chapter 11: financial markets section 1 -...

Chapter 11: Financial MarketsChapter 11: Financial MarketsSection 1Section 1

Key TermsKey Terms

• investment: the act of redirecting resources from being consumed today so that they may create benefits in the future

• financial system: the network of structures and mechanisms that allows the transfer of money between savers and borrowers

• financial asset: a claim on the property or income of a borrower

Key Terms, cont.Key Terms, cont.

• financial intermediary: an institution that helps channel funds from savers to borrowers

• mutual fund: an organization that pools the savings of many individuals and invests this money in a variety of stocks, bonds, and other financial assets

• hedge fund: a private investment organization that employs risky strategies to try to make huge profits for investors

Key Terms, cont.Key Terms, cont.

• diversification: the strategy of spreading out investments to reduce risk

• portfolio: a collection of financial assets• prospectus: an investment report that

provides information to potential investors• return: the money an investor receives

above and beyond the sum of money initially invested

Investing and Free EnterpriseInvesting and Free Enterprise

• Investing is essential to the free enterprise system.– It promotes economic growth and contributes

to a nation’s wealth.– People deposit money into a savings account

and the bank lends this money to businesses.– Businesses can then increase production,

which leads to expansion and growth.

The Financial SystemThe Financial System

• Financial systems are established in an economy so investments can take place.

• When people save money they are really loaning it to other people. – Savers receive a document, such as a

passbook or a bond certificate, that confirms their purchase or deposit.

– These documents represent the claims, or financial assets, of the borrower.

Savers and InvestorsSavers and Investors

• Financial systems bring together savers and investors, or borrowers, which fuels investment and economic growth.– Savers include:

• Households• Individuals• Businesses

– Investors include:• Businesses• Government

Financial IntermediariesFinancial Intermediaries

• Financial intermediaries, including banks and other financial institutions, accept funds from savers to make loans to investors.

Sharing RiskSharing Risk

• Dealing with financial intermediaries offers three advantages:– Sharing risk– Providing information– Providing liquidity

• Sharing risk– Diversification allows you to spread out your

investments so that you don’t put all of your money into one single investment.

– Sharing risk helps ward against losing everything on a bad investment.

Types of RiskTypes of Risk

• Investors must weigh the risks of investment against the potential rate of return on their investment.– How does diversification lessen the risks described in

the chart?

Providing Information and LiquidityProviding Information and Liquidity

• By providing vital data, either in a portfolio or a prospectus, financial intermediaries reduce the costs in time and money that lenders and borrowers would pay if they had to get the information on their own.

• Financial intermediaries also help people get access to their money when they need it, depending on how liquid the investment is.

Return and RiskReturn and Risk

• Some investments, like CDs, are very safe because they are insured by the government.

• Investing in a new business is far riskier, but if the business is a success, the return could be very big.

Return and Risk, cont.Return and Risk, cont.

• In general, the higher the potential return, the riskier the investment.

• Whenever people evaluate their potential investments, they must balance the risks involved with the rewards they expect to gain.

Chapter 11: Financial MarketsChapter 11: Financial MarketsSection 2Section 2

Key TermsKey Terms

• coupon rate: the interest rate that a bond issuer will pay to the bondholder

• maturity: the time at which payment to a bondholder is due

• par value: a bond’s stated value, to be paid to the bondholder at maturity

• yield: the annual rate of return on a bond if the bond is held to maturity

• savings bond: a low-denomination bond issued by the United States government

Key Terms, cont.Key Terms, cont.

• inflation-indexed bond: a bond that protects the investor against inflation by its linkage to an index of inflation

• municipal bond: a bond issued by a state or local government or a municipality to finance a public project

• corporate bond: a bond issued by a corporation to help raise money for an expansion

• junk bond: a bond with high risk and potentially high yield

Key Terms, cont.Key Terms, cont.

