CHAPTER 16
Stocks and Bonds
SECTION 1
Stocks
Financial Markets
Stocks and bonds are bought and sold in a financial market.
Financial markets channel money from some people to other
people.
• They bring together people that have money to invest with
other people who would like to start a new company or
expand an existing one.
What Are Stocks?
A stock is a claim on the assets of a corporation that gives the
purchaser a share of the corporation.
Where Is Stock Bought and Sold?
Stocks are bought and sold through these venues:
• The New York Stock Exchange (NYSE)
• Stock brokers over the phone, in person, or online
• Other stock exchanges, such as the American Stock
Exchange (AMEX) and the National Association of
Securities Dealers Automated Quotations (NASDAQ)
• NASDAQ is an electronic stock market where trades are
executed through a sophisticated telecommunications
network
Americans can also buy and sell stock in foreign exchanges
and markets.
The Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average (DJIA) is the most popular,
most widely cited indicator of day-to-day stock market activity. The
DJIA is a weighted average of 30 widely traded stocks on the New
York Stock Exchange.
Why did Charles Dow create the DJIA?
• Answer: To tell people something about what was really
happening in the market. At the time he created it, people were
suspicious of the stock market so he wanted to create a way to
keep people informed about more than just individual stocks.
Thirty stocks currently make up the DJIA. The list changes from
time to time, as determined by the editors of the Wall Street Journal.
In addition there are other commonly cited stock indices in the U.S.
including the NASDAQ Composite, the Standard & Poor’s 500 and
the Wilshire 5000.
The 30 Stocks of the Dow Jones Industrial Average
How the Stock Market Works
If a company wants to raise money, it has three sources:
(1) borrowing from a bank
(2) issuing bonds
(3) selling or issuing stock in the company
An initial public offering (IPO) is a company’s first offering of
stock to the public.
Typically, an investment bank acts as an intermediary between the
company that issues the stock and the public that wishes to buy the
stock.
People buy a particular stock if they think that the earnings of the
company are likely to rise.
Remember that a share of stock represents ownership in the
company. The more profitable the company becomes, the greater the
demand for the stock of that company.
Why Do People Buy Stock?
Millions of people, in countries all over the world, buy stock
every day.
Some people buy stocks for the dividends, which are payments
made to stockholders based on a company’s profits.
Another reason to buy stocks is for the expected gain in price.
People also sell stock for many reasons, including paying for
college expenses, helping finance a house, or because they
expect the price of the stock to go down in the future.
How to Buy and Sell Stock
Buying and selling stock is relatively easy.
You can buy or sell stock through brokerage firms, or online.
An account can usually be opened by depositing a certain
amount of money, typically between $1,000 and $2,500.
With a full-service broker, you may call your broker and ask
for recommendations, and he or she will place an order to
purchase the stocks you desire.
If you do not require help to buy stocks you can go to either a
discount broker or to an online broker.
Deciding Which Stocks to Buy
One way to buy stocks is to purchase shares of companies that
are familiar to you, such as Coca Cola, Disney, or Microsoft.
Mutual funds are a commonly used method of investing in
stocks. A mutual fund is a collection of stocks managed by a
fund manager. Several hundred people often own shares in
each mutual fund. It is up to the fund manager to do what she
or he thinks is best to maximize the overall returns from the
fund.
Another strategy for buying stocks is to buy the stocks that
make up a stock index. An index is a portfolio of stocks, which
represents a particular market or a portion of it, used to
measure changes in a market or an economy. The DJIA is a
stock index.
How to Read the Stock Market Page
The newspaper is a good source for stock prices. Most stock
price listings contain the same components.
• “52W high” is the highest price of the stock during the
past year, or the past 52 weeks.
• “52W low” is the lowest price of the stock during the
past 52 weeks.
• The “Stock” column provides an abbreviated name of
the company.
• The “Ticker” column contains the stock or ticker
symbol for the company.
• In the “Div” column you will find the amount of the
last annual dividend.
• “Yield %” is the dividend divided by the closing price.
• “P/E” is the price-earnings ratio, and is obtained by taking
the latest closing price per share and dividing it by the latest
available net earnings per share. A high PE ratio usually
indicates that people believe the stock will experience
higher than average growth in earnings.
