Financial MarketsChapter 11

The Financial System Bear Market

Investors generally sell because they are expecting lower profits

Bull Market

Investors usually buy because they are expecting higher profits

Financial Assets

• When savers invest, they receive documents known as financial assets.

Financial intermediaries are institutions that help channel funds from savers to borrowers.

Banks, Savings and Loan AssociationsTake in deposits from savers and then lend some of these funds to various businessesCredit UnionsMember-owned organization to make money for its members, usually considered community-based and more interested in “doing the right thing”

Finance CompaniesMake loans to consumers and small businesses, but charge borrowers higher fees and interest rates to cover possible losses

Mutual FundsPool the savings of many individuals and invest this money in a variety of stocks and bonds – usually diversified with less risk

Life Insurance CompaniesProvide financial protection to the family, or other beneficiaries, of the insured. The premium is usually paid monthly

Pension FundsAre set up by employers who withhold a certain percentage of a workers’ salary to deposit in a fund distribute for payment when the worker retires – usually covers many years

Financial Intermediaries

Investing

• Financial Planning- financial plans include: spending and saving plan, investment plan, retirement plan, estate plan.

Important factors in financial planning

• Budget- list of fixed and flexible expenses.

• Fixed Expenses- remain constant from month to month.

• Flexible Expenses- can vary from month to month.

Your investment Plan• Stocks are pay the highest reward, but have

the greatest risk

• You don’t want to be risking your money as you get older

• The general rule is to subtract your age from 110 to find the percentage of stocks you should have in your portfolio(110 – 30 = 80% or 110 – 55 = 55%)

Stocks Fixed Income Cash Ave return since 1970

Conservative (50 +) 20% 50% 30% 7.9%

Moderate (35-50) 60% 35% 5% 9.8%

High risk (under 35) 95% 0% 5% 10.4%

Risk and ReturnReturn and Liquidity• Savings accounts have

greater liquidity, but in general have a lower rate of return.

• Certificates of deposit usually have a greater return but liquidity is reduced.

• Liquidity is important if you might need quick access to the funds

Return and Risk• Investing in a friend’s

Internet company could double your money, but there is the risk of the company failing.

• In general, the higher potential return of the investment, the greater the risk involved.

Bonds as Financial AssetsBonds are basically loans, or IOUs, that represent debt that the government or a corporation must repay to an investor. Bonds have three basic components:

1. The coupon rate — the interest rate that the issuer will pay the bondholder.

2. The maturity — the time when payment to the bondholder is due.

3. The par value — the amount that an investor pays to purchase the bond and that will be repaid to the investor at maturity.

Not all bonds are held to maturity. Sometimes bonds are traded or sold and their price may change. Economists therefore refer to a bond’s yield, which is the annual rate of return on the bond if the bond were held to maturity.

How Bonds WorkEagle Corporation sells a 4%, 20-year, $1,000 par value bond that pays interest semiannually

The coupon payment to the holder is $20 every 6 months (.04 x 1,000, divided by 2)

When the bond reaches maturity after 20 years the debt is retired and the holder gets the par value of $1,000

Bonds can be compared by using the current yield

(annual interest divided by the purchase price)

Bond RatingsStandard & Poor’s

Highest investment grade

High grade

Upper medium grade

Medium grade

Lower medium grade

Speculative

Vulnerable to default

Subordinated to other debt rated CCC

Subordinated to CC debt

Bond in default

AAA

AA

A

BBB

BB

B

CCC

CC

C

D

Moody’s

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

Aaa

Aa

A

Baa

Ba

B

Caa

Ca

C

D

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.

Advantages and Disadvantages to Bond Issuers

• Bonds are desirable from the issuer’s point of view for two main reasons:1. Once the bond is sold,

the coupon rate for that bond will not go up or down.

2. Unlike stock, bonds are not shares of ownership in a company so they have a very small risk – defaulting is the big risk!

• Bonds also pose two main disadvantages to the issuer: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.

Types of BondsSavings Bonds• Savings bonds are low-denomination ($50 to $10,000) bonds issued by the

United States government. Savings bonds are purchased below par value (a $100 savings bond costs $50 to buy), interest is paid when bond matures.

Treasury Bonds, Bills, and Notes• These investments are issued by the United States Treasury Department.

The absolute least amount of risk!

Municipal Bonds• Municipal bonds are issued by state or local governments to finance such

improvements as highways, state buildings, libraries, and schools.

Corporate Bonds• Issued by a corporation to raise money to expand its business.

Junk Bonds• Junk bonds are lower-rated, potentially higher-paying bonds.

(High Risk!!!).

Other Types of Financial Assets

Certificates of Deposit• Certificates of deposit

(CDs) are available through banks, which use the funds deposited in CDs for a fixed amount of time.

• CDs have various terms of maturity, allowing investors to plan for future financial needs.

Money Market Mutual Funds• Investors receive higher

interest on a money market mutual fund than they would receive from a savings account or a CD. However, assets in money market mutual funds are not FDIC insured.

Mutual Funds

• A mutual fund pools investors’ money.

• The fund puts its investors’ money into the markets on their behalf.

• In effect, investors own small amounts of many different assets - diversified.

• Mutual funds enable investors to avoid risk that comes from owning any one asset. In other words, mutual funds make it easy to diversify.

Roth IRA/401(K)

• A Roth IRA is an Individual Retirement Account that is usually not taxed

• Must be 59.6 years to withdraw tax-free money

• In 2013-14 tax year:0-49 years can contribute - $5,50050+ years can contribute - $6,500

• 401(K) a pension plan in which money is deducted from a paycheck before tax (and sometimes by employer). Tax is not paid until it is withdrawnAnnual pre-tax limit (2013) IS $17,500

Stock ExchangesThe New York Stock Exchange (NYSE)• The NYSE is the country’s largest stock exchange. Only stocks

for the largest and most established companies are traded on the NYSE.

NASDAQ-AMEX• NASDAQ-AMEX is an exchange that specializes in high-tech

and energy stock.

The OTC Market• The OTC market (over-the-counter) is an electronic

marketplace for stock that is not listed or traded on an organized exchange.

Daytrading• Daytraders use computer programs to try and predict minute-

by-minute price changes in hopes of earning a profit.

Stock Exchanges• Every country has a stock exchange• On the NYSE movement is measured by the Dow

Jones Industrial Average (Dow).

How Stocks Are Traded

• Stockbroker is a person who links buyers and sellers of stock.

• Stockbrokers work for brokerage firms, or businesses that specialize in trading stock.

• Speculation involves picking high-risk investments in the hope of a high reward

• Odd lot 1-99 shares

• Portfolio is a collection of financial assets

• Diversification is the key!!!!!

Futures

• Trading of various types of products.

• Ex. wheat, soybeans, oats, corn, steel, coal, gold, silver, diamonds, etc.

• High risk investments.

• Contracts where investors give money today for the promise of a commodity delivered at a later date. Investor hopes that price of the commodity will rise and the contract can be resold for a profit.

Regulating the Market• Congress is the top regulator

• SEC- securities and exchange commission- set up after big stock market crash - 1929 - requires that companies who sell stock must meet rigorous standards - supply detailed information including a prospectus.