 Explore the structure of the financial system

 Study the relationship between risk and returns

 Explainhow to calculate present value of an
financial asset
 Introduce the model of loanable fund

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 Saving

Economic Investment
Growth

Foreign
borrowing

3
 FINANCIAL SYSTEM

Financial Financial
markets intermediaries

Stock Bond Commercial Mutual

market market Bank funds

4
 Financial
markets are the institutions through
which savers can directly provide funds to
borrowers.

 Financial
intermediaries are financial institutions
through which savers can indirectly provide funds
to borrowers.

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 OU
I

 Who issues stock and bond?

 What is
the position of the stockholder and the
bondholder in the company?
 Where do returns of holding stock and bond come
from?
 Which is riskier and which offers a higher average
return?

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 The Bond Market
 A bond is a certificate of indebtedness that specifies
obligations of the borrower to
the holder of the bond.

 Characteristics of a Bond
 Term: The length of time until the bond matures.
 Credit Risk: The probability that the borrower will fail to
pay some of the interest or principal.
 Normally, bonds have a fixed interest rate

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 How can we calculate the present value of a bond, which promises to pay
$1,000 in 20 years, assume interest rate now is 10%?

$1, 000 =
Present value = = $148.64
(1 + 0.10) 20

How can we calculate the present value of a bond, which promises to pay $100
each year for next 20 years, assume interest rate now is 10%?

$100 $100 $100

Present value = + + ... = $851.35
(1 + 0.10) (1 + 0.10) 2
(1 + 0.10) 20

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 Now assume interest rate is 2%, other things being equal. What would happen
to the answers of two cases above?

$1, 000
Present value = = $673
(1 + 0.02) 20

$100 $100 $100

Present value = + + ... = $1635.14
(1 + 0.02) (1 + 0.02) 2
(1 + 0.02) 20

When interest falls, the present value of a given payment in

the future increase!!!

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 The Stock Market

 Stock represents a claim to partial ownership in a firm and is

therefore, a claim to the profits that the firm makes.
 The sale of stock to raise money is called equity financing.
 Compared to bonds, stocks offer both higher risk and potentially
higher returns.

 The most important stock exchanges in the United States are

the New York Stock Exchange, the American Stock Exchange,
and NASDAQ.

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 Returns to stockholder are expressed in two types:
 Dividends (divided profits)

 Capital gains/losses (net change in stock price)

 This is determined by demand/supply of its stock in the market,
which in turn is determined by that firm’s retained earnings and
profitability.

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The market value, or price, of the stock can be explained in terms of
investors’ forecasts of dividends and price and the expected return
offered by other equally risky stocks.

Price today = Present value of (DIV1, DIV2,…, DIVt,…)

DIV1 DIV2 DIV3 DIVt

= + + + ... + + ...
1 + r (1 + r ) (1 + r )
2 3
(1 + r )
t

THE DIVIDEND DISCOUNT MODEL

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 When the risk is higher, the required rate of return
should be higher to compensate for risk-taker
 Whenthe rate of return offered is higher, it should be
remembered that you are exposed to higher risk

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 The Stock Market

 Most newspaper stock tables provide the following

information:
 Price (of a share)
 Volume (number of shares sold)
 Dividend (profits paid to stockholders)
 Price-earnings ratio

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A lot of challenges for partners when undertaking transactions
through financial markets!!!

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That explains why we need financial intermediaries!!!

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 Banks
 take deposits from people who want to save and use the deposits to
make loans to people who want to borrow.
 pay depositors interest on their deposits and charge borrowers
slightly higher interest on their loans.

 Mutual Funds
 A mutual fund is an institution that sells shares to the public and
uses the proceeds to buy a portfolio, of various types of stocks,
bonds, or both.
 They allow people with small amounts of money to easily diversify.
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 Diversification into a portfolio of financial assets – or not
putting all the eggs in one basket – can reduce the risk.

 Purchasing insurance policy can help reduce the size of

loss when the bad outcome realizes.
 Examples: fire insurance, deposit insurance, CDS – credit
default swap

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 To veil the risk of individual financial assets and
enhance its liquidity, financial intermediaries can
purchase loans, re-package them, and sell them to the
financial markets

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 Leverage, which means using borrowed funds to
purchase assets, also increase the risk that financial
intermediaries undertake.

