Chapter 04 The Financial System And Interest

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FINANCIAL MANAGEMENT PART 4

Chapter 04 The Financial System And Interest

  1. 1. The Financial System and Interest Chapter 4
  2. 2. The Financial System <ul><li>Production vs. Consumption sectors </li></ul><ul><ul><li>Cash flows between sectors </li></ul></ul><ul><ul><ul><li>Workers receive wages from production sector which are spent in the consumption sector </li></ul></ul></ul><ul><ul><ul><li>Production spends income on inputs (consumption) to produce more, and so the cycle goes </li></ul></ul></ul>
  3. 3. Figure 4.1: Every Day Money Flows Between Sectors
  4. 4. Savings and Investment <ul><li>Consumption sector </li></ul><ul><ul><li>Most people do not consume all of their income — they save a portion </li></ul></ul><ul><ul><li>Need a place to deposit those savings and to earn a return </li></ul></ul><ul><li>Production sector </li></ul><ul><ul><li>Companies need to raise money to finance production </li></ul></ul><ul><ul><ul><li>Spend money on everyday operations, new factories, additional equipment, new enterprises </li></ul></ul></ul>
  5. 5. Savings and Investment <ul><li>Financial markets connect production’s need for money with consumption’s available savings </li></ul><ul><ul><li>The buyers and sellers of financial assets meet in a financial marketplace </li></ul></ul><ul><ul><ul><li>Companies issue stocks or bonds to raise money </li></ul></ul></ul><ul><ul><ul><li>Savers purchase these securities hoping to earn a return on their savings (investment) </li></ul></ul></ul><ul><ul><ul><ul><li>Consumer savings equals industrial investments </li></ul></ul></ul></ul>
  6. 6. Figure 4.2: Flows Between Sectors
  7. 7. Raising and Spending Money in Business <ul><li>Businesses spend money on: </li></ul><ul><ul><li>Day-to-day operations (inventory, wages, etc .) </li></ul></ul><ul><ul><ul><li>Money is raised for these operations using operating funds (money generated from day-to-day operations) </li></ul></ul></ul><ul><ul><li>Capital investments (new fixed assets such as new production line, expansion overseas, etc .) </li></ul></ul><ul><ul><ul><li>Money is raised for capital investments in the financial marketplace </li></ul></ul></ul><ul><ul><ul><ul><li>Borrowed money is debt financing </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Money raised through the sale of stock is known as equity financing </li></ul></ul></ul></ul>
  8. 8. Term <ul><li>Term refers to the length of time between now and the end (or term ination) of something </li></ul><ul><ul><li>Long-term projects (typically those lasting over 5-10 years) are usually financed with long-term funds </li></ul></ul><ul><ul><ul><li>Debt (bonds) </li></ul></ul></ul><ul><ul><ul><li>Equity </li></ul></ul></ul><ul><ul><li>Short-term projects (typically those lasting less than 1 year) are usually financed with short-term funds </li></ul></ul><ul><ul><ul><li>Bank loans </li></ul></ul></ul><ul><ul><li>Process is known as maturity matching </li></ul></ul>
  9. 9. Financial Markets <ul><li>Capital Markets </li></ul><ul><ul><li>Trade in stocks and long-term debt </li></ul></ul><ul><li>Money Markets </li></ul><ul><ul><li>Trade in marketable securities such as commercial paper, notes, bills </li></ul></ul><ul><ul><ul><li>Federal government is extremely active in issuing short-term debt </li></ul></ul></ul><ul><ul><ul><ul><li>Federal borrowing supports yearly deficit spending and the national debt </li></ul></ul></ul></ul>
  10. 10. Primary and Secondary Markets <ul><li>Purpose of a financial market is to facilitate the flow of funds from savers to production sector (investment in business projects) </li></ul><ul><ul><li>This occurs in the: </li></ul></ul><ul><ul><ul><li>Primary market (market in which securities are initially sold </li></ul></ul></ul><ul><li>Investors trade securities between each other in the </li></ul><ul><ul><li>Secondary market </li></ul></ul>
