Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

Student Price: Contact us to learn more

Principles of Economics will allow you to learn a new set of tools to use in personal, professional, business, and political decision making.

This content has been used by 3,587 students

What is a Top Hat Textbook?

Top Hat has reimagined the textbook – one that is designed to improve student readership through interactivity, is updated by a community of collaborating professors with the newest information, and accessed online from anywhere, at anytime.


  • Top Hat Textbooks are built full of embedded videos, interactive timelines, charts, graphs, and video lessons from the authors themselves
  • High-quality and affordable, at a significant fraction in cost vs traditional publisher textbooks
 

Key features in this textbook

Our Principles of Economics Textbooks extend beyond the page with interactive graphing tools, real-world news clips and articles that relate to current events and examples that are relevant to millennial audiences.
Our Principles of Micro and Principles of Macro textbooks can be adopted together or separately, giving you the flexibility to customize your course.
Question bank is available with every chapter for easy quiz and test creation.

Comparison of Principles of Economics Textbooks

Consider adding Top Hat’s Principles of Economics textbook to your upcoming course. We’ve put together a textbook comparison to make it easy for you in your upcoming evaluation.

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Pricing

Average price of textbook across most common format

Up to 40-60% more affordable

Lifetime access on any device

$130

Hardcover print text only

$175

Hardcover print text only

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Content meets standard for Introduction to Anatomy & Physiology course, and is updated with the latest content

In-Book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

Read the fully unlocked textbook below, and if you’re interested in learning more, get in touch to see how you can use this textbook in your course today.

Chapter 17: Capital and Financial Markets

Figure 17.1: Prices in financial markets are constantly changing, leading to gains and losses for market participants.​ [1]​

17.1 Introduction

When you put money into a bank or invest in the stock market or take out a student loan, you are interacting with financial markets. What determines the interest rates that your bank pays you or the interest rates that you pay your bank? Why do companies sell shares of stock, and how do they benefit when their shares are traded? How do we make sense of rises and falls in the stock market? In this chapter, you will learn the basic features of financial markets as well as the economic tools necessary to begin to answer questions like these. 

Why do financial markets exist? Some individuals and businesses want to save. Others want to invest, but do not have the funds to do so. Financial markets bring the two groups together, allowing savers and investors to communicate with each other, exchange financial assets, and thus save and invest. Savers have a place to put their savings. Firms that want to invest have places to go to obtain the financial resources they need to make investments.

In this chapter, we will explore how firms’ demand for physical capital helps to determine the price of financial resources. We will explore how firms generate funds in financial markets to pay for that capital. Markets for international currencies will also be discussed.

17.2 Objectives

After reading this chapter and completing the questions and exercises, you will be able to:

  • Explain the supply and demand for physical capital and the determination of prices and quantities produced.
  • Identify the factors influencing prices and rates of returns of financial instruments like stocks and bonds.
  • Use a supply and demand model to explain international currency markets.

17.3 Physical and Financial Capital

When we first began to discuss firm decision-making, we talked about firms using capital to produce goods and services. Producers must have space, equipment, automobiles, and trucks in order to produce goods and services. All of the physical equipment and material a firm uses in the production of goods and services are called physical capital.

It includes the machines, tools, buildings, and even inventories of raw materials and finished goods. Government buildings, roads, and equipment are all examples of physical capital.

A firm has to purchase, rent, or manufacture its physical capital in order to produce its goods and services. It does so by using the owners’ funds, past savings or past profits to reinvest in the business, by borrowing money through a loan from a bank, or by getting others to make financial investments in the firm.

Figure 17.2: Even huge companies have to borrow in order to be able to afford something like this. [2]​

Houses are also part of the physical resources that we use to produce goods and services. In the case of housing, we are producing the ‘services’ of a house in which to live. An individual buying a new house does so by using past savings or by borrowing from a bank or other financial institution.

Graphing Question 17.01

17.4 Markets for Physical Capital

Markets for physical capital are much like the labor market we explored in Chapter 14: Markets for Labour, and we can use a similar analysis. Because physical capital and labor are both used in the production of a final product, their worth to the firm using or employing them is determined by their contribution to production and by how much the final product is worth.

17.4.1 Demand for Capital

Students and their parents purchase higher education, and in so doing, they indirectly demand the capital that goes into producing that education. The amount of capital used in higher education, whether it is computers, lab equipment, or buildings, depends upon and is “derived” from the demand for education itself. Demand for capital is a derived demand – a demand that is “derived” from the demand for the goods and services produced by the capital. If demand for higher education increases, than the demand for the capital that is used in higher education increases. If demand for higher education decreases, the demand for the capital that is used in higher education will also decrease.

Consumers demand a firm’s goods and services. In turn, the firm demands capital to produce those goods and services. Consumers are not directly demanding the capital used, but they are demanding the products that are produced by that capital.

To increase production, firms can increase the amount of capital used. How much capital is needed at each level of output depends upon the other resources available and their marginal products and prices. As the amount of capital used increases, the total amount of output increases. We measure the contribution of capital by looking at the increases in output produced by each additional unit of capital. Just as the marginal product of labor diminished as we increase the amount of labor, the marginal product of capital eventually decreases as capital is increased if other inputs are held constant.

Now, we can derive a new concept, but one that should appear familiar – the value of the marginal product of capital. In a competitive market, the value of the marginal product of capital is the price of the good produced times the marginal product of the capital. In other words, it is the addition to revenues that results if an additional unit of capital is used. In a perfectly competitive market, the price facing the firm stays the same, but the marginal product declines as more machines are used. The value of the marginal product of capital, if everything else is held constant, will eventually decline as more capital is used. Why? Because the law of diminishing marginal returns holds here, just like in the case of labor. When we plot the value of the marginal product of capital against the amount of capital used, we get a relationship describing that particular firm’s demand for capital.

Suppose that the relation between the number of machines and the marginal product of each machine is shown in Table 17.1. Assume that all other inputs are fixed. The price of the good produced is $100.

Table 17.1: This schedule captures the relationship between the marginal product of capital and the number of machines in use for a hypothetical firm.​


Question 17.01

How many machines will the firm use if the cost of capital (the cost of each machine) is $8000?

question description
A

1 machine

B

2 machines

C

3 machines

D

4 machines

E

5 machines


Question 17.02

How many machines will the firm use if the cost of capital is $6000?

A

1 machine

B

2 machines

C

3 machines

D

4 machines

E

5 machines


Question 17.03

How many machines will the firm use if the cost of capital is $4000?

A

1 machine

B

2 machines

C

3 machines

D

4 machines

E

5 machines


Question 17.04

Suppose that the price of the good produced in Question 17.01 increased to $200. If the cost of capital is $6,000, how many machines will the firm use?

Question 17.05

Figure 17.3: This graph relates the number of machines used to the value of the marginal product of capital.​


Question 17.05

Looking at Figure 17.3 above, explain in your own words why the value of the marginal product at each level of capital used gives us a demand curve for capital.

Hover here to see the hint for Question 17.05.
Click here to see the answer to Question 17.05.

Question 17.06

Question 17.06

What happens to demand for capital if the marginal product of capital increases?

Hover here to see the hint for Question 17.06.
Click here to see the answer to Question 17.06.

Question 17.07

Question 17.07

What happens to the value of the marginal product of capital if the price of the good or service being produced falls?

Hover here to see the hint for Question 17.07.
Click here to see the answer to Question 17.07.

17.4.2 Market Demand for Capital

Just like the demand for goods and services, we can calculate the market demand for a particular type of capital. In markets for goods, we added the quantity demanded by each consumer at each price to the quantities demanded by all of the other consumers at each price in order to get the total quantity demanded at each market price. We do the same here. The market demand for a type of capital is the amount of capital that will be demanded by each firm added together at each cost. So, for example, at a cost of $4,000 per hour, each firm will demand four machines and the quantity demanded in the market at a price of $4,000 is the number of firms times four machines.

Graphing Question 17.02

17.5 Supply of Physical Capital

The marginal cost functions of the firms producing capital are the individual firm supply curves. The market supply is the sum of all the individual firm supply functions. The price of capital, then, is determined in the market in the same fashion we have discussed since the beginning of the course. When the marginal costs faced by capital producers change, this will change the market supply and affect the price of capital. When the value of the marginal product of capital changes, this will affect demand for capital and similarly alter capital’s price.

17.5.1 Cost of Physical Capital

The actual price or cost of physical capital consists of interest and depreciation costs. Firms borrow funds to finance the purchase of the capital. They then use up a portion of the physical capital each year.

The cost of the capital is different from the prices of many other goods and services and inputs. The cost of labor (or the price of labor to the firm), for example, is the wages and benefits firms must pay to hire labor. In the case of capital, much of what firms use will last over a period of years and then perhaps even be sold for its new market value. It would be inappropriate to consider the entire purchase price as the cost of capital if one piece of capital would last 10 years and another only one. If all capital only lasted one year and had no value at the end of the year, the purchase price would be a reasonable estimate of the cost of the capital for that year.

However, most capital lasts for a period of years, and the way to calculate the “price” or the cost to the firm of using one more unit of capital is the price of the capital in the market minus what that capital can be sold for when the firm is finished with the capital. For an annual cost calculation, that cost is spread out over the number of years that the capital is likely to be used. This is the annual depreciation of the capital – that is, how much capital is actually used up each year.

But there is something else: the opportunity cost. That is what the funds could have been used for if the capital had not been purchased. In this case, it might be the amount of interest that must be paid to the bank loaning the money or to the bondholders who have loaned the firm money to purchase the physical capital.

The cost of a particular piece of capital for one year then becomes the interest the firm gives up plus the depreciation.

Question 17.08

An increase in the marginal product of capital does what to the price and quantity of capital? Why?

A

Price will increase and quantity will decrease.

B

Price and quantity will increase.

C

Price and quantity will decrease.

D

Price will decrease and quantity will increase.


Question 17.09

A decrease in demand for a product will do what to the price and quantity of the capital used in its production? Why?

