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Understanding Financial Markets: Key Concepts, Debt, Deficit, and Market Dynamics

This lecture explores essential financial concepts including financial literacy and numeracy, and how they apply to the U.S. economy. Students learn to differentiate between primary and secondary markets, the significance of stocks versus flows versus trades, and understand the U.S. federal debt versus deficit dynamics. Key topics include the valuation of investments, market capitalization, and the mechanics of stock and bond markets. By connecting theoretical knowledge with real-world examples, this lecture equips students with the necessary tools to navigate the financial landscape confidently.

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Understanding Financial Markets: Key Concepts, Debt, Deficit, and Market Dynamics

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  1. Financial Markets Overview IEMS 326

  2. Why this Lecture? • Goals: • financial literacy • financial numeracy • Will this be on the exam? • Yes. • Know definitions • Primary vs. Secondary markets • Stocks vs. Flows vs. Trades • Know orders of magnitude, relative sizes. • Market functions

  3. Debt versus Budget • What’s bigger, the debt or deficit of the US? • U.S. federal debt: over $11T • U.S. federal deficit 2009: about $1½T • In general, distinguish among 3 things: • stocks—e.g. how much has been invested? • flows—an increase or decrease in stocks • trades—exchanges of ownership • (may not affect the real economy)

  4. Debt, Deficit, Bonds • The U.S. federal debt is a… • stock—total amount borrowed • The U.S. federal deficit is a… • flow—this year’s increase in the debt • When I buy a U.S. Treasury bond, it’s a… • trade—if I buy it from you • flow—if I buy it from the U.S. Treasury

  5. Budgets • The U.S. federal budget is… • about $3T • about twice the U.S. federal deficit • about $10K per person (population ~300M) • Illinois has population ~13M and its state budget is… • about $50B • about $4K per person

  6. Budgets • The City of Evanston’s budget is… • $191M • about $2.5K per person (population ~75K) • Northwestern’s budget is… • $1.6B • about $100K per student (~16K students)

  7. Values of Investments • What’s worth more, American Airlines or Northwestern’s endowment? • Our endowment: about $6B (~$400K/student) • American Airlines (AMR): • market capitalization $2.1B • = (# shares of stock)*(price of a share) • = 333M shares * $6.33/share

  8. Shareholding and Market Cap • If I buy 333 shares of American Airlines… • a trade on the NYSE stock exchange • …I’ll own 1 millionth of the corporation • If NU tries to buy all 333M shares… • the price would probably go up • Market capitalization: valuation of the whole company based on small trades now.

  9. Typical share prices • From $1 to $100s • Not too low… • (penny stocks) • …or too high! • Berkshire Hathaway

  10. How to make money in stocks • buy low • sell high • …or collect dividends • When the share price goes up, (trade) • the company is more expensive • shareholders are happy • real economy vs. financial trades

  11. Primary&Secondary Equity Market • primary equity market: (flow) • e.g. initial public offering (IPO) • Google issued new shares • sold them to investors for $30B • invested $30B in cool stuff • secondary equity market (exchanges): (trade) • $36.6T total • shares and $$ change hands • brokers get ¢ (~0.1% of value)

  12. Bond Market • primary bond market: • U.S. Treasury or G.E. borrows money by issuing bonds to investors • secondary bond market: • bonds and $$$ change hands • brokers get $ (1-2% value) • trades: $1T/day

  13. Global Bond Market • $80T oustanding • (stock) • about $13K/person

  14. Foreign Exchange Market • currency: trade $ for euros • open 24/7 • trades: about $3T/day • about $500/person/day • about $200K/person/year • purposes: • international trade • hedging • speculation

  15. Foreign Exchange Market

  16. Commodities Markets • spot vs. futures • exchanges: • CME/CBoT • NYMEX, etc. • pork bellies • 20 tons, frozen • physical delivery • hedging, speculation

  17. Derivatives

  18. Backup slides

  19. How companies make money • successful business projects… • create positive earnings • increase book value • make it possible to pay higher dividends • real economy vs. financial trades

  20. Bonds issued

  21. Nationality of bond issuer

  22. Nationality of bond holder

  23. Government Bonds

  24. Bond market

  25. Foreign Exchange Market: What?

  26. Foreign Exchange Market: Where?

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