CHAPTER 1 1. What is a Financial Market? ● A financial market is a place where people buy and sell financial assets (also called securities) such as stocks (ownership shares of companies) and bonds (loans to companies or governments) . ● Money (funds) moves in these markets when one person sells an asset and another person buys it. ● These markets help households (people), businesses (companies), and governments to either get money or invest money. 2. Role of Financial Markets ● Financial markets transfer money from those who have extra money to those who need money. ● Example: ○ College students can get student loans. ○ Families can get home loans (mortgages). ○ Businesses can borrow money to expand. ○ Governments can borrow money to pay for expenses. � Without financial markets, many people couldn’t study, buy homes, companies couldn’t grow, and governments couldn’t pay for many services. 3. Surplus Units and Deficit Units ● Surplus Units (Investors): ○ These are people or groups who have extra money (more money than they spend). ○ They give this extra money to financial markets so it can be lent or invested. ○ In return, they earn profit/interest/dividends (reward for investing). ● Deficit Units (Borrowers): ○ These are people or groups who need more money than they currently have. ○ They borrow money from the financial markets by issuing securities (like bonds, loans, or shares). � Example: ● Students usually are in deficit units because they borrow money for education. ● After finishing their degree and getting a job, they become surplus units because they earn more than they spend. ● Later, if they buy a home, they may borrow again and become deficit units. Sometimes, a person can be both surplus and deficit at the same time: ● For example, depositing savings in a bank (surplus role) while also taking a home loan from the same bank (deficit role). 4. How Deficit Units Get Money ● Deficit units (like companies or governments) get money from financial markets by issuing securities. ● Securities are simply a promise or claim made by the borrower to the lender. There are two main types: 1. Debt Securities (Loans/Bonds): ○ This is borrowed money. ○ The company/government borrows from investors and promises to: ■ Pay interest (usually every 6 months). ■ Return the full borrowed money at a maturity date (the final due date). 2. Example: A government sells a bond worth $1,000 to an investor. ○ The government promises to pay interest (say $50 every year). ○ After 10 years (maturity date), the government will give back the full $1,000. ✅In short: ● Financial markets move money from savers (surplus units) to borrowers (deficit units). ● This allows students to study, families to buy houses, businesses to grow, and governments to pay for expenses. ● Borrowers issue securities like stocks (ownership) or bonds (debt) to raise money. ● Savers (investors) earn returns in exchange for supplying funds. 1. Securities: Debt vs Equity ● Debt securities = Loans (borrowed money). The borrower (government or company) promises to repay with interest + give back the borrowed money (principal) at maturity. ● Equity securities (Stocks) = Ownership. When you buy stock, you own a small part of the company. � Example: ● If the U.S. government needs $70 billion more than tax money it collected, it issues Treasury securities (debt) to raise funds. ● If Google needs $40 million, it can: ○ Issue debt securities (borrow money) OR ○ Issue equity securities (sell ownership shares). Both methods raise money, but each has different pros and cons. 2. Why Issue Securities? ● Governments and companies often spend more than they earn, so they need extra money. ● By issuing securities, they get money from surplus units (investors/savers). ● This is how financial markets help them spend more than their normal income. 3. Types of Financial Markets Different markets exist because: ● Some investors want short-term investments, some want longterm. ● Some investors are okay with high risk, others want low risk. ● Some borrowers prefer loans (debt), others prefer stocks (equity). So, there are different financial markets to match these preferences. 4. Money Markets vs Capital Markets ● Money Markets = For short-term funds (maturity ≤ 1 year). ○ Example: Treasury bills, commercial paper. ○ Safer, more liquid. ● Capital Markets = For long-term funds (maturity > 1 year). ○ Example: Stocks, corporate bonds, Treasury bonds. ○ Riskier, but can give higher returns. 5. Primary Markets vs Secondary Markets ● Primary Market = When a company or government sells NEW securities for the first time. ○ Example: Google issues new stock. ○ Money goes to Google (the issuer). ● Secondary Market = When investors trade existing securities with each other. ○ Example: You sell your Google stock to another investor. ○ Money goes from one investor to another, not to Google. � Important: ● Primary = company/government gets money. ● Secondary = investors trade among themselves. 6. Liquidity ● Liquidity = How quickly and easily you can sell a security without losing much value. ● High liquidity = Many buyers & sellers →easy to sell at fair price. ● Low liquidity = Few buyers →you may need to sell at a discount (lower price). � Example: ● Big company stocks (like Apple) = very liquid (lots of buyers). ● Rare or complex securities = less liquid. ● During the 2008–2009 financial crisis, many securities became illiquid. Investors struggled to sell them without losing huge value. ✅In short: ● Debt securities = borrowing, Equity securities = ownership. ● Governments & companies issue securities to raise money. ● Money markets = short-term, Capital markets = long-term. ● Primary markets = new securities sold, Secondary markets = existing securities traded. ● Liquidity is key →investors prefer assets they can sell easily without loss. 1. Problem in 2008–2009 (Credit Crisis Example) ● Investors were afraid that some debt securities (like bonds, mortgage-backed securities) would default →meaning borrowers wouldn’t be able to pay back interest + principal. ● Because of this fear, investors stopped buying these securities. ● As a result, the secondary market (where investors sell securities to each other) became illiquid →investors who already held these securities couldn’t easily sell them without losing a lot of money. � Lesson: If investors lose confidence, financial markets can freeze up. 2. Three Segments of Finance Finance is usually divided into 3 main parts (Exhibit 1.1 shows this): 1. Corporate Finance →How companies raise money and decide how to use it (for operations & expansion). 2. Investment Management →How investors decide where to put their money (which stocks, bonds, etc.). 3. Financial Markets and Institutions →The system (markets + banks) that connects investors and corporations. 3. How Financial Markets Help Corporations ● Corporations need money to run daily operations and to expand. ● Financial markets bring money from investors (savers) to corporations. � Two ways corporations get money: ● Money markets = short-term borrowing (to support daily operations, like paying workers or buying raw materials). ● Capital markets = long-term borrowing or equity (to expand business, like building a new factory). � The decisions of managers in public companies directly affect: ● The performance of the firm, ● The stock price, ● And the returns that investors earn. So, good financial decisions = higher stock prices = happier investors. 4. How Financial Markets Help Investors (Investment Management) ● Investors have many choices: ○ U.S. Treasury securities, ○ Government agency securities, ○ Corporate stocks and bonds. ● Their main job: decide which securities to buy. � When investing in stocks, investors: ● Look for companies that are undervalued (cheap now but likely to grow). ● Monitor how managers run those companies. ● Sometimes even influence company decisions to make sure managers try to maximize stock price. � The stock price acts like a scorecard for how well managers are doing. 