  11. 11. Primary and Secondary Markets <ul><li>Corporations, even though they do not raise money in the secondary market, are interested in the stock’s price in the secondary market </li></ul><ul><ul><li>Influences how much money can be raised in future stock issues </li></ul></ul><ul><ul><li>Senior management’s compensation is usually tied to the stock price </li></ul></ul>
  12. 12. Direct and Indirect Transfers, Financial Intermediaries <ul><li>Primary market transactions can occur </li></ul><ul><ul><li>Directly (issuing firm sells directly to buyers or through an investment bank) </li></ul></ul><ul><ul><ul><li>An investment bank helps companies market their securities </li></ul></ul></ul><ul><ul><ul><ul><li>Lines up investors and functions as a broker </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Brings buyers and sellers together </li></ul></ul></ul></ul></ul><ul><ul><li>Indirectly (financial intermediary—such as a mutual fund—buys securities and sells shares in the fund to buyers) </li></ul></ul><ul><ul><ul><li>No one mutual fund owner can identify specific stocks/bonds within the mutual fund as belonging only to him. </li></ul></ul></ul><ul><ul><ul><ul><li>The portfolio is owned collectively by individuals </li></ul></ul></ul></ul>
  13. 13. Figure 4.3: Transfer of Funds From Investors to Businesses
  14. 14. Direct and Indirect Transfers, Financial Intermediaries <ul><li>Institutional investors </li></ul><ul><ul><li>Mutual funds and similar financial intermediaries </li></ul></ul><ul><ul><li>Play a major role in today’s financial markets </li></ul></ul><ul><ul><ul><li>Own ¼ of all stocks but make over ¾ of all trades </li></ul></ul></ul><ul><ul><li>Examples include </li></ul></ul><ul><ul><ul><li>Mutual funds </li></ul></ul></ul><ul><ul><ul><li>Pension funds </li></ul></ul></ul><ul><ul><ul><li>Insurance companies </li></ul></ul></ul><ul><ul><ul><li>Banks </li></ul></ul></ul>
  15. 15. The Stock Market and Stock Exchanges <ul><li>Stock market—a network of exchanges and brokers </li></ul><ul><ul><li>Exchange—a physical marketplace (NYSE, AMEX, regional exchanges) </li></ul></ul><ul><ul><li>Broker—individual whose job is to assist people in buying and selling securities </li></ul></ul><ul><ul><ul><li>Work for brokerage firms </li></ul></ul></ul><ul><ul><ul><li>Members of stock exchange </li></ul></ul></ul>
  16. 16. Trading—The Role of Brokers <ul><li>What brokers do… </li></ul><ul><ul><li>An investor will open an account with a broker and place trades via telephone or online </li></ul></ul><ul><ul><li>Local broker will forward order to floor broker on trading floor of exchange </li></ul></ul><ul><ul><li>Floor broker trades on the floor of the exchange </li></ul></ul><ul><ul><ul><li>Each stock is traded in a particular spot on the exchange floor using an auction-like process </li></ul></ul></ul><ul><ul><ul><ul><li>Trading is supervised by a specialist </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Specialists make markets in designated securities </li></ul></ul></ul></ul></ul><ul><ul><li>Confirmation of trade is forwarded to local broker and investor </li></ul></ul>
  17. 17. Figure 4.4: Schematic Representation of a Stock Market Transaction
  18. 18. Exchanges <ul><li>New York Stock Exchange (NYSE) </li></ul><ul><ul><li>Trades securities for  1,200 of largest, strongest companies in U.S. </li></ul></ul><ul><ul><li>Handles about 85% of trading activity </li></ul></ul><ul><li>American Stock Exchange (AMEX) </li></ul><ul><ul><li>Handles slightly smaller, younger firms than NYSE </li></ul></ul><ul><li>Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc .) </li></ul><ul><li>Exchanges are linked electronically </li></ul>
  19. 19. Exchanges <ul><li>The Market </li></ul><ul><ul><li>The stock market refers to the entire interconnected set of places, organizations and processes involved in trading stocks </li></ul></ul><ul><li>Regulation </li></ul><ul><ul><li>Securities are regulated under state and federal laws </li></ul></ul><ul><ul><ul><li>Securities Act of 1933 </li></ul></ul></ul><ul><ul><ul><ul><li>Required companies to disclose certain information </li></ul></ul></ul></ul><ul><ul><ul><li>Securities Act of of 1934 </li></ul></ul></ul><ul><ul><ul><ul><li>Set up Securities and Exchange Commission </li></ul></ul></ul></ul><ul><ul><li>Securities law is primarily aimed at disclosure </li></ul></ul>
