Financial Markets and Investing

What do you know about investing? Has anyone here ever
made an investment?
 How many of you follow the stock market, or read the business
section of the paper?
 What’s a prospectus?
 What is selling short and why do some people HATE it?
 How does the stock market relate to the economy as a whole?
 Why do we have a stock market?
 Think about this statement:
 “Saving money makes economic growth and investment
possible, since one man’s savings is another man’s loan.”
Financial Markets: Basic Tenets
Financial systems consist of financial institutions/
intermediaries that transfer savings to investors
Banks, Savings and Loan Associations, & Credit Unions
take in deposits from savers and then lend some of these
funds to various businesses. Banks don’t just keep your
money under a rock in the vault!!!!!
When savers invest, they receive documents confirming
their deposit or bond purchase, such as passbooks or bond
These documents are known as financial assets. They
represent claims on property or income of the borrower.
Governments and businesses are the largest borrowers.
Financial assets include savings accounts, certificates of
deposit, and either corporate or government bonds
Non-bank Financial Intermediaries
Finance Companies--Make loans to consumers and small
businesses, but charge borrowers higher fees and interest rates to
cover possible losses. They buy installment contracts from
merchants who sell goods on credit. Many offer loan consolidation.
Mutual Funds--Pool the savings of many individuals and invest this
money in a variety of stocks and bonds. Gives “common folk” a
chance to invest in the market at lower risk (?)
Life Insurance Companies--Provide financial protection to the
family or other beneficiaries of the insured. Companies invest
premiums until death benefits must be paid out. Some build cash
value—can be “cashed in.”
Pension Funds---Are set up by employers to collect deposits and
distribute payments to retirees. They receive money from
employers/employees (some nice employers offer matching
contributions) and invest in corporate stocks and bonds.
EX: 401 (k)—key advantage: TAX DEFERRED! AKA IRA’s (Individual
Retirement Accounts. Roth IRAs are financially attractive—
contributions are made after taxes, so none are taken out at
Real Estate Investment Trusts (REIT)—borrow money from banks
& loan it to construction companies who build homes
The Flow of Savings and
Services Provided by
Financial Intermediaries
Sharing Risk--Diversification is the spreading out of
investments to reduce risk. Financial intermediaries
help individual savers diversify their investments.
Providing Information--Financial intermediaries reduce
the costs in time and money that lenders and
borrowers would pay if they had to search out
investment information on their own.
Providing Liquidity--Financial intermediaries allow savers
to easily convert their assets into cash.
Private Enterprise and Investing
Investment is the act of redirecting resources
from being consumed today so that they may
create benefits in the future.
In short, investment is the use of assets to
earn income or profit.
When people save or invest their money, their
funds become available for businesses to use to
expand and grow. In this way, investment
promotes economic growth.
Risk and Return
• Return is the money an investor receives above and
beyond the sum of money initially invested (principal)
• Savings accounts are very liquid, but in general have a
lower rate of return. Statement savings slightly higher.
 Certificates of deposit usually have a greater return but
liquidity is reduced. Usually penalties for early
 Stocks vary—remember that holding stocks can lead to
a loss of principal. Enron situation is typical.
In general, the higher potential return of the
investment, the greater the risk involved.
• EX: Investing in a friend’s Internet company could
make you filthy rich, but there is risk of company failure
• EX2: “Blue chip” stocks offer medium returns, but as
established companies, it’s pretty difficult for you to
lose money. Well, it WAS pretty difficult.
Investment Review: Section 1
1. Investment is
(a) providing money for your family.
(b) the act of redirecting resources from being
consumed today so that they may create benefits in
the future.
(c) an institution that helps channel funds from savers
to borrowers.
(d) a collection of financial intermediaries.
2. The money an investor receives above and beyond the
money initially invested is called
(a) investment.
(b) savings.
(c) return.
(d) prospectus.
Basic Investment Considerations
The type of investment chosen should depend
on the goals of the investor and your
willingness to accept RISK!
