Chapter 11Chapter 11

Financial Markets and Financial Markets and InvestingInvesting

InvestingInvesting Investing – the act of Investing – the act of

redirecting resources from redirecting resources from consumption today so that consumption today so that they may create additional they may create additional benefits in the futurebenefits in the future

Investment sacrifices spending Investment sacrifices spending today to have more in the today to have more in the futurefuture

SavingSaving In the end, saving your In the end, saving your

money is really lending it to money is really lending it to othersothers

The people you place your The people you place your money with are called money with are called financial intermediaries – financial intermediaries – they channel funds from they channel funds from savers to borrowerssavers to borrowers

Types of Financial Types of Financial IntermediariesIntermediaries

Banks, S&Ls, and Credit Banks, S&Ls, and Credit Unions – take deposits and Unions – take deposits and loan out the moneyloan out the money

Types of IntermediariesTypes of Intermediaries Mutual Funds – take the Mutual Funds – take the

savings of many individuals savings of many individuals and place them in a variety of and place them in a variety of stocks and bondsstocks and bonds

Life Insurance Companies – Life Insurance Companies – collect premiums (fees) from collect premiums (fees) from many savers, and guarantee many savers, and guarantee financial protection to family financial protection to family members who lose someonemembers who lose someone

Types of IntermediariesTypes of Intermediaries

Pension Funds – collect funds from Pension Funds – collect funds from many employees, then pay pensions to many employees, then pay pensions to employees who retireemployees who retire These funds usually invest the money paid These funds usually invest the money paid

inin 401(k) – Retirement account where you 401(k) – Retirement account where you

save and invest part of your paychecksave and invest part of your paycheck Employers will usually match what you put Employers will usually match what you put

in, to a certain pointin, to a certain point

Sharing RiskSharing Risk

It’s a bad idea to place all of It’s a bad idea to place all of your financial faith in one place your financial faith in one place – you might lose everything!– you might lose everything!

Diversification – spreading out Diversification – spreading out investments to reduce riskinvestments to reduce risk

Typical Risk ModelTypical Risk Model

0

10

20

30

40

50

60

70

80

20 40 60

Stocks

Bonds

Banks

Other Key TermsOther Key Terms Portfolio – collection of financial Portfolio – collection of financial

assetsassets Prospectus – an investment Prospectus – an investment

report provided by your report provided by your intermediaryintermediary

Liquidity – the ease with which Liquidity – the ease with which you can convert assets into cashyou can convert assets into cash

Return – money you make on the Return – money you make on the investmentinvestment

Return vs. LiquidityReturn vs. Liquidity Many times, investment Many times, investment

decisions depend on what decisions depend on what you value more of the twoyou value more of the two

Assets that can become cash Assets that can become cash easily often have a low returneasily often have a low return

Assets that have a high Assets that have a high return are difficult to convert return are difficult to convert into cash quicklyinto cash quickly

Return vs. RiskReturn vs. Risk

Assets that have a high Assets that have a high potential return are usually potential return are usually very riskyvery risky

Assets that have low risk Assets that have low risk usually provide a low usually provide a low potential returnpotential return

BondsBonds

Bond – a piece of paper Bond – a piece of paper signifying a loan given to the signifying a loan given to the government or a corporationgovernment or a corporation

Bonds pay the investor (or Bonds pay the investor (or lender) a fixed interest rate lender) a fixed interest rate for a certain amount of timefor a certain amount of time

Generally low risk, low returnGenerally low risk, low return

3 Components of Bonds3 Components of Bonds Coupon Rate – interest rate the Coupon Rate – interest rate the

bond issuer will paybond issuer will pay Maturity – the time at which Maturity – the time at which

payment to the bondholder is due payment to the bondholder is due (usually 10 to 30 years)(usually 10 to 30 years)

Par Value – the amount the Par Value – the amount the investor pays to purchase the investor pays to purchase the bond, to be paid back upon bond, to be paid back upon maturitymaturity

Bond RatingsBond Ratings Standard & Poor’s and Moody’s Standard & Poor’s and Moody’s

rate bonds based on their rate bonds based on their assessment of the issuer’s ability assessment of the issuer’s ability to repay the loanto repay the loan Letter grade system: AAA is best, Letter grade system: AAA is best,

D means company is in defaultD means company is in default Higher risk bonds usually offer a Higher risk bonds usually offer a

higher interest ratehigher interest rate

That’s all well and good, but how do bonds

work?

