Chapter 11 Financial MarketsChapter 11 Financial Markets1.1. Savings and InvestingSavings and Investing2.2. Bonds and Financial AssetsBonds and Financial Assets3.3. The Stock MarketThe Stock Market

How do your savings and investments affect your future?

1. Savings and Investing1. Savings and Investing What is your investment? Right now!What is your investment? Right now!

Investing and Free EnterpriseInvesting and Free Enterprise Investing Investing -- the act of the act of redirecting resourcesredirecting resources from being from being

consumed todayconsumed today so that it may create so that it may create benefits in the futurebenefits in the future

I really want that new phone, but I would rather save for my

car.

The Financial SystemThe Financial System The The network network of structures and mechanisms that allow the of structures and mechanisms that allow the

transfer of moneytransfer of money between between savers savers and and borrowersborrowers Financial AssetsFinancial Assets –– a claim on the property or income of a a claim on the property or income of a

borrowerborrower

WHAT DO YOU OWN?

An IPOD, a baseball card, a car, a home

Financial IntermediariesFinancial Intermediaries Helps Helps channel funds from savers to borrowerschannel funds from savers to borrowers Banks, Savings and Loans, Credit UnionsBanks, Savings and Loans, Credit Unions Mutual FundsMutual Funds --organization that pools the savings of many organization that pools the savings of many

individuals and invests this money in a variety of stocks, bondsindividuals and invests this money in a variety of stocks, bonds, , and other financial assetsand other financial assets

Hedge fundHedge fund –– private investment that employs risky strategiesprivate investment that employs risky strategies Life insurance companiesLife insurance companies --financial protection to familiesfinancial protection to families Pension FundsPension Funds --money received after retirementmoney received after retirement

Sharing Risk and Providing Sharing Risk and Providing InformationInformation

Diversification Diversification –– spreading out investmentsspreading out investments PortfoliosPortfolios --a collection of financial assetsa collection of financial assets Prospectus Prospectus –– investment report provides information to potential investment report provides information to potential

investorsinvestors

Liquidity, Return, and Risk Liquidity, Return, and Risk Liquidity Liquidity --ability to use cashability to use cash Return Return –– the the money money an investor receives an investor receives beyond the sum of beyond the sum of

investedinvested Risk Risk –– higher risks greater chance of failure or successhigher risks greater chance of failure or success

“The risk/return tradeoff could easily be called the ‘ability –to-sleep-at-night test.’ While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important. . . .” Forbes, “The Risk-Return Tradeoff”

Which investment has greater liquidity, a saving account or a certificate of deposit?

Types of RisksTypes of Risks

LiliLili invests $100 in Mayinvests $100 in May’’s cleaning s cleaning business to be repaid at 5 percent business to be repaid at 5 percent interest for one year later. Six interest for one year later. Six months later, months later, LiliLili is unable to invest is unable to invest in Soniain Sonia’’s pets pet--sitting business, sitting business, which pays 10 percent interest, which pays 10 percent interest, because she has already invested because she has already invested her savings.her savings.

You may have to pass up better You may have to pass up better opportunities for investmentopportunities for investmentTime RiskTime Risk

Ricardo lends Jeff $1,000 for one Ricardo lends Jeff $1,000 for one year at 10 percent interest. If the year at 10 percent interest. If the inflation rate is 12 percent, Ricardo inflation rate is 12 percent, Ricardo loses money.loses money.

Inflation rate erodes the value of Inflation rate erodes the value of your assetsyour assetsInflation Rate RiskInflation Rate Risk

Your MP3 player is worth $100. You Your MP3 player is worth $100. You need cash to buy concert tickets, need cash to buy concert tickets, so you decided to sell your MP3 so you decided to sell your MP3 player. To convent your MP3 player player. To convent your MP3 player into cash on short notice, you have into cash on short notice, you have to discount the price to $75.to discount the price to $75.

You may not be able to convert the You may not be able to convert the investment back into cash quickly investment back into cash quickly enough for your needsenough for your needs

Liquidity RiskLiquidity Risk

You lend $20 to your cousin, who You lend $20 to your cousin, who promises to pay you back in two promises to pay you back in two weeks. When your cousin fails to weeks. When your cousin fails to pay you on time, you donpay you on time, you don’’t have t have money for the basketball tickets money for the basketball tickets you had planned to buy.you had planned to buy.

Borrowers may not pay back the Borrowers may not pay back the money they have borrowed, or they money they have borrowed, or they may be late in marking period.may be late in marking period.

Credit RiskCredit Risk

ExampleExampleDescriptionDescriptionNameName

2. Bonds and other Financial Assets2. Bonds and other Financial Assets

Why are bonds bought and sold? Why are bonds bought and sold? Helps the government finance Helps the government finance big projectsbig projects

No, not Barry Bonds!

As Financial AssetsAs Financial Assets--Three Three componentscomponents

Coupon RateCoupon Rate –– the interest rate that a bond issuer will pay to the interest rate that a bond issuer will pay to the bondholderthe bondholder

MaturityMaturity –– the time at which payment to a bondholder is duethe time at which payment to a bondholder is due Par ValuePar Value-- bondbond’’s stated value, to be paid at maturitys stated value, to be paid at maturity (Yield(Yield--the annual rate of return on a bond if held until maturity)the annual rate of return on a bond if held until maturity)

Types of BondsTypes of Bonds Savings BondsSavings Bonds --low denomination bond issued by federal governmentlow denomination bond issued by federal government Treasury BondsTreasury Bonds --offer different lengths of maturityoffer different lengths of maturity Municipal BondsMunicipal Bonds --state or local government to finance a public projectstate or local government to finance a public project Corporate BondsCorporate Bonds –– issued by a corporation to help raise money for issued by a corporation to help raise money for

expansionexpansion Junk BondsJunk Bonds --high risk and potential high yieldhigh risk and potential high yield

