FIN 30220: Macroeconomics Capital Markets The US Capital market by the numbers Capital Markets Capital Markets

FIN 30220: Macroeconomics Capital Markets The US Capital market by the numbers Capital Markets Capital Markets www.phwiki.com

FIN 30220: Macroeconomics Capital Markets The US Capital market by the numbers Capital Markets Capital Markets

Miles, Dietra, Host has reference to this Academic Journal, PHwiki organized this Journal FIN 30220: MacroeconomicsCapital MarketsRecall the identity output equals expenditures Employment is determined in the labor market which determines GDPExpenditures are determined in the capital market. If the capital market is in equilibrium, expenditures equal GDPThe accounting identities imply that if output equals expenditures, then borrowing equals lending – this is how we will look at the capital ,arketThe US Capital market by the numbers Total Assets$200TCommercial Banks$20TBond Market$37TEquities / Mutual Funds$48TPension Entitlements$20TOther$75TSource: Flow of Funds

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Capital MarketsHouseholds$68T Assets$14T LiabilitiesBusiness $105T Assets$102T LiabilitiesGovernment$5T Assets$22T LiabilitiesRest of the World$23T Assets$10T LiabilitiesThe Capital Markets connect the various sectors of the economySource: Flow of Funds Households were net lenders in 2014 Gross Saving: $2,300B + Borrowing: $420BIncome Minus Taxes Minus Consumption of Non-Durables in addition to ServicesBank Loans: $122BMortgages: $50BConsumer Credit: $248B$2,720B Real Assets Purchased: $1,811BConsumer Durables : $1,229BResidential: $453BNon-Residential: $137BOther: -$8BFinancial Assets Acquired: $1,265BDeposits: $481BBonds: -$477BEquities: $29BMutual Funds: $520BPension Fund Entitlements: $548Other: $164BTotal Financial Assets – Total Borrowing = Net Lending$420B$1,265B-=$845BNote: Sector Discrepancy = -$356B Source: Flow of FundsHouseholdsBusinesses (Financial + Non-Financial)Rest of WorldGovernmentNet SaversNet BorrowersCapital Markets$845B$166B$213B$794B Approximately $1T Passed through the capital market in 2014Source: Flow of FundsNote: Statistical Discrepancy = $4B

Non-Financial Business were net borrowers they used these funds primarily as long as capital investment Gross Saving: $2,058B + Total Borrowing: $683B$2,702B Undistributed ProfitsBank Loans: $379BBonds: $265BOther:$39BCapital Expenditures: $2,040BResidential: $99BNon-Residential: $1,859BOther: $82Financial Assets Purchased: $375BDeposits: $120BEquities: $255BNote: Sector Discrepancy = $287BTotal Borrowing – Financial Assets = Net Borrowing$375B$683B-=$308BSource: Flow of FundsNon-Financial Business were net borrowers they used these funds primarily as long as capital investmentCapital Expenditures: $2,040BResidential: $99BNon-Residential: $1,859BOther: $82Recall our expression as long as the evolution of the nation’s capital stock .In 2014Capital Stock: $40TDepreciation: $1.5T (4%)$40T$1.5T$2TIn 2015Capital Stock: $40.5TInvestment Banks vs. Commercial Banks

Investment banks in addition to commercial banks provide the same service. They connect borrowers with lenders.Commercial banks accept deposits from households – they pay interest on some of these depositsCommercial banks use these deposits to provide loans – they charge interest on these loansA bank makes money from the spread between these interest ratesIf we model the capital market using commercial banks, we get this Real Interest rateLoanable FundsThe supply of loanable funds comes from household savings The dem in addition to as long as loanable funds comes from borrowers (both private in addition to public)We should be able to find an equilibrium interest rate where supply of loanable funds equals dem in addition to In equilibrium, household savings equals private plus public borrowingInvestment banks in addition to commercial banks provide the same service. They connect borrowers with lenders.Investment banks buy bonds from borrowers (governments in addition to businesses) at a posted priceInvestment banks then sell these securities to savers (households) at a posted priceInvestment banks make money from the spread between these prices

