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Financial Markets. Businesses can borrow savings to: produce new goods and services build new plants and equipment create more jobs. Financial Markets. Financial Asset: Legal claim on the property and income of the borrower.

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financial markets

Financial Markets

Businesses can borrow savings to:

produce new goods and services

build new plants and equipment

create more jobs

financial markets1

Financial Markets

Financial Asset:

Legal claim on the property and income of the borrower.

e.g. certificate of deposit – a piece of paper that says, “ABC Bank has my $1000 and promises to repay me on this date.”

I (lender) have provided ABC Bank with funds that they can loan.

My CD is a claim on the property/income of the bank for that $1000.

financial markets2

Financial Markets

Lenders (businesses/individuals):

can provide funds directly to the borrower (govt./business)

Stocks, bonds – financial assets in the hands of the lenders.

financial markets3

Financial Markets

Financial intermediaries (“lying between”)

Institutions that collect and channel funds from savers to borrowers.

Borrowers use the funds to:

Invest in capital equipment

Build plant

Hire and train workforce

financial markets4

Financial Markets

Benefits of capital formation:

Lenders:

Don’t have to find borrowers

Liquidity

Less risk

Credit underwriting

Pooled portfolio

“Guaranteed” rate of return (FDIC)

financial markets5

Financial Markets

Benefits of capital formation:

Borrowers:

Don’t have to find lenders

Economies of scale

Reduced time and expense

Ready capital

financial markets6

Financial Markets

Non-bank financial intermediaries

Pooled loan capital

Life Insurance companies (e.g. MetLife)

Collect premiums

Long-term finance

Pension Funds (e.g. MD State Retirement and Pension System)– set aside assets which must be invested.

financial markets7

Financial Markets

Non-financial intermediaries (contd.)

Finance company (e.g. Ford Motor Credit)

Nontraditional loans

Installment contracts

financial markets8

Financial Markets

Investment Considerations:

Consistency:

“Can’t beat the market.”

11% historical average

Magic of compounding (1¢ or $5 million)

financial markets9

Financial Markets

Investment Considerations:

Simplicity:

KISS

Credit Default Swaps

financial markets10

Financial Markets

Investment Considerations:

Risk:

“The degree to which the outcome is uncertain, but a probable outcome can be estimated.

financial markets11

Financial Markets

Investment Considerations:

Objective:

Rainy Day Fund

House Down payment

College Tuition

Retirement

financial markets12

Financial Markets

Junk bonds

Speculative stock

Debt Instruments

Common stock

Preferred stock

Investment-grade bonds

Prime commercial paper

U.S. Treasury bills

financial assets

Financial Assets

Bonds:

Long-term financing instruments that pay principle and interest.

Coupon rate

Maturity

Par (face) value

financial assets1

Financial Assets

Bond prices change when:

Market interest rates change:

Ex: You hold a 10-yr. bond paying 7.5%, but market rates have declined to 5.5%;

Investors will pay a premium to own the higher yielding bond.

Company’s ability to repay changes

financial assets2

Financial Assets

Bonds are rated by:

Standard and Poor’s (S&P)

Moody’s

Determine the basic financial health of the issuer.

Ratings range from AAA (highest quality) to D (junk).

Investment grade bonds are rated BBB and above.

financial assets3

Financial Assets

Bond yield (rate of return) – seller wants to profit from market price:

Coupon rate ÷ market price

Ex: $60 ÷ 950 = 6.32%

$60 ÷ 850 = 7.01%

$60 ÷ 1100 = 5.45%

financial assets4

Financial Assets

Bond Types:

CDs – issued by banking entities

$500- 1000

Varying maturities, “penalty for early withdrawal”

FDIC insured

Taxable income

financial assets5

Financial Assets

Corporate bonds:

$1000 – 10,000

Long-term investment

Easily liquidated in the market

Taxable income

financial assets6

Financial Assets

Municipal bonds (“munis”):

Low-risk “borrower”

Government repays easily since it can tax

Tax-exempt interest

Easier and cheaper for the issuer to borrow

financial assets7

Financial Assets

U.S. Savings Bonds:

$50 - $10,000

50% discount from face value

Accrued interest collected upon redemption

Easy to obtain

“No” risk

financial assets8

Financial Assets

Treasuries:

T-bills:

1, 3, 6 month maturities

Discounted like savings bond

T-notes – 2-10 year maturities

T-bonds – 10-30 year maturities

financial assets9

Financial Assets

IRAs – long-term, tax sheltered

Various investment amounts

Reduced taxable income

Interest earned tax deferred

equities and options

Equities and Options

Value of a share of stock depends on:

Outstanding number of shares

Company profitability

Market expectations

equities and options1

Equities and Options

The market is infinitely efficient:

Efficient Market Hypothesis (EMH) – there are no bargain-priced stocks.

Portfolio diversification – “win some, lose some”:

401 (k), 403 (b) –tax-deferred income

Lowers taxable personal income taxes

Usually employer-matched

Mutual funds

Share of stock in a portfolio of stocks

Managed by experts

equities and options2

Equities and Options

Trading – 3 markets:

NYSE – largest and most profitable corps.

AMEX – smaller corps. offering more speculative stocks

NASDAQ (OTC) – all stocks not traded on the other two organized exchanges.

equities and options3

Equities and Options

Measurement:

DJIA (“the Dow”) – 30 major corps.

S&P 500 – 500 representative stocks

NASDAQ – tracks all the stocks traded on this exchange (about 3300).

equities and options4

Equities and Options

Futures:

different from “spot” trades

An agreement to buy or sell at a future date for a specific price

Ex: On 1/1/10, buy a 7/1/10 gold contract for $600/oz.

I expect gold to rise to $800/oz.

On 7/1/10, I buy $600 worth of gold from contract buyer and sell for $800.

Advantage: I keep $600 for six months.

equities and options5

Equities and Options

Options – suppose you are not sure about the movement of commodity prices:

Call option – the right to buy at a future price

Put option – the right to sell at a future price

Ex: I expect gold to rise to $800/oz. If it doesn’t, I tear up the contract.

Used by industries that want to lock in commodity price (e.g. oil, lumber).