1 contents chapter introduction section 1savings and the financial system section 2investment...

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Contents

CHAPTER INTRODUCTION

SECTION 1 Savings and the Financial System

SECTION 2 Investment Strategies and Financial Assets

SECTION 3 Investing in Equities, Futures, and Options

CHAPTER SUMMARY

CHAPTER ASSESSMENT

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Key Terms

– savings

– financial system

– certificate of deposit

– financial asset

– financial intermediary

– nonbank financial institution

– finance company

– saving

Section 1-2

Study Guide (cont.)

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– bill consolidation loan

– premium

– mutual fund

– net asset value (NAV)

– pension

– pension fund

– real estate investment trust (REIT)

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Section 1-5

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Introduction• For an economic system to grow, it must

produce capital–the equipment, tools, and machinery used in the process of production.

• To produce capital, people must be willing to save so that productive resources are released for use elsewhere.

• To the economist, saving means the absence of spending, while savings refers to the dollars that become available when people abstain from consumption.

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Section 1-6


Introduction (cont.)

• Competitive markets are remarkably innovative.

• The creation of the mutual fund industry is just one of many examples describing how our financial system evolves to meet the needs of savers and investors.

• There are only two things you can do with your income—spend it or save it.

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Section 1-7


Saving and Capital Formation

• Saving money makes economic growth possible.

• One person’s savings can represent another person’s loan.

• Saving make investments possible.

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Section 1-10

Financial Assets and the Financial System

• A financial system consists of a network of savers, investors, and financial institutions that work together to transfer savings to investors.

• Financial assets include savings accounts, certificates of deposit, and government and corporate bonds.

• Financial assets represent claims on the borrower.

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Section 1-10

Financial Assets and the Financial System (cont.)

• Financial intermediaries are financial institutions that bring together savers and lenders.

• The circular flow of funds shows how funds are transferred from savers to borrowers.

• Any part of the economy can supply and borrow savings, but governments and businesses are the largest borrowers.

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Section 1-13b

Figure 12.1Overview of the Financial System

Financial Assets and the Financial System (cont.)

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Section 1-16


Nonbank Financial Intermediaries

• Nonbank financial institutions are nondepository institutions that channel savings to borrowers.

• Finance companies buy installment contracts from merchants, who sell goods on credit, and make the loans directly to consumers.

• Many finance companies offer bill consolidation loans to consumers who use these loans to pay off other bills immediately, and then pay off the finance company over time.

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Section 1-16


Nonbank Financial Intermediaries• Life insurance companies receive money

by selling life insurance for a premium, monthly, quarterly, or annual fee.

• Life insurance companies can then invest these funds with institutions.

• Mutual funds are companies that sell shares of their own stock to individual investors and invest the money they receive in corporate stocks and bonds.

• Mutual funds give people the ability to invest in the market at low risk.

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Section 1-16


Nonbank Financial Intermediaries

• Pension funds receive money from employers and invest the money in corporate stocks and bonds to be disbursed among the employees eligible for retirement, old-age, or disability.

• Real estate investment trusts (REIT) borrow money from banks and lend it to construction companies that build homes.

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Section 2-1


Study GuideMain Idea

To invest wisely, investors must identify their goals and analyze the risk and return involved.

Reading StrategyGraphic Organizer Using a graphic organizer like the one on page 318 of your textbook, identify at least four financial assets.

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Section 2-2


Key Terms

– 401(k) plan

– coupon

– maturity

– par value

– current yield

– municipal bond

– tax-exempt

– savings bond

– Treasury note

– risk

Study Guide (cont.)

– Treasury bond

– Treasury bill

– Individual Retirement Account (IRA)

– Roth IRA

– capital market

– money market

– primary market

– secondary market

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– Identify four important investment considerations.

– Describe the three characteristics of bonds.

– Describe the characteristics of major financial assets.

– Understand four views of markets for financial assets.

Section 2-3

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Story.


ObjectivesAfter studying this section, you will be able to:

Applying Economic ConceptsRisk-Return Relationship Riskier projects must offer higher returns to be attractive.

Study Guide (cont.)

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Section 2-4


Introduction

• Before you invest in a financial asset, it helps to have a basic understanding of investment considerations.

• Possessing this information will help you make your own investment goals and decide whether a plan like the 401(k) is right for you.

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Section 2-4


Did You Know?

