EconomicsEconomicsChapter 11 Financial MarketsChapter 11 Financial Markets

Section 1Section 1Saving and InvestingSaving and Investing

Private Enterprise and InvestingPrivate Enterprise and Investing

Investment is the use of assets to earn Investment is the use of assets to earn income or profitincome or profit..

When people save or invest their money, When people save or invest their money, their funds become available for their funds become available for businesses to use to expand and grow. In businesses to use to expand and grow. In this way, investment promotes economic this way, investment promotes economic growth.growth.

The Financial SystemThe Financial System

A A financial systemfinancial system is a is a system that allows the system that allows the

transfer of money between transfer of money between savers and borrowers.savers and borrowers.

Financial AssetsFinancial Assets

When savers invest, they receive When savers invest, they receive documents confirming their deposit or documents confirming their deposit or bond purchase, such as passbooks or bond purchase, such as passbooks or bond certificates.bond certificates.

These documents are known as These documents are known as financial assetsfinancial assets. They represent . They represent claims on property or income of the claims on property or income of the borrower. borrower.

Financial IntermediariesFinancial Intermediaries

Financial intermediariesFinancial intermediaries are institutions are institutions that help channel funds from savers to that help channel funds from savers to

borrowers. borrowers. Banks, Savings and Loan Associations, Banks, Savings and Loan Associations, and Credit Unionsand Credit UnionsFinance CompaniesFinance CompaniesMutual FundsMutual FundsLife Insurance CompaniesLife Insurance CompaniesPension FundsPension Funds

The Flow of Savings and The Flow of Savings and InvestmentsInvestments

Financial intermediaries accept funds Financial intermediaries accept funds from savers and make loans to from savers and make loans to

investors. investors.

SaversMake

Deposits

FinancialInstitutions

CollectSavings andMake Loans

InvestorsBorrowMoney

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Services Provided by Services Provided by Financial IntermediariesFinancial Intermediaries

Providing Liquidity:Providing Liquidity:

Financial intermediaries allow Financial intermediaries allow savers to easily convert their savers to easily convert their assets into cash. assets into cash.

Providing Information:Providing Information:

Financial intermediaries reduce Financial intermediaries reduce the costs in time and money the costs in time and money that lenders and borrowers that lenders and borrowers would pay if they had to search would pay if they had to search out investment information on out investment information on their own.their own.

Sharing Risk:Sharing Risk:

Diversification is the spreading Diversification is the spreading out of investments to reduce out of investments to reduce risk. Financial intermediaries risk. Financial intermediaries help individual savers diversify help individual savers diversify their investments.their investments.

Risk and ReturnRisk and Return

Return is the money an investor receives above and beyond the sum of money initially invested.

Return and LiquidityReturn and Liquidity

Savings accounts have greater Savings accounts have greater liquidity, but in general have a liquidity, but in general have a lower rate of return.lower rate of return.

Certificates of deposit usually Certificates of deposit usually have a greater return but have a greater return but liquidity is reduced. liquidity is reduced.

Return and RiskReturn and Risk

Investing in a friend’s Internet Investing in a friend’s Internet company could double your company could double your money, but there is the money, but there is the riskrisk of of the company failing. the company failing.

In general, the higher potential In general, the higher potential return of the investment, the return of the investment, the greater the greater the riskrisk involved. involved.

Section 2Section 2Bonds and Other Financial Bonds and Other Financial

AssetsAssets

Bonds as Financial AssetsBonds as Financial Assets

Bonds are basically loans, or Bonds are basically loans, or IOUs, that represent debt that IOUs, that represent debt that the government or a the government or a corporation must repay to an corporation must repay to an investor. Bonds have three investor. Bonds have three basic components:basic components:

1. The 1. The coupon ratecoupon rate — the — the interest rate that the issuer interest rate that the issuer will pay the bondholder.will pay the bondholder.

2. The 2. The maturitymaturity — the time — the time when payment to the when payment to the bondholder is due. bondholder is due.

3. The 3. The par valuepar value — the — the amount that an investor pays amount that an investor pays to purchase the bond and that to purchase the bond and that will be repaid to the investor at will be repaid to the investor at maturity.maturity.