 Short-term: low risk or (virtually) no risk:
(CAN’T lose principal). Stick with savings
accounts, short-term CDs, money market funds
 Intermediate: low to moderate risk, largely
determined by investor. High-grade corporate
bonds and stocks
 Long-range: growth funds, moderate risk
 Key to any successful plan: DIVERSIFICATION.
 Some stocks, some bonds, some liquid assets
Bonds as an Investment Vehicle
Bond: a long-term obligation by the government or a
corporation to pay a fixed amount of interest every
year until maturity. Bonds have 3 components:
The coupon rate--the interest rate that the bond
issuer will pay to the bondholder.
The maturity-- the time at which payment to the
bondholder is due.
Par Value--the amount that an investor pays to
purchase the bond and that will be repaid to the
investor at maturity. Par value is also called face
value or principal.
Bond Prices are determined by supply and demand
Current yield= (Annual int. rate)/(purchase price)
Bonds CAN be called early 
Bond Value—an Example
Suppose you have a $10,000 bond earning
7% interest, or $700/year. The face value is
$10,000 and is payable at maturity.
 If interest rate went to 10%, that bond is
underperforming. So you sell it. But you
won’t get $10,000. It’s only worth $7000. So
you bargain and probably get $8500 for it.
Bond Ratings
Standard & Poor’s and Moody’s rate bonds on a number
of factors, including the issuer’s ability to make future
payments and to repay the principal when the bond
matures. A high bond rating usually means that the
bond will sell at a higher price, and that the firm will be
able to issue the bond at a lower interest rate.
Standard & Poor’s
Highest investment grade
High grade
Upper medium grade
Medium grade
Lower medium grade
Vulnerable to default
Subordinated to other debt rated CCC
Subordinated to CC debt
Bond in default
Best quality
High quality
Upper medium grade
Medium grade
Possesses speculative elements
Generally not desirable
Poor, possibly in default
Highly speculative, often in default
Income bonds not paying income
Interest and principal payments in default
Types of Bonds
Savings Bonds-- are low-denomination ($50 to
$10,000), non-transferable bonds issued by the United
States government. Savings bonds are purchased
below par value (a $100 savings bond costs $50 to buy)
and interest is paid only when the bond matures.
 Treasury Bonds, Bills, and Notes--These investments
are issued by the United States Treasury Department.
 Municipal Bonds--are issued by state or local
governments to finance such improvements as
highways, state buildings, libraries, and schools.
Federally tax-exempt in most cases
 Corporate Bonds-- are bonds that a corporation issues
to raise money to expand its business.
 Junk Bonds--are lower-rated, potentially higher-paying
bonds. EX: Comcel, cellular telephone company in
“T-eed off”
Treasury Bill (T-Bill): Short-term bill used to finance
federal government borrowing (13, 26, or 52 weeks).
Sold on a discount basis.
Treasury Notes—2-10 year bonds
Treasury Bonds—10 to 30 years.
Notes and bonds for 2-3 years are $5000
denominations, longer than 4 years $1000. Periodic
interest is paid by the government via a computer
Collateral: faith in the US government, ability to raise
taxes, etc.
Low return, very low risk
Advantages/Disadvantages of Bonds
1. Once the bond is
sold, the coupon
rate for that bond
will not go up or
2. Unlike stock,
bonds are not
shares of ownership
in a company.
1. The company must make
fixed interest payments,
even in bad years when it
does not make money.
2. If the issuer does not
maintain financial health,
its bonds may be
downgraded to a lower
bond rating. This makes it
harder to sell future bonds
unless a discount or higher
interest rate is offered.
Other Types of Financial Assets
Certificates of Deposit
Money Market Mutual Funds
 Money market mutual funds
are special types of mutual
Certificates of deposit
(CDs) are available
through banks, which
use the funds deposited  Investors receive higher
interest on a money market
in CDs for a fixed
mutual fund than they
amount of time.
would receive from a
CDs have various terms
savings account or a CD.
of maturity, allowing
However, assets in money
investors to plan for
market mutual funds are
future financial needs.
not FDIC insured.