  20. 20. Private, Public, and Listed Companies, and the NASDAQ Market <ul><li>Assume a business is successful and the owner decides to raise money for expansion by incorporating and selling stock to others </li></ul><ul><ul><li>Privately held companies—can’t sell securities to the general public (also, sale of securities is severely restricted by regulation) </li></ul></ul><ul><ul><li>Publicly traded companies—have received approval of the SEC to offer securities to the general public </li></ul></ul><ul><ul><ul><li>Process of obtaining approval and registration is known as ‘going public’ </li></ul></ul></ul>
  21. 21. Private, Public, and Listed Companies, and the NASDAQ Market <ul><ul><li>Process of ‘going public’ </li></ul></ul><ul><ul><ul><li>Use an investment banking firm to determine </li></ul></ul></ul><ul><ul><ul><ul><li>If a market exists for shares of your company </li></ul></ul></ul></ul><ul><ul><ul><ul><li>The likely price for your firm’s stock </li></ul></ul></ul></ul><ul><ul><ul><li>Develop a prospectus—provides detailed information about company </li></ul></ul></ul><ul><ul><ul><ul><li>Financial statements </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Key executives/background </li></ul></ul></ul></ul><ul><ul><ul><li>SEC reviews prospectus </li></ul></ul></ul><ul><ul><ul><ul><li>An unapproved prospectus is call a ‘red herring’ </li></ul></ul></ul></ul>
  22. 22. Private, Public, and Listed Companies, and the OTC Market <ul><li>The IPO </li></ul><ul><ul><li>Once prospectus is approved by SEC securities can be sold to public </li></ul></ul><ul><ul><ul><li>Initial sale is known as an IPO or initial public offering </li></ul></ul></ul><ul><ul><ul><ul><li>Market for IPOs is very volatile and risky </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Prices can rise (or fall) very dramatically </li></ul></ul></ul></ul></ul><ul><ul><li>Investment banks usually line up buyers prior to the actual sale of securities </li></ul></ul><ul><ul><ul><li>Buyers are usually institutional investors </li></ul></ul></ul><ul><ul><li>IPO occurs in primary market, but once securities are placed with investors, trading begins in the secondary market </li></ul></ul>
  23. 23. The NASDAQ Market <ul><li>After a company goes public, its shares are usually traded in the over-the-counter (OTC) market </li></ul><ul><li>Eventually a firm may wish to be listed on an exchange </li></ul><ul><ul><li>Loosely organized network of brokers </li></ul></ul><ul><ul><ul><li>The National Association of Securities Dealers Automated Quotation System (NASDAQ) is the market’s computer system </li></ul></ul></ul>
  24. 24. Reading Stock Quotations <ul><li>Stock prices are quoted online and in newspapers </li></ul><ul><ul><li>Quotes report the </li></ul></ul><ul><ul><ul><li>Stock price, including yearly high and low </li></ul></ul></ul><ul><ul><ul><li>Ticker symbol </li></ul></ul></ul><ul><ul><ul><li>Dollar dividend and dividend yield </li></ul></ul></ul><ul><ul><ul><li>Price-earnings ratio </li></ul></ul></ul><ul><ul><ul><li>Volume </li></ul></ul></ul><ul><ul><ul><li>Daily high and low </li></ul></ul></ul><ul><ul><ul><li>Closing price </li></ul></ul></ul><ul><ul><ul><li>Net change </li></ul></ul></ul>
  25. 25. Figure 4.7: Stock Market Quotation for General Motors Corporation, March 11, 2003
  26. 26. Interest <ul><li>Interest rates typically refer to the rate charged on a debt instrument </li></ul><ul><ul><li>There are MANY interest rates, including the prime rate, the federal funds rate, etc . </li></ul></ul><ul><ul><ul><li>Interest rates tend to move in tandem </li></ul></ul></ul>
