Lecture%2024%20-%20Gains%20from%20Divers.%20and%20Bond%20Markets

Lecture%2024%20-%20Gains%20from%20Divers.%20and%20Bond%20Markets

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Unformatted text preview: 1 1 International Financial Markets: The Big Picture To finance trade: countries specialize in industries for which they have a comparative advantage, exchange goods markets: currency markets, forward markets, credit markets to finance short-term trade imbalances 2 The Gains from Trade 1. Exchange goods for other goods Y 2 Y 1 = widgets Y 2 = sprockets P = P 1 /P 2 = terms of trade (world relative price of Y 1 ) Home country produces more Y 1 relative to rest of world Y 1 A C B 2 3 To finance investment: firms borrow to finance long-term projects governments borrow to finance expenditure on public goods (transportation, education, social security) markets: bond and equity markets 4 2. Trade over time: exchange goods for financial assets. Y 2 Y 1 = goods now Y 2 = goods later P = P 1 /P 2 = 1 + r Borrows against higher future income, r is the price of borrowing Y 1 A C B 3 5 How do firms/countries borrow? From banks, by issuing bonds 6 To manage risk: firms and investors hedge exchange rate risk (forward market, derivative markets) firms specialize in production and spread risk across investors markets: equity and bond markets 4 7 3. Trading Risk: Exchange financial assets for financial assets. Example: innovations in computer technology. Event 1: discovery occurs in the US, so US production increases. Event 2: discovery occurs in Japan, so Japanese production increases. Event Prob. US prod Japans prod 1 0.5 150 50 2 0.5 50 150 8 Equity(Stocks) vs. Bonds Bonds: fixed-income debt securities the issuer owes the holders a debt and is obliged to pay the principal (face value) and interest (the coupon ) bond issuers: borrowers bond holders: lenders Equities: stocks shareholder owns a stake in the firm and receives returns from dividends and stock prices 5 9 Equity(Stocks) vs. Bonds Q: If a bond is a fixed-income security (coupons prespecified, face value known, etc.) does this mean there is no risk? 10 Equity(Stocks) vs. Bonds Q: If a bond is a fixed-income security (coupons prespecified, face value known, etc.) does this mean there is no risk? A: No, there is default risk, interest rate risk, and - in the case of foreign bonds - currency risk 6 11 Basics of Bond Markets Bonds have been traded for centuries. International bond markets have been interrupted by wars in early 1900s. The total market size: grows rapidly from under $4 trillion in 1981 to $29.9 trillion in 1999 This growth reflects: c the tendency of governments to run fiscal deficits and turn to bond financing d the rapid expansion of corporate borrowing 12 41.1% 17.6% 8.2% 3.9% 3.1% 2.0% 1.6% 1.0% 1.0% 0.8% 0.8% 0.6% 1.0% 0.5% 0.5% 0.6% 15.6% 2 4 6 8 10 12 14 8 3.1% 1.6% 1.0% 0.8% 1.0% 0.5% E b o n d O t h e r s A u s t r i a A u s t r a l i a S p a i n S w e d e n S w i t z e r l a n d D e n m a r k N e t h e r l a n d s B e l g i u m C a n a d a K a n c e I...
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This note was uploaded on 04/12/2008 for the course ECON 442 taught by Professor Chari during the Winter '08 term at University of Michigan.

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Lecture%2024%20-%20Gains%20from%20Divers.%20and%20Bond%20Markets

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