• “Junk bonds” are very risky bonds. The market for these bonds has grown dramatically in recent years. For example, in 1995, Comcel, a cellular telephone company in Bogotá, Colombia, issued $150 million in junk bonds to pay off a bridge loan. In Brazil, NetSat, a direct broadcast satellite company, raised $200 million. With analysts becoming increasingly more sophisticated in evaluating the projects of emerging countries, junk bonds will continue to attract investors seeking high yields.

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Section 2-6


Figure 12.2The relationship Between Risk and Return

• High risk investments pay higher rates of return than low risk investments.

Basic Investment Considerations

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Section 2-12


Figure 12.3The Power of Compound Interest

• The type of investment chosen depends on the goals of the investor.

• Consistent investing can yield large returns.

Basic Investment Considerations (cont.)

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Section 2-12


Figure 12.3The Power of Compound Interest

• Investors should avoid complex investments they do not understand.


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Section 2-15

Figure 12.4How Much Will You Have at Retirement?

• A 401 (k) plan is a tax-deferred investment plan that acts as a personal pension fund for employees.


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Section 2-17


Bonds as Financial Assets

• Bonds have three main components: the coupon, the maturity, and the par value.

• Bond prices are determined by supply and demand.

• The current yield on a bond is the annual interest rate divided by the purchase price.

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Section 2-23


Bond Ratings

• Most bonds are rated on the financial health of the issuer, the ability to make future coupon and principal payments, and the issuer’s past credit history.

• Bond ratings, ranging from D (lowest) to AAA (highest), indicate the quality of the bond.

• If a bond is in default, it means the issuer has not kept up with the interest or the par value payments.

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Section 2-26


Financial Assets and Their Characteristics

• Certificates of deposit are issued by financial institutions and are the most common form of investments available.

• Corporate bonds are issued by corporations and are usually used for long-term investment because they can be liquidated quickly.

• Municipal bonds are bonds issued by state and local governments and are regarded as a safe, tax-exempt investment.

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Section 2-26


Financial Assets and Their Characteristics (cont.)

• Savings bonds are low-denomination, nontransferable bonds issued by the federal government and are very attractive because they have a virtually no risk of default.

• Treasury notes and bonds are large long-term obligations issued by the federal government and are seen as the safest of all financial assets.

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Section 2-26


Financial Assets and Their Characteristics (cont.)

• Treasury bills are large short-term obligations issued by the federal government.

• Individual Retirement Accounts (IRAs) are long-term, tax-sheltered time deposits intended for retirement.

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Section 2-40


Markets for Financial Assets

• Capital markets are markets in which money is loaned for more than one year.

• Money markets are markets in which money is loaned for less than one year.

Figure 12.6Financial Assets and Their MarketsFigure 12.6Financial Assets and Their Markets

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Section 2-43

Money Markets (cont.)

• Primary markets are markets in which only the original issuer can repurchase or redeem a financial asset.

• Secondary markets are markets in which financial assets can be resold to new owners.


End of Section 2

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Section 3-1


Study GuideMain Idea

Equities, or stocks, represent ownership of a corporation.

Reading StrategyGraphic Organizer As you read the section, use a graphic organizer like the on on page 328 of your textbook to list three different organized stock exchanges.

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Section 3-2


Key Terms

– Efficient Market Hypothesis (EMH)

– portfolio diversification

– stockbroker – securities exchange – seat – over-the-counter

market (OTC) – Dow-Jones Industrial

Average (DJIA)

– equities

Study Guide (cont.)

– Standard & Poor's 500 (S&P 500)

– bull market – bear market – spot market – futures contract – futures market – option – call option – put option – options market

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Section 3-3

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Story.


ObjectivesAfter studying this section, you will be able to:

Applying Economic ConceptsFutures Exchanges Have you ever negotiated to receive your allowance early, or asked to be paid right away for a service to be completed later? Find out how this corresponds to a futures market.

Study Guide (cont.)

– Describe the major stock exchanges.

– Explain how stock market performance is measured.

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Section 3-4


Introduction• In addition to financial assets, investors

may buy equities.

• Equities are stocks that represent ownership shares in corporations.

• The markets for equities are reasonably competitive because there are a large number of buyers and sellers, and investors possess reasonably good information.

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Section 3-4


Introduction

• Investor confidence is important for market stability.

• After the attack on the World Trade Towers, for example, investor uncertainty caused a temporary 14 percent decline in overall stock prices.

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Section 3-4


Did You Know?