  27. 27. The Relationship Between Interest and the Stock Market <ul><li>The stock market reacts to changes in interest rates (even though interest rates are related to the bond market) </li></ul><ul><ul><li>Stocks (equity) and bonds (debt) compete for investor’s dollars </li></ul></ul><ul><ul><ul><li>Stocks offer higher returns but have more risk </li></ul></ul></ul><ul><li>If you could earn 10% by investing in a bond of IBM, what return would you want to invest in IBM’s stock? </li></ul><ul><ul><li>More than 10% because the stock is more risky </li></ul></ul>
  28. 28. The Relationship Between Interest and the Stock Market <ul><li>If interest rates were to rise to 12% on IBM’s bonds, what would happen to your required rate of return on IBM’s stock? </li></ul><ul><ul><li>Your required return on IBM’s stock would rise and therefore, the value of IBM’s stock would drop in the market </li></ul></ul><ul><li>Interest rates and security prices move in opposite directions </li></ul><ul><ul><li>Good reason for us to have an interest in interest rates </li></ul></ul>
  29. 29. Interest and the Economy <ul><li>Would you be more likely to buy a house/car when interest rates are high or low? </li></ul><ul><li>Interest rates have a significant effect on the economy </li></ul><ul><ul><li>Lower interest rates stimulate business and economic activity </li></ul></ul><ul><ul><ul><li>Businesses and individuals use credit a great deal </li></ul></ul></ul><ul><ul><ul><ul><li>Interest rates represent the cost of borrowing money (credit) </li></ul></ul></ul></ul>
  30. 30. Debt Markets <ul><li>Interest rates are set by supply and demand </li></ul><ul><li>Supply and Demand—A Brief Review </li></ul><ul><ul><li>A demand curve relates price and quantity for a product or service </li></ul></ul><ul><ul><ul><li>Reflects desires and abilities of buyers at a particular point in time </li></ul></ul></ul><ul><ul><ul><li>Demand curves usually slope downward to the right </li></ul></ul></ul><ul><ul><ul><ul><li>People buy more when the price of a product is low </li></ul></ul></ul></ul><ul><ul><li>A supply curve relates prices with quantities supplied by producers </li></ul></ul><ul><ul><ul><li>Generally upward sloping to the right </li></ul></ul></ul><ul><ul><ul><ul><li>Suppliers are willing to produce more when the price is high </li></ul></ul></ul></ul><ul><ul><li>Where the supply and demand curve intersect represents equilibrium </li></ul></ul><ul><ul><li>If conditions change the curves shift and a new equilibrium price is reached </li></ul></ul>
  31. 31. Figure 4.8: S&D Curves for a Product or Service
  32. 32. Supply and Demand for Money <ul><li>In the debt market the supply curve represents those willing to lend money </li></ul><ul><ul><li>The demand curve represents those people or companies desiring to borrow money </li></ul></ul><ul><li>The price represents the interest rate </li></ul><ul><li>Debt securities are bills, notes and bonds </li></ul><ul><li>Borrowers sell bonds and lenders buy bonds </li></ul><ul><ul><li>Borrowers include the government and companies </li></ul></ul><ul><ul><ul><li>Will borrow more when interest rates are lower </li></ul></ul></ul>
  33. 33. The Determinants of Supply and Demand <ul><li>Demand for borrowed funds depend on </li></ul><ul><ul><li>Opportunities available to use these funds </li></ul></ul><ul><ul><li>Attitudes of people and businesses about using credit </li></ul></ul><ul><ul><ul><li>If people feel good about the economy they will go on vacation, buy houses and cars, etc . </li></ul></ul></ul><ul><ul><ul><li>Businesses will borrow for expansion and new projects </li></ul></ul></ul>
