Midterm #2 Flashcards
opportunity cost of leisure
- the cost of spending time not working
- what you would have earned
substitution effect
demand for leisure decreases if wage rates increase
-workers want to work more because they earn more per hour
income effect
demand for leisure increases if wage rates increase
-workers want to work less because they earn more per hour
Utility
measure of overall happiness
preference for leisure
defined by the amount of utility that one gains from leisure and income
-shown on indifference curve
indifference curve
curve showing each combination of leisure and income that would yield the same amount of utility
steep indifference curve= high value placed on leisure
flatter indifference curve= low value placed on leisure
budget constraint
line showing every possible combination of leisure and income possible with specific amount of hours and wages
-utility is maximizing point where the budget constraint is tangent to the indifference curve
4 principles of indifference curve
1) utility curves cannot intersect
2) they are negatively sloped
3) utility are convex
4) everyone’s utility curve is different
worker’s reservation wage is
the lowest wage the person would accept to offer his labour services
expected utility
utility that the consumer would expect to receive on average
risk averse
- prefers certain income over risky income of equal value
- more worried about losing investment, do not like investing in riskier products
- more likely buy insurance products
risk neutral
- indifferent between certain income and risky income of equal value
- slope is constant
- marginal utility is constant at all income levels
risk loving
- some who loves risk
- slope is always increasing
risk premium
amount of money a risk averse person will pay to avoid taking risk
risk averse- amount they would have to give up to eliminate risk
risk lover- amount they would have to be paid to eliminate risk
reference point
point of view from which you make a decision or an opinion
endowment effect
when people value a good more because they own it
loss aversion
its when we have something but don’t want to lose it
anchoring
being influenced into a decision based on a certain piece of info
framing
relying on a context in which a choice is presented when making a decision
the law of small numbers
overstate the probability that something will happen when faced with relatively little info
what type of risk is avoidable with proper diversification
unsystematic risk
How does the diversification of an investor’s portfolio avoid risk?
buying stocks that are negatively correlated, as the number of stock held increases, the overall variance of the portfolio decreases
What is a financial market?
channel from those who have a surplus of funds to those that have a shortage
saved money= lenders
shortage= borrowers
Direct vs indirect finance
direct finance- borrowers borrow the funds directly from the lenders in financial markets by selling them securities
indirect finance- financial intermediaries borrow the funds from the lenders and lend them to the borrowers
3 ways to diminish risk
1) diversification
2) insurance
3) gain more info
debt
contractual agreements between the borrower and the lender
ex) bonds, mortgages, and other loans
borrower
- sells fraction of ownership to the lender in exchange for funds
- doesn’t get money back
ex) common shares and preferred shares
Primary market vs secondary
primary- where securities are issued for the first time, the investor is buying securities directly from the issuer
secondary- securities are previously issued are resold or traded to other investors
exchanges
where buyers, sellers, brokers, and agents meet to conduct trades
ex) Toronto stock exchange
over-the-counter markets (OTC)
decentralized exchange where parties buy and sell financial instruments to each other
-various locations
Money market
Capital market
- short term debt and other instruments (maturity is less than one year) are traded in this market
- long term debt and other instruments (maturity is one year or more) are traded in this market
Money market instruments are
- short term debt instruments
- little fluctuation in price
- least risky
- lower expected returns
Treasury bills (t-bills)
short term debt issued by government of Canada with maturity of less than a year
-risk free
Certificates of deposit (CD)
- debt instruments sold by banks to depositors
- pays annual interest
ex) bearer deposit notes, term deposit receipts and common names certificates of deposits
commercial paper
- unsecured short term debt instrument issued by bank and corporations
- interest rate depends on the risk
repurchase agreements (repos)
short term loan maturity is less than 2 weeks
-t bills held are collateral
overnight funds
overnight loans between banks
interest rate= overnight interest rate
capital market instruments are
1) longer-term instruments
2) wider price fluctuation
3) more risky
4) higher expected return
stocks
represent fractional ownership in a corporation
mortgages
-loans to purchase real estate
corporate bonds
- long term bonds issued by corporations
- corporation pays semi annual interest payments to the investor
government of Canada bonds
- intermediate term bonds (1-10 years) issued by the government of canada
- used to finance the government’s deficit
canada savings bond
- non marketable government bonds
- do not change in value
provincial and municipal government bonds
used to finance local expenditures like schools, road, and other programs
government agency securities
-long term bonds issued by various government agencies
consumer and bank commercial loans
loans made to consumers and business by banks
International bond market
1) bonds can be traded internationally
2) type of bond depends on issuer and currency
foreign bond
- bonds sold in foreign country
- same currency as foreign country
eurobond
- bond is not in the same currency as the country it was issued in
ex) issued in Japan but in US dollars
eurocurrency
foreign currency deposited in banks outside of the home country
transactional costs