No risk, low return.
Financial Asset Markets
One way to classify financial asset markets is according
to the length of time for which the funds are lent.
Capital markets are markets in which money is lent
for periods longer than a year. CDs and corporate
bonds are traded in capital markets.
 Money markets are markets in which money is lent
for periods of less than a year. Short-term CDs and
Treasury bills are traded in money markets.
Markets can also be classified according to whether
assets can be resold to other buyers.
 Primary markets involve financial assets that cannot
be transferred from the original holder, such as
savings bonds.
 Secondary markets involve financial assets that can
be resold, such as stocks, bonds, and treasury bonds
and notes (but not bills!). See figure 12-6 in text.
Section Review—Risk and Bonds
1. A bond is a
(a) loan that represents debt that the government or a
corporation must repay to an investor.
(b) portion of ownership in a corporation.
(c) system that allows the transfer of funds between
savers and borrowers.
(d) collection of financial assets.
2. How does the risk involved in a money market mutual
fund compare with the risk of a certificate of deposit?
(a) The risk of the money market mutual fund is less
than the certificate of deposit.
(b) The risk of the money market mutual fund is
slightly greater than the certificate of deposit.
(c) The risk of the money market mutual fund is much
greater than the certificate of deposit.
(d) The risk of both is about the same.
Purchasing Stock
Corporations can raise money by issuing stock, which
represents ownership in the corporation.
 A portion of stock is called a share. Stocks are also
called equities.
Stockowners can earn a profit in two ways:
1. Dividends, which are portions of a corporation’s
profits, are paid out to stockholders of many
corporations. The higher the corporate profit, the
higher the dividend.
2. A capital gain is earned when a stockholder sells
stock for more than he or she paid for it. A
stockholder that sells stock at a lower price than the
purchase price suffers a capital loss.
Stock Market Efficiency
Efficient Market Hypothesis: It is not possible to “beat
the market” regularly.
 This explains the plight of daytraders. Daytraders use
computer programs to try and predict minute-byminute price changes in hopes of earning a profit.
Consistent investing over the long-term, however, can
create large gains
 Instead of trying to beat the market, investors should
diversify their portfolio to scatter risk. Most CFP’s
recommend a combination of stocks, bonds, and highliquidity investments. Also scatter your risk by having
some higher risk stocks and some lower risk stocks.
Types of Stock
Dividend Differences
Income stock pays
dividends at regular
times during the year.
Growth stock pays few
or no dividends.
Instead, the issuing
company reinvests
earnings into its
Investors who buy
common stock are voting
owners of the company.
Preferred stock owners
are nonvoting owners of
the company, but receive
dividends before the
owners of common stock.
Stock Splits
A stock split is the division of a single share of
stock into more than one share.
 Stock splits occur when the price of a stock
becomes so high that it discourages potential
investors from buying it.
 They generally favor investors who hold the stock
 Reverse stock splits can also occur—if the value of
stock seems diluted or the company wishes to
redeem shares
Potential Risks in Buying Stock
The firm selling the stock may encounter
economic downturns that force dividends
down or reduce the stock’s value. It is
considered a riskier investment than bonds.
 Recent accounting scandals have plagued the
markets, sapping the confidence of investors
 Even so, staying in the stock market for the
long run seems to be the best financial
decision. The biggest risk is NOT
Investment Approaches
Conservative—concentrate on highly rated stock and
fixed income investments. Main goal: Beat inflation
but don’t lose principal. EX: Retirees
Moderate—Take risks by going into growth stocks,
mutual funds, bonds.
EX: Younger people with years to work.
The closer you get to retirement, the less risk you
want. Investment firms vary widely in the advice they
give in allocating your financial resources. Also, you
have to decide what risk you’re comfortable with.