A

Price will increase and quantity will decrease.

B

Price and quantity will increase.

C

Price and quantity will decrease.

D

Price will decrease and quantity will increase.


Question 17.10

An increase in the cost of producing capital will do what to the price and quantity of capital produced? Why?

A

Price will increase and quantity will decrease.

B

Price and quantity will increase.

C

Price and quantity will decrease.

D

Price will decrease and quantity will increase.


Question 17.11

An increase in interest rates will cause which of the following?

A

Increase the use of capital

B

Decrease the use of capital

C

Not change the use of capital

D

One cannot tell


Question 17.12

An increase in the price of the good produced with capital will cause which of the following?

A

The price and quantity of capital will increase.

B

The price of capital will increase and the quantity will decrease.

C

The price of capital will decrease and the quantity will increase.

D

The price and quantity of capital will decrease.


Question 17.13

If an increase in the cost of producing capital occurs at the same time as the marginal product of capital increases, what will happen to the equilibrium quantity of capital used?

A

Increase

B

Decrease

C

Not change

D

One cannot tell


Question 17.14

If an increase in the cost of producing capital occurs at the same time as the marginal product of capital increases, what will happen to the equilibrium price of capital used?

A

Increase

B

Decrease

C

Not change

D

One cannot tell


Question 17.15

If interest rates increase, what is likely to happen to the marginal product of capital?

A

The marginal product of capital will rise.

B

The marginal product of capital will fall.

C

The marginal product of capital will not change.

D

One cannot tell what will happen to the marginal product of capital.

17.6 Financial Capital

We have seen the importance of physical capital in enabling firms to produce goods and services. The value of the marginal product of capital and the costs of the physical capital determine how much physical capital firms will want to buy. However, firms often do not have enough cash on hand to build or purchase the buildings, machines, equipment, software, and tools that they might need. In order to obtain physical capital, they will need to raise funds from people outside of the firm called financial capital. There are several different ways in which a firm can raise money for these purchases. First, a firm might borrow the money. When a firm borrows in order to purchase physical capital, it issues debt. That is, it signs an agreement with a bank or other lender in which it agrees to pay back the amount borrowed over a specified period of time and also agrees to pay interest on the loan.

If a firm borrows from insurance companies, pension funds, university endowments, or individuals who have saved, the firm may issue bonds. A bond is simply a formal agreement to pay a lender a specific amount of money on a certain date. The bond states exactly when that amount will be paid back (the bond’s maturity date) and sets the intervening interest payments. The advantages of a bond over a bank loan are that a corporation can usually borrow more by selling bonds to a large number of individuals or institutions than a bank may be willing to lend and a firm may be able to borrow the money over a longer time period and at a lower cost due to borrowing directly from the investors. The term principal is used to describe the amount of the loan, and the interest payment is the amount of interest that will be paid each year.

There are a variety of types of bonds, with the most common being those issued by corporations (corporate bonds). Municipal, state, and federal governments also issue bonds (municipal, state, and federal bonds) to finance physical capital such as roads and buildings, and in some cases, current spending. Bonds with relatively short maturities are known as bills and notes.

The primary alternative to borrowing by issuing debt is for a firm to sell shares of stock, that is, shares of ownership, in order to generate funds to purchase physical capital. In so doing, the company sells a part of itself to new owners. Often described as equity, each share entitles the owner to a portion of the value of the firm if it is ever sold and a portion of all future profits. Some firms will pay dividends, a part of the profits, to the owners of its stock. When a firm “goes public,” this means that a firm has changed from ownership by a single individual or a few individuals, who often founded the firm or are senior managers, to selling shares of ownership to a significantly larger number of people – the public. The initial offering (called an IPO, an initial public offering) raises funds for investment purposes. When firms sell newly-created stocks or bonds to the public (as in an IPO), they are said to be selling in the primary market. However, very few people would buy stocks on the primary market if they were not able to then turn around and re-sell them when they want to. This is the role that is served by secondary markets.

17.7 Markets for Financial Capital

Once stocks and bonds have been created and sold in primary markets, they can be resold by their original purchasers. That selling and buying of already-existing stocks and bonds takes place in what is known as the secondary market. The most well-known of these is the stock market at the New York Stock Exchange. There are many other regional, national, and international markets for all kinds of financial instruments – the NASDAQ, a so-called over-the-counter market (in reality, an electronic market), the American Stock Exchange, and markets in Chicago, Boston, and Cincinnati. Note that when stocks or bonds are resold in these markets, and the prices fluctuate up or down, the company which originally issued the security doesn’t gain or lose money from those transactions. They only directly gain funds from the initial sale, in the primary market. However, the fact that the secondary market exists means that more people are willing to buy new stocks and bonds in the first place. Think about what would be more valuable to you, a share of stock which you could easily resell or one which you would have trouble selling? All other things equal, an investor places more value on stocks and bonds which are more easily resold in secondary markets.

Figure 17.4: The floor of the New York Stock Exchange is
the central physical location for the trading of stocks listed on the NYSE. [3]​


ECN17_Table17.2_updated.jpg
Table 17.2: Quotes of the three major U.S. stock indices as of May 3, 2019

Stock indexes, or types of averages, are discussed on the nightly news and in newspapers every day the equity and bond markets are open. Changes indicate general directions in equity prices, but even though an index rises one day, numerous stock prices may fall and vice versa. The “last” is the last reported level of the index, which constantly changes throughout the trading day. The change is the change in the value of the index since the previous day’s closing value (called the “close”). The percent change is the actual change divided by the previous day’s closing price. In addition to the three indexes in Table 17.2, the Russell 2000 and NYSE Composite indexes are often reported.

17.8 Stocks

Companies issue shares of stock as a means of raising funds needed to purchase physical capital. In some cases, shares of stock are issued to finance purchases of raw materials and to pay labor costs or even to purchase another company, but the most common purpose is for physical investment. That is, to create physical capital.

By doing so, companies are selling part of the ownership of their company. If there are one million shares, the ownership of a single share of stock represents one-millionth of the company. As an owner, the shareholder is entitled to a share of the current and future profits, a share of the current and future dividends, if paid, and a share of the assets of the company, if it is sold. Successful companies earn current profits and expect to earn profits into the foreseeable future. Those current and future expectations, along with the value of its current assets, are what give a share of stock in a company value.

The return to an owner of a share of stock consists of the current and future dividends, and possible appreciation in the value of the stock as the company increases in value. The rate of return is the sum of the dividends and the appreciation in the value of the stock divided by the price paid for the shares of stock. The rate of return is normally expressed as an annual rate. The dividend divided by the price is the dividend yield, usually expressed as a percentage of the price of the stock.

A capital gain is an increase in the market price of a share of stock and is often expressed as a percentage of the purchase price. A fall in the price of the stock is described as a capital loss. (A capital gain tax is due when a stock or other asset is sold. The tax is a percentage of the difference between the price paid and the price received for the asset.)

ECN17_Table17.3_updated.jpg
Table 17.3: Quotes of the four major NYSE stocks as of May 10th, 2019. The first column contains the company name, and the second contains its unique stock ticker symbol. The third and fourth columns show the prices that the stock opened and closed trading with (in dollars), and then following column shows the percentage change over the trading. The volume of trading in the next column captures the number of shares of each stock bough and sold during the day. The next two columns show the highest and lowest prices (in dollars) over the last year. The dividend column shows the annual dividend per share of stock, again in dollars. The blanks for CarMax is due to the fact that CarMax did not pay dividends during the year. The yield is the annual dividend divided by the current price of the stock. This gives a partial measure of the rate of retun from owning the stock. "PE" is the price-earnings ratio - the price of the stock divided by the earnings per share. The blank for Twitter means that Twitter did not earn a profit this year (nor did it pay dividends).


Figure 17.5: Google Finance is a common place to go for information on a single stock. This contains the same information as shown in the table above, but also more statistics on the stock as well as news and analysis of recent trends in the stock.​

17.8.2 Changes in Stock Prices

Stock prices change for a variety of reasons. For example, overall levels of stock and equity prices increase as buyers and holders become more optimistic about the future of the economy. Stock prices in a specific industry rise if future profits are expected to increase.

Stock prices rise for individual companies if the prospects for future growth and profits in that company are enhanced and fall if prospects decline. The price-earnings ratio, a commonly reported statistic, is the price of a stock divided by its annual earnings per share and is used as a crude tool to reflect the relationship between earnings and the price of the stock. Suppose there are two firms, each with past earnings of $1 per share and stock prices of $10. One firm announces that its earnings per share have increased this year by more than market participants expected. What will happen to the price of the stock? We would expect the price to increase as well. The price-earnings ratio captures this relationship between earnings and stock prices.

Opportunity costs, not surprisingly, also play a role. The greater the opportunity cost, say an alternative interest rate that could be earned by the financial investor, the less valuable any single financial investment will be. Thus, changes in the expected rate of return of other investments will affect stock prices. As we will eventually see, risk also plays a role.

17.8.3 Dividends

If a firm earns higher profits and increases its dividends as a result, income for the stock owners increases. The financial investment is a more valuable and attractive financial investment as a result. Other financial investors may be willing to pay more for the stock.

If, on the other hand, the firm does not pay dividends but keeps the larger profits and reinvests them profitably, the company may become even larger and even more profitable. The value of the company increases and the price of its shares rise, as financial investors are willing to pay even more.

Because of these two possibly conflicting events, we cannot say whether an increase in dividends will positively affect stock prices.

17.8.4 Expected Rate of Return

Expected annual dividends plus expected appreciation in price divided by the current price of a share of stock is the expected rate of return. If the dividends paid or the expected appreciation increase, the rate of return will increase. If the current price increases and everything else remains the same, the expected rate of return will decrease.

Question 17.16

If the current price of a stock increases by 10% and the expected dividends and appreciation increase by 10%, will the expected rate of return increase, decrease, or stay the same?

A

Increase

B

Decrease

C

Stays the same

Question 17.17

Question 17.17

Why?

