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.
Businesses can borrow savings to:
produce new goods and services
build new plants and equipment
create more jobs
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.
can provide funds directly to the borrower (govt./business)
Stocks, bonds – financial assets in the hands of the lenders.
Financial intermediaries (“lying between”)
Institutions that collect and channel funds from savers to borrowers.
Borrowers use the funds to:
Invest in capital equipment
Hire and train workforce
Benefits of capital formation:
Don’t have to find borrowers
“Guaranteed” rate of return (FDIC)
Benefits of capital formation:
Don’t have to find lenders
Economies of scale
Reduced time and expense
Non-bank financial intermediaries
Pooled loan capital
Life Insurance companies (e.g. MetLife)
Pension Funds (e.g. MD State Retirement and Pension System)– set aside assets which must be invested.
Non-financial intermediaries (contd.)
Finance company (e.g. Ford Motor Credit)
“Can’t beat the market.”
11% historical average
Magic of compounding (1¢ or $5 million)
Credit Default Swaps
“The degree to which the outcome is uncertain, but a probable outcome can be estimated.
Rainy Day Fund
House Down payment
Prime commercial paper
U.S. Treasury bills
Long-term financing instruments that pay principle and interest.
Par (face) value
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
Bonds are rated by:
Standard and Poor’s (S&P)
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.
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%
CDs – issued by banking entities
Varying maturities, “penalty for early withdrawal”
$1000 – 10,000
Easily liquidated in the market
Municipal bonds (“munis”):
Government repays easily since it can tax
Easier and cheaper for the issuer to borrow
U.S. Savings Bonds:
$50 - $10,000
50% discount from face value
Accrued interest collected upon redemption
Easy to obtain
1, 3, 6 month maturities
Discounted like savings bond
T-notes – 2-10 year maturities
T-bonds – 10-30 year maturities
IRAs – long-term, tax sheltered
Various investment amounts
Reduced taxable income
Interest earned tax deferred
Value of a share of stock depends on:
Outstanding number of shares
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
Share of stock in a portfolio of stocks
Managed by experts
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.
DJIA (“the Dow”) – 30 major corps.
S&P 500 – 500 representative stocks
NASDAQ – tracks all the stocks traded on this exchange (about 3300).
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.
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).