Ch 23

Question 1

Financial intermediaries

Answer 1

are firms that extend credit to borrowers using funds raised from savers
Thousands of commercial banks accept deposits from individuals and businesses
They take these deposits and make loans with them
When loans are paid back, with interest, banks keep some of the interest and give some back to depositors
Intermediary: standing between savers and borrowers. E.g. savings and loans associations, credit unions

Question 2

Banks provide access to credit for small businesses and homeowners

Answer 2

May be the only source of credit for some investments by small businesses (vs. big corporations)

Question 3

A bond

Answer 3

a legal promise to repay a debt

When you buy a bond, you’re lending your money to a company or a government (the bondissuer) for a set period of time

Question 4

Each bond specifies

Answer 4

Principal amount, the amount originally lent
Maturation date, the date when the principal amount will be repaid
The term of a bond is the length of time from issue to maturation
Coupon payments, the periodic interest payments to the bondholder
Coupon rate, the interest rate that is applied to the principal to determine the coupon payments

Question 5

Bonds can be sold before their maturation date

Answer 5

Market value at any time is the price of the bond

Price depends on the relationship between the coupon rate and the interest rate in financial markets

Question 6

A two-year government bond with principal $1,000 is sold for $1,000, 1/1/18

Answer 6

Coupon rate is 5%
$50 will be paid 1/1/19
$1,050 will be paid 1/1/20

Question 7

A share of stock

Answer 7

a claim to partial ownership of a firm

Question 8

The current stock price would be higher if:

Answer 8

Dividend were higher
Price of stock in one year were higher
Interest rate were lower

Question 9

Risk premium

Answer 9

is the rate of return investors require to hold risky assets minus the rate of return on safe assets

Question 10

Suppose interest on a safe investment is 6%

Answer 10

FortuneCookie.com is risky, so 10% return is required
Stock will sell for $80 in 1 year; dividend will be $1
(Stock price) (1.10) = $81
Stock price = $73.64

Question 11

Channel funds from savers to borrowers with productive investment opportunities

Answer 11

Sale of new bonds or new stock can finance capital investment

Question 12

Like banks, bond and stock markets allocate saving

Answer 12

Provision of information on investment projects and their risks
Provide risk sharing and diversification across projects
Diversification is spreading one’s wealth over a variety of investments to reduce risk

Question 13

Geography

Answer 13

diversifying assets globally can help to reduce the risk of being exposed to any single country

Question 14

Economic sector

Answer 14

By holding investments across a broad range of industries, you can protect your portfolio from downturns in any one sector.

Question 15

Number and concentration of holdings

Answer 15

A larger, more diverse number of investments with less concentration in any one holding, can reduce a portfolio’s exposure to company-specific risks.

Question 16

Management style

Answer 16

Diversifying by management style can help smooth portfolio returns as different management styles react uniquely to market conditions.

Question 17

Market capitalization

Answer 17

Diversifying by size – small-cap, mid-cap, or large-cap companies – can provide you with a range of investments with exposure to broad market opportunities.

Question 18

Savers can put saving into a variety of financial assets

Answer 18

Diversification makes risky but potentially valuable projects possible
No individual saver bears the whole risk
Society is better off

Question 19

A mutual fund

Answer 19

is a financial intermediary that sells shares in itself to the public, then uses the funds raised to buy a wide variety of financial assets.
Diversified asset for the saver
Less costly and time-consuming than buying many stocks and bonds directly

Question 20

International Capital Flows

Answer 20

Investments flow between countries on international financial markets

Question 21

Trade balance

Answer 21

another name for net exports (NX)

Value of a country’s exports minus the value of its imports

Question 22

A trade surplus

Answer 22

a positive trade balance

Exports > imports

Question 23

A trade deficit

Answer 23

a negative trade balance

Imports > exports

Question 24

International capital flows

Answer 24

are purchases or sales of real and financial assets across international borders
Capital inflows are purchases of domestic assets by foreign households and firms
Capital outflows are purchases of foreign assets by domestic households and firms
Net capital inflows (KI) are capital inflows minus capital outflows

Question 25

Two Roles of International Capital Flows

Answer 25

Trade Imbalances | Efficient Allocation of Savings

Question 26

Trade Balance (NX) and Net Capital Inflows (KI)

Answer 26

NX + KI = 0 U.S. resident purchases Japanese car for $20,000 Imports = $20,000 Manufacturer holds $20,000 in a U.S. bank account Option 1: purchase $20,000 of U.S. goods and services so exports = $20,000 Option 2: purchase U.S. bonds or U.S. real estate NX = – $20,000, KI = $20,000 Option 3: sell dollars for yen Follow the dollars and see what the purchaser does with them to determine NX and KI

Question 27

Savings, Investment, Capital Inflows

Answer 27

``` Definition of output Y = C + I + G + NX Solve for I Y – C – G – NX = I National savings, S, is (Y – C – G) S – NX = I Also NX + KI = 0 OR KI = – NX So S + KI = I ```

Question 28

Developing countries fund their growth with capital inflows

Answer 28

Incomes are too low for large domestic savings | High rates of return on infrastructure and early investments

Question 29

Interest on foreign loans and eventually, the principle, must be paid

Answer 29

If investments are not productive, there are insufficient funds to pay interest and repay the loan: a debt crisis

Question 30

What causes trade deficits?

Answer 30

Not the production of inferior goods Not the result of unfair trade restrictions A low rate of national saving is the primary cause

Question 31

Recall S – I = NX

Answer 31

Hold I fixed High level of S implies a high level of NX Low level of S implies a low level of NX

Question 32

Why is a low rate of national saving associated with a trade deficit?

Answer 32

Low savings implies high spending High spending includes more spent on imports High domestic spending leaves less available for export High imports and low exports

Question 33

Trade deficit country receives capital inflows

Answer 33

Lack sufficient saving to finance domestic investment | Interest rate will rise and attract capital inflows

Question 34

The U.S. Trade Deficit

Answer 34

U.S. trade balanced until the mid 1970’s Large deficits since the mid 1970’s National saving has been less than investment since the mid 1970’s Decline in private saving in the 1990’s as consumption spending surged More spending on imports Trade deficits are not a problem as long as the economy continues to grow