Hover here to see the hint for Question 17.17.
Click here to see the answer to Question 17.17.

17.8.5 An Example

Suppose that most stocks with similar risks to a new music company currently have a rate of return of eight percent. One of the music companies increases its profits so that its likely rate of return increases to 12 percent. This stock then becomes a very attractive financial investment. The buyers bid up the price of the stock as a result. The stock price is likely to continue to rise until the anticipated rate of return is eight percent. The increase in demand will no longer result in a continuation of the rise in price.

Use the concept of economic profit in competitive markets to predict the effects of each of the following. In each case, identify the change in the price of a share of stock and the likely return to stockholders and new purchasers.

Question 17.18

What will happen to prices of shares of Microsoft if expected profits increase? (Use the concept of normal profit of a competitive business as an opportunity cost, but apply the idea to an individual financial investor. Also, assume that nothing else changes.)

A

The price of the stock will rise.

B

The price of the stock will fall.

C

The price of the stock will not be affected.

Question 17.19

Question 17.19

From the previous question, explain what will happen and why to the rate of return that new buyers of Microsoft shares receive after the price of Microsoft shares responds to the increase in expected profits.

Hover here to see the hint for Question 17.19.
Click here to see the answer to Question 17.19.

Question 17.20

What will happen to equity prices if interest rates rise?

A

Equity prices will increase.

B

Equity prices will decrease.

C

Equity prices will stay the same.

D

We cannot tell.


Question 17.21

What will happen to Microsoft’s share price if health insurance costs rise?

A

The price of the stock will rise.

B

The price of the stock will fall.

C

The price of the stock will not be affected.

Question 17.22

Question 17.22

What will happen if the stock splits, that is, issues a new share of stock to each of the current owners of stock so that the number of outstanding shares of stock doubles?

Hover here to see the hint for Question 17.22.
Click here to see the answer to Question 17.22.

Question 17.23

Question 17.23

Assume that companies similar to Microsoft have rates of return of eight percent. If Microsoft currently has a rate of return of eight percent and profits double, what will happen to the price of a share of Microsoft and the rate of return relative to other similar companies?

Hover here to see the hint for Question 17.23.
Click here to see the answer to Question 17.23.

Question 17.24

What if Microsoft, with 11 billion outstanding shares, now issues an additional 1.1 billion shares and participants in the market believe that it will increase future profits by more than 10 percent?

A

The price of the stock will rise.

B

The price of the stock will fall.

C

The price of the stock will not be affected.


Question 17.25

How will a decrease in the expected earnings of all other companies affect the price of a share of stock in a company whose expected earnings have not changed?

A

The price of the stock will rise.

B

The price of the stock will fall.

C

The price of the stock will not be affected.


Question 17.26

In the previous question, what happens to the expected rate of return for the company?

A

The expected rate of return of the stock will rise.

B

The expected rate of return of the stock will fall.

C

The expected rate of return of the stock will not be affected.


Question 17.27

How will a fall in demand for the product of the company likely affect the price of a share of stock?

A

The price of the stock will rise.

B

The price of the stock will fall.

C

The price of the stock will not be affected.

17.9 Risk Versus Rate of Return

Imagine that you are investing your money for retirement, and you have two potential assets that you could invest in. Both assets have an expected yearly return of 7%, but for one of those assets that return is almost certain, while for the other the return could vary widely around the 7% average (in other words, you could get a return much higher than 7% or a return much lower). Which asset would you choose to invest in?

As you might have guessed, the difference between these two assets is the level of risk that they face. In economics, the risk of a financial instrument refers specifically to the volatility of the price or the return for that instrument. In other words, risk captures how widely the actual return of an investment will fluctuate around the expected, or average, return.

Let’s return to the two hypothetical assets with a 7% expected return. If you responded to that situation by choosing the safer investment instead of the riskier one, then you view risk the same way most investors do; that is, you would prefer to have less of it. Given assets with different levels of risk and the same return, investors will consistently buy the safer asset. This means that there are almost never assets with the same return and different levels of risk. If that were the case for two assets, investors would all buy the safer asset, driving its price up and the price of the riskier asset down. As a result, the safer asset now has a lower expected return, while the riskier asset will have a higher return due to its lower price. Because investors behave this way, riskier assets will generally offer higher returns than safer ones. This feature of financial assets is referred to as the risk-return tradeoff.




















Figure



17.6: The expected rates of return



on two different investments with different levels of risk.​

Question 17.28

Question 17.28

Explain why the expected rates of return for the two assets in Figure 17.6 differ so much.

Hover here to see the hint for Question 17.28.
Click here to see the answer to Question 17.28.

Consider the two financial investments in Figure 17.7 below plots the relationship between risk and return for the insured bank deposit and the software company stock. The line that connects them represents the risk-return tradeoff between the two assets. Now we’ll think about what would happen to another asset without the tradeoff between risk and return. To do so, consider an asset with the same level of risk as the software company stock, but with only a 3% return (shown as Asset C in Figure 17.7)

Figure 17.7: The relationship between risk and return for three different assets​.


Question 17.29

What will happen to the price of asset C and then its rate of return?

A

The price of stock C will rise and its return will rise.

B

The price of stock C will fall and its return will rise.

C

The price of stock C will fall and its return will fall.

D

The price of stock C will rise and its return will fall.

Question 17.30

Question 17.30

For the previous question, explain why the price and rate of return for asset C will change in that scenario.

Hover here to see the hint for Question 17.30.
Click here to see the answer to Question 17.30.

Consider a stock that is initially on the risk-return line; that is, its current expected return is in line with its level of risk. Suppose that some positive news is released about the company, and investors begin to expect a higher rate of return. The expected return of this stock is now above that of other stocks with similar risk. The result will be that investors favor buying this stock over those other stocks. This will bid up the price of the stock, decreasing the expected return. The price will be bid up until the expected rate of return falls in line with other stocks with similar risk, and investors no longer have an incentive to buy this stock over others.

Table 17.4: Average rates of return for real assets increase along with their risk.​

Table 17.4 shows the historical rates of return for different types of assets, along with a measure of risk. The measure of risk used is the standard deviation, which captures how much the returns in each year vary away from the average return. The relationship is clear: the riskier the asset, the higher the average rate of return.

17.9.1 A Variety of Sources of Risk

For any stock, there are several reasons why its actual return might be higher or lower than its expected return. In other words, there are a number of sources of risk. There could be risk factors related to the individual company, the industry in which it operates, or the entire economy. Finally, changes in expectations of the future affect risk as well. We will go through each of these in turn.

17.9.2 The Individual Company

A company’s current and expected future profits will positively affect its stock price. Increases in profits will cause the price of the stock to increase. The riskier that company becomes because of increasing costs or potential competition or the dependence upon the success of a new invention, the less desirable the firm is as a financial investment and the less the price of the stock will be.

If a company is interested in buying another company, the price of a share of stock of the purchased company will likely rise as the purchaser must offer a high enough price to convince current stockholders to sell. But if potential owners come to believe that the deal may not happen, the share price of the (would-be) purchased company will likely fall.

A brand-new company with no track record may well be perceived as riskier than a similar company with established management.

17.9.3 The Industry

When an entire industry’s prospects change, the price of even a profitable, attractive company can change. As lawsuits and health concerns have affected the demand for cigarettes and the costs of producing cigarettes, the prices of shares of stock of even the well-run companies have fallen.

As oil prices rise throughout the world, the prospects for increased profits of oil companies owning substantial amounts of oil increase and their stock prices rise.

Automobile companies’ profits typically vary a great deal in response to change in interest rates and overall economic conditions. Food companies are more stable in response to the same kinds of changes.

17.9.4. The Economy

As economies come out of recessions, stock prices rise as buyers and sellers expect increasing spending, sales, and profits for all firms. If the economy is entering a recession, expected profits fall and equity prices are likely to fall for nearly all stocks.

17.9.5 Expectations

The most difficult to predict and understand is the role of expectations. Most important of all, more important than what is actually going to happen to sales, costs, profits, competition, lawsuits, new product creation, or any of the many things that can affect stock prices, are changes in buyers’ expectations of future changes. If enough buyers expect prices to increase or decrease, the prices will increase or decrease until the expected rates of return have adjusted accordingly.



Question 17.31

Question 17.31

Suppose you are considering two stocks. One of the companies, Newtech, is likely to earn higher average profits per share than the other company, Intertrode. The more profitable firm, Newtech, earns more profits on average, but those profits vary a great deal from year to year. Which stock would you prefer? Why?

Hover here to see the hint for Question 17.31.
Click here to see the answer to Question 17.31.

Graphing Question 17.03

17.10 Interest Rates 

There are hundreds of interest rates – interest rates for consumers (like those for credit cards, home mortgages, college loans, and personal loans), interest rates that corporations pay, and interest rates that governments pay.

Table 17.5: This table shows a few key interest rates on different types of loans and bonds. Longer-term securities and riskier securities tend to have higher interest rates.​

The highest rates are normally for those loans or bonds that are the riskiest for the lender or have the longest term or the least collateral. For example, credit card loan interest rates are higher than rates on personal loans, personal loan rates are higher than mortgage rates, mortgage rates are higher than rates charged to large successful corporations, and corporate rates are higher than the federal government interest rates. In addition to risk, the length of the loan and tax treatment of interest income influence the level of a specific interest rate.

In turn, the interest rate charged for a loan determines the number of loans that people are willing to take out. When an interest rate is higher, it is more expensive to take out and repay the loan, and fewer people will borrow. At lower interest rates, borrowing is cheaper, so more people will take out loans.

Most of the time, interest rates move together in the same direction, and news reports will often talk about changes in interest rates as though they are all the same and moving in the same direction.

The Federal Reserve, through its buying and selling of short-term Treasury bills, determines interest rates on loans among banks for very short periods of time. As banks have more reserves as a result of Federal Reserve purchases of Treasury bills, interest rates fall. If bank reserves shrink, the supply of reserves falls and interest rates rise.

