Chapter 15 - The Financial Sector

Examines the three major financial institutions that connect savers to investors (introduced as the market for loanable funds): banks, the bond market, and the stock market.

Key Concepts

• Banks borrow from savers (deposits) and lend to investors (loans), keeping only a fraction as reserves
• The money multiplier shows how initial deposits create a multiple of new loans
• Bond prices and yields move inversely — understanding this is critical for exam questions
• Stocks are priced by the present value of all future dividends
• The Efficient Market Hypothesis: stock prices already reflect all publicly available information
• Speculative bubbles arise when prices exceed fundamental value; all bubbles eventually burst
• Six financial lessons: harness compound interest, diversify, use index funds, minimize fees

1. Banks

How Banks Work

Banks are financial intermediaries that:

• Accept deposits from savers (this is the bank borrowing from you)
• Make loans to investors and consumers (this is the bank lending out your money)
• Keep reserves — a fraction of deposits held back to meet withdrawal demands

Required Reserve Ratio

The fraction of deposits a bank must keep on hand (not lend out). Set by the central bank.

The Money Multiplier

When a bank receives a deposit, it loans out $(1-\text{reserve ratio})$ of it. That loan becomes a deposit elsewhere, which is loaned out again, and so on.

$\text{Money Multiplier}=\frac{1}{\text{Reserve Ratio}}$

Money Multiplier

Reserve ratio = 10% = 0.10 $\text{Money Multiplier}=\frac{1}{0.10}=10$ A $1,000depositcancreateupto$10,000 in total deposits/loans across the banking system.

Exam Alert

A lower reserve ratio → larger money multiplier → more money creation. A higher reserve ratio → smaller money multiplier → less money creation.

Bank Balance Sheet (Simplified)

Assets	Liabilities
Loans (to borrowers)	Deposits (from savers)
Reserves (vault cash + central bank)

Banks earn profit on the spread between the interest rate they charge on loans and the rate they pay on deposits.

2. The Bond Market

Bond

A bond is an IOU — a promise by the borrower (issuer) to pay the lender (bondholder) a fixed coupon payment each period, plus the face value at maturity.

Bonds are how large organizations (governments, corporations) borrow large amounts of money.

Bond Prices and Yields

Exam Alert

Bond prices and yields (interest rates) move in opposite directions.

$\text{Yield}\approx \frac{\text{Annual coupon payment}}{\text{Bond price}}$

• If bond price ↑ → yield ↓
• If bond price ↓ → yield ↑

Bond Price-Yield Relationship

A bond pays $50/year.Ifthepriceis$1,000, yield = 5%. If the price falls to $500, yield = 10%.

Bond Risks

1. Duration (Interest Rate) Risk The risk that rising interest rates will reduce the value of existing bonds.

• Long-term bonds are more sensitive to interest rate changes than short-term bonds
• Why: a long-term bond locks in a fixed coupon for many years; if rates rise, that fixed coupon is worth less relative to new bonds

2. Default Risk The risk that the borrower fails to make payments.

• Government bonds (e.g., Canada, USA): very low default risk → lower yield
• Corporate bonds: higher default risk → higher yield to compensate investors
• Junk bonds: high default risk → highest yields

Remember

Higher risk → higher yield demanded by investors (risk-return tradeoff).

3. The Stock Market

Stock (Share / Equity)

A stock represents partial ownership of a company. Shareholders are entitled to a proportional share of the company’s profits (paid as dividends) and residual assets.

Unlike bonds, stocks have no fixed payments and no maturity date.

Valuing Stocks: Fundamental Value

A stock’s fundamental value is the present value of all future dividends:

$\text{Stock Price}=\frac{\text{Dividend}}{\text{Interest Rate}}=\frac{D}{r}$

(This is the perpetuity formula — appropriate if dividends are roughly constant.)

Stocks are worth more when:

• Expected future dividends are higher
• The real interest rate is lower (higher PV of future cash flows)

Price-to-Earnings (P/E) Ratio

$\text{P/E Ratio}=\frac{\text{Stock Price}}{\text{Earnings Per Share}}$

• A high P/E ratio suggests investors expect strong future earnings growth
• Used for relative valuation: if Company A and Company B are similar, they should have similar P/E ratios

Relative Valuation

Compare a company’s metrics to a similar benchmark company to estimate fair value.

Relative Valuation (P/E Method)

Nike’s P/E ratio = $160.63/$3.56 = 45.12 Lululemon’s earnings per share = $5.39

If Lululemon should have the same P/E as Nike: $\text{Lululemon price}=45.12\times \$5.39=\$243$

Relative Valuation (Price-to-Book Method)

Nike’s price-to-book ratio = $160.63/$8.09 = 19.86 Lululemon’s book value per share = $20.26

$\text{Lululemon price}=19.86\times \$20.26=\$402$

Note: The two methods give different values ($243vs$402) — this is why stock valuation is uncertain. Lululemon’s actual price ranged between $269and$400 over 52 weeks.

