FinMan 4 Financial Institutions and Markets Neither a borrower, nor a lender be; For loan oft loses both

itself and friend, And borrowing dulls the edge of husbandry. -Shakespeare, Hamlet Borrowers in search of. . . We take on debt in various forms for a variety of reasons. Consumers, for example, borrow for short periods of time when they use credit cards instead of cash to make purchases. Households also borrow for periods of up to thirty years when financing purchases of homes. Business firms often incur debt when acquiring equipment or when modernizing or building factories. And, of course, governments borrow to cover the excess of their expenditures over their income from the collection of taxes and other fees. Savers in search of. . . We save when the level of our income exceeds expenditures. Motivated to save by a variety of economic and non-economic factors, consumers not only hold their savings in traditional forms such as savings deposits at banks or thrift institutions, but in corporate stocks, bonds and pension or retirement plans, as well. Business firms also save when they retain the profits remaining after business-related expenses, taxes and dividend payments to shareholders have been deducted from revenue. Interest rates Interest rates are the signals that affect the channeling of funds to demanders or borrowers from suppliers or savers, directly or through financial intermediaries. Since interest rates and time are closely related, the expression that time is money is helpful in understanding the financial demand supply linkage and, in turn, the determination of interest rates. What are interest rates? The amount charged or paid for the use of money; it is often expressed as a percentage per annum of the principal. -Penalty to borrowers for consuming before earning. -Reward to savers for postponing consumption. Interest rates are classified as to: -the tenor or the maturity period: short-term (less than one year); medium-term (more than one year but less than five years); and long-term (more than five years).

-the type of instruments (e.g., traditional deposit instruments like savings deposit, time deposit, and some demand or current accounts, and investment instruments like bonds, securities) and on the tenor of investment. Nominal Interest Rates - The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. A nominal variable is one where the effects of inflation have not been accounted for. Example: If the nominal rate on a loan is 5%, then borrowers can expect to pay Php 50 of interest for every Php 1000 loaned to them. Real Interest Rate - Real interest rates are interest rates adjusted for the expected erosion of purchasing power resulting from inflation. The real interest rate is so named because it states the real rate that the lender or investor receives after inflation is factored in. Nominal interest rate Inflation= Real interest rate For example, a bond with a 3% nominal rate will have a real interest rate of -1% if the inflation rate is 4%. Effective Interest Rate - One other type of interest rate that investors and borrowers should know is called the effective rate which takes the power of compounding into account. For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who invests Php 1,000 in this bond will receive Php 30 of interest after the first 6 months (Php 1,000 x .03), and Php 30.90 of interest after the next 6 months (Php 1,030 x .03). Illustration: If you purchase a bond for one year that pays 6% interest at the end of the 12 months, a Php 100 investment would return Php 106. Imagine investing in the same bond and accounting for a 3% inflation rate for the year. What will be the total cost? Alternatively, imagine investing the same Php100 into the bond over 12 months. At 6%, your money would return Php 106 after one year. However, if interest is compounded every six months, will you earn more? Factors that affect the cost of debt for individuals The interest is the price paid to borrow debt capital. With equity capital, investors expect to receive dividends and capital gains, whose sum is the cost of equity money. The factors that affect supply of and demand for investment capital, hence the cost of money. 1. Production Opportunities The returns available within an economy from investments in productive (cash-generating) assets. 2. Time Preferences for Consumption The preferences of consumers for current consumption as opposed to saving for future consumption. 3. Risk- In a financial market context, the chance that an investment will provide a low or negative return. 4. Inflation- The amount by which prices increase over time. CVM.