Interest rates on longer-term deposits, loans, and bonds are all determined in markets. The interest rate on a loan is essentially the price paid from the borrower to the lender for the loan, and as such, it is set by the forces of supply and demand just like any other price. The supply of loans is determined by the amount of money that individuals, businesses, and governments are willing to save. To see this, think for a moment about what happens when you save money. If you put it into a savings account at a bank, you will earn interest on that money. The bank will then use the money you have deposited to make more loans (of course, they have to keep some of that money in the vault, but they will lend most of it out). If interest rates went up, you would have more of an incentive to put money into that savings account, and when you put more money in, the bank will have more money to lend. Thus, when interest rates are higher and all else equal, banks will have more deposits and make more loans. This means that the supply curve for loans is upward sloping, like all supply curves; at higher interest rates, more loans will be supplied.

On the other hand, the demand for loans represents the quantity of loans that individuals, businesses, and governments want to take out at different interest rates. Now think about taking out a loan to buy a car or a house. If the interest rate is very high, this will be expensive, and you will be less likely to do so (or you will take out a smaller loan). In general, high interest rates make borrowing more expensive, and potential borrowers want to take out fewer loans. This makes the demand curve for loans downward sloping (so no violations of the law of demand!). Figure 17.8 shows the supply and demand for loans, which together determine the equilibrium interest rate and amount of borrowing.

Figure 17.8: The supply and demand for loans​.

Here, the equilibrium interest rate is 6%. If the supply of funds were to increase, the equilibrium interest rate would fall below 6%; if supply were to decrease, interest rates would rise above 6%. On the other hand, if the demand for funds increases, then interest rates increase as well. If demand falls, then interest rates fall.

Question 17.32

Suppose that lenders become more confident about future economic conditions and decide to increase their loans now. What will happen in the market for loans?

A

The supply of loans will increase.

B

The supply of loans will decrease.

C

The demand for loans will increase.

D

The demand for loans will decrease.


Question 17.33

Consider the previous question. If that is the only change, then the equilibrium interest rate will ______________ and the equilibrium amount of borrowing will ______________.

A

Increase; increase

B

Increase; decrease

C

Decrease; increase

D

Decrease; decrease

17.11 Bonds

Treasury yields jump off 1-month low after upbeat economic data [1]

“Treasury prices fell, pushing yields up from the lowest level in a month, Tuesday as better-than-expected economic data raised inflation expectations, dulling appetite for government bonds. The yield on the 10-year Treasury note rose 3.8 basis points to 2.411%, ending a two session skid for yields, which hit the lowest level since Feb. 28 on Monday.” 

                      - Sunny Oh for Market Watch, March 28, 2017

When a large company or a government wishes to raise funds through borrowing, they will typically issue bonds. In essence, bonds are similar to all loan agreements. When a student borrows money to pay tuition, the student signs a paper promising to pay interest and to pay the principal back over time. Mortgages, car loans, and personal loans for vacations are much the same.

A bond is a piece of paper issued when a corporation or a local, state, or federal government borrows money. It represents an agreement between the issuer of the bond and the purchaser that the issuer will pay the amount borrowed (the face value) to the owner of the bond after a certain number of years (called the bond’s maturity date). For example, a bond might have a face value of $1,000, which the person that owns the bond will receive 30 years after the bond was issued. Usually, the borrower also promises to pay the lender a specific amount of interest each year before the bond matures. This interest rate (the coupon rate, which is stated on the bond) will usually be close to the market interest rate for the level of risk inherent in that bond.




















Figure



17.9: When bonds used to be physical pieces of



paper, they would state the principal, the coupon rate, and the maturity date



right on the bond. Today bonds are almost always digital, but the principal,



coupon rate, and maturity date are still stated at purchase. [4]​

Bonds are typically issued by corporations and governments, but they can also come from surprising sources. In 1997, an investment bank raised $55 million in the sale of bonds that were backed by revenues from David Bowie’s first 25 albums. In essence, David Bowie was borrowing money based on his ability to generate royalties on his past recordings.

The federal government issues bonds when it borrows money to finance its deficit. That is, when it spends more than it receives in taxes, it must borrow in order to be able to spend the difference. Corporations sell bonds when they want to borrow money to finance the cost of new factories or retail stores or inventories or the purchase of another corporation.

After bonds are issued by the borrower, they can be resold again before they mature in secondary markets, just like stocks. In fact, bonds are sold among individuals, financial institutions, and corporations every day in very active bond markets. The price of the sale is determined in bond markets by the forces of supply and demand. Thus, bond prices change daily as news about the bond issuer and market conditions change. For example, if news came out that a particular company might go bankrupt and not be able to pay back the face value on its bonds, the price of those bonds would fall immediately as demand for those bonds falls.

The price of a particular bond, in turn, determines the current yield of the bond. The current yield is the annual return that you earn from a bond’s coupon payments as a percentage of its current price. Recall that coupon payments are stated as terms of the bond and do not change. This means that the current yield only changes when the price of the bond changes.

The price of a bond and the current yield will always move in opposite directions. The reason for this is simple. If the price of a bond falls, that means that it is now cheaper to buy the bond. However, the bond still offers the same coupon payments as before, so you get the same future payments for a smaller initial investment (buying the bond at the current price). Thus, the rate of return that you would earn by buying that bond and collecting the payments has gone up. When the bond price fell, the current yield rose.

Table 17.6: This bond table shows some important characteristics of the bonds of four major companies.​ The first column shows the name of the company issuing the bond (that is, the company borrowing the funds). The second column shows the yearly interest payment on the bond as a percentage of the bond’s principal (called a coupon payment). The maturity date is the date on which each bond will pay back the principal (the original amount of the loan). The price is the closing price on the bond market that day. Finally, the current yield is the rate of return based on the current price of the bond and the interest payment.

What will happen to bond prices as overall interest rates in the economy change? Consider the following example. Suppose your parents bought a newly issued bond ten years ago for $1,000. The bond matures 20 years from now and, in the meantime, pays $40 a year in interest. Now they decide to sell the bond to help pay tuition. How much could they get? Is the bond still worth $1,000?

The answer depends upon the current level of interest rates. Interest rates for this type of bond may have increased since your parents purchased the bond. So what will happen to the value? This bond will not be very attractive, because it pays less interest than the bonds that are issued now. If they try to sell the bond, they will not be able to sell it for the full $1,000. The price of the bond will fall as interest rates rise.

Thus, we see headlines like the quote at the beginning of this section. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the prices of existing bonds fall. As current interest rates fall, the prices of existing bonds rise.

Question 17.34

Consider a bond that was issued 5 years ago for $1000. The price of that bond is now $600. If nothing else about the issuer changed in the meantime, it is likely that interest rates have ______________ since the bond was issued.

A

Increased

B

Decreased

C

We cannot tell

17.11.1 Risk and Bonds

Some of the reasoning about risk and rates of return to stockholders carries over to bonds. A risky bond will have a higher rate of return because demand will fall, lowering its price and raising effective interest rates. If future appreciation and dividends stay the same, the expected rate of return rises. Thus, corporate bonds have greater returns than government bonds because they are considered riskier, and the bonds of smaller and younger companies will generally have greater returns than the bonds of well-established companies. This also fits with our discussion of interest rates on loans earlier. As with regular loans, interest rates on bonds are higher for riskier bonds.

Bonds will also have higher returns when there is a long time from the present until maturity. This occurs because the rate of inflation and the conditions of the company are more difficult to predict over a longer time span, and therefore the bond is more subject to risk when the maturity rate is further away.

17.12 Diversification for an Individual Investor

Financial investors are often searching for ways to increase the rate of return from a personal financial investment without increasing risk. One straightforward way to do just that is to diversify – that is, to own a number of different stocks whose prices move somewhat independently from one another.

For example, suppose a stock has a 50 percent chance of equaling $90 at the end of the year and a 50 percent chance of equaling $120 at the end of the year. If the current price is $100, half of the time you will lose $10 (a -10% return) and half of the time you will gain $20 (a 20% return). On average, you expect a 5% return (the average of -10% and 20%) when both possibilities are equally likely.

Suppose instead that you purchased two different stocks, each with the same possible outcomes as above (a return of either -10% or 20%, both equally likely). Suppose that these stocks are from different companies in different industries, and so they will move independently of one another (meaning that one stock going up doesn’t increase or decrease the chance that the other stock goes up as well). If you do this instead of buying only one stock, then you have successfully decreased your risk. Table 17.7 below demonstrates this by showing the possible outcomes for this ‘portfolio’ of two stocks.

Table 17.7: Four possible outcomes for the value of a portfolio of Stock A and B​.

Each stock can either go up to $120 or down to $90, so altogether there are a total of four possible outcomes, and each occurs one-fourth of the time. Now there is only a one-in-four chance of losing 10% of the investment, and only a one-in-four chance of making an extra 20%. The other two times, you earn the average return of 5%. Averaging together all of the different possibilities, you still expect an overall return of 5%. However, the risk of the outcomes being very different from 5% is much less, because now half the time you get exactly 5%. The diversification has paid off. You will have the same income, but with much less risk.

Notice that diversification decreased risk because the movements of the two assets were not correlated with one another. However, the returns of actual financial assets always have some correlation with each other. Recall from Section 17.7 that the risks of an individual stock can be due to that particular company, the overall industry, or the entire market. Diversifying away from that stock can eliminate the risk that is particular to the company, and diversifying outside of the industry can eliminate industry risk. However, diversification cannot eliminate the risk that the entire market moves up or down.

Question 17.35

Rank these assets by their level of risk, from high to low risk, based on what they might be worth in one year.

A

A stock with a 50% chance of being worth $90 and a 50% chance of being worth $110

B

A stock with a 25% chance of being worth $90¸ a 50% chance of being worth $100¸ and a 25% chance of being worth $110

C

A stock with a 50% chance of being worth $150 and a 50% chance of being worth $250


Question 17.36

Rank the portfolios by the relative level of diversification, from low to high levels of diversification.

