Ch. 11: Financial Markets

Sec. 1: Savings and Investment

The Financial System

Savings – Investments – is the use of income today in a

way that allows for a future benefit Economic investment – Personal investment – refers to the act of

individuals putting their savings into financial assets – CDs, stocks, bonds or mutual funds putting money into a savings account you benefit – earn interest others benefit – funds available to lend

Financial system –

Bringing Savings and Investment Together

Individuals and businesses can save surplus funds in many ways

Savings accounts at commercial banks/S & Ls, certificates of deposit, corporate or govt. bonds, stocks agent receiving funds is a borrower issues savers written confirmation of

transaction Financial asset –

Bringing Savings and Investment Together Financial market – Financial intermediary – is a financial

institution that collects funds from savers and then invests these funds in loans and other financial assets bring savers, borrowers, and financial

assets together – see figure 11.1

Financial Intermediaries

Bring savers & investors together One group –

other financial intermediaries – ▪ finance companies – make small loans▪ pension funds – ▪ life insurance companies –

Financial Intermediaries

Mutual fund – investors own shares of the entire fund

based on the amount invested gather money in different ways &

provide many different financial assets to a variety of investors

Example: Banking Financial Intermediaries

Includes commercial banks, S & Ls, & credit unions provide checking and

saving accounts - depositors earn interest on both in some cases

most offer CDs & money market deposits accounts that have higher interest rates

federal govt. insures deposits up to $250,000 per depositor in any given bank

Example: Banking Financial Intermediaries

Lend a portion of their deposits to borrowers banks charge a higher

interest rate to pay back savers & make a profit

if borrower does not pay back loan –

Can also offer other financial assets – federal govt. does not

insure these funds

Example: Nonbank Financial Intermediaries

Includes – finance companies make loans to

households & small businesses loans generally under $2000 &

paid back in monthly installments with interest

Mutual fund pools money from many personal investors each investor receives shares in

a fund made up of a large # & variety of stocks, bonds, or other financial assets

make it more affordable for individual investors to own a wide variety of financial assets

once investors purchase a share of funds –

Example: Nonbank Financial Intermediaries

Pension funds allow employees to save money for - then invests pooled

contributions in various financial assets that will increase in value

Life insurance companies allow -

Companies lend or invest some of the income earned from policyholders in a variety of financial assets

Financial Asset Markets-categorize markets based on 2 factors

TIME – HOW LONG THE LOAN IS FOR Capital market – Money market –

WHETHER THE FINANCIAL ASSETS CAN BE RESOLD

Primary market – Secondary market –

Factor 1: Time-2 time sensitive market

Capital markets – ex of assets – b/c loans are for longer

periods - money may be invested in projects that require large amounts of capital

building homes, building new factories, financing govt. projects

Money markets - ex of assets – short

term CDs that can be redeemed in a few months & treasury bills (allow govt. to borrow money for short periods)

Factor 2: Resalability

2 markets based on whether financial assets can be resold

Primary markets are for financial assets that can be redeemed only by the original buyer ex – also refers to market

where the 1st issue of a stock is sold to the public through investment bankers

Secondary markets are resale markets for financial assets offer liquidity to

personal investors investors able to

turn assets into cash relatively quickly

ex –

Sec. 2: Investing in a Market Economy

Investment objective – *ex –

*goals help -

Investment Objective

2 issues will help determine which investment will help achieve objective

Time – amount of time influences kind on

investment is most appropriate Income –

leads to other questions: Will income change in the future? Money available for emergencies?

Need a savings plan that is realistic & flexible enough to adjust to changing circumstances other questions:▪ Do you have outstanding debts?▪ Are you paying taxes on time?

Paying off debts first step to investing generally –

Tax considerations most important to investors with higher incomes subject to higher tax rates

Saving for emergencies – Saving for vacation –

Long term goals – CDs – timing with major purchases or starting

college bonds from state & local govt. offer tax free

earnings

Economic Pacesetters: Mellody Hobson: Investing in the Future

Pres. of Ariel Capital Management, LLC – b. April 3, 1969 discovered her career

investing as a college intern

received degree in 1991 & position in marketing department of Ariel Capital Management

In 2000 – became pres. of the company runs an operation with

over $21 billion in assets

Ariel was first minority owned mutual fund company in the country pioneers programs to teach inter-city kids about investing she give presentations about investing

Developed 1st study of investing by African-Americans & looked for ways to increase participation marketing efforts – events with Chicago Bulls & a stock

picking contest with hip-hop artists In 2000 – became financial contributor to the Good

Morning America show able to reach millions with easy to understand info about

economic matters

Risk and Return

Risk – Return –

can be interest paid on savings account, CD, or increase in value of stock over time

most saving are insured against a loss – an investments are not

investors try to balance risk & return through diversification

Diversification –

What Kind of Risk Are You Willing to Take?

