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Summary of Chapter 24: Saving, Investment, and the Financial System
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Chapter 24: Saving, Investment, and the FinancialSystem
The financial system consists of those institutions in the economy that help to make one
person’s saving with another person’s investment. This chapter examines how the financial
system brings together savers and borrowers.
Financial Institutions in the Economy
At the broadest level, the financial system moves the economy’s scarce resources from
savers to borrowers. Many savers supply their money to the financial system with the
expectations that they will get it back with interest at a later date. The financial system is
made up of various financial institutions that help coordinate savers and borrowers. Financial
institutions can be grouped into two categories - financial markets and financial
intermediaries.
Financial Markets
Financial markets are the institutions through which a person who wants to save can directly
supply funds to a person who wants to borrow. Two of the most important financial markets
in advanced economies are the bond market and the stock market.
The Bond Market
When a company wants to borrow money to finance a major new exploration project, it can
borrow money directly from the public. It does this by selling bonds. A bond is a certificate of
indebtedness that specifies the obligations of the borrower to the holder of the bond. Put
simply a bond is an IOU (I owe you). It identifies the time at which the loan will be repaid,
called the date of maturity, and the rate of interest that will be paid periodically (called the
coupon) until the loan matures. The buyer of the bond gives the company their money in
exchange for this promise of interest and eventual repayment of the amount borrowed (the
principal). The buyer can hold the bond until maturity or can sell the bond at an earlier date
to someone else. The first characteristic is a bond’s term - the length of time until the bond
matures. Some bonds have short terms, such as a few months, while others have terms as
long as 30 years. The second characteristic of a bond is its credit risk - the probability that
the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a
default. When the national government wants to borrow money to finance public spending,
they issue bonds. These are referred to as sovereign debt. Some government is considered
a safe credit risk, such as Germany. In contrast, financially shaky corporations raise money
by issuing junk bonds, which pay a very high-interest rate.
Bond Prices and Yield
Assume a corporation issues a 1000 euro bond over 10 years with a coupon of 3.5%. For
the next 10 years, the corporation will have to pay the bondholder 35 euros a year, and
when the bond matures the corporation will have to pay back the 1000 euro principal. The
yield of the bond is given by:
Coupon
∗100 // Coupon is not the same as the coupon rate
Price
The reason why bond prices rise and fall on the market is due to the demand and supply of
bonds. Bond prices are affected by existing bonds in the market, the issue of new bonds, the
, likelihood of the bond issuer defaulting and the interest rate on other securities. The issue of
a new bond is also affected by these factors. If current interest rates are high, new issues
have to have a coupon that will compete and vice versa.
The Stock Market
One way for a company to raise funds is to sell stock in the company. Stock represents
ownership in a firm and is, therefore, a claim to the future profits that the firms make. A stock
is also commonly referred to as a share or as equity. Sales of stock to raise money is called
equity finance, whereas the sale of bonds is called debt finance. Although corporations use
both equity and debt finance to raise money for new investments, stock and bonds are very
different. If a company is very profitable, the shareholders enjoy the benefits of these profits,
whereas the bondholders only get the interest on their bond. If the company runs into
financial difficulty, the bondholders are paid what they are due before shareholders receive
anything at all. Compared to bonds, stocks offer the hold both higher risk and potentially
higher returns. Corporations can issue stock by selling shares to the public through
organized stock exchanges. These first-time sales are referred to as the primary market.
Shares that are subsequently traded among stock-holders on stock exchanges are referred
to as the secondary market. The prices at which shares trade on stock exchanges are
determined by the supply and demand for the stock in these companies. Because stock
represents a claim to future profits in a corporation, the demand for a stock reflects people’s
perception of the corporation’s future profitability. A stock index is computed as an average
of a group of share prices.
Financial Intermediaries
Financial intermediaries are financial institutions through which savers can indirectly provide
funds to borrowers. The term intermediary reflects the role of these institutions in standing
between savers and borrowers. The two most important intermediaries are banks and
investment funds.
Banks
If the owner of a small business wants to finance an expansion of their business, they most
likely finance their business expansion with a loan from a bank. Banks are the financial
intermediaries with which people are most familiar. A primary function of a bank is to take in
deposits from people who want to save and use these deposits to make loans to people who
want to borrow it. Depositors receive interest on their deposits and borrowers pay slightly
higher interest on their loans. In other words, banks help create a special asset that people
can use as a medium of exchange. A medium of exchange is an item that people can easily
use to engage in transactions. Stocks and bonds, like bank deposits, are a possible store of
value for the wealth that people have accumulated in past saving.
Investment or mutual fund
An investment or mutual fund is a vehicle that allows the public to invest in a selection, or
portfolio, of various types of shares, and bonds, or both shares and bonds. The primary
advantage of these funds is that they allow people with small amounts of money to diversify.
Buyers of shares and bonds are well-advised to heed the adage, ‘don’t put all your eggs in
one basket.’ Investment funds make this diversification easy. With only a few hundred euros,
a person can buy shares in an investment fund and, indirectly, become the part-owner or
creditor of hundreds of major companies.
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