Speculative—Take major risks in hopes of striking it
rich. High volatility (sudden swings in value) stocks
How Stocks are Traded
A stockbroker is a person who links buyers
and sellers of stock.
Stockbrokers work for brokerage firms, or
businesses that specialize in trading stock.
Some stock is bought and sold on stock
exchanges, or markets for buying and
selling stock.
E-Trade and Ameritrade now make it possible
for individual investors to place trade orders
How to Buy Stock (Long)
Suppose you think NBC is a strong company, makes
good television programs
Determine the Parent Company: General Electric
Research the company; see if the fundamentals are
strong in all components
Look up the stock symbol (GE)
Purchase the stock if you think it is a good value—you
must go through a stockbroker unless you trade online
(which is still going through a broker)
Tips on Purchasing Stock: What to Look For
Recommendations by analysts, commentators
 Low P/E ratio, at/off 52 week high*, undervalued company
 Strong company earnings (EPS or dividends or both)
 Company news: New products, advantages over competitors,
favorable market conditions or legislation
 EX: Corning (GLW), Level Three (LVLT), Valero (VLO)
 M&A Activity: Generally the acquiring company goes DOWN in
the short run and hopefully up in the long run (acquired
company usually spikes to deal price). Try to find companies
that are ripe for a takeover.
 Insider buying and selling or company stock buybacks generally
means that management feels the stock price is undervalued
 This is by no means exhaustive; there are many reasons, some
rational and some irrational, why stocks appreciate/depreciate
Selling Short
You can make a profit off other people’s
Simply find a stock you think will decline in
Borrow SHARES of the stock from a
When the price falls, repay the shares (it will
take less money than you borrowed) and
pocket the profit.
Your risk is UNLIMITED, unlike a long position
Example: Selling Short
DCX stock sells for $50 a share. You borrow 100
shares ($5000)
 Price drops to $20 a share. You pay the
stockbroker back the loan for $2000.
 The extra $3000 is yours to keep!
 But if stock appreciates, you will dig into your
pocket, possibly deeply
 Safer way: short and ultra-short mutual funds
Buying on Margin
How to: Open an account with your
money and broker’s money.
Margin calls force you to put more cash
in or sell and take the loss right then
and there
Organized Stock Exchanges
New York Stock Exchange (NYSE): About
3,000 companies, 1,400 seats with access to
the trading floor. 9:30 AM- 4 PM Mon-Fri.
Only stocks for the largest and most
established companies are traded on
the NYSE. Examples: GM, DCX, USX.
 American Stock Exchange (AMEX): 1,000
 World exchanges: FTSE (London), Nikkei
(Tokyo), also Frankfort, Hong Kong,
Over-the-counter Market
Most shares are not traded on exchanges but
in electronic over-the-counter trades.
NASDAQ lists information on companies
traded this way.
 National Association of Securities Dealers
Automated Quotations (NASDAQ): focuses
on newer companies, has a lot of the high
tech and energy stocks. EX: Microsoft is
listed here
 OTC Trades are executed in the same fashion
as trades done on stock exchanges
Futures and Options
Futures are contracts to buy or sell at a specific date in
the future at a price specified today. Often used with
commodities (pork bellies)
Options are contracts that give investors the option to
buy or sell stock and other financial assets. There are
two types of options:
1. Call options give buyers the option to buy shares of
stock at a specified time in the future. Also called
warrants. You exercise a warrant if it would help
you. Often sold by companies that want to issue
stock or sell reserve stock.
2. Put options give buyers the option to sell shares of
stock at a specified time in the future.
Why Do Futures Markets
Some people simply like trading this way
 Others need to lock in a firm price—DCX
needs to know what the cost of steel will be
for an entire run of cars. They are willing to
pay a little bit more for an assurance that
the price will not rise for the life of a
contract. That way, they need not worry
about adjusting prices and slumping
Measuring Stock Performance
Bull and Bear Markets
When the stock market rises steadily over time, a bull
market exists.