• capital market: a market in which money is lent for periods longer than a year

• money market: a market in which money is lent for periods of one year or less

• primary market: a market for selling financial assets that can be redeemed only by the original holder

• secondary market: a market for reselling financial assets

IntroductionIntroduction

• Why are bonds bought and sold?

– Bonds are sold by governments and or corporations to finance projects.

– Bonds offer a higher return than savings accounts, although they are generally riskier than savings accounts.

Bonds as Financial AssetsBonds as Financial Assets

• Bonds are loans that represent debt that the seller must repay to the investor.

• Bonds have three basic components:– Coupon rate - the

interest rate that a bond issuer will pay to a bondholder

– Maturity - the time at which payment to a bondholder is due

– Par value - the amount to be paid to the bondholder at maturity

Discounts From ParDiscounts From Par

• Investors can not only earn money from the interest on their bonds but they can also earn money by buying bonds at a discount, called a discount from par.

Bond Ratings Bond Ratings

• In order to decide which bonds to buy, investors can check bond quality through independent firms, such as Standard & Poor’s and Moody’s, which publish bond issuers’ credit ratings.– These firms rate bonds on the issuer’s

financial strength, its ability to make future interest payments, and its ability to repay the principal when the bond matures.

– A high grade, such as AAA, means that the bond is safe to invest in.

Advantages and DisadvantagesAdvantages and Disadvantages

• Advantages– Once a bond is sold, the coupon rate remains

the same.– The company does not have to share profits with

bondholders if it is doing well.

• Disadvantages– The company must make fixed interest payments and

cannot change its interest payments.– A firm’s bonds may be given a low bond rating and be

harder to sell when the firm is not doing well.

Types of BondsTypes of Bonds

• Savings Bonds– Low-denomination

bonds issued by the U.S. government, who pays interest on the bonds.

• Treasury Bonds, Bills, and Notes– The U.S. Treasury

Department issue Treasury bonds, bills, and notes, which are among the safest investments in terms of default risk.

Which of these three types of government securities is the most liquid?

Municipal BondsMunicipal Bonds

• State and local governments issue municipal bonds to finance such projects as highways, libraries, parks, and schools.

• These are attractive to long-term investments and are relatively safe.

Corporate and Junk BondsCorporate and Junk Bonds

• Corporate bonds are issued by corporation to help raise money to expand business.– These bonds have a

moderate risk level because investors must depend on the corporation’s success.

• Junk bonds are bonds with a high risk and a potentially high return.– Investors in junk bonds

face a strong possibility that some of the issuing firms will default on their debt.

Other Types of Financial AssetsOther Types of Financial Assets

• Certificates of Deposit– CDs are available through banks, which lend

out funds deposited in CDs for a fixed amount of time.

• Money Market Mutual Funds– Investors receive higher interest on a money

market mutual fund than they would on a savings account. These funds, however, are not covered by FDIC insurance.

Financial Asset MarketsFinancial Asset Markets

• Bonds, CDs, and money market mutual funds are traded on 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

• In these markets, money is lent for periods longer than a year, like in a CD.

– Money Markets• In these markets, money is lent for periods of a year or

less and include Treasury bills and money market mutual funds.

Financial Asset Market, cont.Financial Asset Market, cont.

• Markets may also be classified according to whether or not assets can be resold to other buyers.– Primary Markets

• In a primary market, financial assets can be redeemed only by the original holder. Examples include savings bonds and small CDs.

– Secondary Markets• In a secondary market, financial assets can be

resold, which provides liquidity to investors.

Chapter 11: Financial MarketsChapter 11: Financial MarketsSection 3Section 3

Key TermsKey Terms

• share: a portion of stock• capital gain: the difference between the selling

price and purchase price that results in a financial gain for the seller

• capital loss: the difference between the selling price and purchase price that results in a financial loss for the seller

• stock split: the division of each single share of a company’s stock into more than one share

• stockbroker: a person who links buyers and sellers of stock

Key Terms, cont.Key Terms, cont.