NOTENOTE::

Not all bonds are held to maturity. Not all bonds are held to maturity. Sometimes bonds are traded or Sometimes bonds are traded or

sold and their price may change. sold and their price may change. Economists therefore refer to a Economists therefore refer to a

bond’s bond’s yieldyield, which is the annual , which is the annual rate of return on the bond if the rate of return on the bond if the

bond were held to maturity. bond were held to maturity.

Buying Bonds at a DiscountBuying Bonds at a Discount

Investors earn interest on the Investors earn interest on the bonds they buy. They can bonds they buy. They can also earn money by buying also earn money by buying bonds at a discount from par.bonds at a discount from par.

Illustration Page 278 (11.3)

Bond RatingsBond RatingsStandard & Poor’s, Securities & Exchange Standard & Poor’s, Securities & Exchange Commission, and Moody’s rate bonds on a Commission, and Moody’s rate bonds on a number of factors, including the issuer’s number of factors, including the issuer’s ability to make future payments and to repay ability to make future payments and to repay the principal when the bond matures. the principal when the bond matures.

A high bond rating usually means that the A high bond rating usually means that the bond will sell at a higher price, and that the bond will sell at a higher price, and that the firm will be able to issue the bond at a lower firm will be able to issue the bond at a lower interest rate.interest rate.

Chart page 279Chart page 279

Advantages and Advantages and Disadvantages Disadvantages to Bond Issuersto Bond Issuers

AdvantagesAdvantages

Bonds are desirable from the issuer’s Bonds are desirable from the issuer’s point of view for two main reasons:point of view for two main reasons:

1. Once the bond is sold, the coupon 1. Once the bond is sold, the coupon rate for that bond will not go up or rate for that bond will not go up or down. down.

2. Unlike stock, bonds are not shares 2. Unlike stock, bonds are not shares of ownership in a company. of ownership in a company.

DisadvantagesDisadvantagesBonds also pose two main disadvantages Bonds also pose two main disadvantages to the issuer:to the issuer:1. The company must make fixed interest 1. The company must make fixed interest

payments, even in bad years when it does not payments, even in bad years when it does not make money. make money.

2. If the issuer does not maintain financial 2. If the issuer does not maintain financial health, its bonds may be downgraded to a health, its bonds may be downgraded to a lower bond rating. This makes it harder to sell lower bond rating. This makes it harder to sell future bonds unless a discount or higher future bonds unless a discount or higher interest rate is offered. interest rate is offered.

Types of BondsTypes of Bonds

Savings BondsSavings BondsSavings bonds are low-Savings bonds are low-denomination ($50 to $10,000) denomination ($50 to $10,000) bonds issued by the United bonds issued by the United States government. Savings States government. Savings bonds are purchased below par bonds are purchased below par value (a $100 savings bond costs value (a $100 savings bond costs $50 to buy) and interest is paid $50 to buy) and interest is paid only when the bond matures.only when the bond matures.

Treasury Bonds, Bills, and Treasury Bonds, Bills, and NotesNotes

These investments are issued These investments are issued by the United States Treasury by the United States Treasury Department. Department.

Municipal BondsMunicipal Bonds

Municipal bonds are issued by Municipal bonds are issued by state or local governments to state or local governments to finance such improvements as finance such improvements as highways, state buildings, highways, state buildings, libraries, and schools.libraries, and schools.

Corporate BondsCorporate Bonds

A corporate bond is a bond A corporate bond is a bond that a corporation issues to that a corporation issues to raise money to expand its raise money to expand its business. business.

Junk BondsJunk Bonds

Junk bonds are lower-rated, Junk bonds are lower-rated, potentially higher-paying potentially higher-paying bonds. bonds.

Other Types of Other Types of Financial AssetsFinancial Assets

Certificates of DepositCertificates of Deposit

Certificates of deposit (CDs) are available Certificates of deposit (CDs) are available through banks, which use the funds through banks, which use the funds deposited in CDs for a fixed amount of deposited in CDs for a fixed amount of time.time.