LOW RISK Investor & risk –

even if not get a lot – investments that

guarantee no loss of principal: insured savings deposits & CDs

bonds backed by US govt. are considered risk-free

highly unlikely the govt. would not pay back loans

all other investments carry some risk

HIGHER RISK – STOCKS & CORPORATE BONDS – RETURN DEPENDS ON HOW PROFITABLE THE COMPANY IS

Purchase with expectation that value will appreciate but could lose money if

company runs into problems or other econ. factors

investors than may not be able to sell stock for what they paid –

corporate bonds hold similar risk –

bond holders are paid off before stockholders if company has financial problems

What Kind of Return Do You Want?

With investments – Safest investment –

stocks & bonds are not guaranteed and returns vary at different time

depends on economy as a whole, how well the company is performing

do have a higher return over time then other investments

What Kind of Return Do You Want? Risks & returns are

directly related – investors want highest

return possible – time & income

become important Investing for

retirement in 20-30 years – less time and lower

income will be less risky

Diversification is best way to minimum risk and maximize return ex – 70% in stocks, 20%

in bonds, 10% in CDs – retirement investing

better chance of off-setting losses from one investment with gains from another

Mutual funds help small investors diversify their investments

Sec. 3: Buying and Selling Stocks

The Stock Market

Company 1st issues stock – sold to investment bankers in the primary market called an initial public offer (IPO) – stock then resold to investors through a stock

exchange Stock exchange –

most buy stock as financial investment with expectation that price will rise then they will be able to resell for a profit

Capital gains –

Why Buy Stock?

Investor buy stock for 2 reasons: 1. To earn dividend payments – 2. Earn capital gains by selling the stock

at a price greater than the purchase price▪ if sold below buying price – ▪ if investor wants income – ▪ if investor wants to see investment grow –

Why Buy Stock?

Investing in stocks carries higher risk – corporations not required to pay

dividends – no guarantee that stock price will be

higher when investor wants to sell

Types of Stock-2 types of stock –

COMMON STOCK –

Both types give ownership in corporation – can receive dividends

Holders of common get one vote per share owned to elect board of directors

PREFERRED STOCK –

Holders of preferred receive guaranteed dividends & paid before common stockholders is company is liquidated

Holders of preferred have no voting rights & dividends do not increase if stock increases in value

Trading Stock

Most invest in stock with goal of earning capital gains when they sell it stock prices determined by supply & demand things affecting stock prices:▪ company profit or losses▪ technological advances that affect company or

industry▪ overall state of economy

Trading Stock If investor perceive that company value will

increase – demand for stock ↑ & price ↑ as price rises – few companies sell directly to an investor

Stockbroker – also called brokers generally work for brokerage

firms interact with customers in person, phone or

online job – buy & sell on a variety of stock exchanges

Organized Stock Exchanges

New York Stock Exchange (NYSE) – located on Wall Street in NY City – about 1.5 billion shares of 2,800 of largest

companies in US traded each day brokerage firms pay for privilege of being one

of 1,336 members of exchange Smaller American Stock Exchange (AMEX)

located in NYC trading structure similar to NYSE –

2006 – introduced practice to combine floor & electronic trading

Organized Stock Exchanges Traditionally trading organized in auction format

each stock had specific location of trading post on the floor Specialist representing that stock ran the auction to

match buyers & sellers though open bidding to determine the price of shares prices vary from minute to minute as auction continues

through the day since 1996 – floor trades use hand held computers to

execute trades more than half of order to buy & sell are done electronically

2006 – NYSE merged with Archipelago Exchange(electronic trading company) – to speed up transactions & trade stocks in electronic markets

Electronic Markets

Over-the-counter (OTC) – 1970 – National Association of Securities Dealers

(NASD) introduce centralized computer system that allows OTC traders around the country to make trades at best prices possible automated quote system called NASDAQ

2005 – companies covers many sectors – but most are

technology NASD also regulates OTC Bulletin Board as an

electronic market for trading shares in companies too small to be traded on NASDAQ

Futures and Options Markets

Complicated and high risk investments that involve trying to predict the future

Future – investor who wants to buy in futures wants to

lock in a low price investor who wants to sell in futures wants to

lock in a high price Option –

the investor pays a small fraction of a stock’s current price for the option to buy or sell the stock at a better price in the future

Recent Developments

Late 1990s – stocks listed on any exchange available to any

trading firm growth of electronic communication networks (ECN)

increased electronic stock trading trading now takes place 24 hrs a day – not just when

the exchanges are open many investors have internet access and are more

knowledgeable about trading▪ huge growth in online brokerages▪ investors can trade at any time and pay lower commissions▪ combines rapid trades and best possible prices

Measuring How Stocks Perform

About half of all US households now own stock

Stock index – an instrument used to measure and report change in prices of a set of stocks

Measure the performance – of many individual stocks & the stock market as a whole

Stock Indexes - each index measures the performance of a different group of stocks