5. Role of Financial Institutions ● Financial institutions (banks, mutual funds, insurance companies, etc.): ○ Act as middlemen (intermediaries) →they help move money from investors to corporations. ○ They also often invest their own money directly into corporations. � Without financial institutions, the flow of funds in financial markets would not work smoothly. 6. Exhibit 1.1 (Simplified Flow) Here’s the flow in simple steps: 1. Investors (including banks, funds, etc.) put in money. 2. Money goes through Financial Markets & Institutions. 3. Corporations receive money →to run operations & expand. 4. Corporations give back returns (interest, dividends, or profits) → flows back to investors. So it’s a continuous cycle: � Investors →Markets →Corporations →Back to Investors. ✅In short: ● During crises, markets can become illiquid if investors lose trust. ● Finance has 3 parts: corporate finance, investment management, and financial markets/institutions. ● Financial markets help corporations raise money (short-term & long-term). ● Financial markets help investors invest wisely and measure firm performance. ● Financial institutions act as middlemen, making the flow of money possible. � Key Concepts You Must Understand First ● Securities = financial instruments like bonds, stocks, etc. (ways for investors to give money to borrowers in return for some benefit like interest or profit). ● Risk = uncertainty about how much return (profit/interest) you’ll get. ● Return = the money you expect to earn from your investment. ● Liquidity = how easily you can sell an investment and get cash without losing value. 1. � What Is Risk in Financial Markets? ● Risk means: You don’t know exactly how much money you’ll earn from your investment. ● Some investments are very safe (like government securities), others are risky (like stocks or corporate bonds). ● Example: ○ If you invest in a 1-year U.S. Treasury bill, you know exactly how much you’ll get back. Very low risk. ○ If you invest in a company’s bond or stock, there’s a chance the company might fail →you might lose your money. That's a high risk. � So, the more uncertain the return, the higher the risk. 2. � Investors Are Different ● Every investor is different. Some want: ○ Low risk (safety). ○ High liquidity (easy to sell quickly). ○ Tax benefits. ● Others are okay with taking risks if they might earn a higher return. � Most investors try to find a balance between: ● High return � ● Low risk ⚠️ ● Enough liquidity � 3. � Types of Securities in Financial Markets Securities are grouped into three major categories: � A. Money Market Securities ● Definition: Short-term debt securities (maturity = 1 year or less). ● Main features: ○ Low risk. ○ Low return. ○ Highly liquid (easy to sell). ● Common examples: ○ Treasury Bills (T-bills) →issued by the government. ○ Commercial Paper →short-term loan issued by companies. ○ Certificates of Deposit (CDs) →issued by banks. � Used by people or institutions who want to keep their money safe and still earn a small return. � B. Capital Market Securities ● Definition: Long-term securities (maturity = more than 1 year). ● Purpose: Companies and governments use them to raise money for long-term things like buildings, machines, etc. ● Three common types: 1. Bonds ● Long-term debt securities issued by: ○ Companies. ○ Government agencies. ● Investors earn interest (called coupon payments) usually every 6 months. ● At maturity, the principal (original money) is paid back. ● Bonds can be sold in secondary markets before maturity. ● Risk: If the issuer fails to pay interest or principal, the investor can lose money. ● Expected return: Higher than money market securities, but also riskier. 2. Mortgages ● Long-term loans used to buy real estate (houses, land, buildings). ● Borrowers repay with interest + principal over time. ● Risk: Some borrowers may fail to repay →risky mortgages. ● Lenders (banks) check income and other factors to decide whether to give a mortgage. 3. Stocks (Equity Securities) ● Represent ownership in a company. ● No fixed interest or maturity. ● Investors earn through: ○ Dividends (profit sharing). ○ Capital gains (selling stock at a higher price). ● High risk: Value depends on how well the company performs. ● High return potential, but not guaranteed. Mortgages ● A mortgage is a loan people take to buy a home. ● There are two main types: 1. Prime mortgages →given to borrowers who have good income, good credit history, and can make a down payment. 2. Subprime mortgages →given to people who don’t have enough income, or can’t make a down payment. ○ These are riskier because the borrower is more likely to not pay back (default). ○ So, lenders charge higher interest rates and extra fees to cover this risk. ○ Subprime mortgages became famous because many people couldn’t pay them back, which caused the 2008 financial crisis. Mortgage-Backed Securities (MBS) ● Mortgage-backed securities are investments that are created from a group (package) of mortgages. ● The investors who buy these securities get the monthly payments made by homeowners on those mortgages. Step 1: The Bank Gives Mortgages ● Mountain Savings Bank gives out 100 mortgages (loans) to people who want to buy houses. ● Normally, if the bank keeps these mortgages, it has to wait years to slowly get back its money (as monthly payments). ● But the bank wants its money back sooner to make more loans and earn more profit. Step 2: The Bank Creates Mortgage-Backed Securities (MBS) ● Instead of holding onto the 100 mortgages, the bank packages them together into one big financial product →Mortgage-Backed Securities (MBS). ● It then sells these securities to 8 financial institutions (investors). ● Basically, the investors are buying the right to receive the future payments from the homeowners. Step 3: Monthly Payments Flow ● Homeowners pay their mortgage every month (interest + principal) to Mountain Savings Bank. ● The bank doesn’t keep this money →it simply passes the money to the 8 investors who bought the securities. ● So: ○ Homeowners →Bank →Investors Step 4: Risk of Default ● If all homeowners pay on time, investors make good money. ● But if some homeowners default (stop paying), the cash inflow drops. ● That means the investors’ returns fall. ● This is why MBS are risky: they depend on whether homeowners keep paying their mortgages. Step 5: If the Bank Doesn’t Know How to Make MBS ● Not every bank knows how to package mortgages into securities. ● In that case, a bigger financial institution collects mortgages from several banks (including Mountain’s 100 mortgages). ● It then bundles all of them together into one big MBS. ● Investors who buy this bundle are indirectly financing many mortgages from different banks. Step 6: 2008–2009 Crisis ● Many subprime borrowers (risky borrowers) couldn’t pay back their loans. ● As a result: ○ Cash inflows to investors dried up. ○ The value of mortgage-backed securities collapsed. ● Financial institutions that invested a lot in MBS lost billions. ● This was a key cause of the 2008 global financial crisis. � In short: ● The bank wants quick money, so it sells mortgages as securities to investors. ● Investors earn money from homeowners’ monthly payments. ● If homeowners don’t pay, investors lose money. ● In 2008, too many people defaulted →investors + banks lost huge amounts. Real-Life Example (No Finance Words) 1. You lend money to friends ○ Imagine you lend money to 100 of your friends so they can buy something (like houses). ○ Each friend promises: “I’ll give you back a little money every month.” 2. You don’t want to wait ○ But you don’t want to wait years to get your money back. ○ You want money right now to use for yourself. 3. You sell the promise ○ So you go to 8 other people and say: “Hey, if you give me money right now, you can collect the monthly payments from my 100 friends.” ○ Those 8 people agree. ○ Now they get the money your friends pay each month. 