Other TypesOther Types Certificate of DepositsCertificate of Deposits (CDS) (CDS) –– most common form low riskmost common form low risk Money Market Mutual FundsMoney Market Mutual Funds ––medium risk (not covered by FDIC)medium risk (not covered by FDIC)

Treasury Bonds, Notes, and BillsTreasury Bonds, Notes, and Bills

$100$100$100$100$100$100DenominationDenomination

$100$100$100$100$100$100Minimum Minimum purchasepurchase

Liquidity and Liquidity and SafeSafe

SafeSafeSafe Safe Liquidity and Liquidity and safetysafety

4, 13, 26, or 52 4, 13, 26, or 52 weeksweeks

2,5, or 10 years2,5, or 10 years30 years30 yearsMaturityMaturity

Short termShort termIntermediate Intermediate termterm

Long termLong termTermTerm

Treasury BillTreasury BillTreasury NoteTreasury NoteTreasury BondTreasury Bond

Financial Asset MarketsFinancial Asset Markets Capital MarketsCapital Markets -- money is lent for periods longer than a yearmoney is lent for periods longer than a year Money MarketsMoney Markets –– money is lent for less than a yearmoney is lent for less than a year Primary MarketsPrimary Markets –– selling financial assets that can be redeemed selling financial assets that can be redeemed

only by the original holderonly by the original holder Secondary MarketsSecondary Markets –– reselling financial assetsreselling financial assets

Average Bond YieldsAverage Bond Yields From the early 1990s to the early 2000s, bond yields dipped sligFrom the early 1990s to the early 2000s, bond yields dipped slightly for all htly for all

three types of bonds shown. Which type of bond had the highest ythree types of bonds shown. Which type of bond had the highest yield? Which ield? Which of the three types of bonds would you expect to carry the least of the three types of bonds would you expect to carry the least risk? Explain.risk? Explain.

0

2

4

6

8

10

12

1994

1996

1998

2000

2002

2004

2006

Corporate

20 yearTreasury

Municipal

3. The Stock Market3. The Stock Market LetLet’’s Play the Stock Game!s Play the Stock Game!

Well, Honey I lost my shirt, literally!Maybe you should

give it a shot!

Buying StockBuying Stock SharesShares –– a portion of stocksa portion of stocks Benefits of StocksBenefits of Stocks

DividendsDividends Capital GainsCapital Gains --financial gain; purchase price is higher than financial gain; purchase price is higher than

the selling pricethe selling price

Types of StocksTypes of Stocks Income StockIncome Stock -- provides investors with incomeprovides investors with income Growth StockGrowth Stock --pays a few dividendspays a few dividends Common StockCommon Stock –– involved in votinginvolved in voting Preferred StockPreferred Stock --get dividends back before common, but non get dividends back before common, but non

votingvoting

How Stocks Are TradedHow Stocks Are Traded StockbrokersStockbrokers –– person who links buyers and sellers in stockperson who links buyers and sellers in stock Brokerage firmsBrokerage firms –– a business that specializes in trading stocksa business that specializes in trading stocks Stock ExchangeStock Exchange –– a market for buying and selling stock (New a market for buying and selling stock (New

York Stock Exchange and York Stock Exchange and NasdaqNasdaq))

Futures and OptionsFutures and Options FuturesFutures –– contract to buy or sell commoditiescontract to buy or sell commodities at a particular at a particular

date in thedate in the futurefuture at a at a price specified todayprice specified today OptionsOptions –– contractscontracts that give investors the that give investors the right to buy and sellright to buy and sell

stock and other stock and other assetsassets Call Option Call Option –– buy stock at a price until a specified future datebuy stock at a price until a specified future date Put Option Put Option –– sell stock at a price until a specified future datesell stock at a price until a specified future date

Measuring Stock PerformanceMeasuring Stock Performance Bull MarketBull Market –– steady rise in the marketsteady rise in the market Bear MarketBear Market ––steady drop in the marketsteady drop in the market

The Great CrashThe Great Crash Speculation Speculation –– practice of making high practice of making high ––risk investments with risk investments with

borrowed money in hopes of getting a big returnborrowed money in hopes of getting a big return October 29, 1928 October 29, 1928 ––Black TuesdayBlack Tuesday 16.4 million shares sold 16.4 million shares sold

starting the Great Depressionstarting the Great Depression Attitudes towards stock changed and many peoples felt it was Attitudes towards stock changed and many peoples felt it was

too riskytoo risky

Risk, Liquidity, and ReturnRisk, Liquidity, and Return

Potentially. Less Potentially. Less return than stocks, return than stocks, more than bondsmore than bonds

Cab be sold at Cab be sold at current price on current price on stock marketstock market

Less Risk than Less Risk than stocks; more stocks; more than bondsthan bonds

Mutual FundsMutual Funds

Greatest potential Greatest potential returnreturn

Can be sold at Can be sold at current price on the current price on the stock marketstock market

Greater RiskGreater RiskIndividual Individual StocksStocks

Greater return than Greater return than CDs, but potentially CDs, but potentially less return than less return than individual stocks and individual stocks and mutual fundsmutual funds

Must be held to Must be held to maturity; however maturity; however can be sold on bond can be sold on bond market for current market for current priceprice

Minimal RiskMinimal RiskBondBond

Potentially, least Potentially, least returnreturn

Least liquidityLeast liquidityMinimal RiskMinimal RiskCertificate of Certificate of DepositDeposit

ReturnReturnLiquidityLiquidityRiskRisk