• brokerage firm: a business that specializes in trading stocks

• stock exchange: a market for buying and selling stock

• futures: contracts to buy or sell commodities at a particular date in the future at a price specified today

• options: contracts that give investors the right to buy or sell stock and other financial assets at a particular price until a specified future date

• call option: a contract for buying stock at a particular price until a specified future date

Key Terms, cont.Key Terms, cont.

• put option: a contract for selling stock at a particular price until a specified future date

• bull market: a steady rise in the stock market over a period of time

• bear market: a steady drop or stagnation in the stock market over a period of time

• speculation: the practice of making high-risk investments with borrowed money in hopes of getting a big return

IntroductionIntroduction

• How does the stock market work?– Stock, or shares in a company, are bought

and sold on the stock market.– Stock brokers help individuals and businesses

invest their money in the stock market.– Investors can keep track of the stock market

by checking their local paper. When the market is doing well, people see a large return on the initial investment. When it is not doing well, people may lose a great deal of money.

Benefits of Buying StockBenefits of Buying Stock

• In addition to selling bonds, corporations can raise money by selling stock shares in that corporation.

• The benefits of buying stock include:– Dividends—part of the

firm’s profits– Capital gains—selling

the stock for more than you paid for it

Types of StockTypes of Stock

• Stock may be classified by whether or not it pays dividends.– Income stock—provides investors with income by

paying dividends– Growth stock—pays few or no dividends and earnings

are reinvested in the company

Types of Stock, cont.Types of Stock, cont.

• Stock is also classified by whether or not the holder has a voice in the company:– Common stock: These holders are voting

members of the company.– Preferred stock: These holders are nonvoting

members of the company.

• Common stock owners may initiate a stock split when the price of a stock becomes to high.

Risks of Buying StockRisks of Buying Stock

• Buying stock is risky because the dividends are determined by how well a company is doing.

• Because of the laws governing bankruptcy, stocks are riskier than bonds since bondholders are paid before stockholders when a company goes bankrupt.

How Stocks are TradedHow Stocks are Traded

• If you want to buy stock, you would first contact a stockbroker to advise you on which stocks to buy.

• You buy stocks on a secondary market known as a stock exchange.– The New York Stock Exchange is the country’s

largest and most powerful exchange, handling stock and bond transactions for the top companies in the United States and the world.

– The Nasdaq is the second largest securities market and the largest electronic market.

Futures and OptionsFutures and Options

• Futures are contracts to buy or sell commodities at a particular date in the future at a specified price today.

• Similarly, options are contracts that give investors the choice to buy or sell stock and other financial assets.

• Most people who buy stock hold their investment for a significant period of time. – Day traders, on the other hand, trade stocks

daily, which is very risky.

Measuring Stock PerformanceMeasuring Stock Performance

• When the stock market rises steadily over a period of time it is known as a bull market.

• When the stock market falls or stagnates for a significant period it is a bear market.

• The Dow Jones Industrial Average measures stock performance. It represents the average value of a particular set of stocks, and it is reported as a certain number of points.

The Great CrashThe Great Crash

• In the 1920s, the stock market was soaring.– Speculation and buying on margin, however, led to a crash

in the market that crippled the U.S. economy.

• The Dow began steadily dropping in September, 1929. People began to sell their shares and companies couldn’t keep up with it. On October 29, 1929, a record 16.4 million shares were sold and the market crashed.

The AftermathThe Aftermath

• The Crash led to the Great Depression.– Many people lost everything—their homes, their jobs,

and their farms.

• After the Depression, many people saw stocks as risky investments and avoided them.

• By the 1980s, with the development of mutual funds, Americans became more comfortable with stock ownership once again.– The stock market crashed again in 1987 but was able

to recover much faster than in did in 1929.

Scandals & the Stock Market TodayScandals & the Stock Market Today

• By the 1990s, when people began once again to buy more stock, investors started to worry that many companies could not make enough money to justify their high stock prices.

• The Enron scandal and others caused many investors to question how much they knew about the companies they invested in.

• In 2008, the stock market began falling, causing a major economic crisis in the United States once again.