Conversely, when the stock market falls over a period
of time, it’s called a bear market.
Stock Performance Indexes
The Dow Jones Industrial Average--is an index that
shows how stocks of 30 companies in various industries
have changed in value.
The S & P 500--is an index that tracks the performance
of 500 different stocks in both the NYSE and NASDAQ
Also the Russell 2000, Wilshire 5000
Reasons for the 1929 Stock Market Crash/Great
PRODUCTION instead of capital improvement
The Great Crash of 1929: Results of
“Black Thursday”
The Crash contributed to the Great Depression during which
many people lost jobs, homes, and farms.
Americans also became wary of buying stock. As recently as
the early 1980s, only about 25 % of households in the
United States owned stock. Around 2000, it was almost
50%. It’s going down slightly now. Joe Kennedy story.
Market crashes and “adjustments” continue to spook some
people, but important changes have been made to avoid
huge 1-day losses
SEC Created, along with Glass-Steagall Banking Act (now
repealed by 1999’s Gramm-Leach-Riley Law)
Effects of crashes can also be mitigated--In October 1987,
for instance, the Fed simply opened its monetary spigots and
a major economic downturn was avoided.
“Crash” Safeguards (After 1987)
A crash may be dangerous because emotions often rule
people, not their heads.
A selling frenzy could cause people to go nuts. Trading
happens so fast there isn’t time to think. Computers
can trade millions of shares in an instant.
The 1987 crash (Black Monday) was precipitated by
computer trades that sunk the market very quickly. As
a result, new rules were instituted to delay a downturn,
or at least make it happen over several days.
150 pt. swing either way shuts off program trading—
this is referred to as a “market curb” (“Curbs in”).
Curbs end when the market approaches 70 pt range of
the previous day’s close.
When the Dow loses a certain # of points, the “circuit
breaker” goes off and markets shut down to let people’s
emotions cool. It then reopens, but if it falls
significantly, the market will close for the day.
Market Circuit Breakers
p.m. 1:59
p.m. 2:29
2:30 p.m. or later
Decline in
the Dow
1 Hour
1 Hour
½ Hour
No Halt; If Decline
Continues To 20% Then
Close For Day
Decline in
the Dow
2 Hour
1 Hour
For Day
Close For Day
Decline in
the Dow
For Day
For Day
Close For Day
Computing Annual Return
Problem: In January 1996, I put $3000 into the stock
market. My broker took his commission of $120 off the
In January 1998, I sold the mutual fund shares to get
money for college. I received $4500.
What was my annual return and the return of the fund?
(Gross Profit or loss) / (Purchase Price) / (years) =
Annual Return
(1500)/ (3000)= 50%/ (2 years)= 25.0% Return for
(1620)/ (3000)= 54%/ (2 years)= 27.0% for fund
Losses generate negative numbers.
