Ch. 11: Financial Markets

Savings –
Investments – is the use of income today in a
way that allows for a future benefit
 Economic investment –
 Personal investment – refers to the act of
individuals putting their savings into financial
assets – CDs, stocks, bonds or mutual funds
 putting money into a savings account
 you benefit – earn interest
 others benefit – funds available to lend
Financial system –
Individuals and businesses can save surplus
funds in many ways
Savings accounts at commercial banks/S &
Ls, certificates of deposit, corporate or govt.
bonds, stocks
 agent receiving funds is a borrower
 issues savers written confirmation of transaction
Financial asset –
Financial market –
Financial intermediary – is a financial
institution that collects funds from savers and
then invests these funds in loans and other
financial assets
 bring savers, borrowers, and financial assets
together – see figure 11.1
Bring savers & investors together
One group –
 other financial intermediaries –
▪ finance companies – make small loans
▪ pension funds –
▪ life insurance companies –
Mutual fund –
 investors own shares of the entire fund based on
the amount invested
 gather money in different ways & provide many
different financial assets to a variety of investors
Includes commercial
banks, S & Ls, & credit
 provide checking and
saving accounts depositors earn interest on
both in some cases
 most offer CDs & money
market deposits accounts
that have higher interest
 federal govt. insures
deposits up to $250,000
per depositor in any given
Lend a portion of their
deposits to borrowers
 banks charge a higher
interest rate to pay back
savers & make a profit
 if borrower does not pay
back loan –
Can also offer other
financial assets –
 federal govt. does not
insure these funds
Includes –
 finance companies make loans to
households & small businesses
 loans generally under $2000 &
paid back in monthly installments
with interest
Mutual fund pools money from
many personal investors
 each investor receives shares in a
fund made up of a large # &
variety of stocks, bonds, or other
financial assets
 make it more affordable for
individual investors to own a wide
variety of financial assets
 once investors purchase a share
of funds –
Pension funds allow
employees to save
money for  then invests pooled
contributions in various
financial assets that will
increase in value
Life insurance companies
allow Companies lend or invest
some of the income
earned from
policyholders in a variety
of financial assets
Capital market –
Money market –
Primary market –
Secondary market –
Capital markets –
 ex of assets –
 b/c loans are for longer
periods - money may be
invested in projects that
require large amounts of
 building homes, building
new factories, financing
govt. projects
Money markets  ex of assets – short term
CDs that can be
redeemed in a few
months & treasury bills
(allow govt. to borrow
money for short periods)
2 markets based on
whether financial assets
can be resold
Primary markets are for
financial assets that can
be redeemed only by the
original buyer
 ex –
 also refers to market
where the 1st issue of a
stock is sold to the public
through investment
Secondary markets are
resale markets for
financial assets
 offer liquidity to personal
 investors able to turn
assets into cash relatively
 ex –
Investment objective –
*ex –
*goals help -
2 issues will help determine which investment
will help achieve objective
Time –
 amount of time influences kind on investment is
most appropriate
Income –
 leads to other questions:
 Will income change in the future?
 Money available for emergencies?
Need a savings plan that is realistic & flexible
enough to adjust to changing circumstances
 other questions:
▪ Do you have outstanding debts?
▪ Are you paying taxes on time?
Paying off debts first step to investing
 generally –
Tax considerations most important to investors
with higher incomes subject to higher tax rates
Saving for emergencies –
Saving for vacation –
 Long term goals –
 CDs – timing with major purchases or starting college
 bonds from state & local govt. offer tax free earnings
Pres. of Ariel Capital
Management, LLC – b.
April 3, 1969
 discovered her career
investing as a college
 received degree in 1991 &
position in marketing
department of Ariel Capital
In 2000 – became pres.
of the company
 runs an operation with
over $21 billion in assets
Ariel was first minority owned mutual fund company
in the country
 pioneers programs to teach inter-city kids about investing
 she give presentations about investing
Developed 1st study of investing by African-Americans
& looked for ways to increase participation
 marketing efforts – events with Chicago Bulls & a stock
picking contest with hip-hop artists
In 2000 – became financial contributor to the Good
Morning America show
 able to reach millions with easy to understand info about
economic matters
Risk –
Return –
 can be interest paid on savings account, CD, or
increase in value of stock over time
 most saving are insured against a loss – an
investments are not
 investors try to balance risk & return through
Diversification –
Investor & risk –
 even if not get a lot –
 investments that guarantee
no loss of principal: insured
savings deposits & CDs
 bonds backed by US govt. are
considered risk-free
 highly unlikely the govt.