• “Vol 00s” is the volume, in this case represented in
hundreds, of shares that were bought and sold on that
particular day.
• “High” is the high price the stock traded for on that day.
• “Low” is the low price the stock traded for on that day.
• “Close” is the share price of the stock when trading stopped
that day.
• “Net chg” is the difference between the current closing
price and the previous day’s closing price.
Stock Quotes
SECTION 2
Bonds
What Is a Bond?
A bond is an IOU, or a promise to pay, issued by companies,
governments, or government agencies to borrow money.
The Components of a Bond
The face value, or par value, of a bond is the dollar amount
specified on a bond. It is the total amount the bond issuer will
repay to the bond buyer.
The maturity date is the day when the bond issuer must pay the
bond buyer the face value of the bond.
The coupon rate is the percentage of the face value that the
bondholder receives each year until the bond matures.
Bond Ratings
The more likely the bond issuer will pay the face value of the
bond at maturity and will meet all scheduled coupon payments,
the higher the bond’s rating.
Two of the best-known rating agencies are Standard & Poor’s
and Moody’s.
A bond rating of AAA from Standard & Poor’s or a rating of
Aaa from Moody’s is the highest rating possible.
• Bonds rated in the B to D category are lower-quality bonds
that may be in jeopardy of being in default (the issuer
cannot pay off the bond)
Bond Prices and Yields
The price that a person pays for a bond depends on market
conditions.
The yield on a bond is equal to the annual coupon payment
divided by the price paid for the bond.
• For example, if you pay $985 for a bond with a face value
of $1,000, and the annual coupon payment is $40, the bond
yield is 4.06 percent.
• The yield on bonds can also be referred to as the “interest
rate”
Write this
formula in
your
notes!!!
Types of Bonds
A corporate bond is issued by a private corporation. Corporate bonds
typically have $10,000 face values. Corporate bonds may sell for a price
above or below the face value depending on current supply and demand
conditions for the bond. The interest that corporate bonds pay is fully
taxable.
Municipal bonds are issued by state and local governments. Municipal bond
interest is not subject to federal taxes.
Treasury bills (T-bills), notes, and bonds are issued by the federal
government. The only difference between them is their time to maturity.
Treasury bills mature in 13, 26, or 52 weeks. Treasury notes mature in 2 to
10 years, and Treasury bonds mature in 10 to 30 years. They are considered
safe investments because the government is unlikely to default.
A new issue for the federal government is inflation-indexed bonds. The
government will increase the coupon payment to match inflation.
Risk and Return
Stocks and bonds often come with different risk and return
factors.
Treasury bonds often pay relatively low returns because they
carry the least risk.
What Would Life Be Like Without Financial Markets?
In a world of financial markets, people with good ideas can be
matched with people who have saved money that they would
like to invest. The result is that society produces more goods
and services than it would otherwise.
Applying the Principles (Stocks)
1. What are dividends?
DIVIDENDS ARE PAYMENTS MADE TO STOCKHOLDERS
BASED ON A COMPANY’S PROFITS.
2. If you own 100 shares of company A and company A pays an
annual dividend of $1.32 per share, how much would you receive
in dividend payments for the year?
YOU WOULD RECEIVE $132 (100 x $1.32 = $132) FOR THE
YEAR.
Applying the Principles (Stocks)
3. The dividend for a stock is listed as 1.43. What does this mean?
IT MEANS THAT THE LAST ANNUAL DIVIDEND PER
SHARE OF THE STOCK WAS $1.43. IT FOLLOWS THEN,
THAT A PERSON WHO OWNS 100 SHARES OF STOCK
WOULD HAVE RECEIVED $143 IN DIVIDENDS.
4. If the closing price of a stock is $53.48 and its dividend is $1.22,
what is the yield? (Yield should be written as a percentage
rounded to the second decimal place)
THE YIELD IS THE DIVIDEND PER SHARE DIVIDED BY
THE CLOSING PRICE PER SHARE: $1.22 / $53.48 = 2.28%.
Applying the Principles (Stocks)
5. Which stock has the highest yield?
PEPSICO – 3.30%
6. If you bought 100 shares of Sirius Satellite Radio at the highest
price for the year and sold it at the lowest price for the year, what
was your capital loss? Explain.