Dow 30 Components
3M Co. (NYSE: MMM) (conglomerates, "manufacturing")
ALCOA Inc. (NYSE: AA) (aluminum)
Altria Group, Inc. (NYSE: MO) (tobacco, foods)
American International Group, Inc. (NYSE: AIG) (property & casualty insurance)
American Express Co. (NYSE: AXP) (credit services)
AT&T Inc. (NYSE: T) (telecoms)
Boeing Co., The (NYSE: BA) (aerospace/defense)
Caterpillar, Inc. (NYSE: CAT) (farm & construction equipment)
Citigroup, Inc. (NYSE: C) (money center banks)
Coca-Cola Co. (NYSE: KO) (beverages)
E.I. du Pont de Nemours & Co. (NYSE: DD) (chemicals)
Exxon Mobil Corp. (NYSE: XOM) (major integrated oil & gas)
General Electric Co. (NYSE: GE) (conglomerates, media)
General Motors Corporation (NYSE: GM) (auto manufacturers)
Hewlett-Packard Co. (NYSE: HPQ) (diversified computer systems)
Home Depot, Inc. (NYSE: HD) (home improvement stores)
Honeywell International, Inc. (NYSE: HON) (conglomerates)
Intel Corp. (NASDAQ: INTC) (semiconductors)
International Business Machines Corp. (NYSE: IBM) (diversified computer systems)
JPMorgan Chase and Co. (NYSE: JPM) (money center banks)
Johnson & Johnson Inc. (NYSE: JNJ) (consumer and health care products conglomerate)
McDonald's Corp. (NYSE: MCD) (restaurant franchise)
Merck & Co., Inc. (NYSE: MRK) (drug manufacturers)
Microsoft Corp. (NASDAQ: MSFT) (software)
Pfizer, Inc. (NYSE: PFE) (drug manufacturers)
Procter & Gamble Co. (NYSE: PG) (consumer goods)
United Technologies Corp. (NYSE: UTX) (conglomerates)
Verizon Communications (NYSE: VZ) (telecoms)
Wal-Mart Stores, Inc. (NYSE: WMT) (discount, variety stores)
Walt Disney Co., The (NYSE: DIS) (entertainment)
Annual Return’s not that
simple though….
The method of computing return can vary—
performance can be averaged or
compounded. See p. 123 of supplement.
We’ll save the math for the credit chapter.
 Return is hard to guesstimate on real estate
 Don’t forget taxes—they take a bite out of
net return.
 Rule of 69.3 (aka rule of 70 and 72): 69.3/
Interest rate will tell you how long it takes for
your money to double
Mutual Funds
Combinations of stock and/or other financial
assets managed by brokerage firms
 New trend: Exchange traded funds can be
tracked in real time (provided they don’t
contain any non-stock assets)
 Offers diversification, scatters risk
 Can be broad indexes (Spiders track the SP500)
 EX: Powershares QQQ tracks the NASDAQ
 ProShares offers SHORT funds
Section Review: Stocks
1. A share of stock represents
(a) debt that the government or a corporation must
repay to an investor.
(b) a portion of ownership in a corporation.
(c) a system that allows the transfer of funds between
savers and borrowers.
(d) a collection of financial assets.
2. Which of the following represents a way to profit from
buying stock?
(a) capital gains
(b) portfolios
(c) speculation
(d) capital losses
Group Critical Thinking Question
Accept, reject, or modify this statement:
“The United States government should allow people to
invest their social security trust fund money in the
Consider the following:
Market has returned 10%+ per year over the past 50
years—even counting recessions
Market soared 50% in early 1990s
Market has lost roughly 20% in last 4 years
Currently social security earns 1-1.5%. Inflation has
been negligible, but June ’02 was 6%.
If people lose retirement money, they’re in trouble!
Should there be age or other restrictions/regulations?
Caps on what you can risk in the market?
A Word about Asset Allocation
The newest idea in the CFP world is “rebalancing.” In other
words, keep your portfolio VALUE at 50% stocks and 50%
bonds. If stocks decline, bonds usually go up. Sell some bonds
and buy more stock, or vice versa.
Stock prices and Bond Yields move in tandem
Higher bond prices=lower yields
This means that stock prices and bond prices move INVERSELY
When one of your assets appreciates considerably, take some
money off the table and move it
Also, if you like a stock, add to your position slowly
Bulls make money, bears make money, hogs get slaughtered
Concluding Thoughts
Where to look for advice?
TV-FOX Business Block, CNBC Mad Money, Fast Money,
Worldwide Exchange, Squawk Box,
Magazines-like Money, Fortune
Websites like, Motley Fool, MSN Money, Yahoo
SEC Website can give you insider trade filings:
Papers: Investor’s Business Daily, Wall St. Journal
Watch the operations of the Fed. Reserve. Rate cut=stocks up
Now, we’ll learn how to read a stock index and a bond index.
Go to page 134 in the supplemental reader.