• The 30 stocks included in the Dow-Jones Industrial Average represent about a fifth of the $8 trillion-plus market value of all U.S. stocks and about a fourth of the value of stocks listed on the New York Stock Exchange.

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Section 3-5


Market Efficiency

• The Efficient Market Hypothesis states that it is not possible to “beat the market” regularly.

• Instead of trying to beat the market, investors should diversify their portfolios by holding a large number of stocks, or enlist the assistance of a stockbroker.

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Section 3-11


Organized Stock Exchanges• The New York Stock Exchange (NYSE)

lists the shares of about 2,800 large companies, and has 1,400 seats or memberships with access to the trading floor.

• The American Stock Exchange (AMEX) lists the shares of about 750 companies.

• Regional stock exchanges list shares that are too small or too new to be listed on the NYSE or the AMEX.

• Global stock exchanges include stock exchanges around the world.

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Section 3-13b

The New York Stock Exchange (cont.)

Figure 12.7

The New York Stock Exchange

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Section 3-20


The Over-the-Counter Market

• Most shares are not traded on exchanges but in electronic over-the-counter (OTC) trades.

• NASDAQ lists information on companies traded OTC.

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Section 3-23

Measures of Stock Performance

• The Dow-Jones Industrial Average is an index made up of 30 stocks.

• Standard & Poor’s 500 is a index made up of 500 representative stocks.


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Section 3-24b

Figure 12.8

Tracking Stocks With the DJIA and the S&P 500

• A bull market is a market in which prices are rising; a bear market is a market in which prices are falling.

Measures of Stock Performance

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Section 3-28


Trading in the Future

• A spot market is a market in which transaction are made at the prevailing price.

• A futures market is a market in which futures contracts are bought and sold.

• Futures contracts are agreements to sell at a specific date at a predetermined price.

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Section 3-28


Trading in the Future

• An options market is a market in which put and call options are bought and sold.

• A call option gives the owner the right to buy a share of stock at a specified price some time in the future.

• A put option gives the owner the right to sell a share of stock at a specified price in the future.

End of Section 3


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Chapter Summary 1

Section 1: Savings and the Financial System


• Saving is a process that makes savings available for others to invest.

• The economy has a financial system that transfers savings to investors.

• Financial assets are the receipts savers get when they loan funds to individuals, businesses, and governments.

• Financial intermediaries help facilitate the transfer of funds from savers to other investors.

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Chapter Summary 2

Section 1: Savings and the Financial System (cont.)

• Financial intermediaries include finance companies, life insurance companies, mutual funds, pension funds, and real estate investment trusts, or REITs. These institutions are part of the financial system, even though they do not take deposits like commercial banks, savings banks, or credit unions.

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Chapter Summary 3


Section 2: Investment Strategies and Financial Assets

• Investors generally require larger returns to compensate for situations with greater risk.

• Successful investors analyze their goals, invest consistently, and avoid complexity.

• 401(k) plans are popular investments that offer simplicity and relatively high returns.

• Bonds are popular financial assets. The three components of bonds are the coupon, the maturity, and the par value.

• Current yield is a measure of return on bonds. Bond ratings are widely available and can be used as a measure of the bond’s risk.

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Chapter Summary 4


Section 2: Investment Strategies and Financial Assets (cont.)

• Financial markets are named for the characteristics of the assets traded in them. Capital markets have financial assets with maturities of more than one year, while money markets have assets with maturities of less than one year.

• Assets traded in primary markets are those that have to be redeemed by the issuer.

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Chapter Summary 5


Section 3: Investing in Equities, Futures, and Options

• Equities, or stocks, are different from financial assets because equities represent ownership of a corporation rather than a loan to it.

• Because equity markets are reasonably efficient, most investors diversify their portfolio to protect against risk.

• Many stocks are traded on organized exchanges such as the NYSE, the AMEX, and a number of regional stock exchanges.

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Chapter Summary 6

Section 3: Investing in Equities, Futures, and Options (cont.)

• The majority of stocks are traded in a computerized marketplace of organized dealers called the over-the-counter market. These stocks represent newer and sometimes smaller companies that could not get listed on the NYSE.

End of Chapter Summary


51The Chapter Assessment is on pages 336–337.

Chapter Assessment 1

Identifying Key TermsFor each of the investments below, write a brief paragraph that describes at least three of the term’s principal characteristics.

1. Treasury bond 6. Individual Retirement Account

2. Treasury bill 7. 401(k)3. equities 8. Roth IRA4. Treasury note 9. option5. futures 10. municipal bond

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