Ch. 11: Financial Markets

What to do with money:

• Make a list of as many places you can think of that you could invest money...

What to do with money:

• Make a list of as many things you can think of to do with money…– Spend it– Savings account– Certificate of Deposit– Real Estate– Stock Market– Savings Bond– Mutual Fund– Business Loan

Section 1: Saving and Investing

• Investors decide where to place their resources based on several factors.

Investment

• Investment is the directing of resources to create future benefits.

Financial Systems

• Any system that allows the transfer of money between savers and borrowers.

Financial Intermediaries• Institutions that channel funds from savers to

borrowers. – Banks– Finance companies– Stock brokerages

Risk and Reward

• Risk is the extent to which you could lose your investment.

• Reward is the extent to which your investment could be profitable. – High risk = high (potential) reward– Low risk = low reward

Diversification• Diversification is spreading out investments to reduce

risk.– “Don’t put all your eggs in one basket”

Diversification: Mutual Funds

• Mutual Funds are diversified pools of many different stocks and bonds. – Buying 1 share of a mutual fund means you are buying

100s (maybe 1000s) of different stocks and bonds. – Reduces risk

Portfolio

• Portfolio is the compilation of an individual’s investments.

Liquidity

• Can an investment easily be turned into spendable cash? If so- it is a “liquid” investment.

• Rank the liquidity of the following investments– Real Estate– Savings Account– Certificate of Deposit– Retirement Fund

Return and Percentages

• Return in the amount received from an investment.

• Investors consider interest percentages to determine how profitable an investment is.

Section 2: Bonds and Financial Assets

• Bonds are loans to organizations (government or business)

Bonds vs. Stocks

• Buying stocks is buying a portion of a business• Buying bonds is loaning money to a business

or government– As a bond holder, you are not an owner– Means less risk/reward than stocks

Bond Components

• Coupon Rate: the interest rate at which a bond is purchased (5%)

• Maturity: the amount of time a bond must be held before payment can be received (10 years)

• Par Value: amount the investor pays initially ($1,000)

Problem: Compound Interest

• Assume the following bond example: – $1000 par value– 10% coupon rate– 10 year maturity

• How much will the bond holder get back at the end of the 10 years?

Problem: Compound Interest

• Assume the following bond example: – $1000 par value– 10% coupon rate– 10 year maturity

• How much will the bond holder get back at the end of the 10 years?

• Answer: 2,593.74 - Why?

Understanding Compound Interest

• If you clap now• Clap again in 1 second• Clap again in 2 seconds• Clap again in 4 seconds, in 8 seconds, 16

seconds…• How many times will you clap in a year?

Understanding Compound Interest

• Compound interest applies the new interest to the old principal, making growth exponential…

• 25 by 25 scenario…– If you invest $25,000 by the age of 25… – With 10% interest, how much will it be at a

retirement age of 67 (42 years?)

Rule of 72

• 72/Interest Rate = Years for Money to Double• 72/10 = 7.2– 0 years = 25,000– 7 years = 50,000– 14 years = 100,000– 21 years = 200,000– 28 years = 400,000– 35 years = 800,000– 42 years = 1,600,000

500 Million Dollar Bet

• 2 Professors, experts in aging, made a bet. One believed someone currently alive will live to 150, the other disagreed.

• They bet 500 Million Dollars.• How?• http://discovermagazine.com/2003/nov/cover

Types of Bonds

• US Savings Bonds: loans to the US government• Municipal Bonds: loans to state and local

governments. • Corporate Bonds: loans to corporations

(usually higher denominations $5,000-10,000)• Junk Bonds: low-rated corporate bonds that

are high yielding, but likely to fail

Risk vs. Reward

Low Risk/Low Return High Risk/High Return

Risk vs. Reward

Low Risk/Low Return High Risk/High Return

Savings AccountsCDs

US Savings Bonds

Real EstateHigh Risk Stocks/Individual Stocks

Low Risk Stocks/Mutual Funds

Junk Bonds

Section 3: The Stock Market

• Stocks are ways to assume ownership of a corporation.

Stocks & Shares

• Publicly traded corporations issue shares of stock, ownership, in their business.

• Shares are portions of stock (ownership)

Dividends & Capital Gains

• Dividends are payments to shareholders. Usually quarterly (4x a year).

• Capital gain is when shareholders sell their stock for more than they bought it for.

Types of Stock

• Income stock: stock that pays dividends throughout the year.

• Growth stock: the stock does not pay dividends, but reinvests earnings and stock value grows.

Stock Splits

• A stock split is when companies split shares into more than one share.– 10 shares @ $10/share = 20 shares @ $5/share– OR 5 shares @ $20

• To understand how a corporation is valued- you need to look at the quantity of shares, not just the price.

Trading Stocks• Stocks are purchased through stockbrokers who work

for brokerage firms.• Brokerage firms charge commission.– Online brokerages have become common, as they are

automated and charge less commission.

Stock Exchanges

• Brokers trade through stock exchanges.• New York Stock Exchange (NYSE) and Nasdaq.

Day Trading and Financial Engineering

• The stock market has become a playground that can resemble gambling more than investing.

• Through options, futures, short-sales, and complex indexes- you can bet on anything.– Businesses failing, the weather, entire countries.– Day traders hold shares for just one day.

Bull and Bear Markets

• Bull Markets are markets that are on the rise; investors are buying.

• Bear Markets are markets that are falling; investors are selling.

Dow Jones / S&P 500

• The Dow Jones takes 30 diverse corporations that represent the entire stock market, and average them.

• The S&P 500 takes 500 corporations• Both are designed to reflect overall trends of

the market.