4. How the money moves ○ Friends (borrowers) →pay you every month. ○ You →just pass the money to the 8 new people (investors). ○ You already got your money back quickly, so you’re happy. 5. The risk ○ If all 100 friends pay on time, the 8 people (investors) are happy. ○ But if many friends stop paying (default), the 8 investors get less money →they lose. 6. Big problem in 2008 ○ In real life, lots of risky borrowers couldn’t pay their loans. ○ So the investors who bought those “promises” lost huge amounts of money. ○ That’s what caused the 2008 financial crisis. � In one line: It’s like you lend money to friends, but then you sell the “right to collect that money” to someone else. If your friends stop paying, the new person who bought the right loses. Stocks (Equity Securities) ● Stocks = partial ownership in a company. ● They are capital market securities (long-term) because they have no maturity date. ● Companies may: 1. Pay dividends →give part of their profits to shareholders every quarter. 2. Reinvest profits →keep money in the business to grow bigger. How stocks work: ● Owning stock means you are a part-owner of the company. ● If the company grows and becomes more valuable, the stock price goes up →you can sell it for a profit (capital gain). ● Investors earn in 2 ways: ○ Dividends (if the company pays them). ○ Capital gain (if they sell stock at a higher price). ● But stocks are risky: ○ If the company does poorly, stock prices fall. ○ Investors can lose money. � Compared to long-term debt (like bonds), stocks usually have a higher expected return but also higher risk. Using the Wall Street Journal to Check Stock Performance ● The Wall Street Journal (WSJ) shows information about how stocks have recently performed. ● It has charts for different stock indexes. ● Example: The Dow Jones Industrial Average (DJIA) →this index shows the performance of 30 big, famous U.S. companies. ● In the chart, you can see the range of prices (high and low) over time. ○ This helps you understand how volatile (how much the price moves up and down) the index is. ● The WSJ also shows the daily trading volume →how many shares were traded on the New York Stock Exchange (NYSE), measured in billions of shares. � What are Derivative Securities? ● A derivative is like a side deal (contract). ● Its value depends on something else →like a stock, a bond, or even gold, oil, or the dollar. ● You don’t directly own that thing; instead, you make an agreement about how its price will move. � Example: Instead of buying Apple stock, you make a contract that says “I’ll win money if Apple’s stock goes up (or down).” � Why Do People Use Derivatives? 1. Speculation (Betting / Trying to Make Profit) ● Derivatives let you bet on price changes without owning the real thing. ● You can profit if the price: ○ Goes up (some derivatives work this way). ○ Goes down (other derivatives work this way). ● You can make more money faster than if you just bought the stock or bond. ● BUT ⚠️ if your guess is wrong →you can also lose money very fast. � Example: Imagine mangoes cost $10 per kilo today. You don’t buy mangoes, but you make a deal: ● If mango prices go up next week, you’ll earn money. ● If mango prices go down, you’ll lose money. That’s speculation with derivatives. 2. Risk Management (Protection / Insurance) ● Derivatives can also be used like insurance for investments. ● If the value of something you own falls, the derivative can give you money to reduce the loss. � Example: ● You own $1,000 worth of bonds. ● You’re worried bond prices might fall. ● So, you buy a derivative that pays you if bond prices drop. ● If bonds really fall, you lose money on your bonds but gain money on the derivative, so your loss is smaller. It’s just like buying insurance for your car: ● If the car crashes, insurance pays you. ● If nothing happens, you lose the small insurance fee — but you had peace of mind. Derivative Securities ● Besides money market securities and capital market securities, there are also derivative securities. ● A derivative security is a financial contract whose value depends on (is “derived” from) another asset. ○ Example: A derivative might be linked to a stock or a bond. ● Derivatives are used mainly for two purposes: speculation and risk management. 1. Speculation ● Derivatives let investors bet on the movement of the underlying asset’s value without owning it. ● Some derivatives let you profit if the asset’s value goes up. ● Other derivatives let you profit if the asset’s value goes down. ● Using derivatives for speculation can give higher returns than directly investing in the asset. ● But: they also carry higher risk (because if your bet is wrong, you lose). 2. Risk Management ● Derivatives can also be used for protection. ● They can give profits if the value of the underlying asset drops, which helps cover losses. ● Example: A financial institution that owns a lot of bonds might use derivatives to protect itself. ● If bond prices fall, the derivative could give them gains to balance out the loss. ● This way, derivatives can help companies adjust the level of risk in their investments. � Explanation in Super Easy Way (with Examples) 1. Stock Information in WSJ ● Think of the Dow Jones index like a report card of 30 top companies. ● If the index goes up →those companies are doing well. ● If it goes down →they are doing badly. ● WSJ shows: ○ High and low prices →to see how much stocks are jumping around. ○ Volume →how many people are buying/selling stocks daily. � Example: If 2 billion shares were traded yesterday, it means people were very active in buying/selling. 2. Derivative Securities ● A derivative is like a side bet about another asset. ● You don’t own the asset, but you’re betting on whether its price will go up or down. Speculation Example: ● Imagine a stock is at $100. ● You don’t buy the stock, but you buy a derivative contract that says: ○ If the stock goes to $110, you earn money. ○ If the stock goes to $90, you lose money. ● If you’re right, you can make more profit than if you just owned the stock. ● But if you’re wrong, you can lose faster and bigger. Risk Management Example: ● Suppose you already own bonds worth $1,000,000. ● You’re scared that bond prices might go down. ● So, you buy a derivative that will give you money if bond prices fall. ● If bonds drop in value, you lose money on the bonds, but you gain money from the derivative, so your total loss is smaller. � That’s like buying insurance for your investments. Example: Using Derivatives to Reduce Risk ● A company may own a lot of bonds. ● If bond prices go down, the company will lose money. ● To protect itself, the company can take a position in derivative securities that will make money if bond prices fall. ● This way: ○ Loss on bonds →is covered by gains on derivatives. ● So, derivatives can help reduce risk. Valuation of Securities in Financial Markets ● Every type of security (stocks, bonds, etc.) gives investors some cash flows (payments). ● Each security also has a different level of uncertainty (risk) about those cash flows. ● To find the value of a security: ○ You calculate the present value of its expected future cash flows. ○ You use a discount rate that reflects the level of risk (uncertainty). ● Since each security has different cash flows and risks, each security has a unique value. Example: Nike Stock ● If you buy Nike stock, you can get cash flows in two ways: ○ Quarterly dividends (if Nike pays them). ○ The price of the stock when you sell it in the future. ● The problem: both the future dividends and the future stock price are uncertain. ● Investors try to estimate future cash flows by looking at: ○ Reports about the athletic shoe industry. ○ Announcements from Nike about sales. ○ Opinions about Nike’s management ability. Impact of Information on Valuations ● All investors use valuation to decide whether to invest. ● But: different investors may look at information differently. ○ Some focus more on economic/industry conditions. ○ Others focus more on management quality or news about the company. ● When new information comes in (like better sales reports or reduced risks), investors update their valuations. ○ If the new info shows higher expected cash flows or less risk, the valuation of the security will increase. Exhibit 1.2 (Explained in Words) To decide whether to buy a security, investors use 3 kinds of information: 1. Economic conditions (overall economy health). 