  34. 34. The Determinants of Supply and Demand <ul><li>Supply of loanable funds depends on the time preference for consumption of individuals </li></ul><ul><ul><li>Whether a person would rather spend money now or invest it </li></ul></ul><ul><ul><ul><li>Most people spend for current consumption and save only a small portion of their income </li></ul></ul></ul><ul><ul><ul><ul><li>Money saved by individuals becomes loanable funds (or the supply of debt) </li></ul></ul></ul></ul><ul><li>A decrease in the preference for consumption will lead to an increase in loanable funds </li></ul><ul><ul><li>Leads to a rightward shift in the supply curve </li></ul></ul><ul><li>Constant changes cause the supply and demand curves to slide back and forth </li></ul><ul><ul><li>Market interest rate moves up and down all the time </li></ul></ul><ul><ul><ul><li>In the 1970s the movement in interest rates became more dramatic </li></ul></ul></ul><ul><ul><ul><ul><li>Unable to consistency forecast interest rates with accuracy </li></ul></ul></ul></ul>
  35. 35. The Components of an Interest Rate <ul><li>Interest rates include base rates rates and risk premiums </li></ul><ul><li>Interest rate will be represented by the letter k </li></ul><ul><ul><li>k = base rate + risk premium </li></ul></ul><ul><li>Components of the Base Rate </li></ul><ul><ul><li>The base rate is pure interest plus expected inflation </li></ul></ul><ul><ul><ul><li>The rate at which people lend money when no risk is involved </li></ul></ul></ul><ul><ul><li>Pure interest rate is AKA earning power of money </li></ul></ul><ul><ul><ul><li>An unobservable rate that would exist in the real world if there were no inflation </li></ul></ul></ul><ul><ul><ul><li>Generally considered to be between 2% and 4% </li></ul></ul></ul>
  36. 36. The Components of an Interest Rate <ul><li>The Inflation Adjustment </li></ul><ul><ul><li>Inflation refers to a general increase in prices </li></ul></ul><ul><ul><li>Refers to the fact that, if prices rise, $100 at the beginning of the year will not buy as much at the end of the year </li></ul></ul><ul><ul><li>If you loaned someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year </li></ul></ul><ul><ul><ul><li>Interest rates include estimates of average annual inflation over loan periods </li></ul></ul></ul>
  37. 37. Risk Premiums <ul><li>Risk in loans refers to the chance that the lender will not receive the full amount of principal and interest payments agreed upon </li></ul><ul><li>Some loans are more risky than others </li></ul><ul><li>Lenders demand a risk premium of extra interest for making risky loans </li></ul>
  38. 38. Different Kinds of Lending Risk <ul><li>Bond lending losses can be associated with fluctuations in the prices of bonds as well as with the failure of borrowers to repay the loans </li></ul><ul><li>Default Risk </li></ul><ul><ul><li>The chance the lender won't pay principal of interest </li></ul></ul><ul><ul><ul><li>Losses can be the entire amount or anywhere in between </li></ul></ul></ul><ul><ul><li>Investors demand a default risk premium which depends on the investor's perception of the creditworthiness of the borrower </li></ul></ul><ul><ul><ul><li>Perception is based on the firm's financial condition and credit record </li></ul></ul></ul>
  39. 39. Different Kinds of Lending Risk <ul><li>Default Risk (continued) </li></ul><ul><ul><li>Premiums range from 0% to 6 or 8 % </li></ul></ul><ul><ul><ul><li>Once a company's default risk becomes too high, they will be unable to borrow at any interest rate </li></ul></ul></ul><ul><ul><li>Default doesn't actually have to occur for problems to exist </li></ul></ul><ul><ul><ul><li>If investors realize that a firm is having difficulty making interest payments (although it is still making them) the bond's price will probably fall </li></ul></ul></ul><ul><ul><li>A time dimension is involved in the risk of default </li></ul></ul><ul><ul><ul><li>The longer the time period involved with the debt instrument the more likely that the firm will face financial difficulty </li></ul></ul></ul>
  40. 40. Different Kinds of Lending Risk <ul><li>Liquidity Risk </li></ul><ul><ul><li>Associated with being unable to sell the bond of an little known issuer </li></ul></ul><ul><ul><li>Debt of small firms are particularly hard to market </li></ul></ul><ul><ul><ul><li>Said to be illiquid </li></ul></ul></ul><ul><ul><ul><ul><li>Sellers must reduce their prices to encourage investors to buy the illiquid securities </li></ul></ul></ul></ul><ul><ul><li>Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk </li></ul></ul><ul><ul><li>Very short-term securities usually bear little liquidity risk </li></ul></ul>