A

Multiple stocks from different industries in different countries

B

Multiple stocks from different industries within a country

C

Multiple stocks from a single industry

17.13 Efficiency in Financial Markets

Suppose a stock is likely to appreciate from the current price of $40 to a price of $45 per share at the end of one year. If you truly believe that, what would you be willing to pay for 100 shares now?

If there were no costs, the price would be bid up to very near the expected $45 sale price. However, you will have to give up $4,000 (the $40 price times the 100 shares) for one year. Thus, you would give up interest that could have been earned, say $200.

Plus it will cost something to buy and sell it. Say $1 per share to both buy and sell. Assume that the current interest rate means that the opportunity cost is about $200. The lost interest and the $100 commission costs would mean that the most you would be willing to pay would be $4,200, or $42 per share. That is, the $4,500 expected price, minus the lost interest and commission costs. Of course, you would rather pay the current price of $4,000. But if you and many others recognize the same opportunity and have the same costs, the price will immediately go to $42 per share.

That is what happens if the market is competitive. With many buyers and sellers, lots of information, ease of entry and exit, and all shares identical, the market will go to $4,200 now. In other words, it is difficult to make a profit above and beyond the opportunity cost in a competitive market. Efficient markets are those that are very competitive, and the implication is that prices will already be where buyers and sellers expect them to be. The current prices reflect all that is known about the company, the industry, and the economy. Thus, making a profit above and beyond the normal rate of return (an economic profit) is difficult.

Market efficiency is thus why it is very difficult for stock market investors to consistently ‘beat the market’ or consistently attain a higher return than the overall market. Suppose some positive information is released about a company’s stock that increases the expected future profits of that happen. Investors will move very quickly to purchase that stock, increasing its price and driving the rate of return back down. There is very rarely anything that you might know about a stock that is not already factored into its price, so you will not be able to consistently earn returns that are better than the market. In fact, most economic research shows that investors who do very well in one year (in terms of outperforming the market) are no more likely to beat the market the following year than investors that did poorly. If markets are truly efficient, then investors that did particularly well in a given year can credit their high returns primarily to luck.

This idea of market efficiency is related to the concept of economic efficiency introduced in Chapter 2: An Economic Model, but is also somewhat distinct. Before, we meant efficiency in that we were producing as much as we could, and we were producing the right mix of stuff. We have seen that the price system facilitates this efficiency. Financial market efficiency addresses the question of whether these prices are as accurate as possible, which is necessary for price to play its role in coordinating economic activity.

Question 17.37

Suppose that some people in the market face lower costs of buying and selling than others. Specifically, some people can buy and sell stocks with a cost of $.50 per share instead of $1. If everyone in the market knows about this, what will be the new price per share of this stock if the current price per share of this stock is $42?

A

$42.00

B

$42.50

C

$44.50

D

$45.00

Suppose that your great-aunt gives you a suggestion about a super new high-tech company. Explain the effects of efficient markets on your decision to place part of your college fund into that new high-tech company.

Question 17.38

Question 17.38

Should you place part of your college fund in a new high-tech company? Why or why not?

Hover here to see the hint for Question 17.38.
Click here to see the answer to Question 17.38.

Question 17.39

Question 17.39

Explain, in your own words, why risk and return are directly related, that is, why financial investments with greater risk will likely have greater returns.

Hover here to see the hint for Question 17.39.
Click here to see the answer to Question 17.39.

Question 17.40

Question 17.40

Explain in your own words how diversification can reduce risk while maintaining the higher yields associated with riskier stocks.

Hover here to see the hint for Question 17.40.
Click here to see the answer to Question 17.40.

Question 17.41

Question 17.41

Explain in your own words how diversification can increase yield without changing risk.

Hover here to see the hint for Question 17.41.
Click here to see the answer to Question 17.41.

17.14 Present Value of Future Income and Payments.

Which would you rather have: $1,000 today or $1,000 one year from now? Assume that the payment is guaranteed both times. You will definitely get the money.

You probably answered by saying that you would rather have the dollars today because you can spend and enjoy the money sooner. That is, there is a real opportunity cost to waiting. There is another opportunity cost. If you took the $1,000 today, you could also put it in a bank, earn interest for a year and at the end of the year, have $1,000 plus the interest earned. If the current interest rate you could earn is 5 percent, we can calculate what $1,000 would become one year from now. $1,000(1 + .05) = $1,050. The $1,000 today will be worth $1,050 a year from now. So to compare the choices, the $1,000 today will be worth more than a $1,000 payment one year from now. In fact, $50 more. A rational individual chooses the $1,000 payment now.

To be more precise, we can formally calculate what the $1000 payment received now will be worth one year from now if we take advantage of this interest rate

                                                                  or

The present value (the value of the $1000 now, simply $1000) plus the interest earned is equal to the future value, or with 5 percent interest:


So the future value of this $1000 is $1050 because that’s what we will have in the future given this rate of interest. Alternatively, we can calculate the present value of a sum payable in the future. A little algebra leads us from:


to:

Suppose that we wanted to know how much that $1000 paid one year from now is actually worth today. The present value of $1,000 paid one year from now is:


(To be exact = $952.38)

Question 17.42

Suppose the interest rate goes up from 5% to 8%. What is the new future value of receiving $1000 today and earning interest for one year?


Question 17.43

Suppose we have the option to receive $2000 one year from now, and the interest rate is 8%. What is the present value of this future payment of $2000?

17.14.1 Multiple Years

An interest rate of 10 percent will mean that $1,000 placed in a bank will be worth $1,100 in a year (or $1,000(1 + .10)). After second year, the original $1,000 will be worth $1,100 (1 + .10) or $1,210. After the third year, the process continues:

To calculate the value of money earning interest over time:

where i = the interest rate and t = the number of years.

Question 17.44

Suppose the interest rate (earned every year) is 7%, and you invest $10,000 at that interest rate today. What will that money be worth in 5 years?

17.14.2 Bond Prices and Interest Rates

This idea can also be used to calculate current bond prices. Consider a bond with a face value of $1000 that matures in 30 years and pays a steady interest payment in the meantime. In order to figure out how much that face value payment of $1000 is worth today, we would want to discount it by 30 years at the current market interest rate. Similarly, we would discount the interest payment we will receive next year by one year, the following interest payment by two years, and so on. This means that in total, a bond maturing (that is, paying back the original loan) in 30 years would today be worth:


Recall from Section 17.9 that if interest rates increase, bond prices fall. Conversely, if interest rates fall, bond prices increase. We can now see this from the formula for the value of a bond given its payments and the interest rate above. Verify this idea for yourself with an example of a $1,000 bond maturing one year from now and making one more interest payment of $100 at the end of the year. (The original interest rate must have been 10 percent. That is, the original principal was $1,000, and if the interest payment is $100, the interest rate would have been $100/ $1,000 or 10 percent.)

Question 17.45

Question 17.45

If current interest rates are 5 percent (that is, they have fallen since the bond was issued) what is the present value of the bond?

Click here to see the explanation to Question 17.45.

Question 17.46

Question 17.46

What if interest rates rise to 20 percent?

Click here to see the explanation to Question 17.46.

Why would anyone pay $1200 for a bond that will only repay $1000 when it matures 30 years from now? The answer has two parts. If the interest payments earned in the meantime are high compared to the alternatives, then the $200 loss thirty years from now may be worth it. The second part of the answer is that it does not make a whole lot of difference because the value of the $200 difference in what the bond costs now and what you will receive 30 years from now is not actually $200.

Question 17.47

Question 17.47

Which would you rather have $200 now or $200 30 years from now? Make sure you can articulate why.

Hover here to see the hint for Question 17.47.
Click here to see the answer to Question 17.47.

The real cost of not getting the last $200 back at the bond’s maturity is simply the present value of that $200, which is much less than the full $200.

17.14.3 Calculating the Present Value of a Stream of Profits

One way to value a bond or a stock is to calculate the present value of a stream of future profits (or interest payments and principal in the case of a bond). A financial analyst estimates future profits, determines the proper interest rate, and then calculates the present value of that stream of profits. The result is what the value of the financial security should be, given the estimates of the stream of profits and the specification of a relevant interest rate to use in discounting.

17.15 International Currency Markets

Table 17.8: Foreign exchange rates for four different currencies against the U.S. dollar as of February 9th, 2017. The second column shows the number of dollars it currently takes to purchase one unit of the foreign currency. For example, an Argentine peso current costs $ .26. The next column is the inverse. It takes 3.81 Argentine pesos to purchase 1 U.S. dollar.​

Think of markets for currencies that stretch from international city to international city – at airports where tourists come and go, at waterfronts where ships arrive and depart, or at financial institutions around the world. Currencies can be bought and sold for twenty-four hours a day, as we move around the world throughout the day and night from London to New York to Hong Kong to Jakarta to New Delhi and back to London.

Question 17.48

Question 17.48

Think of a supply and demand model to describe a currency market. What would be bought and sold? What would be the price?

Hover here to see the hint for Question 17.48.
Click here to see the answer to Question 17.48.

In a supply and demand model for a currency market, it is a particular currency that is bought and sold, and the price of that currency would be the number of units of another currency it takes to buy it. One such market might be the market for U.S. dollars. The price would be the number of yen per dollar, the number of Euros per dollar, the number of pesos per dollar, or some other currency. That price is called the exchange rate and can actually be stated in two ways – the number of yen per dollar or the number of dollars per yen. With a little bit of arrogance, in the U.S. we often define exchange rates as the number of units of the other currency it takes to buy a dollar. In daily newspapers and on television news, the term “value of the dollar” is often used to mean the same thing. If it takes more of a foreign currency to buy a dollar, the value of the dollar has gone up and vice versa. Keep in mind when you hear the phrase “international value of a dollar,” it is always in terms of another currency (or a basket of currencies).