2. Industry conditions (how the company’s industry is doing). 3. Firm-specific information (details about the company, like: ○ Information provided by the company itself. ○ Information from other sources, like analysts or news reports). � They combine all this info →to make a valuation of the security → then decide whether to buy or not. � Super Easy Explanation with Example Imagine you want to buy shares of Nike: ● You’ll get money from: 1. Dividends Nike might pay. 2. The price you sell the stock for later. But the future is uncertain — maybe Nike sells more shoes, maybe less. ● If Nike announces strong sales, investors think: “Okay, I’ll get more cash flows in the future.” →Valuation goes up. ● If Nike faces bad news (like a scandal or drop in sales), investors think: “Future cash flows will be lower.” →Valuation goes down. � That’s why the value of securities changes all the time — it depends on future cash flows and how risky they are. Example: How Information Affects Security Prices When investors get good news about a security (like a stock), they expect higher future cash flows or a lower discount rate. This makes the security look more valuable. At the old price, it now seems undervalued, so more people want to buy it (demand goes up), while fewer want to sell it (supply goes down). Because of this, the price rises until it reaches a new equilibrium (balance). On the other hand, when investors get bad news, they expect lower cash flows or use a higher discount rate. This makes the security less valuable. Investors lower their valuations, which shifts demand and supply, and the price of the security falls to a new equilibrium. If an announcement doesn’t contain any new information, it won’t affect prices. Sometimes investors expect certain announcements in advance and already adjust prices before the announcement happens. In that case, when the announcement comes, the market shows no reaction because it was already “priced in.” Impact of the Internet on Valuation The Internet has improved how securities are valued: ● Prices of securities are available online anytime, so investors can check them instantly. ● For some securities, investors can even track the exact order of transactions in real time. ● More information about companies is available online, which helps securities be priced more accurately. ● Investors can now buy or sell securities online, making price adjustments happen faster when new information comes out. Market Efficiency Because securities have market-based prices, their good or bad qualities (as investors see them) are already reflected in those prices. When security prices reflect all available information, we call this an efficient market. ● In an efficient market, securities are fairly priced. ● If a stock is clearly undervalued based on public information, some investors will quickly buy it. Their strong demand will push the price up until the undervaluation disappears. ● These investors make higher returns, but once the price adjusts, the opportunity is gone. ● This process motivates investors to always watch market prices. Their actions usually make sure securities stay properly priced, based on the available information. Even in efficient markets, there is still uncertainty. Prices can change a lot over time because investors don’t have perfect information about a company, its industry, or the whole economy. Example: Google’s IPO When Google first issued stock on August 18, 2004, there was huge uncertainty about its value. Investors knew that Google’s stock price would depend on: ● its management, ● industry conditions (like competition), and ● economic conditions. But no one knew exactly how these would play out. Some investors thought the starting price of $85 per share was too high, while others bought as many shares as they could. Within the first year, as more information became available about Google’s business plans and performance, its stock price tripled. So, if someone invested $1,000 at the IPO, their investment was worth over $3,000 within a year. Role of Information from Firms Much of the information investors use to value a company’s securities comes from the managers of those companies. Investors also depend on accounting reports (revenue, expenses, profits) to estimate future cash flows. Firms that are publicly traded (listed on stock exchanges) are required by law to share this financial information with investors. Asymmetric Information Even though firms disclose information through reports and accounting statements, managers often know more about the company’s real financial condition than outside investors. When managers have information that investors do not, it is called asymmetric information. Sometimes, even if managers share information, it can be misleading. In that case, asymmetric information problems still exist. Behavioral Finance Sometimes, securities are not priced correctly because investors’ decisions are influenced by psychology rather than facts. This area is called behavioral finance, which applies psychology to financial decision-making. It explains why markets are not always efficient. Example: Nadal Company ● A positive earnings report increased demand for Nadal’s stock, and the price went up by 2% — this was justified by the news. ● Later, as the media repeated the story, more investors bought the stock, and the price rose by another 4%. ● The next day, even more media hype pushed the price up another 3%. ● So, the stock price increased much more than it should have, not because of the actual news, but because of investor psychology and media attention. ● Eventually, when the hype faded, the price dropped back down. This shows that behavioral finance can sometimes explain why prices of a single stock—or even the whole market—move in ways that are not justified by real information. Financial Market Regulation Securities markets are regulated to make sure all participants are treated fairly. Many rules were created after fraudulent practices contributed to the Great Depression. 1. Disclosure Rules ● Incorrect or hidden information can lead investors to make bad decisions. ● Regulations try to ensure that businesses share accurate information. ● If information is given only to a small group of investors, those people get an unfair advantage. ● Regulations therefore aim to provide equal access to information for all investors. Key laws: ● Securities Act of 1933 →Ensured full disclosure of relevant financial info on newly offered (public) securities and prevented fraud in selling securities. ● Securities Exchange Act of 1934 →Extended disclosure requirements to the secondary market (where existing securities are traded). It also: ○ Made misleading financial statements illegal. ○ Banned strategies designed to manipulate prices. ○ Created the Securities and Exchange Commission (SEC) to oversee securities markets. ● Over time, the SEC has added more rules. ● Important note: Securities laws do not stop investors from making bad decisions. Instead, they just make sure information is complete and not fraudulent. 