4. What Drives Financial Prices?

The Efficient Market Hypothesis (EMH)

Efficient Market Hypothesis

The theory that at any point in time, stock prices reflect all publicly available information. Stock prices represent the collective judgment about a company’s fundamental value.

Key implications:

• It’s tough to beat the market (unless you have insider information)
• Forward-looking traders eliminate all predictable price changes — only unpredictable changes remain
• Prices follow a random walk: an unpredictable path

Exam Alert

The EMH does not say prices are correct. It says they reflect all available information. Prices can still be wrong if all available information is wrong.

Evidence Against Beating the Market

• A stock-picking contest: a cat named Orlando beat professional wealth managers, stockbrokers, and fund managers
• S&P 500 index fund (7.77% avg. annual return, 2003–2018) outperformed actively managed mutual funds (6.28%)
• Warren Buffett bet the S&P 500 index would outperform hedge funds over 10 years — he was correct
• 100% of economists surveyed strongly agree or agree: a low-cost index fund beats stock picking for most investors

Remember

Past performance is almost completely unrelated to future performance for individual stocks.

Active vs. Passive Funds

Fund Type	Description	Fees	Avg. Return (2003–2018)
Actively managed	Stock pickers select individual stocks	High	6.28%
Index fund	Tracks a broad market index (e.g., S&P 500)	Low	7.77%

Stock Market as Economic Predictor

Stock prices embed enormous collective expertise and information:

• S&P 500 tends to rise in anticipation of a strong economy
• S&P 500 tends to fall in anticipation of an economic downturn

Financial Bubbles

Speculative Bubble

When the price of an asset rises above its fundamental value, fueled by expectations that prices will keep rising.

Infamous bubbles: dot-com bubble (late 1990s — NASDAQ rose +592% from Feb 1995 to Feb 2000, then crashed); Dutch Tulip Mania (17th century).

Why do bubbles form? The “puppy beauty contest” analogy:

• Don’t pick the stock you think is most valuable
• Pick the stock others think others will think is most valuable
• Everyone is guessing what everyone else will do → self-fulfilling price escalation

Greater Fool Theory

Buying an asset not because of its fundamental value, but because you expect to sell it to a greater fool at a higher price. All bubbles eventually burst — when you can no longer find the greater fool, you’re the greater fool.

5. Personal Finance: Six Financial Lessons

Exam Alert

Six Financial Lessons:

1. Harness compound interest — start saving early; a small amount grows enormously over time
2. Don’t pick individual stocks — the EMH is at least mostly right
3. Diversify your portfolio to reduce risk — easiest way: buy index funds
4. Past performance is no guarantee of future performance
5. Minimize fees — management fees compound just like returns, but in reverse
6. Follow all five rules with low-cost index funds

$\$100,000\text{ invested (2003–2018)}:\{\begin{array}{ll}\text{S\&P 500 index fund}& \to \$307,000\\ \text{Actively managed fund}& \to \$249,000\end{array}$

Definitions

Financial Intermediary An institution (like a bank) that channels funds from savers to borrowers.

Reserve Ratio The fraction of deposits a bank keeps on hand rather than lending out.

Money Multiplier $1/\text{Reserve Ratio}$; the total increase in deposits created from an initial deposit.

Bond A debt instrument where the issuer promises to make fixed coupon payments and repay the face value at maturity.

Bond Yield The effective interest rate on a bond: approximately coupon / price. Moves inversely with bond price.

Duration Risk The risk that rising interest rates will reduce the market value of existing (fixed-rate) bonds. Greater for longer-maturity bonds.

Default Risk The risk that a bond issuer will fail to make promised payments.

Stock (Share) A certificate of partial ownership in a company, entitling the holder to dividends and residual assets.

Dividend A payment made by a company to its shareholders from profits.

Fundamental Value The present value of all future dividends a stock is expected to pay.

P/E Ratio (Price-to-Earnings) Stock price divided by earnings per share; a measure of how much investors pay per dollar of earnings.

Efficient Market Hypothesis (EMH) The theory that stock prices reflect all publicly available information at all times.

Random Walk When a price follows an unpredictable path; the result of efficient markets eliminating all predictable changes.

Speculative Bubble When asset prices rise above fundamental values, sustained by expectations of further price increases.

Greater Fool Theory Buying an overvalued asset expecting to sell it at a higher price to a “greater fool.”

Index Fund A mutual fund that passively tracks a broad market index (e.g., S&P 500/TSX), with low management fees.