Chapter 13 Saving, Investment, and the Financial System

Chapter 13 Saving, Investment, and the Financial System -...


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Chapter 13 Saving, Investment and the Financial System The Financial System The group of institutions in the economy that help to match one person’s saving with another person’s investment. 1. Financial markets Financial institutions through which savers can directly provide funds to borrowers. The Bond Market A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond, it is an IOU. It identifies: 1. the date of maturity (time at which the loan will be repaid) 2. and the rate of interest that will be paid periodically until the loan matures. The buyer of the bond gives his or her money to the bond issuer in exchange for interest and eventual repayment (principal) 3 Characteristics of bonds: 1. Term = The length of time until the bond matures. A special bond that never matures is called a perpetuity , which pays interest forever but the principal is never repaid. The interest rate depends partially on the term. Long term bonds are usually riskier because it takes longer for the buyer to get his or her money back, which is why its interests rates are normally higher. If the buyer needs the money back before the date of maturity, the buyer can sell the bond to someone else, perhaps at a lower price. 2. Credit Risk= The probability that the borrower will fail to pay some of the interest or prin- cipal. The failure to pay is called the default, a default on loans can be done by declaring bank- ruptcy. When bond buyers perceive that the probability of default is high, they demand higher in- terest rate to compensate them for this risk. The US governments considered a safe credit risk so government bonds tend to pay low interest rates; whereas financially shaky firms issue junk bonds, which pay very high interest rates. Various private agencies such as Standard’s and Poor’s rate the credit risk of different bonds. 3. Tax Treatment = The way the tex laws treat interest earned on the bond. Most bonds have a taxable interest which means the bond owner has to pay part of the interest in income taxes. Mu- nicipal bonds are bonds issues by local and state governments that do not require the bond own- ers to pay federal income tax on interest income. This is why municipal bonds pay a lower in- terest rate than bonds issued by corporations or the federal government.
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The Stock market Stock represents ownership in a firm and is, therefore, a claim to the profits that the firm makes. The sale of stock is called equity finance, whereas the sale of bonds is called debt fin-
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