2. Response to Financial Scandals The scandals of 2001–2002 (like Enron and WorldCom) showed that old regulations were not strong enough. ● These companies exaggerated their earnings and hid negative information, misleading investors. ● Companies that sell stock and debt must hire independent auditors to check that their reports are accurate. ● However, in some cases, auditors failed to do their job properly, which allowed fraud to continue. Sarbanes-Oxley Act (SOX) After the financial scandals, the Sarbanes-Oxley Act (SOX) was passed. ● It required companies to provide more complete and accurate financial information. ● It placed restrictions to ensure proper auditing by auditors. ● It also required better oversight by the company’s board of directors. ● The main goal was to regain investor trust, since investors provide the funds that flow into financial markets. ● These measures were designed to reduce or eliminate asymmetric information (where managers know more than investors). Cycle of Scandals and Regulations ● Because there is so much money to gain, some people will always try to cheat the system. ● This means new scandals will always happen, followed by new regulations, and then new types of scandals that find ways around the latest rules. ● The most harmed are usually the naive investors (those with the least knowledge). Example: 2008 Crisis ● Financial institutions like Bear Stearns, Lehman Brothers, and AIG had major financial problems. ● Many investors were caught by surprise. ● This raised concerns that firms were not providing enough information. ● Limited financial disclosure creates uncertainty about how to properly value a company. Global Financial Markets Financial markets are being developed all over the world to help move money from surplus units (savers) to deficit units (borrowers). ● But markets are more advanced in some countries than others. ● They differ in: 1. The total amount of funds being transferred. 2. The types of funding available (loans, stocks, etc.). Development in Developing Countries ● Since the early 1990s, many private businesses have been created in developing countries. ● Governments allowed privatization (selling government-owned firms to individuals). ● Some businesses began issuing stock, letting outside investors become part-owners. ● Financial markets were created in these countries so businesses could get funding from surplus units. ● As a result: ○ Private businesses can now raise money by borrowing or selling stock. ○ Individuals can now lend money or buy shares in companies. International Corporate Governance Financial markets only work if surplus units (investors) are willing to provide funds. For this to happen, there must be: ● enough information about securities, and ● safeguards to make sure investors are treated fairly. If these don’t exist, investors will not participate, and the market will not have enough liquidity (ease of trading). Why Some Developing Countries Have Weak Markets Financial markets have grown slowly in some countries because of several problems: 1. Issuers of debt securities do not give enough financial information to show how they will repay investors. 2. Regulatory agencies do little enforcement to ensure information is accurate. 3. Businesses that fail to repay investors are rarely punished. 4. Courts are inefficient, so investors can’t easily recover the money they are owed. Global Integration Many financial markets are now connected globally, which means investors can easily move their money from one country’s markets to another’s. ● Foreign investors play a big role in the U.S. by buying U.S. Treasury securities and securities issued by U.S. businesses. ● Similarly, U.S. investors often buy securities from foreign corporations and foreign government agencies, becoming surplus units (lenders) for those countries. Investors compare the risk and return of securities in different countries and invest where the balance matches their preferences. Because markets are so connected, movements in the U.S. markets affect foreign markets, and foreign markets also affect the U.S. ● Interest rates, which depend on the supply and demand for funds, are now more sensitive to foreign borrowing and lending. Europe’s Progress ● Europe has made the most progress in integrating financial markets. ● Many regulations were removed, so surplus and deficit units in one European country can use financial markets throughout Europe. ● Some European stock exchanges merged, making it easier for investors to trade in one place. ● In 1999, 16 European countries adopted the euro as their currency (called the eurozone). ○ Now, transactions between these countries are all in euros. ○ Securities are also issued in euros. ○ This means investors and consumers don’t need to convert currencies when trading within the eurozone. Role of the Foreign Exchange Market For most international financial transactions (except those inside the eurozone), currencies must be exchanged. ● The foreign exchange market helps make this exchange possible. ● Commercial banks and other financial institutions act as intermediaries by matching people who want to buy one currency with those who want to sell it. ● Some financial institutions also act as dealers, taking positions in currencies to handle foreign exchange requests. Like securities, currencies also have a market-determined price, called the exchange rate, which changes based on supply and demand. ● If corporations, governments, or individuals suddenly demand more of a certain currency, or if more supply of that currency becomes available, its price (exchange rate) will change. Role of Financial Institutions If financial markets were perfect, things would look like this: ● All information about securities (including how creditworthy issuers are) would be free and always available. ● Investors who want to buy and sell securities would easily find each other. ● Securities could be broken into any size an investor wanted. ● Transaction costs would not exist. ● In such a case, there would be no need for financial intermediaries (like banks). But in reality, markets are imperfect: ● Buyers and sellers of securities do not have complete information. ● People with extra money (surplus units) don’t always know how to find creditworthy borrowers (deficit units) to lend their funds to. Part 1: Overview of the Financial Environment Sometimes, individual people or businesses (called surplus units) who have extra money do not have the knowledge or ability to check if borrowers (called deficit units) are trustworthy. Because of this, financial institutions are needed to solve such problems. These institutions take money from surplus units (those with extra funds) and lend or invest it with deficit units (those who need money). Without financial institutions, the cost of finding borrowers and handling transactions would be too high. Financial institutions are divided into two groups: 1. Depository institutions 2. Non-depository institutions Role of Depository Institutions Depository institutions are banks and similar organizations that help money flow smoothly in the economy. They do two main jobs: 1. Take deposits →from people or businesses who have extra money (called surplus units). 2. Give loans or invest →to people or businesses who need money (called deficit units). ✅Why are they so useful? ● They let people keep money safely in deposit accounts (and you can take out cash whenever needed). ● They give out loans of different sizes and time periods depending on what borrowers need. ● They take on the risk if borrowers don’t pay back. ● They are better at checking borrowers’ reliability than ordinary people. ● They lend to many people at once, so if one person doesn’t pay back, the bank can still manage. � What if banks didn’t exist? Without depository institutions: ● Every saver would need to find a borrower by themselves. ● The saver would need to check if the borrower is trustworthy. ● The saver would carry all the risk if the borrower doesn’t pay back. � This would make lending so difficult that most people would just hold on to their money instead of lending. That means the flow of money in the economy would stop. � How Loans Work When a bank gives you a loan, it acts like a creditor (someone who lends money). ● It’s a bit like when investors buy debt securities (like bonds). ● But here’s the difference: ○ Loans are harder to sell later because each loan has many specific rules and terms (interest rate, repayment