  41. 41. Different Kinds of Lending Risk <ul><li>Maturity Risk </li></ul><ul><ul><li>Bond prices and interest rates move in opposite directions </li></ul></ul><ul><ul><li>Long-term bond prices change more with interest rate swings than short-term bond prices </li></ul></ul><ul><ul><ul><li>Gives rise to maturity risk </li></ul></ul></ul><ul><ul><li>Investors demand a maturity risk premium </li></ul></ul><ul><ul><ul><li>Ranges from 0% to 2% or more for long-term issues </li></ul></ul></ul>
  42. 42. Comparison of Similar Risk Bonds With Different Maturities
  43. 43. Putting the Pieces Together <ul><li>The factors that make up an interest rate, k, can be expanded to include the particular types of risk </li></ul><ul><ul><li>K = K Pure Interest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium </li></ul></ul><ul><ul><li>K is known as the nominal or quoted interest rate </li></ul></ul><ul><li>Setting Interest Rates </li></ul><ul><ul><li>Interest rates are set by the forces of supply and demand </li></ul></ul><ul><ul><ul><li>Thus the interest rate model above is only an economic model of reality </li></ul></ul></ul><ul><ul><ul><ul><li>Represents an explanation of what generally has to be behind the interest rate needs of investors </li></ul></ul></ul></ul>
  44. 44. Federal Government Securities, Risk Free and Real Rates <ul><li>Federal Government Securities </li></ul><ul><ul><li>Cities, states and federal governments issue long-term bonds </li></ul></ul><ul><ul><li>Federal treasury also issues short-term securities </li></ul></ul><ul><ul><ul><li>Known as Treasury securities </li></ul></ul></ul><ul><ul><ul><ul><li>Treasury bills have terms from 90 days to a year </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Treasury notes have terms from 1 to 10 years </li></ul></ul></ul></ul><ul><ul><li>No default risk associated with federal government debt </li></ul></ul><ul><ul><ul><li>Can print money to pay off all of its debt </li></ul></ul></ul><ul><ul><li>No liquidity risk for federal government debt </li></ul></ul><ul><ul><ul><li>Always an active market </li></ul></ul></ul>
  45. 45. The Risk-Free Rate <ul><li>The risk-free rate is approximately the yield on short-term Treasury bills </li></ul><ul><ul><li>Includes the pure rate and an allowance for inflation </li></ul></ul><ul><ul><ul><li>Same as the base rate discussed earlier </li></ul></ul></ul><ul><li>Viewed as a conceptual floor for the structure of interest rates </li></ul><ul><li>Denoted as k RF </li></ul>
  46. 46. The Real Rate of Interest <ul><li>Real refers to values that have the effects of inflation removed </li></ul><ul><li>Tells investors whether or not they are getting ahead </li></ul><ul><ul><li>If you earn a real rate of 8% on an investment and inflation turns out to be 10%, you are losing purchasing power on your investment </li></ul></ul><ul><li>There are periods in time when the real rate of interest has been negative </li></ul><ul><ul><li>Because we don't really know what the rate of inflation is at a point in time when nominal rates are set </li></ul></ul><ul><li>The Real Risk-Free Rate </li></ul><ul><ul><li>Implies that both the inflation adjustment and the risk premium is zero </li></ul></ul>
  47. 47. Yield Curves—The Term Structure of Interest Rates <ul><li>The relationship between interest rates and the term of debt is known as the term structure of interest rates </li></ul><ul><ul><li>The yield curve is a graphical representation of the term structure of interest rates </li></ul></ul><ul><li>Most of the time short-term rates are lower than long-term rates </li></ul><ul><ul><li>However at times the opposite is true </li></ul></ul><ul><ul><ul><li>Known as an inverted yield curve </li></ul></ul></ul>
  48. 48. Figure 4.10: Yield Curves