How Bonds WorkHow Bonds Work

2 different ways2 different waysCorporate bonds, treasury Corporate bonds, treasury bonds, and municipal bondsbonds, and municipal bondsPay you the % interest of Pay you the % interest of the bond each year, then the bond each year, then give you the par value at give you the par value at maturitymaturity

How Bonds WorkHow Bonds Work

2 different ways2 different waysSavings bondsSavings bonds

Bond grows in value over Bond grows in value over time and can be redeemed time and can be redeemed for twice the value at for twice the value at maturitymaturity

Types of BondsTypes of Bonds

Savings Bonds – issued by the Savings Bonds – issued by the U.S. government to finance U.S. government to finance their debttheir debt

Treasury Bonds – like a Treasury Bonds – like a corporate bond from the U.S. corporate bond from the U.S. government, and tax freegovernment, and tax free

Types of BondsTypes of Bonds Municipal Bonds – issued by the city Municipal Bonds – issued by the city

to pay for parks or libraries, etc. to pay for parks or libraries, etc. Corporate Bonds – cannot guarantee Corporate Bonds – cannot guarantee

repayment, but have a higher repayment, but have a higher interest rate than U.S. gov’t bondsinterest rate than U.S. gov’t bonds Junk Bonds – Higher risk, higher Junk Bonds – Higher risk, higher

return corporate bonds (rated BBB return corporate bonds (rated BBB or lower)or lower)Still lower risk than most stocks, Still lower risk than most stocks, thoughthough

With Members of the U.S. With Members of the U.S. CongressCongress

How do you Profit?How do you Profit? 2 Ways to Profit:2 Ways to Profit:

Dividends – some corporations Dividends – some corporations pay part of their profits out to pay part of their profits out to stockholders quarterly (4 times stockholders quarterly (4 times a year)a year)

Capital Gains – selling the stock Capital Gains – selling the stock for more than you paid for itfor more than you paid for it

How do you Profit?How do you Profit? If you are interested in receiving If you are interested in receiving

dividends, you should buy dividends, you should buy income stockincome stock

If you’re more interested in If you’re more interested in capital gains, you should buy capital gains, you should buy growth stockgrowth stock – pays no dividend – pays no dividend

Stock SplitStock Split Companies can decide to split Companies can decide to split

stocks – double the number of stocks – double the number of shares, while cutting their shares, while cutting their value in halfvalue in half

50 shares worth $20 each 50 shares worth $20 each becomes 100 shares worth becomes 100 shares worth $10 each$10 each

In both situations, the stock is In both situations, the stock is worth a total of $1,000worth a total of $1,000

How do you buy Stock?How do you buy Stock? Must go through Must go through

a brokerage firm a brokerage firm – they are – they are licensed by the licensed by the SEC to conduct SEC to conduct stock tradesstock trades Stockbroker – a Stockbroker – a

person who links person who links buyers and buyers and sellers of stocksellers of stock

Examples of Brokerage Examples of Brokerage FirmsFirms

Examples: Charles Examples: Charles Schwab, Edward Schwab, Edward Jones, Merrill Lynch, Jones, Merrill Lynch, Smith Barney, AIGSmith Barney, AIG

Online Brokerages: Online Brokerages: TD Ameritrade, TD Ameritrade, Scottrade, ETrade, Scottrade, ETrade, Fidelity (do it Fidelity (do it yourself, but reduced yourself, but reduced commission)commission)

Stock ExchangesStock Exchanges

Stock Exchange – market for Stock Exchange – market for buying and selling stockbuying and selling stock

Newspapers and websites publish Newspapers and websites publish information on what happens in information on what happens in the major stock exchangesthe major stock exchanges

Major Stock ExchangesMajor Stock Exchanges

New York Stock Exchange New York Stock Exchange (NYSE) – largest and most (NYSE) – largest and most powerful companiespowerful companies

NASDAQ – specializes in tech NASDAQ – specializes in tech companies, usually higher companies, usually higher risk than NYSErisk than NYSE

Major Stock ExchangesMajor Stock Exchanges The OTC Market – “over the The OTC Market – “over the

counter”counter” Not an actual stock exchangeNot an actual stock exchange Traded through an electronic Traded through an electronic

marketplacemarketplace Mostly new and growing Mostly new and growing

companiescompanies Most stocks traded this wayMost stocks traded this way

Futures and OptionsFutures and Options Futures – contracts to buy or Futures – contracts to buy or

sell a particular commodity sell a particular commodity on a specific date in the on a specific date in the future at a price set todayfuture at a price set today

Investors may buy futures Investors may buy futures now, hoping the price of the now, hoping the price of the commodity will rise before commodity will rise before they must sell itthey must sell it

Futures and OptionsFutures and Options Options – contracts that give Options – contracts that give

investors the choice to buy or investors the choice to buy or sell stock and other financial sell stock and other financial assets LATER for TODAY’S assets LATER for TODAY’S pricepriceCall Option – choice to buyCall Option – choice to buyPut Option – choice to sellPut Option – choice to sell

Measuring Stock Measuring Stock PerformancePerformance

““Bull Market” – stock market Bull Market” – stock market is rising steadilyis rising steadily

““Bear Market” – stock market Bear Market” – stock market is fallingis falling

1980’s and 1990’s were the 1980’s and 1990’s were the longest sustained bull longest sustained bull markets in U.S. historymarkets in U.S. history

The Dow Jones Industrial The Dow Jones Industrial AverageAverage

Shows the Shows the performance of 30 performance of 30 stocks from stocks from various industries various industries as a representation as a representation of the whole of the whole marketmarket

What is the deal with the

Dow?

The S&P 500The S&P 500

Just like the Dow Jones, but Just like the Dow Jones, but uses 500 different companiesuses 500 different companies

Mostly NYSE stocks, but also Mostly NYSE stocks, but also some from NASDAQ-AMEX some from NASDAQ-AMEX and OTCand OTC