time, conditions, etc.), which are different for each borrower. ○ If another investor wanted to buy a loan from the bank, they would have to read all the loan details carefully before agreeing. That’s why loans are less “liquid” (less easy to trade) than securities like bonds. � In super simple terms: Banks make life easier by connecting savers and borrowers, taking the risk, and making the process smooth. Without them, lending would be messy and risky. How Loans Work When a depository institution gives a loan, it acts like a creditor (similar to buying a debt security). But loans are less marketable (harder to sell later) than debt securities. This is because loan agreements are very detailed and vary a lot between borrowers. If another investor wanted to buy such a loan, they would have to carefully review all terms before purchasing. Types of Depository Institutions 1. Commercial Banks ● These are the most important and common banks. ● They help surplus units (people or businesses with extra money) by offering different deposit accounts (like savings accounts, current accounts, etc.). ● They use the money deposited to: ○ Give loans directly to borrowers. ○ Buy debt securities (like government bonds). ● They serve everyone →households, businesses, and even government agencies. ● Some commercial banks are huge, holding more than $100 billion in assets. � Examples: Bank of America, J.P. Morgan Chase, Citigroup, SunTrust Banks. 2. Federal Funds Market ● Not all banks have the same money situation: ○ Some banks get more deposits than they need. ○ Others get less deposits than they need to meet customer loan demands. ● To fix this imbalance, the federal funds market exists. ● In this system: ○ Banks with extra funds lend money to banks that need more funds. ○ These loans are very short-term, usually lasting 1 to 5 days. ● This keeps the banking system balanced and ensures money flows smoothly between banks. � Simple Example: ● Imagine Bank A has a lot of extra deposits, but Bank B doesn’t have enough to give loans to its customers. ● Bank A lends money to Bank B for a few days through the federal funds market. ● Later, Bank B returns the money with a little interest. ● This way, banks help each other, and the whole financial system runs smoothly. Chapter 1: Role of Financial Markets and Institutions Savings Institutions Savings institutions, also called thrift institutions, are another type of depository institution (like banks that take deposits). These include: ● Savings and Loan Associations (S&Ls) ● Savings Banks S&Ls accept deposits from people and then lend that money to others, just like commercial banks. But while commercial banks usually focus on giving business loans, S&Ls mostly focus on giving residential mortgage loans (home loans). Because of this difference, the financial performance of commercial banks and S&Ls has often been different. In recent decades, however, government deregulation has allowed S&Ls more freedom in how they use their funds. Now, their activities look more similar to commercial banks. S&Ls can be owned by shareholders, but most are mutual organizations—meaning they are owned by their depositors. Savings Banks are similar to S&Ls, but they have usually invested their funds in a wider range of things. Over time, the differences between savings banks and S&Ls have become very small. Like S&Ls, most savings banks are also mutual (owned by depositors). Like commercial banks, savings institutions also use the federal funds market. They lend their extra funds there or borrow short-term funds if they need them. Credit Unions Credit unions are different from commercial banks and savings institutions in two main ways: 1. They are nonprofit organizations. 2. They only provide services to their members, who must share a common bond (like working for the same employer or being part of the same union). Because of this common bond, credit unions are usually much smaller than other depository institutions. Most of their funds are used to give loans to their members. Some of the biggest credit unions are: ● Navy Federal Credit Union ● State Employees Credit Union of North Carolina ● Pentagon Federal Credit Union Each of these has assets of more than $5 billion. Role of Nondepository Financial Institutions Nondepository institutions do not rely on deposits to get funds. Instead, they use other sources, but they still play an important role in connecting borrowers and lenders (financial intermediation). These include: Finance Companies ● They collect money by selling securities (like bonds). ● Then, they lend this money to people and small businesses. ● Similar to banks, but they only focus on specific types of loans or markets. ● Big companies like American Express and General Electric own many finance companies. � Think of them as special lenders who don’t take deposits like banks but still give loans. Mutual Funds ● They sell shares to people who want to invest. ● The money collected from all investors is used to buy a basket of investments (stocks, bonds, etc.). ● They are the largest non-bank financial institution. Types: 1. Capital Market Mutual Funds →invest in stocks & bonds (longterm). 2. Money Market Mutual Funds →invest in short-term, safer investments. ● Mutual funds usually buy in big amounts, more than what one small saver can afford. ● By joining a mutual fund, small investors pool their money and get a diversified portfolio (many different investments, which reduces risk). � Think of them as investment clubs where everyone puts money together to buy big investments and share the returns. Securities Firms ● These companies help in buying and selling financial products (like stocks & bonds). ● Often act as brokers (middlemen between buyer and seller). ● Transactions are standardized for simplicity. ○ Example: Stock trades usually happen in multiples of 100 shares. ● The delivery process (transfer of securities) is also made standard to make trading faster and easier. � Think of them as market helpers who make sure buying and selling of stocks happens smoothly and quickly. Part 1: Overview of the Financial Environment Brokers Brokers charge a fee for helping people buy and sell financial assets . This fee is usually included in the difference between the price they are willing to buy at (bid) and the price they are asking for (ask). The fee is often higher for unusual transactions because it takes more time to find a buyer or seller. Small transactions also usually have higher fees so brokers are fairly compensated for their time. Securities firms don’t just help people buy and sell stocks or bonds—they also provide investment banking services. This means they help companies and governments sell new stocks or bonds to raise money. This process happens in the primary market, which is where securities are sold for the first time. When a securities firm underwrites new securities, it basically promises to help sell them. They might either: 1. Guarantee a price – the company is sure to get a certain amount of money no matter what. 2. Sell at the best price – the firm tries to get the highest possible price but doesn’t guarantee it. Securities firms can also work as dealers. This means they buy securities themselves and keep them in their own inventory, then sell them to others. ● A broker mainly makes money from fees by helping people trade securities. ● A dealer makes money depending on how well the securities they own increase in value. Some firms do both—they act as brokers and dealers—so they can earn money in two ways. Another service that securities firms offer is advising companies on mergers and corporate restructuring. They help a company plan changes in its structure and may also help sell the company’s securities. Big firms like Morgan Stanley and Goldman Sachs are involved in brokerage, underwriting, and advisory services. Insurance Companies Insurance companies provide policies to protect individuals and businesses against financial loss from death, illness, or