  49. 49. Yield Curves—The Term Structure of Interest Rates <ul><li>Theories have developed attempting to explain the term structure of interest rates </li></ul><ul><ul><li>Expectations theory </li></ul></ul><ul><ul><ul><li>Today's rates rise or fall with term as future rates are expected to rise or fall </li></ul></ul></ul><ul><ul><li>Liquidity preference theory </li></ul></ul><ul><ul><ul><li>Investors prefer shorter term securities and must be induced to make longer loans </li></ul></ul></ul><ul><ul><li>Market segmentation theory </li></ul></ul><ul><ul><ul><li>Loan terms define independent segments of the debt market which set separate rates </li></ul></ul></ul>
  50. 50. APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island <ul><li>If we lived in a primitive world without money would interest still exist? </li></ul><ul><li>On A Desert Island </li></ul><ul><ul><li>You are stranded on a deserted island with no need for protective clothing or shelter </li></ul></ul><ul><ul><li>However, food is a problem </li></ul></ul><ul><ul><ul><li>You have to spend all your time digging up edible roots bare handed </li></ul></ul></ul><ul><ul><ul><ul><li>No time for leisure and no ability to make anything extra </li></ul></ul></ul></ul>
  51. 51. <ul><li>Making a tool </li></ul><ul><ul><li>If you were to make a tool, you could dig more efficiently </li></ul></ul><ul><ul><ul><li>But it would take you five days to make a shovel, and you need to spend those five days digging for food </li></ul></ul></ul><ul><ul><ul><ul><li>So if you make a shovel, during the five days you will go hungry </li></ul></ul></ul></ul>APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island
  52. 52. <ul><li>Life with Tools—Savings and Investment </li></ul><ul><ul><li>You make the shovel and now you can dig twice as fast as before </li></ul></ul><ul><ul><ul><li>Now have the option of leisure time </li></ul></ul></ul><ul><ul><li>Shovel is a piece of capital equipment </li></ul></ul><ul><ul><li>You invested your savings to make it </li></ul></ul><ul><ul><ul><li>You saved productive capacity by not digging food while you made the shovel </li></ul></ul></ul><ul><ul><ul><ul><li>Willing to forego current consumption to devote resources to a future something </li></ul></ul></ul></ul>APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island
  53. 53. <ul><li>A New Arrival—And a Request to Borrow </li></ul><ul><li>Another castaway arrives on the island </li></ul><ul><ul><li>He is a loner and digs for edible roots using his bare hands </li></ul></ul><ul><ul><li>Decides he wants to borrow your shovel </li></ul></ul><ul><li>The Cost of Borrowed Shovels </li></ul><ul><ul><li>If you lend your shovel, some compensation is in order—perhaps food or labor services </li></ul></ul><ul><ul><li>However, you have the following ideas </li></ul></ul><ul><ul><ul><li>He has to receive productive benefit from using the shovel </li></ul></ul></ul><ul><ul><ul><ul><li>He will want to be able to dig more roots or the same amount of roots in a shorter amount of time than he could barehanded </li></ul></ul></ul></ul><ul><ul><ul><li>You might not get the shovel back--he might break it or refuse to return it (risk!) </li></ul></ul></ul><ul><ul><ul><li>The shovel may not be returned in its original condition </li></ul></ul></ul>APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island
  54. 54. <ul><li>Tying back to Interest </li></ul><ul><ul><li>K = K Pure Interest Rate + Inflation + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium </li></ul></ul><ul><ul><ul><li>The incremental productive power is the same as the pure interest rate </li></ul></ul></ul><ul><ul><ul><li>The compensation required for the chance of losing the shovel is the same as default risk </li></ul></ul></ul><ul><ul><ul><li>The worry that the shovel might not be returned in its original condition is the same as the inflation adjustment </li></ul></ul></ul>APPENDIX 4-A : Can There Be Interest Without Money? The Desert Island

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