PROVIDE A SNAPSHOT OF HOW THE STOCK MARKET IS PERFORMING The Dow –

Standard & Poor’s 500 –

The NASDAQ Composite

GLOBAL STOCK INDEXES – Hang Seng Index –

Hong Kong

The DAX –

Nikkei 225 – Japan

TSE 300 –

FTSE 100 – Britain

THE DOW JONES COMPANY

Publisher of Wall Street Journal – 1st published the DJIA in 1896 only had 12 companies and

reflected agriculture & mining Since 1928 – the Dow has

included 30 companies – General Electric is only 1 of original companies left

US economy has changed from agriculture to industry to service – companies in the index change to reflect the most successful companies in most important sectors called blue chip stocks

THE DJIA IS A PRICE INDEX Measures changes in the

prices at which stocks are traded original DJIA was the actual

average of the prices of the 12 stocks

Now – the average is weighted so the higher priced stocks have more influence on the average the # quoted is not a price

– but an average measured in points not dollars

Tracking the Dow

Changes in the Dow reflect trends in stock market prices

Bull market – Bear market –

track the market to determine if market is trending toward bull or bear

THE 1ST DJIA MEASURE WAS 40.94 In 1972 it reached 1,000

for the 1st time In May 1999 – it topped

11,000 for the 1st time – topped out at 11,722.98 on Jan 14, 2000 – ended longest bull market in history during the 1990s – market

climbed from 2,800 to its peak most bull markets last 2 or 3

years

WELL KNOWN BEAR MARKET FOLLOWED THE STOCK MARKET CRASH OF 1929

During the 20s – the Dow rose from 60 to 381.17 in month after Oct 29,

1929 – dropped to a low of just under 199

next closing price of 400 was Dec. 29, 1954

Sec. 4: Bonds and Other Financial Instruments

Why Buy Bonds?

Bond – govt. can also issue bonds

Par value – the amount that the bond issuer promises to pay the buyer at maturity

Maturity – Coupon rate – is the interest rate a

bondholder receives every year until a bond matures

2 reasons to invest in bonds – 1. 2.

Most people buy bonds for the interest bonds considered less risky b/c holders

are paid before stockholder

Yield – important to determine this when deciding

whether to buy or sell▪ if sold at par value – ▪ if sold for less than par value – yield higher than

coupon rate▪ if demand strong & price is higher than par value –

Generally – why? – more uncertainty and risk involved

with repayment dates that are farther in the future

Type of Bonds

Many different kinds of bonds like stocks – higher the risk – classified by who issues the bonds

US Govt. issues securities called

Treasury bonds, notes or bills

money borrowed through this helps keep the govt. running

.

risk of international bonds depends on financial strength of that particular govt.

Treasury bonds –

Treasury bills –

State and local govt. issue

municipal bondsfinance govt. projects – construction of roads,

bridges, schools…

interest earned on many municipal bonds not subject

to federal income tax

why? – state & local govt. collect taxes so will be able to pay interest and repay the buyer upon maturity

Companies finance

expansion by issuing

corporate bondspay higher

coupon rate than govt.

bonds b/c risk is higher

Junk bond – is considered high risk but has the

potential for high yield

Buying Bonds

Need to determine reason for buying to know which type to purchase

Most investors want the guaranteed interest income yield most important to these investors coupon rate and price relative to par value

will determine yield if want to sell bonds before maturity –

study bond market to see if can sell for profit

Buying Bonds

Market interest rate are important to bond investors inverse relationship between price of

existing bonds & interest rates▪ if interest rates ↑, ▪ if interest rates ↓,

Buying Bonds

Main risk faced by bond purchaser is the issuer will default level of risk is directly tied to the

financial strength of the bond issuer When govt. or corp. want to issue

bonds – investor than have standard to judge the

risk of the bonds

Buying Bonds

Systems of bond ratings: 1. Standard & Poor’s 2. Moody’s▪ use a system of letters to designate relative

credit risk of bonds See figure 11.11

Other Financial Instruments

Other options –

Both have very low risk & provide income in the form of interest

Certificates of Deposit

Form of time deposit offered primarily by banks, S & Ls and credit unions have a maturity date - issuer pays either a fixed or variable interest

during period CD is held usually interest is reinvested in CD so investor

gets compound interest CD with longer maturity date get higher

interest rates▪ ex – 6 month CD – 3.4%▪ ex – 5 year CD – 4.4%

Federal govt. insures funds deposited in CDs at most banks & credit unions up to $100,000 per depositor in any given institution main risk – might face interest rate risk it rates rise

and funds are locked for a length of time at a lower rate

Money Market Mutual Funds

Money market involves financial assets with maturities of 1 yr or less mutual funds allow investors to buy

shares that represent an investment in all the financial assets held by the fund

money market mutual funds (MMMF) – ▪ ex –

Money Market Mutual Funds

Give investors a higher yield than banks saving accounts – but similar level of liquidity can redeem shares by check, phone or electronic

transfer to a separate checking account federal govt. does not insure MMMFs – funds are

tightly regulated▪ considered quite safe with regard to loss of principal

Less interest rate risk than with CDs b/c money is not committed for a specific length of time yield varies based on the yield of the assets in the

fund