Lectures-No3 - Intertemporal exchange Intertemporal...

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Intertemporal exchange Intertemporal exchange – trading current consumption for future consumption; i.e. lending and borrowing. Consumption smoothing – spending is ‘smoother’ than income over time.
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Intertemporal exchange consumption labor income Age $ Saving Borrowing
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Intertemporal exchange Households – net lenders Firms, government – net borrowers Financial system exists to facilitate intertemporal exchange: borrowing and lending
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Services of financial system Reduce transactions costs of borrowing and lending Allow risk-sharing Provide liquidity Providing information
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Financial markets Direct finance – lenders and borrowers directly interact through the exchange of securities or financial instruments. Lenders buy securities of borrowers. Primary and secondary markets Debt and equity instruments/securities Government debt International borrowing and lending
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Financial intermediaries Indirect finance – lenders lend to intermediaries, which in turn lend to borrowers; lenders do not directly hold securities of ultimate borrowers. Examples: banks (depository institutions), pension funds, insurance companies.
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Asymmetric information Borrowers are better informed than lenders about the use of funds, leading to costs: Adverse selection (the lemons problem) – costs associated with distinguishing good from bad borrowers. Before the transaction Moral hazard – costs associated with verifying and monitoring borrower’s use of funds. After the transaction
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Banks and asymmetric information Specialize in obtaining relevant information. Make private loans, so there are incentives for information gathering. Require borrowers to put up collateral. Internal finance versus external finance.
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US bank loans
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Private loans versus securitization Securitization of loans An example: Fannie Mae, Freddie Mac and mortgage- backed securities Fannie and Freddie _____________________________________________ Mortgage loans $1,500 b | $1,350 b MBS | $ 150 b Equity
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Fannie and Freddie MBS Owners share cash flow (P&I) from underlying mortgages. Different from bonds because of principal pre- payment. Lower yields Backed by pools of mortgages Government guarantee of principal and interest (no longer implicit!)
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Measuring interest rates Interest rates in general measure the tradeoffs of intertemporal exchange – the marginal costs and benefits of current and future consumption. Two concepts: Yield-to-maturity = interest rate that equates the present value of a securities payoffs to its current price. Rate of return = rate of gain or loss over a given holding period.
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YTM: Multi-period coupon bond Any debt security is characterized by 1) price; 2) payoffs (face value and interest); and 3) timing of payoffs. P = price
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Lectures-No3 - Intertemporal exchange Intertemporal...

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