THE HIGHEST PRICE FOR THE YEAR WAS $3.89 AND THE
LOWEST PRICE FOR THE YEAR WAS $0.08.
THE CAPITAL LOSS WAS $381.
•
$0.08 - $3.89 = $-3.81
•
$-3.81 x 100 = $-381
Applying the Principles (Stocks)
7. If you bought 100 shares of Best Buy at the lowest price for the
year and sold it at the closing price on February 6, what was
your capital gain? Explain.
THE LOWEST PRICE FOR THE YEAR WAS $16.42 AND
THE CLOSING PRICE WAS $29.84. THE CAPITAL GAIN
WAS $1,342.
•
$29.84 - $16.42 = $13.42
•
$13.42 x 100 = $1,342
Applying the Principles (Stocks)
8. If you bought 100 shares of Google at the lowest price for the
year and sold it at the highest price for the year, what was your
capital gain/loss? Explain.
THE LOWEST PRICE FOR THE YEAR WAS $247.30 AND
THE HIGHEST PRICE FOR THE YEAR WAS $602.45. THE
CAPITAL GAIN WAS $35,515.
•
$602.45 - $247.30 = $355.15
•
$355.15 x 100 = $35,515
Applying the Principles (Stocks)
9. How many shares of Microsoft traded on Friday, February 6?
86,717,800 SHARES
10. What was the closing price of Pepsico on Thursday, February 5?
PEPSICO CLOSED $1.18 HIGHER ON FRIDAY THAN IT DID
THE DAY BEFORE. SO THE CLOSING PRICE OF PEPSICO
ON THURSDAY WAS $53.53 - $1.18 = $52.35.
Applying the Principles (Stocks)
11. If you have owned 100 shares of Kellogg for a year, how much
money did you receive in dividend payments last year?
$136 ($1.36 PER SHARE x 100 SHARES)
12. If you owned 200 shares of Wal-Mart, how much would you
expect to receive in dividend payments this year?
$190 ($0.95 PER SHARE x 200 SHARES)
Applying the Principles (Stocks)
13. What might you conclude about Sirius, which has a closing price
but does not have a PE ratio?
BECAUSE THE PE RATIO IS CALCULATED BY DIVIDING
THE CLOSING PRICE PER SHARE BY THE NET EARNING
PER SHARE, SIRIUS MAY NOT HAVE ANY NET EARNINGS.
14. What is Wal-Mart's PE ratio and what does it mean?
WAL-MART’S PE RATIO IS 14. THIS MEANS THAT THE
SHARE PRICE OF WAL-MART STOCK IS 14 TIMES ITS
EARNINGS PER SHARE. IN OTHER WORDS, INVESTORS
ARE WILLING TO PAY $14 FOR EVERY $1 OF LAST
YEAR’S EARNINGS.
Applying the Principles (Stocks)
15. What does Google’s relatively high PE ratio signify?
IT SIGNIFIES THAT THE PEOPLE WHO ARE BUYING
GOOGLE STOCK TODAY (AT A SHARE PRICE OF 28
TIMES SHARE EARNINGS) BELIEVE THAT THE FUTURE
GROWTH OF GOOGLE WILL WARRANT THE
RELATIVELYL HIGH PRICE (OVER EARNINGS) THEY
ARE CURRENTLY PAYING.
16. Why are people willing to buy stock with a high PE ratio?
A STOCK WITH A HIGH PE RATION MAY NOT BE A GOOD
VALUE BASED ON CURRENT EARNINGS, BUT IF THE
COMPANY GROWS AT A FAST RATE, THE STOCK MAY
PROVE TO BE A GOOD INVESTMENT IN THE FUTURE.
Applying the Principles (Bonds)
What are the three ways a company can raise money?
TAKING OUT A LOAN FROM A BANK
ISSUING STOCK
ISSUING BONDS
What is a bond?