damage to property. They charge a premium for this service. The money they collect is invested until it is needed to pay insurance claims. Insurance companies usually invest in stocks or bonds from companies or government bonds. By doing this, they help provide funds to businesses or governments that need money, making them important financial intermediaries. Their success depends on how well the stocks and bonds they invest in perform. Big insurance companies include State Farm, Allstate, Travelers, CNA, and Liberty Mutual. Pension Funds Many companies and government agencies offer pension plans to their employees. Employees, employers, or both put money into these plans regularly. Pension funds are a good way for people to save for retirement. Pension funds manage these contributions until employees retire and withdraw the money. The funds are often invested in company stocks or bonds, or government bonds. Like insurance companies, pension funds provide money to those who need it and act as important financial intermediaries. Comparison of Financial Institutions Financial institutions help move money from people who have extra funds (surplus units) to those who need funds (deficit units). 1. Depository institutions take deposits from surplus units and give loans to deficit units. 2. Finance companies sell securities, like commercial paper, to investors and use that money to lend to deficit units. 3. Securities firms, insurance companies, and pension funds also collect funds from investors and provide them to those who need financing. This way, financial institutions play a key role in moving money efficiently between those who have it and those who need it. Exhibit 1.3: Comparison of Roles among Financial Institutions Depository Institutions (like Commercial Banks, Savings Institutions, Credit Unions) ● Surplus units (people or entities with extra money) deposit their funds in these institutions. ● These institutions then provide loans to deficit units (firms, government agencies, or some individuals who need funds). Finance Companies ● They get money from surplus units by issuing securities (like bonds). ● Then, they lend this money to deficit units. Mutual Funds ● Surplus units buy shares from mutual funds. ● Mutual funds use this money to purchase debt and equity securities from deficit units. Insurance Companies ● Surplus units pay premiums. ● The insurance companies use this money to invest in stocks and bonds of deficit units. Pension Funds ● Employers and employees make contributions. ● Pension funds invest these contributions in securities issued by deficit units. Key Point: ● Deficit units get funding from finance companies, mutual funds, insurance companies, and pension funds. ● Because insurance companies and pension funds buy large amounts of stocks and bonds, they provide a lot of funding to big deficit units like corporations and government agencies. ● Financial institutions that invest money from surplus units are called institutional investors. Securities Firms ● Though not shown in Exhibit 1.3, securities firms are important. ● They help move money between financial institutions and deficit units by acting as brokers. ● Sometimes, funds go directly from surplus units to deficit units through securities transactions, with securities firms helping in the process. Role as Monitors of Publicly Traded Firms ● Financial institutions also watch over publicly traded firms. ● Insurance companies, pension funds, and some mutual funds are big investors in stocks, so they can influence how these firms are managed. ● Recently, large institutional investors have criticized management in certain firms, which has led to corporate changes or even firing of executives. Institutional Investors and Corporate Control ● Institutional investors don’t just provide money to companies; they can also influence how companies are run. ● By acting as activist shareholders, they make sure that managers of publicly traded companies make decisions in the best interest of the shareholders. Relative Importance of Financial Institutions ● Exhibit 1.4 shows the sizes of different financial institutions based on their total assets. ● The percentages show each type’s share of the total assets held by all financial institutions, which together total about $46 trillion. Key Figures from Exhibit 1.4: ● Commercial Banks: $11.2 trillion (24%) – largest among depository institutions. ● Mutual Funds: $11.2 trillion (24%) – largest among nondepository institutions. ● Pension Funds: $10.2 trillion (22%). ● Insurance Companies: $6.3 trillion (14%). ● Securities Firms: $3.1 trillion (7%). ● Savings Institutions: $1.8 trillion (4%). ● Finance Companies: $1.46 trillion (3%). ● Credit Unions: $758 billion (2%). Sources and Uses of Funds (Exhibit 1.5) ● Depository institutions serve households with savings. ● Each type of financial institution collects funds from certain sources (like deposits, premiums, or contributions) and then uses those funds to provide loans or invest in assets. Exhibit 1.5: Summary of Sources and Uses of Funds by Financial Institutions Financial Main Sources of Funds Main Uses of Funds Institution Commercia Deposits from Loans to businesses and l Banks households, businesses, households; purchase of and government government and corporate agencies securities Savings Deposits from Mortgages and other loans to Institution households, businesses, households; some business s and government loans; purchase of government agencies and corporate securities Credit Deposits from credit Loans to credit union members Unions union members Finance Securities sold to Loans to households and Companies households and businesses businesses Mutual Shares sold to Purchase of long-term Funds households, businesses, government and corporate and government securities agencies Money Shares sold to Purchase of short-term Market households, businesses, government and corporate Funds and government securities agencies Insurance Insurance premiums and Purchase of long-term Companies earnings from government and corporate investments securities Pension Employer/employee Purchase of long-term Funds contributions government and corporate securities Key Points: ● Households with savings use depository institutions and finance companies. ● Large corporations and governments that issue securities get financing from all types of financial institutions. ● Different regulations apply to different financial institutions, which can give some an advantage over others. Consolidation of Financial Institutions ● Many financial institutions have merged in recent years to reduce costs and serve more customers efficiently. ● Commercial banks acquire other banks to handle more business with the same infrastructure, lowering average costs. ● Savings institutions consolidate to save costs in mortgage lending. ● Insurance companies merge to reduce the average cost of providing insurance services. ● From the 1980s to 2000s, regulations became less strict, allowing financial institutions to offer more types of services (economies of scope). ● Commercial banks have merged with savings institutions, securities firms, finance companies, mutual funds, and insurance companies. ● Financial conglomerates allow customers to get all financial services from one place and reduce risk because they are more diversified. Example: ● Wells Fargo started as a commercial bank but now offers mortgages, small business loans, consumer loans, real estate, brokerage, investment banking, online financial services, and insurance. Wells Fargo Example – Diversified Financial Services ● Wells Fargo emphasizes that it is more than a traditional bank; it is a diversified financial services company. ● Being diversified allows it to handle downturns better because different parts of the financial industry are affected differently at any given time. Typical Structure of a Financial Conglomerate ● A financial conglomerate is a company that owns multiple types of financial