- costs related to financial market transactions
- includes commissions, brokerage fees
- higher costs when smaller amounts are invested
economies of scale
financial institutions can decrease transaction costs by bundling the funds of many investors
expertise
financial institutions can decrease transaction costs by using expertise they have developed
asymmetric information
when one party does not have enough info about the other to make an accurate decision
adverse selection
- happens BEFORE the transaction because of asymmetric info
- one party has more info than the other party, causing the party with less info to try to mitigate risk
moral hazard
- happens AFTER the transaction due to asymmetric info
- when one party behaves in a certain way because they are not responsible for the risk
lemons problem
- result of asymmetric info
- investor does not have enough info to differentiate good and bad firms
Tools to solve adverse selection problems
1) private production and sale of info- does not completely solve the problem due to the free rider effect
- people using info to their advantage
2) government regulations- prevent misleading investors
3) financial intermediation
4) collateral and net worth- property promised to the lender if the borrower defaults
principal-agent problem
principal- owner of the business
agent- managers of the business in charge of representing the owners
-when the interests of the agents are not aligned with the principals
-form of moral hazard
Tools to solve the principal-agent problem
1) monitoring- auditing
2) government regulation
3) financial intermediation
4) debt contracts reduce moral hazard
5) lending the firm more money
tools to solve moral hazard in debt contracts (loans)
1) net worth and collateral
2) monitoring
3) restrictive convenants
4) financial intermediation
function of financial intermediaries- indirect finance
-lower transaction costs ex) economies of scale
-reduce investors risk exposure ex) diversification
-solve asymmetric info problems
adverse selection- gather info about potential borrowers
moral hazard- sign a contract with restrictive covenants
financial capital flows ex)
currency market transactions
Deep integration
trade agreements which do not only contain rules on tariffs and conventional non-tariff trade restrictions, but which also regulate the business environment in a more general sense
financial intermediares are
- transform assets
- borrow from one group of people and lend to another
- include life insurance companies
mortgage backed security
bone like debt instrusments
government regulates financial markets for 2 main reasons
1) to increase info available to investors
2) to ensure soundness of financial intermediaries
Secondary markets DON’T
match lenders (savers) with borrowers in need of funds
intermediate-term
Canada bond with maturity 5-10 years
chartered bank
These financial intermediaries raise funds primarily by issuing chequable deposits, savings deposits, and term deposits.
free rider problem
someone who benefits from resources, goods, or services without paying for the cost of the benefit
what is a bond?
issued by corporations and governments to raise capital for various activities
Coupon rate > YTM
Coupon rate < YTM
Coupon rate = YTM
- bond is sold at a premium
- bond is sold at a discount
- sold at par
zero coupon bonds and T-Bills
also known as discount bond
doesn’t pay coupons
bought at a price less than FV
4 types of credit market instruments
1) simple loan- repay principle with interest
2) fixed payment loan- Pay fixed amount every period throughout loan
3) coupon bond- pay a fixed interest payment every year until maturity date and repay face value
- perpetuity/console bond- no maturity date, pay coupon payments forever
4) discount bond- sells at a price below its FV
real interest rate
adjusted for changes in the price level (inflation)
Prices and returns for long term bonds are
more volatile (fluctuations in prices) than those for shorter term bonds
the concept on time value of money assumes that
money loses value with time
the current yield is a good approximation to yield to maturity when
- the bond price is very close to par
- the maturity of bond occurs over 10 year period
determinants of asset demand (4)
1) wealth
2) expected return
3) risk
4) liquidity- the ease with which the asset can be converted to cash relative to others
the fisher effect with bonds
1) when inflation decreases Bs increases and Bd decreases
2) Inflation decreases the value of future payments
good for bond issuers= payments are less
bad for bond holders= income is less
changes to equilibrium caused by higher inflation
interest rates rise
bond prices fall
bond quantity can either rise or fall
economic expansion
supply and demand for bond both shift to the right
interest rates can rise, fall or stay the same
quantity of bonds rise
supply and demand for money
determines the equilibrium interest rate in terms of the supply and demand for money
all wealth is stored in two places- bonds and money
effects of increasing money supply
1) decreases interest rates initially- liquidity effect
2) interest rate increases over time because of income,, price level, and expected inflation effect
income effect
higher money supply= increases wealth in economy
people spend more money=increase in demand for money
increase in demand for money= increase in interest rates
price level effect
higher money supply= more money purchasing the same assets
asset prices increase=people need more money
increase in demand for money=increase in interest rates
expected inflation effect
higher money supply= increases inflation
expectation for more inflation in the future= higher interest rates
Takes action when liquidity effect income effect price level effect expected inflation effect
1) immediately
2) slowly
3) slowly
4) fast or slow
why does the liquidity effect dominate the other effects
rates fall immediately
increase slowly over time
new interest rate is lower than intial
what is NOT function of secondary markets
matching lenders with borrower in need of funds