A BOND IS AN IOU, OR A PROMISE TO PAY, ISSUED BY
COMPANIES, GOVERNMENT OR GOVERNMENT
AGENCIES FOR THE PURPOSE OF BORROWING
MONEY
Applying the Principles (Bonds)
Component: FACE VALUE
Description: THE FACE VALUE OF A BOND IS THE TOTAL
AMOUNT THE ISSUER OF THE BOND WILL REPAY TO
THE BUYER OF THE BOND.
Component: MATURITY DATE
Description: THE MATURITY DATE OF A BOND IS THE DAY
WHEN THE ISSUER OF THE BOND MUST PAY THE
BUYER OF THE BOND THE FACE VALUE OF THE
BOND.
Component: COUPON RATE
Description: THE COUPON RATE OF A BOND IS THE
PERCENTAGE OF THE FACE VALUE THAT THE
BONDHOLDER RECEIVES EACH YEAR UNTIL THE
BOND MATURES.
Applying the Principles (Bonds)
Elena pays $10,000 for a bond with a face value of $10,000 and a
coupon rate of 6 percent. Scott buys a bond for $9,500. The
face value of the bond is $10,000 and the coupon rate is 6
percent.
Elena will receive a coupon payment of $600 (10,000 x .06) each
year.
When the bond matures, Elena will receive $10,000 (face value)
from the issuer of the bond.
The yield that Elena will receive on the bond is 6.00% (coupon
payment of $600 / the price she paid of $10,000 then move the
decimal two places to the right to make a percentage).
If the maturity date is five years from the day Elena buys the bond,
she will earn a total of $3,000 (coupon payment x 5 years) on her
investment.
Applying the Principles (Bonds)
Elena pays $10,000 for a bond with a face value of $10,000 and a
coupon rate of 6 percent. Scott buys a bond for $9,500. The
face value of the bond is $10,000 and the coupon rate is 6
percent.
Scott will receive a coupon payment of $600 (10,000 x .06) each
year.
The yield that Scott will receive on the bond is 6.31% ($600 /
$9,500).
When the bond matures, Scott will receive $10,000 (face value) from
the issuer of the bond.
If the maturity date is five years from the day Scott buys the bond, he
will earn a total of $3,500 (coupon payment x 5 years + $500
because he paid less than the face value) on his investment.
Applying the Principles (Bonds)
Elena pays $10,000 for a bond with a face value of $10,000 and a
coupon rate of 6 percent. Scott buys a bond for $9,500. The
face value of the bond is $10,000 and the coupon rate is 6
percent.
Both Elena and Scott bought bonds with face values of $10,000,
coupon rates of 6 percent, and maturity dates five years from the
date of purchase. Scott will earn $500 MORE on his investment
than Elena will earn on her investment because he paid $500
LESS than the face value of the bond.
Applying the Principles (Bonds)
What is the main difference among corporate bonds, municipal
bonds, and treasury bills?
THE MAIN DIFFERENCE IS THAT CORPORATE BONDS
ARE ISSUED BY PRIVATE CORPORATIONS,
MUNICIPAL BONDS ARE ISSUED BY STATES AND
LOCAL GOVERNMENT, AND TREASURY BILLS ARE
ISSUED BY THE FEDERAL GOVERNMENT.
Which type of investment, stocks or bonds, is riskier? Why?
AN INVESTMENT IN STOCKS IS RISKIER THAN AN
INVESTMENT IN BONDS BECAUSE STOCKS CAN FALL
IN VALUE AND BONDS (ESPECIALLY GOVERNMENT
BONDS) WILL LIKELY BE PAID OFF.
Applying the Principles (Bonds)
What is the relationship between the returns and the risks of various
investments?
HIGHER RETURNS COME WITH HIGHER RISKS AND
LOWER RETURNS COME WITH LOWER RISKS.
If a person wants high returns from investments and is willing to take
high risks, he or she would likely invest mainly in STOCKS.
If a person wants low risk investing, she or he would likely invest
mainly in BONDS.
If the yield on a 10-year Treasury bond is 4.60 percent and the yield on a 10-year corporate
bond is 5.26 percent, which bond do you think would involve more risk? Why?
THE CORPORATE BOND WOULD LIKELY INVOLVE
MORE RISK BECAUES THE RETURN IS HIGHER ON
THE CORPORATE BOND THAN IT IS ON THE
TREASURY BOND.