17.16 International Demand for Dollars

The next step in developing our model of currency markets is to think what constitutes demand for dollars in the international currency market. Why would individuals, businesses, and governments in other countries demand dollars? Would the slope of the demand curve be positive or negative? Why?

Chinese consumers might want U.S. dollars in order to buy American movies or American cars. The demand for exports from the U.S. lies behind the international demand for the dollar. But there are other reasons to demand dollars. Chinese businesses might demand dollars to buy American raw materials (which are also U.S. exports) or to make investments in the U.S., such as building a factory in the U.S. Chinese banks might want to buy financial assets.

At an exchange rate of 6.88 yuan per dollar, a $20,000 U.S. automobile costs 137,600 yuan. If the exchange rate falls to 5 yuan per dollar, the same automobile costs a Chinese citizen 100,000 yuan. Given the fall in price to Chinese buyers, the quantity demanded of automobiles will increase, and the quantity demanded of dollars to buy those automobiles will likely increase. Thus, the demand curve for currency is downward sloping. At lower values of the dollar, the quantity demanded increases. Figure 17.10 shows the demand curve for U.S. dollars in terms of Chinese yuan.

In international currency markets, the demand for U.S. dollars is the international demand for U.S. products, capital investments, and financial assets. It takes dollars to buy those products and to make those investments. It takes dollars for a foreigner to build a new factory, as when Toyota built its factories in Kentucky and BMW in South Carolina and Mercedes-Benz in Alabama. It is the demand for financial assets; it takes dollars to buy a share of stock on the New York Stock Exchange.

Figure 17.10: The demand for dollars in the international market for currency.​​​

17.17 International Supply of Dollars

The supply is more difficult to think about. People and institutions in the U.S. have the dollars. Why would U.S. citizens want to supply dollars to the international market? Think of the above discussion and then explain. Why would businesses or individuals want to supply dollars to the international market?

Question 17.49

Question 17.49

Why would a business or an individual want to supply dollars to the international currency market?

Hover here to see the hint for Question 17.49.
Click here to see the answer to Question 17.49.

If U.S. individuals, businesses, and governments want to buy Chinese goods and services, make investments in China, or buy Chinese financial assets, they need Chinese yuan in order to do so. To get Chinese yuan, they will have to supply dollars to the international currency market. Thus, the greater the U.S. demand for Chinese goods, the greater the U.S. supply of dollars in the currency market. The greater the U.S. demand for Chinese investment and Chinese financial assets, the greater the U.S. supply of dollars will be in that market.

Figure 17.11: The supply for dollars in the international market for currency.​​​

If the international price of the dollar is 7 yuan per dollar, we can buy 7 yuan’s worth of goods for one dollar. At 3 yuan per dollar, we could buy less than half that number of goods for the same dollar. Thus, the cost of Chinese goods has increased for us, and the quantity we demand of the Chinese goods will decrease. If the quantity of Chinese goods demanded decreases, the supply of dollars to the international currency market decreases. Thus, as shown in Figure 17.11, the supply curve is upward sloping.

Graphing Question 17.04

17.18 Supply and Demand in the Currency Market

The movement to an equilibrium price and an equilibrium quantity in the international currency market is the same process that we encountered in our first discussion of markets. If the price of the dollar is below the equilibrium price Figure 17.12, the quantity demanded will be greater than the quantity supplied. 

Figure 17.12: The demand and supply of dollars in the international market for currency.​​

The shortage will result in the market bidding up the price of the dollar. As the price of the dollar increases, the quantity supplied will increase (as we demand more goods, etc.) and the quantity demanded will decrease (as those in other countries will demand fewer U.S. goods, etc.). As the price of the dollar increases, foreign goods will be cheaper for us, and we will buy more. Our imports will rise. As the price of the dollar increases, our goods will be more expensive for those abroad to buy. Thus, our exports will begin to fall. That process will continue until we reach an equilibrium price – the equilibrium exchange rate.

Question 17.50

Question 17.50

Explain the effects of the following events on exchange rates and the number of dollars bought and sold.

An increase in the popularity of American movies in Japan.

Hover here to see the hint for Question 17.50.
Click here to see the answer to Question 17.50.

Question 17.51

Question 17.51

Explain the effects of the following events on exchange rates and the number of dollars bought and sold.

An increase in the popularity of French wine in the U.S.

Hover here to see the hint for Question 17.51.
Click here to see the answer to Question 17.51.

Question 17.52

Question 17.52

Interest rates increase in the U.S. Think of institutions buying bonds or opening bank accounts in other countries. What is the effect of the increased interest rates in the U.S. on the supply and demand for U.S. currency? What is the effect on the exchange rate?

Hover here to see the hint for Question 17.52.
Click here to see the answer to Question 17.52.

Question 17.53

What is the effect of the change in the exchange rate from the previous question on U.S. exports and U.S. imports?

A

Exports increase and imports increase

B

Exports decrease and imports increase

C

Exports increase and imports decrease

D

Exports decrease and imports decrease

17.19 Determinants of Exchange Rates

Dollar Rises as Expectations Grow for March Rate Hike [2]

"The U.S. dollar advanced against its major rivals on Wednesday after comments from a key Federal Reserve official added to the growing consensus that markets could expect an interest-rate increase at the central bank’s March meeting.

The WSJ Dollar Index, a measure of the U.S. dollar against a basket of major currencies, was up 0.4% at 91.55. The ICE U.S. Dollar Index, which narrows that comparison to six currencies, gained 0.5% to 101.67. Earlier, it rose as high as 101.97 and hit its highest level since Jan. 10."

              - Hiroyuki Kachi & Ryan Vlastelica for Market Watch, March 1, 2017

Question 17.54

Question 17.54

Can you use our supply and demand model to describe what is happening in the above excerpt?

Hover here to see the hint for Question 17.54.
Click here to see the answer to Question 17.54.

17.19.1 Financial Conditions

Forces changing supply and demand for a currency work at different speeds, but all are likely working at any one time. Changes in interest rates in the U.S. relative to Thailand, for example, will change the demand for (and supply of) dollars very quickly. If interest rates are higher here, Thai businesses will demand dollars to earn higher interest, and the international price of the dollar will rise. (And the value of the Thai baht will fall.) You should be able to work out the effects on supply.

17.19.2 Economic Conditions

Changes in income and relative price levels are always affecting exchange rates through changes in the demand for exports and imports. But the economic forces take longer to have an effect than the financial flows around the world. Can you estimate what happens to the value of the dollar if Thai income rises? Think about the Thai demand for imports.

If Thai income increases, Thai consumption will rise. If consumers in Thailand use some of their income to buy U.S. goods, Thai imports of U.S. goods will rise. The international demand for the dollar increases. The value of the dollar will rise.

Question 17.55

What happens to the value of the dollar when prices in the U.S. rise faster than the Thai prices?

A

The value of the dollar will decrease.

B

The value of the dollar will increase.

C

The value of the dollar will stay the same.

17.20 Purchasing Power Parity

Frugal Traveller: In Bali, $3 Goes A Long Way [3]

“I leaned back lazily in my hammock and surveyed the panorama from my private veranda: coconut palms and mango trees in sizzling jungle greens, cascades of purple trumpet vines and pale-yellow frangipani, a tropical explosion of foliage that would have kept Gauguin working overtime for a month. [...] It was all impossibly sweet and delicious, but for a frugal traveler there was something even sweeter about this cottage in the central hills of Bali: the price tab. It was $2.85 a night, breakfast and tax included, at the prevailing rate of 14,000 rupiahs to the dollar.”

                  - Daisann McLane for The New York Times, August 2, 1998




















Figure



17.13: All this for $3?​ [5]

Question 17.56

Question 17.56

Can this $3-a-night dream vacation last forever? Why or why not?

Hover here to see the hint for Question 17.56.
Click here to see the answer to Question 17.56.

Over longer periods of time, exchange rates will approach a level which provides “purchasing power parity,” meaning that prices around the world will tend to be equal – so that the purchasing powers of currencies are equal or “on a par” with one another. Exchange rates will adjust so that goods that can be traded will eventually cost the same all over the world. Differences in prices will eventually be only due to transportation costs. Purchasing power parity has often been described as the “law of one price.”

The Economist, a British news magazine, publishes an index intended to indicate whether a currency is “over- or undervalued” based on the price of a Big Mac in various countries. In 2018, The Economist reported that the Egyptian pound (at an exchange rate of 17.91 pounds per dollar) was the world’s most undervalued currency and the Swiss franc (at an exchange rate of 0.99 francs per dollar) was world’s most overvalued. Using current exchange rates, the price of a Big Mac at McDonald’s restaurants in Egypt, Switzerland, and the U.S. was $1.75, $6.57, and $5.51 respectively (source).

Question 17.57

Question 17.57

Use the concept of purchasing power parity to support or disagree with the magazine’s conclusion.

Hover here to see the hint for Question 17.57.
Click here to see the answer to Question 17.57.

17.20.1 An Example

Compare an automobile made in the U.S. with a very similar automobile made in Japan. Assume the Japanese automobile costs 2,200,000 yen, the U.S. automobile costs $20,000, and the current exchange rate is 100 yen per dollar. Entrepreneurs and arbitragers will have opportunities in this case, and the exchange rates will adjust until the prices of the automobiles are equal. (Assume zero transportation costs.) Can you explain why?

Arbitragers will buy one car in one country and sell it in the other country. The cost in dollars of a Japanese automobile is 2,200,000 yen / (100 yen / $1) = $22,000. Thus arbitragers will buy American autos for $20,000 and ship them to Japan and sell them for $22,000. Their profit per car will be $2,000. The demand for dollars will increase. The supply of dollars will decrease (as Americans buy fewer Japanese cars). The price of the dollar will increase until it is equal to 110 yen per dollar. Thus the price of the Japanese auto will be: 2,200,000 yen / (110 yen / $1) = 2,200,000 yen x $1/110 yen = $20,000.