services, such as banking, mortgages, brokerage, and insurance. ● In the past, each type of financial service had high barriers to entry, so only a few firms competed in each area. ● Today, these barriers are lower, allowing specialized firms to expand into other financial services, often by acquiring other companies. ● Many financial conglomerates now consist of originally independent institutions that have become subsidiaries of the larger conglomerate. Impact of Consolidation on Competition ● As financial institutions expand into new services, competition increases. ● This often leads to lower prices for customers. ● Consolidation also improves convenience: ○ Individual customers can get life/health insurance, brokerage services, mutual funds, investment advice, bank deposits, and personal loans from one conglomerate. ○ Corporate customers can get property/casualty insurance, employee health plans, business loans, restructuring advice, help issuing debt/equity securities, and pension plan management. Exhibit 1.6: Organizational Structure of a Financial Conglomerate ● Holding Company of a Financial Conglomerate ○ Commercial Bank Operations: Commercial loans, other corporate services ○ Thrift Operations: Mortgages ○ Consumer Finance Operations: Consumer loans, small business loans ○ Mutual Fund Operations: Stock funds, bond funds, money market funds ○ Securities Operations: Brokerage, investment banking ○ Insurance Operations: Insurance for individuals, insurance for firms Impact of the Internet on Financial Institutions ● The Internet has increased competition among financial institutions. ● Some banks operate entirely online, which lowers costs. This allows them to: ○ Offer higher interest rates on deposits ○ Offer lower rates on loans ● Other banks also provide online services to reduce costs and improve efficiency. ● Insurance companies use the Internet to conduct business online, lowering costs and forcing competitors to price services more competitively. ● Brokerage firms also operate online, reducing fees and increasing competition among brokers. ● Corporations and municipal governments can now issue securities online and sell directly to investors, bypassing traditional securities firms. This forces securities firms to compete more effectively for business. Global Expansion by Financial Institutions ● Many financial institutions have expanded internationally to use their expertise in new markets. ● International mergers allow two institutions from different countries to offer each other’s services to both customer bases. ○ Example: A U.S. bank specializes in lending, while a European securities firm specializes in underwriting. After merging, the U.S. bank can serve European clients, and the European firm can serve U.S. clients. ● Mergers combine skills and customer bases, enabling financial institutions to provide more services internationally. ● The adoption of the euro by 16 European countries increased cross-border business, creating more competition among European financial institutions. ● Many institutions also target emerging markets, offering: ○ Underwriting services for newly privatized companies and government agencies ○ Loans through expanded commercial banking operations Impact of the Credit Crisis on Financial Institutions ● During 2004–2006, home prices increased rapidly. Many financial institutions increased their holdings of mortgages and mortgagebacked securities. ● Some institutions, especially commercial banks and savings institutions, used loose standards when giving mortgages and did not carefully check the risk of default. ● Other institutions, including banks, savings institutions, insurance companies, securities firms, and pension funds, bought large bundles of mortgages in the secondary market without properly assessing their risk. ● By 2007–2008, this risky behavior contributed to the mortgage and credit crisis. Impact of Mortgage Defaults and the Credit Crisis ● Between 2007–2008, homeowners started defaulting on their mortgages, and home values fell sharply. ● By January 2009, about 10% of American homeowners were behind on payments or had defaulted. ● Mortgage defaults caused the credit crisis, which affected financial institutions in several ways: 1. Mortgages and mortgage-backed securities lost a lot of value. 2. Some institutions lost business because customers feared they might fail. ● Financial institutions rely on funds from surplus units (investors who trust the institutions). During the crisis, investors became extremely cautious, even avoiding financially stable institutions, because limited information about risk was available. Government Intervention ● On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (the bailout act) to resolve liquidity problems and restore investor confidence. ● The Treasury injected $700 billion into the financial system, mainly by buying preferred stock in banks. ● This capital helped large commercial banks cushion losses and reduced the chance of failure. ● The crisis highlighted the need for better regulations to ensure financial institutions remain safe. Summary of Key Points from Chapter 1 1. Role of Financial Markets ○ Financial markets transfer funds from surplus units (those with extra money) to deficit units (those needing funds). ○ Primary markets issue new securities; secondary markets allow trading of existing securities. 2. Types of Securities ○ Money market securities: Short-term (less than 1 year). ○ Capital market securities: Long-term, such as bonds, mortgages, mortgage-backed securities, and stocks. ○ Security prices reflect the present value of expected future cash flows. Prices change when expectations or risks change. 3. Role of Financial Institutions ○ Depository institutions (commercial banks, savings institutions, credit unions) provide loans, assess creditworthiness, and repackage funds to match borrower needs. ○ Nondepository institutions (finance companies, mutual funds, pension funds, insurance companies) are major buyers of securities and fund deficit units. 4. Consolidation and Financial Conglomerates ○ Many financial institutions have merged into conglomerates, where specialized subsidiaries provide a wide range of services. ○ Consolidation allows for economies of scale and scope, improving efficiency, cash flows, and the institution’s overall value. ○ Conglomerates can offer multiple financial services under one organization, providing convenience to customers and reducing risk through diversification. ✨In short: ● Derivatives can protect companies from losses. ● Valuation of securities = Present value of expected cash flows (adjusted for risk). ● Example: Nike stock’s value depends on dividends + stock price when sold, but both are uncertain. ● New information (economy, industry, company news) changes how investors value securities. ✨In short: ● WSJ shows stock performance (prices, highs/lows, volumes). ● Derivatives = contracts linked to another asset. ○ Used for speculation (betting to make profit). ○ Used for risk management (protection/insurance). ✨In short: ● Mortgages = loans for homes (prime = safe, subprime = risky). ● Mortgage-backed securities = investments made from a bunch of mortgages, risky if many people don’t pay. ● Stocks = ownership in companies, can bring dividends + profit but also come with higher risk. � Summary Table (Very Simple) Type Examples Risk Return Maturi Liquidity ty Money T-bills, Market Commercial Low Low ≤1 High (easy to year sell) Paper, CDs Capital Bonds, Medium Medium >1 Varies (bonds: Market Mortgages, –High –High year medium, Stocks ✅In Short: stocks: high) ● Money Market Securities = short-term, low risk, low return, very liquid. ● Capital Market Securities = long-term, higher risk, higher return. ○ Bonds = long-term debt. ○ Mortgages = long-term real estate loans. ○ Stocks = ownership (high risk, high return). ● Investors choose based on how much risk, return, and liquidity they want.
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