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Financial Markets . Chapter 11: Financial Markets. KEY CONCEPT The financial system consists of institutions, such as banks, insurance markets, bond markets, and stock markets, that help transfer funds between savers and investors. . WHY THE CONCEPT MATTERS

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Chapter 11: Financial Markets


  • The financial system consists of institutions, such as banks, insurance markets, bond markets, and stock markets, that help transfer funds between savers and investors.


  • When you open a savings account, you play an important role in our economy. Your savings will be borrowed and invested by businesses and the government. The new products created by these investments help to fuel the nation’s economy.


Savings and Investment

The Financial System


  • Savings—income not used for consumption
  • Investment—use of income now in a way that provides a future benefit

— economic investment: money lent to businesses

— personal investment: individuals putting savings into financial assets

  • Financial system—transfers funds between savers and investors

The Financial System

Bringing Savings and Investment Together

  • People, businesses save funds; receiver issues written confirmation

— confirmation called financial asset, or claim on borrower’s property

  • Financial market—where buyers and sellers exchange assets directly
  • Financial intermediary—collects funds from savers, invests in financial assets

Financial Intermediaries


  • Includes banks, S&Ls, credit unions

— also finance companies, pension funds, life insurance companies

  • Mutual fund—pools individuals’ money to buy range of financial assets

— investors own shares of entire fund


Financial Intermediaries

Example: Banking Financial Intermediaries

  • Provide checking, savings, money market deposit accounts, CDs

— depositors earn interest

— federal government insures deposits up to $100,000

  • Make loans; to make profit charge higher interest than pay depositors
  • Offer uninsured money market mutual funds, stocks, bonds, insurance

Financial Intermediaries

Example: Nonbank Financial Intermediaries

  • Finance companies make small loans to households, small businesses
  • Mutual funds let individuals own many assets; managers make decisions
  • Pension funds invest employees’ money, so will have more at retirement
  • Life insurance companies invest income in financial assets

— let people save by building cash values, protect them against loss


Financial Asset Markets


  • Financial markets categorized according to time, resalability
  • Capital market—for buying and selling long-term financial assets
  • Money market—for buying and selling short-term financial assets
  • Primary market—for financial assets that original buyer must redeem
  • Secondary market—where financial assets are resold

Financial Asset Markets

Factor 1: Time

  • Capital markets—assets held for over a year

— include stocks, bonds, mortgages, long-term CDs

  • Money markets—loans made for less than a year

— include short-term CDs, Treasury bills


Financial Asset Markets

Factor 2: Resalability

  • Primary markets—financial assets can be redeemed only by original buyer

— include savings bonds, small denomination CDs

— also market where first issue of stock sold through investment bankers

  • Secondary markets—resale markets; offer liquidity to investors

— include stocks, bonds


Reviewing Key Concepts

Explain the differences between the terms in each of these pairs:

  • savings and investment
  • capital market and money market
  • primary market and secondary market


Investing in a Market Economy

Why Are You Investing?


  • Personal investing is saving
  • Individual must first determine own investment objective:
  • financial goal investor uses to decide if an investment is appropriate

Why Are You Investing?

Investment Objectives

  • Main considerations: when money will be needed, available income
  • Other issues: need to pay off debts, tax concerns
  • Savings for emergencies should be liquid
  • Long-term investments good for retirement and college
  • Can choose CDs to coincide with timing of savings goals

Mellody Hobson: Investing in the Future

Creating Educated Investors

  • President of Ariel Capital Management, mutual fund company
  • Teaches children, ordinary adults about investing; uses celebrities
  • Developed study on African-American investing; works to promote it
  • Believes more people should participate in stock market

— as financial contributor on ABC, reaches millions with information


Risk and Return


  • Risk—possibility for loss on an investment
  • Return—profit or loss on an investment

— refers to interest paid on savings or increase in value of stock

  • Diversification—investing in different financial assets

— purpose: maximize returns, minimize risk


Risk and Return

What Kind of Risk Are You Willing to Take?

  • Risk usually means loss of part of initial investment, or principal

— no-risk investments: insured savings and CDs, U.S. government bonds

  • Safe investments risk interest rate may not keep up with inflation
  • Return on riskier investments depends on how profitable company is

— bonds less risky than stocks; bondholders paid off first


Risk and Return

What Kind of Return Do You Want?

  • Safe investments have lowest return through fixed interest rates
  • Stocks, bonds—no guaranteed rates; stocks—higher return over time
  • If investing over long period, can risk losses in stock some years

— if less time and money, may want safer investment

  • Diversification gives better chance of offsetting a loss with a gain

Reviewing Key Concepts

Use each of the three terms below in a sentence that illustrates the meaning of the term:

  • investment objective
  • Return
  • diversification


Buying and Selling Stocks

The Stock Market


  • Companies issue stock, sell to investment bankers in primary market

— initial public offering (IPO) is sale that raises money for corporation

  • Stock exchange—secondary market where securities resold and bought

— buyers expect stock price to rise, so they can resell for a profit

  • Capital gains—profit made from sale of stock

The Stock Market

Why Buy Stock?

  • Buy to earn dividends, share of company profits

— investors who want income, want dividends

  • Buy to earn capital gains through resale of stock

— investors who want growth look for potential for capital gains


The Stock Market

Types of Stock

  • Common stock—gives shareholders voting rights, share of profits

— one vote per share owned to elect board of directors

  • Preferred stock—gives shareholders share of profits, no voting rights

— investors get guaranteed dividends, paid off first if company closed

— dividends do not increase if stock increases in value


Trading Stock


  • Most people buy stock to earn capital gains
  • Stock prices determined by demand and supply; influencing factors:

— company profits or losses, technological advances, overall economy

  • Stockbroker—buys and sells securities for customers, earns commission

Trading Stock

Organized Stock Exchanges

  • New York Stock Exchange (NYSE) on Wall Street; oldest, largest in U.S.

