Chapter Outline,3.1 The Financial Market Economy 3.2 Making Consumption Choices Over Time 3.3 The Competitive Market 3.4 The Basic Principle 3.5 Practicing the Principle 3.6 Illustrating the Investment Decision 3.7 Corporate Investment DecisionMaking 3.8 Summary and Conclusions,3.1 The Financial Market Economy,Individuals and institutions have different income streams and different intertemporal consumption preferences. Because of this, a market has arisen for money. The price of money is the interest rate.,The Financial Market Economy: Example,Consider a dentist who earns $200,000 per year and chooses to consume $80,000 per year. He has $120,000 in surplus money to invest. He could loan $30,000 to each of 4 college seniors. They each promise to pay him back with interest after they graduate in one year.,Dentist,Student #1,Student #2,Student #3,Student #4,$30,000,$30,000,$30,000,$30,000,$30,000(1+r),$30,000(1+r),$30,000(1+r),$30,000(1+r),The Financial Market Economy: Example,Rather than performing the credit analysis 4 times, he could loan the whole $120,000 to a financial intermediary in return for a promise to repay the $120,000 in one year with interest. The intermediary in turn loans $30,000 to each of the 4 college seniors.,Student #1,Student #2,Student #3,Student #4,$30,000,$30,000,$30,000,Bank,$120,000,Dentist,$30,000,$30,000(1+r),$30,000(1+r),$30,000(1+r),$30,000(1+r),$120,000(1+r),The Financial Market Economy: Example,Financial intermediation can take three forms: Size intermediation In the example above, the bank took a large loan from the dentist and made small loans to the students. Term intermediation Commercial banks finance long-term mortgages with short-term deposits. Risk intermediation Financial intermediaries can tailor the risk characteristics of securities for borrowers and lenders with different degrees of risk tolerance.,Market Clearing,The job of balancing the supply of and demand for loanable funds is taken by the money market. When the quantity supplied equals the quantity demanded, the market is in equilibrium at the equilibrium price. The price of money is the interest rate.,3.2 Making Consumption Choices over Time,An individual can alter his consumption across time periods through borrowing and lending. We can illustrate this by graphing consumption today versus consumption in the future. This graph will show intertemporal consumption opportunities.,Intertemporal Consumption Opportunity Set,A person with $95,000 who faces a 10% interest rate has the following opportunity set.,One choice available is to consume $40,000 now; invest the remaining $55,000; consume $60,000 next year.,Intertemporal Consumption Opportunity Set,$0,$20,000,$40,000,$60,000,$80,000,$100,000,$120,000,$0,$20,000,$40,000,$60,000,$80,000,$100,000,$120,000,Consumption today,Consumption at t+1,Another choice available is to consume $60,000 now; invest the remaining $35,000; consume $38,500 next year.,Taking Advantage of Our Opportunities,$0,$20,000,$40,000,$60,000,$80,000,$100,000,$120,000,$0,$20,000,$40,000,$60,000,$80,000,$100,000,$120,000,Consumption today,Consumption at t+1,A persons preferences will tend to decide where on the opportunity set they will choose to be.,Ms. Patience,Ms. Impatience,Changing Our Opportunities,$0,$20,000,$40,000,$60,000,$80,000,$100,000,$120,000,$0,$20,000,$40,000,$60,000,$80,000,$100,000,$120,000,Consumption today,Consumption at t+1,A rise in interest rates will make saving more attractive ,and borrowing less attractive.,Consider an investor who has chosen to consume $40,000 now and to consume $60,000 next year.,3.3 The Competitive Market,In a competitive market: Trading is costless. Information about borrowing and lending is available There are many traders; no individual can move market prices. There can be only one equilibrium interest rate in a competitive marketotherwise arbitrage opportunities would arise.,3.4 The Basic Principle,The basic financial principle of investment decision making is this: An investment must be at least as desirable as the opportunities available in the financial markets.,3.5 Practicing the Principle: A Lending Example,Consider an investment opportunity that costs $50,000 this year an provides a certain cash flow of $54,000 next year.,Is this a good deal? It depends on the interest rate available in the financial markets. The investment has an 8% return, if the interest rate available elsewhere is less than this, invest here.,3.6 Illustrating the Investment Decision,Consider an investor who has an initial endowment of income of $40,000 this year and $55,000 next year. Suppose that he faces a 10-percent interest rate and is offered the following investment.,3.6 Illustrating the Investment Decision,$0,Consumption today,Our investor begins with the following opportunity set: endowment of $40,000 today, $55,000 next year and a 10% interest rate.,One choice available is to consume $15,000 now; invest the remaining $25,000 in the financial marke