would not pay back loans
 all other investments carry
some risk
Purchase with expectation
that value will appreciate
 but could lose money if
company runs into problems or
other econ. factors
 investors than may not be able
to sell stock for what they paid
 corporate bonds hold similar
risk –
 bond holders are paid off
before stockholders if company
has financial problems
With investments –
Safest investment –
 stocks & bonds are not guaranteed
and returns vary at different time
 depends on economy as a whole,
how well the company is performing
 do have a higher return over time
then other investments
Risks & returns are
directly related –
 investors want highest
return possible –
 time & income become
 ex – 70% in stocks, 20% in
bonds, 10% in CDs –
retirement investing
 better chance of offsetting losses from one
investment with gains from
Investing for retirement
in 20-30 years –
 less time and lower income
will be less risky
Diversification is best
way to minimum risk and
maximize return
Mutual funds help small
investors diversify their
Company 1st issues stock – sold to investment
bankers in the primary market
 called an initial public offer (IPO) –
 stock then resold to investors through a stock
Stock exchange –
 most buy stock as financial investment with
expectation that price will rise then they will be
able to resell for a profit
Capital gains –
Investor buy stock for 2 reasons:
 1. To earn dividend payments –
 2. Earn capital gains by selling the stock at a price
greater than the purchase price
▪ if sold below buying price –
▪ if investor wants income –
▪ if investor wants to see investment grow –
Investing in stocks carries higher risk –
 corporations not required to pay dividends –
 no guarantee that stock price will be higher when
investor wants to sell
Both types give ownership
in corporation – can receive
Holders of common get
one vote per share owned
to elect board of directors
Holders of preferred
receive guaranteed
dividends & paid before
common stockholders is
company is liquidated
Holders of preferred have
no voting rights &
dividends do not increase if
stock increases in value
Most invest in stock with goal of earning
capital gains when they sell it
 stock prices determined by supply & demand
 things affecting stock prices:
▪ company profit or losses
▪ technological advances that affect company or industry
▪ overall state of economy
If investor perceive that company value will
increase – demand for stock ↑ & price ↑
 as price rises –
 few companies sell directly to an investor
Stockbroker –
 also called brokers generally work for brokerage firms
 interact with customers in person, phone or online
 job –
 buy & sell on a variety of stock exchanges
New York Stock Exchange (NYSE) –
 located on Wall Street in NY City –
 about 1.5 billion shares of 2,800 of largest companies
in US traded each day
 brokerage firms pay for privilege of being one of 1,336
members of exchange
Smaller American Stock Exchange (AMEX)
located in NYC
 trading structure similar to NYSE –
2006 – introduced practice to combine floor &
electronic trading
Traditionally trading organized in auction format
 each stock had specific location of trading post on the floor
Specialist representing that stock ran the auction to match
buyers & sellers though open bidding to determine the
price of shares
 prices vary from minute to minute as auction continues through
the day
 since 1996 – floor trades use hand held computers to execute
 more than half of order to buy & sell are done electronically
2006 – NYSE merged with Archipelago
Exchange(electronic trading company) – to speed up
transactions & trade stocks in electronic markets
Over-the-counter (OTC) –
1970 – National Association of Securities Dealers
(NASD) introduce centralized computer system
that allows OTC traders around the country to
make trades at best prices possible
 automated quote system called NASDAQ
2005 –
 companies covers many sectors – but most are
NASD also regulates OTC Bulletin Board as an
electronic market for trading shares in
companies too small to be traded on NASDAQ
Complicated and high risk investments that
involve trying to predict the future
Future –
 investor who wants to buy in futures wants to lock in a
low price
 investor who wants to sell in futures wants to lock in a
high price
Option –
 the investor pays a small fraction of a stock’s current
price for the option to buy or sell the stock at a better
price in the future
Late 1990s –
 stocks listed on any exchange available to any trading
 growth of electronic communication networks (ECN)
increased electronic stock trading
 trading now takes place 24 hrs a day – not just when
the exchanges are open
 many investors have internet access and are more
knowledgeable about trading
▪ huge growth in online brokerages
▪ investors can trade at any time and pay lower commissions
▪ combines rapid trades and best possible prices
About half of all US households now own stock
Stock index – an instrument used to measure and report
change in prices of a set of stocks
Measure the performance – of many individual stocks &