— traditionally, each stock auctioned from trading post on exchange floor

— today, hand-held computers used to execute many trades

— 2006 merger with Archipelago Exchange allowed electronic trades

  • American Stock Exchange (AMEX) companies smaller than on the NYSE

Trading Stock

Electronic Markets

  • Over-the-counter (OTC) market for stocks not traded on NYSE or AMEX
  • NASDAQ is centralized computer system for OTC trading

— second largest exchange in world in number of companies, shares traded

— companies from many sectors of U.S. economy, most in technology

  • OTC Bulletin Board is electronic market for smaller companies

Trading Stock

Futures and Options Markets

  • Most investors do not trade futures and options
  • Future—contract to buy, sell on specific future date at preset price
  • Option—contract giving right to buy, sell in future at preset price

— investor pays small fraction of stock’s current price for option


Trading Stock

Recent Developments

  • 1990s regulations allow any firm to trade stocks in any exchange
  • Through electronic communications networks (ECNs), 24-hour trading
  • Investors access Internet; huge growth in online brokerage companies

— lower commissions than traditional brokers

— computer technology matches buyers, sellers automatically; rapid trades


Measuring How Stocks Perform


  • About half of U.S. households own stocks
  • Stock index measures, reports the change in prices of a set of stocks

— measures individual stocks and stock market as a whole


Measuring How Stocks Perform

Stock Indexes

  • U.S. indexes: DJIA, Standard & Poor’s 500, NASDAQ CompositeGlobal indexes: Hang Seng, DAX, Nikkei 225, TSE 300, FTSE 100
  • Since 1896, Dow Jones Industrial Average changed with U.S. economy

— includes most successful companies in most important economic sectors

— uses points to measure changes in prices at which stocks traded


Measuring How Stocks Perform

Tracking the Dow

  • Bull market—prices rise steadily over a relatively long period
  • Bear market—prices decline steadily over a relatively long period
  • 1972 to 2000 longest bull market in history; most last two to three years
  • Dow affected by previous close, Fed, foreign indexes, trade balance
  • About 21 stock markets overseas with over 1,000 large companies each

Reviewing Key Concepts

Explain the relationship between the terms in each of these pairs:

  • stock exchange and stockbroker
  • future and option
  • bear market and bull market


Bonds and Other Financial Instruments

Why Buy Bonds?


  • Bonds issued by companies, governments
  • Par value—amount issuer must pay buyer at maturity
  • Maturity—date when bond is due to be repaid
  • Coupon rate—interest rate bondholder gets every year until maturity

Why Buy Bonds?


  • Investors buy bonds for interest paid and gains made by selling
  • Yield—annual rate of return on a bond
  • If bond sold at par value, yield is same as coupon rate

— if sold for less, yield is higher; if sold for more, yield is lower

  • Bonds with longer maturity dates have higher yields than with shorter

Why Buy Bonds?

Types of Bonds

  • U.S. government issues Treasury bonds, notes, bills; very safe
  • Safety of foreign government bonds depends on the country
  • State, local governments issue bonds; no federal income tax
  • Corporate bonds higher risk than government, pay higher coupon rate

— Junk bonds are high-risk, high-yield corporate bonds


Why Buy Bonds?

Buying Bonds

  • Most buyers want guaranteed interest income; yield is most important
  • Investors who sell before maturity want to make profit

— as market interest rates rise, price of bonds with lower rate falls

  • Main risk to investor is default

— governments, companies get evaluated by credit-rating companies


Other Financial Instruments


  • Certificates of deposit (CDs), money market mutual funds (MMMFs):

— are very low risk; provide interest income

— not generally sold for profit


Other Financial Instruments

Certificates of Deposit

  • CDs offered primarily by banking institutions; have maturity date
  • Pay fixed or variable interest, reinvested for compound interest

— longer maturity dates pay higher interest rates

  • Federal government insures funds up to $100,000
  • Risks: can lose interest, some principal if funds withdrawn early

Other Financial Instruments

Money Market Mutual Funds

  • MMMFs’ financial assets have maturities of one year or less
  • Give higher yield than savings accounts with similar liquidity

— can redeem shares by check, phone, electronic transfer

  • Funds not insured but tightly regulated, so principal considered safe
  • Yield varies based on yield of assets in fund

Reviewing Key Concepts

Use each of the terms below in a sentence that illustrates the meaning of the term:

  • coupon rate
  • Maturity
  • yield

The Rise and Fall of Dot-Coms


  • The Internet provided a new tool for accessing potential buyers. Many new companies, known as dot-coms, quickly appeared.
  • The value of dot-com stock rose quickly as investors were encouraged by the initial success of dot-coms and low interest rates in the 1990s. In 2000 and 2001, dot-com stocks fell and many companies went out of business.

What’s the Issue?

  • Why did so many dot-com companies fail?

The Rise and Fall of Dot-Coms {continued}

Thinking Economically

  • During the dot-com bubble, do you think it was relatively easy or difficult for Internet

start-up companies to raise capital? Why?

  • Why do you think so many dot-coms failed? Explain with evidence.
  • What lessons might investors learn from the information presented in documents A and C?

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