The problem with purchasing power parity working perfectly is that the purchasing power parity works for all goods at once, not each and every individual good. In addition, not all goods are traded and for those that are not, purchasing power parity will not work. And there are shipping costs; even with the concept working perfectly, transportation costs will prevent purchasing power parity from holding exactly.

In spite of these barriers, exchange rates will tend in the long run to move in the direction of the purchasing power parity levels.

Question 17.58

Consider the same refrigerator sold in the U.S. and in the U.K. It sells for $1200 in the U.S. and £1000 in the U.K. Suppose the exchange rate is currently 1 pound per dollar. If all of the adjustment occurs through the exchange rate, what will the exchange rate be once arbitrage opportunities are eliminated? Assume no transportation costs. Put your answer in terms of pounds per dollar.

17.21 Other Financial Markets

Markets for short-term bonds (often called bills and notes) are bought and sold in what are called money markets. That is, they are so short-term that they are almost the same as money. There is little cost in converting them into liquid deposits.

Mortgages are bought and sold in mortgage markets. The pieces of paper that you or your parents sign when borrowing money to buy a house or apartment are often sold by the bank that lends you the money. The effects are not obvious to the person who bought the house. The monthly interest payments simply go to a different institution. Even the rights to buy and sell stocks, bonds, and a wide variety of commodities at some point in the future are sold in futures markets.

Rights to pollute are traded among companies in markets. As long as there are buyers and sellers of financial instruments, markets can bring the buyers and sellers together and permit efficient exchange.

Financial markets result in exchanges involving persons and businesses who expect to benefit. If the markets are competitive, the information known by all parties is accurate, and the parties are rational, the outcomes are likely to be economically efficient.

17.22 Summary

  • Physical capital is the resources businesses use in the production of other goods and services. 
  • Physical capital is necessary to purchase prior to the production and sale of the goods and services it will produce. In addition, the cost is often significantly greater than the available funds of the owners. Firms enter financial markets in order to raise financial resources to use to pay for the physical capital in its business.
  • The financial capital businesses obtain is the funds that are used to purchase the physical capital.
  • The price and quantity of physical capital used depend upon the value of the marginal product of the physical capital and the costs of manufacturing the capital. 
  • The value of the marginal product of the physical capital is the demand for the physical capital. 
  • The cost of manufacturing the capital is the basis for the supply of physical capital.
  • Financial capital is raised by borrowing money from a financial institution through a loan, issuing bonds, or selling shares of stock. 
  • Bonds are, in essence, loan agreements. Normally a bond specifies interest payments each year and that the amount borrowed is due a given number of years in the future - the maturity of the bond.
  • Stocks are shares of ownership in a company. Owners are entitled to an appropriate share of profits or assets if the company is sold.
  • The cost of the funds for the business in each case, borrowing from institutions or selling stocks or bonds, is determined in markets.
  • Stock prices depend upon a variety of characteristics of the company, industry, and economy. 
  • Opportunity costs are important. They are what one has to give up if one purchases a stock or bond or lends a company financial capital.
  • Calculation of present value of future payments helps determine the prices of stocks and bonds.
  • Rates of return from financial capital are calculated by dividing the interest, dividends, and/or appreciation in the price of the capital by the purchase price of the instrument.
  • There is a positive relationship between rates of return from financial investments and the amount of risk involved in the investment. Market forces determine that positive correlation. 
  • Markets for currency work just like markets for apples, oranges, automobiles, stocks, and bonds, except that the products bought and sold are currencies, and the demand and supply are derived from demand for uses of currencies.
Locked Content
This Content is Locked
Only a limited preview of this text is available. You'll need to sign up to Top Hat, and be a verified professor to have full access to view and teach with the content.

Key Concepts

  Markets for inputs
  Markets for physical capital
  Markets for financial capital
  Stocks
  Bonds
  Present value of future payments
  Currency markets
  Other financial markets
  Risk premium
          Efficient markets
          Purchasing power parity

17.23 Glossary

Bond: An agreement to repay a principal that has been borrowed at some time in the future and to make interest payments on a regular basis in the meantime.

Capital gain: The increase in the market price of a share of stock. Usually expressed as a percentage of the purchase price.

Capital loss: The decrease in the market price of a share of stock. Usually expressed as a percentage of the purchase price.

Coupon: The interest payment that the firm agrees to pay.

Current yield: The return on a bond for purchasing it at its current market price and holding it to maturity, collecting the coupon payments and the face value at the end of the term.

Derived demand: Demand that is derived from the demand for something else. The demand for an input into a production process is derived from the demand for the goods and services that it produces.

Discounting: Turning a future payment or income into a current value.

Dividend: A distribution of a part of profits, paid to owners of shares of stock.

Dividend yield: The dividend stated as a percentage of the price of the stock.

Earnings: The accounting profits of the firm.

Efficient markets: Markets that adjust quickly to new information. In fact, so quickly that the current price reflects all that is know about economic conditions and the present and future conditions of the company.

Equity: Shares of ownership in a firm.

Expected rate of return: Expected annual dividends and annual appreciation of the price of the stock divided by the current price

Face value: The principal that the firm will pay back at the bond’s maturity.

Interest payment: Payment by borrowers to lenders.  Interest rates are normally expressed as an annual percentage of the value of a loan or bond.  Payments are made monthly, quarterly, or annually.

Maturity: The date at which the principal or face value of the bond will be paid back to the owner of the bond.

Physical capital: Physical resources used in the production of goods and services.

Present value: The current value of future payments or income.

Price-earnings ratio: The price of a stock divided by its annual earnings per share.

Principal: The original amount borrowed. Also, the amount that will be paid back to the holders of the bond at maturity.

Purchasing power parity: The tendency for prices of the same good in different countries to converge over time.

Return: The income earned on a stock. The dividend plus the capital gain. Usually expressed as a percentage of the price of the stock.

Risk premium: The additional return that financial investors require to be willing to purchase a financial instrument with greater risk.

Secondary market: A market in which existing shares of stock can be bought and sold.

Stock: Shares of ownership in a firm.

Value of the marginal product of capital: The increase in revenue resulting from using one additional unit of capital.

Yield: The annual rate of return if the bond is held to maturity.





Locked Content
This Content is Locked
Only a limited preview of this text is available. You'll need to sign up to Top Hat, and be a verified professor to have full access to view and teach with the content.

Answer Keys

Answer to Question 17.05

In Figure 17.3, at a cost of $8,000, the firm will use two machines. The reasoning is that if the firm were to purchase one machine, the value of the marginal product, or the addition to revenue from using that machine, is $10,000; because that amount is $2,000 greater than the cost of using the machine, the firm could expand and increase profits. However, it would not make sense to expand beyond two machines. At three machines, for example, the value of the marginal product would be only $6,000, and the cost of using the machine is greater ($8,000). Thus, the firm would cut back to two machines. That, given a goal of profit maximization, is the quantity demanded if the cost of capital is equal to $8,000. The same logic holds for costs of $6,000 and $4,000.

This entire process is much like the cost/benefit comparisons we have done throughout the course. In attempting to maximize profits, the firm compares the benefits of using one more machine (the value of the marginal product) with the costs of using that machine. As long as the marginal benefits are greater than the marginal costs, the firm expands the number of machines. The expansion causes the marginal product to fall, and eventually, the value of the marginal product equals the marginal cost of capital. The firm stops expanding the number of machines at that point. It would make no economic sense to expand beyond that point, as the cost of the decision would be greater than the benefits.

Given the cost of the capital, machines are going to be purchased or rented up to the point where the value of the marginal product is just equal to the cost of the capital. In other words, the value of the marginal product gives us a demand curve for c

Click here to return to Question 17.05.

Answer to Question 17.06

The demand for capital increases. As the productivity of capital increases, the additional output that a unit of capital can produce rises and thus increases the value of the marginal product at each level of capital used.

Click here to return to Question 17.06.

Answer to Question 17.07

A fall in the price of the goods or services produced will decrease the value of the marginal product of capital at each level of capital. (Thus, the demand curve for capital will decrease.)

Click here to return to Question 17.07.

Answer to Question 17.17

The rate of return will stay the same as the dividends and appreciation increase by the same percentage as the price of the stock. If the dividends or expected appreciation increased and the price stayed the same, the rate of return would increase. If the price increased and the expected dividends and appreciation remained the same, the rate of return would fall.

Click here to return to Question 17.17.

Answer to Question 17.19

The price of Microsoft shares will rise. Although Microsoft shares initially had a higher rate of return, once the price rises in response the expected rate of return will fall until it is approximately equal to that of other stocks once again.

Click here to return to Question 17.19.

Answer to Question 17.22

The price of the stock should fall in half. Each stock represents one-half of the amount of ownership as a previous share, and thus its value should fall in half. (That assumes the overall rate of return stays the same.)

Click here to return to Question 17.22.

Answer to Question 17.23

If similar shares of stocks are returning eight percent per year, and profits double, then the current price of Microsoft should double so that the expected return is equal to eight percent. The current owners of shares of stock will benefit. Future buyers will only earn the normal rate of return on shares of Microsoft.

Click here to return to Question 17.23.

Answer to Question 17.28

If two financial alternatives are paying the same rate of return, and yet one has a significantly higher risk, buyers will be more likely to purchase the stock with the lesser risk. In so doing, they will bid up the price of the investment, and the return will fall.

Ultimately, the average rate of return on loans to companies, bonds, and stocks is going to  equal approximately the value of the marginal product of capital. However, prices of individual stocks will vary according to risks and expectations in general for the industry and for the company.

As we discussed earlier in the chapter, prices of a stock and the rate of return are going to be inversely related. For a given series of future profits and dividends, an increase in the price of the stock lowers the likely future rate of return.

If the typical stock has a rate of return of 7 percent, an increase in the profitability of the company will increase the rate of return, but the demand for the stock will rise. Its price will rise, and its rate of return will fall back to that of the typical stock. If, however, the risk facing the company increases, fewer individuals will want to purchase the stock, prices will fall, and the rate of return will increase.

Click here to return to Question 17.28.