CDs have various terms of maturity, CDs have various terms of maturity, allowing investors to plan for future allowing investors to plan for future financial needs.financial needs.

Money Market Mutual FundsMoney Market Mutual Funds

Money market mutual funds are special Money market mutual funds are special types of mutual funds. types of mutual funds.

Investors receive higher interest on a Investors receive higher interest on a money market mutual fund than they money market mutual fund than they would receive from a savings account or a would receive from a savings account or a CD. However, assets in money market CD. However, assets in money market mutual funds are not FDIC insured. mutual funds are not FDIC insured.

Financial Financial Asset Asset

MarketsMarkets

One way to classify financial asset One way to classify financial asset markets is according to the length of time markets is according to the length of time for which the funds are lent.for which the funds are lent.

– Capital marketsCapital markets are markets in which money are markets in which money is lent for periods longer than a year. CDs is lent for periods longer than a year. CDs and corporate bonds are traded in capital and corporate bonds are traded in capital markets.markets.

– Money marketsMoney markets are markets in which money are markets in which money is lent for periods of less than a year. Short-is lent for periods of less than a year. Short-term CDs and Treasury bills are traded in term CDs and Treasury bills are traded in money markets. money markets.

Markets can also be classified Markets can also be classified according to whether assets can be according to whether assets can be resold to other buyers.resold to other buyers.

–Primary marketsPrimary markets involve financial involve financial assets that cannot be transferred assets that cannot be transferred from the original holder, such as from the original holder, such as savings bonds.savings bonds.

–Secondary marketsSecondary markets involve involve financial assets that can be resold, financial assets that can be resold, such as stocks. such as stocks.

The Stock The Stock MarketMarket

Buying StockBuying Stock

Corporations can raise money Corporations can raise money by issuing stock, which by issuing stock, which represents ownership in the represents ownership in the corporation. A portion of stock corporation. A portion of stock is called a share. Stocks are is called a share. Stocks are also called equities.also called equities.

StockownersStockowners can earn a profit in two ways: can earn a profit in two ways:

1. 1. DividendsDividends, which are portions of a , which are portions of a corporation’s profits, are paid out to corporation’s profits, are paid out to stockholders of many corporations. The stockholders of many corporations. The higher the corporate profit, the higher the higher the corporate profit, the higher the dividend. dividend.

2. A 2. A capital gaincapital gain is earned when a is earned when a stockholder sells stock for more than he stockholder sells stock for more than he or she paid for it. A stockholder that or she paid for it. A stockholder that sells stock at a lower price than the sells stock at a lower price than the purchase price suffers a capital loss.purchase price suffers a capital loss.

Types of StockTypes of Stock

Stocks may be classified either Stocks may be classified either by whether or not they pay by whether or not they pay

dividends or whether or not the dividends or whether or not the stockholder has a say in the stockholder has a say in the

corporation’s affairs.corporation’s affairs.

Dividend DifferencesDividend DifferencesIncome stock pays dividends at Income stock pays dividends at regular times during the year.regular times during the year.

Growth stock pays few or no Growth stock pays few or no dividends. Instead, the issuing dividends. Instead, the issuing company reinvests earnings company reinvests earnings into its business. into its business.

Decision-Making DifferencesDecision-Making Differences

Investors who buy common stock Investors who buy common stock are voting owners of the company. are voting owners of the company.

Preferred stock owners are Preferred stock owners are nonvoting owners of the company, nonvoting owners of the company, but receive dividends before the but receive dividends before the owners of common stock. owners of common stock.

Stock Splits and Stock RisksStock Splits and Stock Risks

Stock SplitsStock Splits

A stock split is the division of a single A stock split is the division of a single share of stock into more than one share.share of stock into more than one share.

Stock splits occur when the price of a Stock splits occur when the price of a stock becomes so high that it discourages stock becomes so high that it discourages potential investors from buying it. potential investors from buying it.

Risks of Buying StockRisks of Buying Stock

Purchasing stock is risky because the firm Purchasing stock is risky because the firm selling the stock may encounter economic selling the stock may encounter economic downturns that force dividends down or downturns that force dividends down or reduce the stock’s value. It is considered reduce the stock’s value. It is considered a riskier investment than bonds. a riskier investment than bonds.

