ul></ul><ul><ul><li>Shift in monetary policy: the actions taken by the Federal Reserve to control the money supply </li></ul></ul><ul><ul><ul><li>Money supply: demand deposits and currency held by the public </li></ul></ul></ul><ul><ul><ul><li>Open market operations: the Fed’s buying and selling of Treasury securities </li></ul></ul></ul>
  37. 37. Why Interest Rates Change Exhibit 5A.2 Impact of an Inward Shift in the Supply Schedule
  38. 38. Why Interest Rates Change <ul><li>Shift in the demand curve </li></ul><ul><ul><li>Any factors that cause a change in the demand for funds </li></ul></ul><ul><ul><li>Shift in the government demand for funds </li></ul></ul><ul><ul><li>Shift in the business demand for funds </li></ul></ul><ul><ul><li>Shift in the household demand for funds </li></ul></ul><ul><li>Combining the factors — changes often occur as the result of a combination of factors </li></ul>
  39. 39. Why Interest Rates Change Exhibit 5.A3: Impact of an Outward Shift in the Demand Schedule
  40. 40. Financial Planning Online: Fed’s Upcoming Meetings <ul><li>Go to: http://www. bloomberg .com/ bbn / fedwatch .html </li></ul><ul><li>This Web site provides updated information about the Fed’s recent actions and upcoming meetings. </li></ul>

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