Answer to Question 17.30

It is likely that asset C will be less attractive than a similar financial instrument that has the same amount of risk, but a greater return (like the software company stock). Thus, the demand for asset C will fall and so will its price. As a result, the rate of return will rise and continue to rise until the rate of return is equal to that of the software stock. See if you can answer the question if the rate of return were greater than a stock with the same risk.

Click here to return to Question 17.30.

Answer to Question 17.31

Without knowing the price, the question is impossible to answer. If the average profits of Newtech are 20 percent higher and the price is 20 percent higher, the preferred stock will likely be the more stable stock, Intertrode.

The rate of return on Newtech will have to be higher than the rate of return for Intertrode in order to convince investors to hold Newtech. Only when the price of Newtech falls enough to make the return sufficiently high to compensate investors for the higher risk will Newtech be more attractive than Intertrode.

Click here to return to Question 17.31.

Answer to Question 17.38

If markets are efficient, the expectation of high future profits for a new company will mean that the price is already bid up to the point where the rate of return (adjusted for risk) is equal to the rate of return for alternative stocks. You cannot earn more with this stock given the level of risk you are accepting, and you could decrease your risk without decreasing your return by diversifying and owning more than this one stock. You should not place a significant portion of your college fund in this one stock.

Click here to return to Question 17.38.

Answer to Question 17.39

If the risk involved in a stock increases, it becomes a less desirable financial investment. Thus, its price decreases, as fewer potential buyers want to hold the stock. Given its prospects for future earnings, the rate of return rises.

Click here to return to Question 17.39.

Answer to Question 17.40

If a large number of stocks are purchased, then the individual risks that each stock faces alone will cancel out on average. Over a given time period, some stocks will rise while others fall, and the value of the overall portfolio is unaffected. Thus, some of the risks are eliminated. Yet the higher rate of return of the riskier stocks is maintained.

Click here to return to Question 17.40.

Answer to Question 17.41

By purchasing a number of higher-risk stocks, a higher rate of return can be earned. However, by purchasing a diversified group of stocks, the risk may not increase. Thus, the rate of return will have increased without an increase in risk.

Click here to return to Question 17.41.

Answer to Question 17.47

You should choose $200 now because you could invest it and have more than $200 thirty years from now. If you chose $200 thirty years from now, the present value of that would be $200 / (1 + i)30. If the interest rate that you could earn in the meantime is 5 percent, then the present value is $200 / (1 + .05)30, or $200/4.32. Thus, the present value of that is $46.30. much less than $200. You should choose $200 now.

Click here to return to Question 17.47.

Answer to Question 17.48

A particular currency is the good that is bought and sold, and the price is the number of units of another currency that it would take to buy it.

Click here to return to Question 17.48.

Answer to Question 17.49

You would need to exchange some of your dollars for yuan. This means that you are supplying dollars to the international market, as well as demanding yuan.

Click here to return to Question 17.49.

Answer to Question 17.50

An increase in the popularity of American movies in Japan means that demand for American movies by the Japanese has increased. The Japanese need more dollars to buy the American products. Demand for dollars will increase. The price of dollars, as measured in yen (the exchange rate), will also increase, and the quantity of dollars bought and sold in the dollar and yen currency market will increase.

Click here to return to Question 17.50.

Answer to Question 17.51

An increase in the popularity of French wine in the U.S. means that the demand for French wine by Americans has increased. Americans need more Euros in order to purchase more wine. Demand for Euros will increase. Therefore, Americans will supply more dollars. The price of dollars as measured in Euros (the exchange rate) will decrease. The quantity of dollars bought and sold in the dollar/Euro currency markets will increase.

Click here to return to Question 17.51.

Answer to Question 17.52

Increased American interest rates mean that U.S. financial assets pay a higher rate of return. Foreign demand for dollars will increase as foreigners try to earn those higher returns by opening U.S. bank accounts and buying bonds. At the same time, the higher interest rates make dollars more attractive to American citizens and foreign currencies less attractive. The supply of dollars falls. Exchange rates rise, and the quantity bought and sold may rise or fall depending on the magnitudes of the supply and demand curve shifts and the shapes of those curves.

Click here to return to Question 17.52.

Answer to Question 17.54

If the U.S. Federal Reserve raises interest rates, U.S. accounts and financial assets become more  attractive to investors. Thus, foreigners will demand more dollars in the international currency market. At the same time, foreign accounts will be less attractive to U.S. investors. The international supply of the dollar decreases. The dollar, therefore, rises for both reasons.

Click here to return to Question 17.54.

Answer to Question 17.56

Many more tourists should eventually start going to Bali. As a result and if nothing else happens, the demand for the Indonesian rupiah should increase. As it does, the cost to Americans of the $3-a-night vacation will start to rise. It is doubtful that this alone will cause the rupiah/dollar exchange rate to rise enough to make the cost of the Bali vacation equal in cost to similar vacations other places.

Click here to return to Question 17.56.

Answer to Question 17.57

If Big Macs cost only $1.75 in Egypt, theoretically arbitrageurs can buy Big Macs in Egypt and ship them to Switzerland. The gain could be $6.57 - $1.75 = $3.82, surely more than enough to pay transportation costs.

The demand for the Egyptian pound would rise, and thus its value would increase until the cost of Big Macs everywhere were equal. (The supply of Swiss francs would increase, thus bringing down the value of the Swiss franc.) This is the concept of purchasing power parity in action. The Economist must be putting the index together in a somewhat tongue-in-cheek manner. Obviously, it would not work with Big Macs, just as it does not with many non-traded goods.

Click here to return to Question 17.57.

Data Sources

Table 17.2 

Table 17.3

Table 17.4 

SBBI 2014 Yearbook

Table 17.5

Rates as of 4/10/2017

Table 17.6

Table 17.8

Source:  

Explanation Keys

Question 17.45

Notice the price has gone up from the original $1,000 to $1,047.62 as the interest rate has fallen.

Click here to return to Question 17.45.

Question 17.46

 In this case, as interest rates increased, bond prices fell from $1,000 to $916.66.

Click here to return to Question 17.46.

Image Credits

[1] Image courtesy of 3112014 in the Public Domain.

[2] Image courtesy of Raimond Spekking under CC BY-SA 4.0.

[3] Image courtesy of Kevin Hutchinson under CC BY 2.0.

[4] Image courtesy of Jherbstman in the Public Domain.

[5] Image courtesy of Chris McClave under CC BY 2.0.

Markets for financial assets. The most common examples are stock, bond, money, and international currency markets
Physical resources used in the production of goods and services.
Demand that is derived from the demand for something else. The demand for an input into a production process is derived from the demand for the goods and services that it produces.
The increase in revenue resulting from the use of one additional unit of capital.
The firm will compare the value of the marginal product of capital to the cost when determining how much capital to purchase.
As the value of the marginal product of capital increases, the firm will compare this new value to the price of capital.
Remember that the value of the marginal product of capital is just the marginal product of capital (in terms of amount being produced) times the price of the good being produced.
Funds used to purchase physical capital.
Agreements to repay a principal that has been borrowed at some time in the future and to make interest payments on a regular basis in the meantime.
The original amount borrowed. Also the amount that will be paid back to the holders of the bond at maturity.
Payment by borrowers to lenders. Interest rates are normally expressed as a annual percentage of the value of a loan or bond. Payments are made monthly, quarterly, or annually.
Shares of ownership in a firm.
A distribution of a part of profits, paid to owners of shares of stock.
Shares of ownership in a firm.
The market in which firms raise funds by selling newly created stocks or bonds to the public.
A market in which existing bonds or shares of stock can be bought and sold.
The income earned on a stock. The dividend plus the capital gain. A rate of return is expressed as percentage of the price of the stock.
The dividend stated as a percentage of the price of the stock.
The increase in the market price of a share of stock. Usually expressed as a percentage of the purchase price.
The price of the stock divided by the earnings per share.
The accounting profits of the firm
Expected annual dividends and annual appreciation of the price of the stock divided by the current price.
If both the price and the expected dividends and appreciation increase by the same percentage, what happens to the ratio of one to the other?
What happens to the expected return for Microsoft’s stock relative to other stocks, and how will the potential buyers of stocks respond?
The overall value of the company has not changed, so with twice as many shares what will be the new price per share?
Think about what the higher profits will do to the current expected rate of return, and how investors will respond to this change in expected return.
The volatility of the price or return of a financial instrument.
The fact that riskier assets will generally offer a higher expected return than safer assets.
Think about the levels of risk that each investment faces.
How will the willingness of investors to buy asset C as opposed to the software company affect the price and returns of asset C?
From what is given in the question, do you know enough to determine what the expected rates of return will be?
The principal that the firm will pay back at the bond’s maturity.
The date at which the principal or face value of the bond will be paid back to the owner of the bond.
The percentage of the bond’s face value which the company pays to the bond owner every year prior to maturity.
The annual return that you earn from a bond’s coupon payments as a percentage of its current price.
Financial markets that adjust quickly to new information. In fact, so quickly that the current price reflects all that is known about economic conditions and the present conditions and future prospects of the company.
If markets are efficient, how easily will you be able to earn particularly high profits from this company?
Think about how investors respond to higher risk and the impact of this on price and therefore return.
Think about the different types of risk that stocks face.
Think about the different types of risk that stocks face.
What is the present value of $200 30 years from now?
What is the ‘good’ that people are hoping to obtain from this market, and how do they obtain it?
the international demand for U.S. goods and services, for U.S. investments, and for U.S. financial assets.
Suppose that the cash that you have is in dollars, but you would like to buy a good from a Chinese company whose price is denominated in yuan. How would you go about getting the yuan necessary to buy that good?
the U.S. demand for other countries’ goods and services, for investment in other countries, and for other countries’ financial assets.
Think about what will happen to the demand for the U.S. dollar by the holders of yen when the Japanese want to purchase more American movies.
Think about what will happen to the demand for Euros by holders of U.S. dollars when Americans want to buy more French wine.