If we model the capital market using investment banks, we get this Bond PriceBondsThe supply of bonds comes from borrowers (both public in addition to private)The dem in addition to as long as bonds comes from savers (households)We should be able to find an equilibrium bond price where supply of bonds equals dem in addition to In equilibrium, household savings equals private plus public borrowingBondsReal Interest rateLoanable FundsCommercial Banks accept deposits from one group (savers) in addition to lends those funds out to others (borrowers)Investment Banks buy bonds from one group (borrowers) in addition to sell those bonds to others (savers)BondsReal Interest rateLoanable FundsSuppose that the government runs a large deficit. The increase in the public dem in addition to as long as loanable funds should increase the interest rateThe government borrows money by selling bonds. The increased supply of bonds should lower bond prices

Treasury Bills are short term ( 1 year or less) securities issued by the federal government. They make no interest payments in addition to there as long as e, sell at a discount from face value. There are currently around $1.5T worth of Treasury Bills outst in addition to ing!!NowPay $99.98590 DaysDiscount YieldBond Equivalent YieldReceive $100Treasury Notes in addition to Bonds are a bit more complicated because they make multiple payments until maturity (semi-annual interest payments)There are currently around $12T worth of Treasury Notes in addition to Bonds outst in addition to ing!!NowPay $100.236 monthsReceive $.811 yearReceive $.811.62% per year5 yearReceive $100.814 year, 6 monthsReceive $.81Yield To Maturity Solve as long as the interest rate .Current YieldNowPay $128.956 monthsReceive $2.6251 yearReceive $2.6255 yearReceive $102.62519 years, 6 monthsReceive $2.625We could do the same thing with corporate bonds 5.25% Annual CouponCoupon YieldYield To Maturity

NowPay $85.191 yearReceive $4.28We could do the same thing with equities(at least those that pay dividends) Dividend YieldForeverWe can really think of a stock as an infinite maturity bond with a potentially variable coupon paymentWhat do all these yields have in commonDividend YieldYield To Maturity Coupon YieldA higher (lower) price implies a lower (higher) yield!Bond Equivalent YieldNominal Return/Price – 1 Year Treasury Bill (1948-2014)Correlation = -1.00Price (per $100 of Face Value)Annual ReturnAverage Yield = 4.36%Average Price = $95.89

Suppose that you pay $95 today as long as a bond that will pay out $100 in one year. Your nominal return would be However, if inflation over the course of the year is 3%NowPay $951 yearReceive $100That $100 you receive in one year will have less purchasing power (3% less). In fact, the inflation adjusted value of that dollar in today’s terms would be There as long as e, in real (inflation adjusted) terms, your return would be Real ReturnNominal ReturnInflationUS Real Returns (1948-2014)Average Real = ~1%Average Nominal = ~4.5%Minus Average Inflation = ~3.5%Negative Real Returns!!!Negative Real Returns!!!Negative Real Returns!!!How can we have negative real returnsSuppose that you pay $95 today as long as a bond that will pay out $100 in one year. Your nominal return would be NowPay $951 yearReceive $100Ex Ante Real ReturnNominal ReturnExpected InflationYou expect inflation to be 3% at the time you purchase the bond. There as long as e, your Ex Ante real return is 2.3%At the end of the year, you learn that you were wrong inflation turned out to be 6%Ex Post Real ReturnNominal ReturnActual InflationUnder predicting inflation can lead to negative ex post returns .

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Inflation vs. Expectations (1978-2014)University of Michigan SurveyInflation Expectation Error (1978-2014)University of Michigan SurveyActual Inflation – Expected InflationUS Ex Ante/Ex Post Real Returns (1978-2014)University of Michigan Survey

We have Treasury Rates as long as a variety of maturities the yield curve.3 Mo.1 Mo.6 Mo.1 Yr.2 Yr.3 Yr.5 Yr.7 Yr.10 Yr.20 Yr.30 Yr.Annual ReturnTreasury Bills (<1 year)Treasury Notes (1 – 10 yrs.)Treasury Bonds (>10 years)6 Mo.5 yr.10 Yr.Inverted Yield Curve6 Mo.5 yr.10 Yr.Flat Yield Curve6 Mo.5 yr.10 Yr.“Normal” Yield CurveUS Treasury RatesInverted/Flat Yield Curves tend to precede recessions

Investment (% Dev. From Trend)Real Interest Rate1973 Arab Oil Embargo1979 Iranian RevolutionIn both cases, the oil price shocks resulted in large declines in both investment in addition to interest rates – this suggests there was a minimal effect on savingsInterest rates in addition to Investment (1972 – 1982)

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