Lecture Notes: Financial Intermediaries and Bond Markets

Introduction to Financial Intermediaries

Definition: A bond is an IOU documenting who owes how much and when payment is due.
Market: Like stocks, bonds are traded on markets.
Large companies with good reputations can borrow directly from investors in the bond market.
- Example: Starbucks has issued over $1 billion in corporate bonds.
Difference from Stocks: Buying a bond means lending money, not owning a part of the company.
Coupon Payments: Some bonds offer regular interest payments.

Governments also issue bonds.
- Example: In 2016, the U.S. government owed nearly $14 trillion in bond payments.
Government borrowing affects the entire market for savings and loans.

Illustration: If the government borrows $100 billion, the demand for loanable funds increases.
- Effect on Interest Rates: Interest rates rise from 7% to 9%.
- Supply of Savings: Savings increase from $200 billion to $250 billion.
- Crowding Out: Increase in government borrowing reduces private consumption and investment by $50 billion each.

Risks: Bonds are less risky than stocks but have default risks.
Default Risk: Risk that borrower cannot repay when due.
Interest Rates: Higher for higher-risk bonds.
Rating Agencies: Agencies like S&P rate bonds from AAA (safest) to D.
- Starbucks has an A- rating, indicating it's relatively safe.

State of Illinois has an A- rating, pays more to borrow than Virginia with AAA rating.

Loans secured with collateral (like a house) have lower interest rates than unsecured loans (like for a vacation).

Aside from banks, stocks, and bonds, there are other financial intermediaries such as hedge funds, venture capital, and mortgages.
Open invitation for further exploration into financial intermediaries.