the stock market as a whole
The Dow –
Standard & Poor’s 500 –
The NASDAQ Composite
Hang Seng Index – Hong
The DAX –
Nikkei 225 – Japan
TSE 300 –
FTSE 100 – Britain
Publisher of Wall Street
Journal – 1st published the
DJIA in 1896
 only had 12 companies and
reflected agriculture & mining
Since 1928 – the Dow has
included 30 companies –
General Electric is only 1 of
original companies left
 US economy has changed
from agriculture to industry
to service – companies in the
index change to reflect the
most successful companies in
most important sectors
 original DJIA was the actual
 called blue chip stocks
Measures changes in the
prices at which stocks are
average of the prices of the 12
Now – the average is
weighted so the higher
priced stocks have more
influence on the average
 the # quoted is not a price –
but an average measured in
points not dollars
Changes in the Dow reflect trends in stock
market prices
Bull market –
Bear market –
 track the market to determine if market is
trending toward bull or bear
In 1972 it reached 1,000 for
the 1st time
 In May 1999 – it topped
11,000 for the 1st time –
topped out at 11,722.98 on
Jan 14, 2000 – ended longest
bull market in history
 during the 1990s – market
climbed from 2,800 to its peak
 most bull markets last 2 or 3
During the 20s – the Dow
rose from 60 to 381.17
 in month after Oct 29, 1929 –
dropped to a low of just under
 next closing price of 400 was
Dec. 29, 1954
Bond –
 govt. can also issue bonds
Par value – the amount that the bond issuer
promises to pay the buyer at maturity
Maturity –
Coupon rate – is the interest rate a
bondholder receives every year until a bond
2 reasons to invest in bonds –
 1.
 2.
Most people buy bonds for the interest
 bonds considered less risky b/c holders are paid
before stockholder
Yield –
 important to determine this when deciding
whether to buy or sell
▪ if sold at par value –
▪ if sold for less than par value – yield higher than coupon
▪ if demand strong & price is higher than par value –
Generally –
 why? – more uncertainty and risk involved with
repayment dates that are farther in the future
Many different kinds of bonds
 like stocks – higher the risk –
 classified by who issues the bonds
US Govt. issues securities
called Treasury bonds,
notes or bills
money borrowed through this helps
keep the govt. running
risk of international bonds depends on
financial strength of that particular govt.
bonds –
Treasury bills –
State and local govt.
issue municipal bonds
finance govt. projects –
construction of roads, bridges,
interest earned on many municipal
bonds not subject to federal
income tax
why? – state & local govt. collect
taxes so will be able to pay interest
and repay the buyer upon maturity
Companies finance
expansion by issuing
corporate bonds
pay higher
coupon rate than
govt. bonds b/c
risk is higher
Junk bond – is
considered high risk
but has the potential
for high yield
Need to determine reason for buying to know
which type to purchase
Most investors want the guaranteed interest
 yield most important to these investors
 coupon rate and price relative to par value will
determine yield
 if want to sell bonds before maturity – study bond
market to see if can sell for profit
Market interest rate are important to bond
 inverse relationship between price of existing
bonds & interest rates
▪ if interest rates ↑,
▪ if interest rates ↓,
Main risk faced by bond purchaser is the
issuer will default
 level of risk is directly tied to the financial strength
of the bond issuer
When govt. or corp. want to issue bonds –
 investor than have standard to judge the risk of
the bonds
Systems of bond ratings:
 1. Standard & Poor’s
 2. Moody’s
▪ use a system of letters to designate relative credit risk of
See figure 11.11
Other options –
Both have very low risk & provide income in
the form of interest
Form of time deposit offered primarily by banks,
S & Ls and credit unions
 have a maturity date -
 issuer pays either a fixed or variable interest during
period CD is held
 usually interest is reinvested in CD so investor gets
compound interest
 CD with longer maturity date get higher interest rates
▪ ex – 6 month CD – 3.4%
▪ ex – 5 year CD – 4.4%
Federal govt. insures funds deposited in CDs
at most banks & credit unions up to $100,000
per depositor in any given institution
 main risk –
 might face interest rate risk it rates rise and funds
are locked for a length of time at a lower rate
Money market involves financial assets with
maturities of 1 yr or less
 mutual funds allow investors to buy shares that
represent an investment in all the financial assets
held by the fund
 money market mutual funds (MMMF) –
▪ ex –
Give investors a higher yield than banks saving
accounts – but similar level of liquidity
 can redeem shares by check, phone or electronic
transfer to a separate checking account
 federal govt. does not insure MMMFs – funds are
tightly regulated
▪ considered quite safe with regard to loss of principal
Less interest rate risk than with CDs b/c money is
not committed for a specific length of time
 yield varies based on the yield of the assets in the