DON’T RISK YOUR OWN MONEY. RISK OTHER’S MONEY ☺

 Regulations on the maximum leverage ratio (debt/equity) can

help reduce the risk

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Other Financial Institutions
 Credit unions
 Pension funds
 Insurance companies
 Loan sharks
Recall that GDP is both total income in an
economy and total expenditure on the
economy’s output of goods and services:
Y = C + I + G + NX

• In a simple economy: Y = C + I
• In a closed economy: Y = C + I + G
• In an open economy: as above
Assume a closed economy – i.e., the
one that does not engage in
international trade:

Y=C+I+G
Now, subtract C and G from both sides of the
equation:
Y – C – G =I
(Y – T – C) + (T – G) = I
(Yd – C) + (T - G) = I
Sp + Sg = I
S=I
T: net taxes = Total tax revenue - TR; Yd: disposable income; Sp:
personal saving; Sg: public saving = government budget balance;
S: national saving
 National Saving
 National saving is the total income in the economy
that remains after paying for consumption and
government purchases.
 Private Saving
 Private saving is the amount of income that
households have left after paying their taxes and
paying for their consumption.
Private saving = (Y – T – C)
Public Saving
 Public saving is the amount of tax revenue
that the government has left after paying
for its spending.
Sg (Public saving) = (T – G)
 Surplus and Deficit
 If T > G, the government runs a budget surplus
(thặng dư ngân sách) because it receives more
money than it spends.
→ The surplus of T - G represents public saving.
 If G > T, the government runs a budget deficit
(thâm hụt ngân sách) because it spends more
money than it receives in tax revenue.
→ The deficit of T - G represents public dissaving
For the economy as a whole, saving
must be equal to investment.
S=I
• Financial markets coordinate the economy’s
saving and investment in the market for
loanable funds.
• The market for loanable funds is the
market in which those who want to save
supply funds and those who want to borrow
to invest demand funds.
• Loanable funds refers to all income that
people have chosen to save and lend out,
rather than use for their own consumption.
The supply of loanable funds comes
from people who have extra income
they want to save and lend out.
The demand for loanable funds
comes from households and firms
that wish to borrow to make
investments.
The interest rate is the price of the loan.
It represents the amount that borrowers
pay for loans and the amount that lenders
receive on their saving.
The interest rate in the market for loanable
funds is the real interest rate.

r = i – β, in which
r = real interest rate; i: nominal interest rate; β: inflation rate
Financialmarkets work much like
other markets in the economy.
 The equilibrium of the supply and
demand for loanable funds determines
the real interest rate.
Interest
Rate Supply

5%

Demand

0 $1,200 Loanable Funds

(in billions of dollars)
Government Policies That Affect
Saving and Investment
 Policy 1: Taxes and saving
 Policy 2: Taxes and investment
 Policy 3: Government budget deficits
Taxes on interest income
substantially reduce the future
payoff from current saving and,
as a result, increase the incentive
to save.
A tax decrease increases the
incentive for households to save at
any given interest rate.
 The supply of loanable funds curve
shifts to the right, downward.
 The equilibrium interest rate
decreases.
 The quantity demanded for loanable
funds increases.
 Interest Supply, S1 S2
Rate

1. Tax incentives for

5%
saving increase the
supply of loanable
4%
funds . . .

2. . . . which Demand
reduces the
equilibrium
interest rate . . .

0 $1,200 $1,600 Loanable Funds

(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
If achange in tax law encourages
greater saving, the result will be lower
interest rates and greater investment.
An investment tax credit increases
the incentive to borrow.
 Increases the demand for loanable
funds.
 Shifts the demand curve to the right,
upward.
 Results in a higher interest rate and a
greater quantity saved.
 Interest
Rate Supply
1. An investment
tax credit
6% increases the
demand for
5% loanable fund s . . .

2. . . . which
raises the D2
equilibrium
interest rate . . . Demand, D1

0 $1,200 $1,400 Loanable Funds

(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
Ifa change in tax laws encourages
greater investment, the result will be
higher interest rates and greater
saving.
When the government spends more
than it receives in tax revenues, the
shortfall is called the budget deficit.
The accumulation of past budget
deficits is called the government
debt.
A budget deficit decreases the supply of
loanable funds.
 Shifts the supply curve to the left, upward.
 Increases the equilibrium interest rate.
 Reduces the equilibrium quantity of
loanable funds.
 Interest S2
Rate Supply, S1

1. A budget deficit
6%
decreases the
5% supply of loanable
funds . . .

2. . . . which
raises the
equilibrium Demand
interest rate . . .

0 $800 $1,200 Loanable Funds

(in billions of dollars)
3. . . . and reduces the equilibrium
quantity of loanable funds.
Government borrowing to finance its
budget deficit reduces the supply of
loanable funds available to finance
investment by households and firms.
This fall in investment is referred to as
crowding out (thoái lui đầu tư).
 The deficit borrowing crowds out private
borrowers who are trying to finance
investments.
When government reduces
national saving by running a deficit,
the interest rate rises and
investment falls → crowding out
Abudget surplus increases the
supply of loanable funds, reduces the
interest rate, and stimulates
investment → crowding in
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Çelik, S., G. Demirtaş and M. Isaksson (2020),
“Corporate Bond Market Trends, Emerging Risks
and Monetary Policy”, OECD Capital Market Series.

www.oecd.org/corporate/Corporate-Bond-Market-
Trends-Emerging-Risks-and-Monetary-Policy.htm

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Çelik, S., G. Demirtaş and M. Isaksson (2020), “Corporate Bond Market Trends, Emerging Risks and Monetary
Policy”, OECD Capital Market Series. www.oecd.org/corporate/Corporate-Bond-Market-Trends-Emerging-Risks-
and-Monetary-Policy.htm
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