How Stocks Are TradedHow Stocks Are Traded

A A stockbrokerstockbroker is a person who links is a person who links buyers and sellers of stock.buyers and sellers of stock.

Stockbrokers work for Stockbrokers work for brokerage firmsbrokerage firms, or , or businesses that specialize in trading stock. businesses that specialize in trading stock.

Some stock is bought and sold on Some stock is bought and sold on stock stock exchangesexchanges, or markets for buying and , or markets for buying and selling stock. selling stock.

Stock ExchangesStock Exchanges

The New York Stock Exchange (NYSE)The New York Stock Exchange (NYSE)

The NYSE is the country’s largest stock The NYSE is the country’s largest stock exchange. Only stocks for the largest and exchange. Only stocks for the largest and most established companies are traded on most established companies are traded on the NYSE.the NYSE.

NASDAQ-AMEXNASDAQ-AMEX

NASDAQ-AMEX is an exchange that NASDAQ-AMEX is an exchange that specializes in high-tech and energy specializes in high-tech and energy stock.stock.

The OTC MarketThe OTC Market

The OTC market (over-the-counter) is an The OTC market (over-the-counter) is an electronic marketplace for stock that is not electronic marketplace for stock that is not listed or traded on an organized exchange. listed or traded on an organized exchange.

Day-tradingDay-trading

Day-traders use computer programs to try Day-traders use computer programs to try and predict minute-by-minute price and predict minute-by-minute price changes in hopes of earning a profit. changes in hopes of earning a profit.

Futures and OptionsFutures and Options

FuturesFutures are contracts to buy are contracts to buy or sell at a specific date in the or sell at a specific date in the future at a price specified future at a price specified today. today.

OptionsOptions are contracts that give investors are contracts that give investors the option to buy or sell stock and other the option to buy or sell stock and other financial assets. There are two types of financial assets. There are two types of options:options:1. 1. Call optionsCall options give buyers the option to buy give buyers the option to buy

shares of stock at a specified time in the shares of stock at a specified time in the future.future.

2. 2. Put optionsPut options give buyers the option to sell give buyers the option to sell shares of stock at a specified time in the shares of stock at a specified time in the future. future.

Measuring Stock Measuring Stock PerformancePerformance

Bull and Bear MarketsBull and Bear Markets

When the stock market rises When the stock market rises steadily over time, a steadily over time, a bull marketbull market exists. Conversely, when the exists. Conversely, when the stock market falls over a period of stock market falls over a period of time, it’s called a time, it’s called a bear marketbear market..

Stock Performance IndexesStock Performance Indexes

The Dow Jones Industrial AverageThe Dow Jones Industrial Average

– The DowThe Dow is an index that shows how is an index that shows how stocks of 30 companies in various stocks of 30 companies in various industries have changed in value.industries have changed in value.

The S & P 500The S & P 500

– The The S & P 500S & P 500 is an index that tracks is an index that tracks the performance of 500 different stocks.the performance of 500 different stocks.

The Great CrashThe Great Crash

Causes of the CrashCauses of the Crash

Many ordinary Americans were struggling Many ordinary Americans were struggling financially: many purchased new financially: many purchased new consumer goods by borrowing money.consumer goods by borrowing money.

SpeculationSpeculation, or the practice of making , or the practice of making high-risk investments with borrowed high-risk investments with borrowed money in hopes of getting a big return, money in hopes of getting a big return, was common. was common.

Effects of the Great CrashEffects of the Great Crash

The Crash contributed to a much wider, The Crash contributed to a much wider, long-term crisis — the Great Depression long-term crisis — the Great Depression during which many people lost their jobs, during which many people lost their jobs, homes, and farms.homes, and farms.Americans also became wary of buying Americans also became wary of buying stock. As recently as the early 1980s, only stock. As recently as the early 1980s, only about 25 percent of households in the about 25 percent of households in the United States owned stock.United States owned stock.

End of Chapter 11!End of Chapter 11!