Download - Ch. 11: Financial Markets
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Ch. 11: Financial Markets
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Sec. 1: Savings and Investment
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The Financial System
Savings – Investments – is the use of income today in a
way that allows for a future benefit Economic investment – Personal investment – refers to the act of
individuals putting their savings into financial assets – CDs, stocks, bonds or mutual funds putting money into a savings account you benefit – earn interest others benefit – funds available to lend
Financial system –
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Bringing Savings and Investment Together
Individuals and businesses can save surplus funds in many ways
Savings accounts at commercial banks/S & Ls, certificates of deposit, corporate or govt. bonds, stocks agent receiving funds is a borrower issues savers written confirmation of
transaction Financial asset –
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Bringing Savings and Investment Together Financial market – Financial intermediary – is a financial
institution that collects funds from savers and then invests these funds in loans and other financial assets bring savers, borrowers, and financial
assets together – see figure 11.1
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Financial Intermediaries
Bring savers & investors together One group –
other financial intermediaries – ▪ finance companies – make small loans▪ pension funds – ▪ life insurance companies –
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Financial Intermediaries
Mutual fund – investors own shares of the entire fund
based on the amount invested gather money in different ways &
provide many different financial assets to a variety of investors
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Example: Banking Financial Intermediaries
Includes commercial banks, S & Ls, & credit unions provide checking and
saving accounts - depositors earn interest on both in some cases
most offer CDs & money market deposits accounts that have higher interest rates
federal govt. insures deposits up to $250,000 per depositor in any given bank
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Example: Banking Financial Intermediaries
Lend a portion of their deposits to borrowers banks charge a higher
interest rate to pay back savers & make a profit
if borrower does not pay back loan –
Can also offer other financial assets – federal govt. does not
insure these funds
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Example: Nonbank Financial Intermediaries
Includes – finance companies make loans to
households & small businesses loans generally under $2000 &
paid back in monthly installments with interest
Mutual fund pools money from many personal investors each investor receives shares in
a fund made up of a large # & variety of stocks, bonds, or other financial assets
make it more affordable for individual investors to own a wide variety of financial assets
once investors purchase a share of funds –
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Example: Nonbank Financial Intermediaries
Pension funds allow employees to save money for - then invests pooled
contributions in various financial assets that will increase in value
Life insurance companies allow -
Companies lend or invest some of the income earned from policyholders in a variety of financial assets
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Financial Asset Markets-categorize markets based on 2 factors
TIME – HOW LONG THE LOAN IS FOR Capital market – Money market –
WHETHER THE FINANCIAL ASSETS CAN BE RESOLD
Primary market – Secondary market –
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Factor 1: Time-2 time sensitive market
Capital markets – ex of assets – b/c loans are for longer
periods - money may be invested in projects that require large amounts of capital
building homes, building new factories, financing govt. projects
Money markets - ex of assets – short
term CDs that can be redeemed in a few months & treasury bills (allow govt. to borrow money for short periods)
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Factor 2: Resalability
2 markets based on whether financial assets can be resold
Primary markets are for financial assets that can be redeemed only by the original buyer ex – also refers to market
where the 1st issue of a stock is sold to the public through investment bankers
Secondary markets are resale markets for financial assets offer liquidity to
personal investors investors able to
turn assets into cash relatively quickly
ex –
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Sec. 2: Investing in a Market Economy
Investment objective – *ex –
*goals help -
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Investment Objective
2 issues will help determine which investment will help achieve objective
Time – amount of time influences kind on
investment is most appropriate Income –
leads to other questions: Will income change in the future? Money available for emergencies?
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Need a savings plan that is realistic & flexible enough to adjust to changing circumstances other questions:▪ Do you have outstanding debts?▪ Are you paying taxes on time?
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Paying off debts first step to investing generally –
Tax considerations most important to investors with higher incomes subject to higher tax rates
Saving for emergencies – Saving for vacation –
Long term goals – CDs – timing with major purchases or starting
college bonds from state & local govt. offer tax free
earnings
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Economic Pacesetters: Mellody Hobson: Investing in the Future
Pres. of Ariel Capital Management, LLC – b. April 3, 1969 discovered her career
investing as a college intern
received degree in 1991 & position in marketing department of Ariel Capital Management
In 2000 – became pres. of the company runs an operation with
over $21 billion in assets
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Ariel was first minority owned mutual fund company in the country pioneers programs to teach inter-city kids about investing she give presentations about investing
Developed 1st study of investing by African-Americans & looked for ways to increase participation marketing efforts – events with Chicago Bulls & a stock
picking contest with hip-hop artists In 2000 – became financial contributor to the Good
Morning America show able to reach millions with easy to understand info about
economic matters
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Risk and Return
Risk – Return –
can be interest paid on savings account, CD, or increase in value of stock over time
most saving are insured against a loss – an investments are not
investors try to balance risk & return through diversification
Diversification –
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What Kind of Risk Are You Willing to Take?
LOW RISK Investor & risk –
even if not get a lot – investments that
guarantee no loss of principal: insured savings deposits & CDs
bonds backed by US govt. are considered risk-free
highly unlikely the govt. would not pay back loans
all other investments carry some risk
HIGHER RISK – STOCKS & CORPORATE BONDS – RETURN DEPENDS ON HOW PROFITABLE THE COMPANY IS
Purchase with expectation that value will appreciate but could lose money if
company runs into problems or other econ. factors
investors than may not be able to sell stock for what they paid –
corporate bonds hold similar risk –
bond holders are paid off before stockholders if company has financial problems
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What Kind of Return Do You Want?
With investments – Safest investment –
stocks & bonds are not guaranteed and returns vary at different time
depends on economy as a whole, how well the company is performing
do have a higher return over time then other investments
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What Kind of Return Do You Want? Risks & returns are
directly related – investors want highest
return possible – time & income
become important Investing for
retirement in 20-30 years – less time and lower
income will be less risky
Diversification is best way to minimum risk and maximize return ex – 70% in stocks, 20%
in bonds, 10% in CDs – retirement investing
better chance of off-setting losses from one investment with gains from another
Mutual funds help small investors diversify their investments
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Sec. 3: Buying and Selling Stocks
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The Stock Market
Company 1st issues stock – sold to investment bankers in the primary market called an initial public offer (IPO) – stock then resold to investors through a stock
exchange Stock exchange –
most buy stock as financial investment with expectation that price will rise then they will be able to resell for a profit
Capital gains –
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Why Buy Stock?
Investor buy stock for 2 reasons: 1. To earn dividend payments – 2. Earn capital gains by selling the stock
at a price greater than the purchase price▪ if sold below buying price – ▪ if investor wants income – ▪ if investor wants to see investment grow –
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Why Buy Stock?
Investing in stocks carries higher risk – corporations not required to pay
dividends – no guarantee that stock price will be
higher when investor wants to sell
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Types of Stock-2 types of stock –
COMMON STOCK –
Both types give ownership in corporation – can receive dividends
Holders of common get one vote per share owned to elect board of directors
PREFERRED STOCK –
Holders of preferred receive guaranteed dividends & paid before common stockholders is company is liquidated
Holders of preferred have no voting rights & dividends do not increase if stock increases in value
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Trading Stock
Most invest in stock with goal of earning capital gains when they sell it stock prices determined by supply & demand things affecting stock prices:▪ company profit or losses▪ technological advances that affect company or
industry▪ overall state of economy
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Trading Stock If investor perceive that company value will
increase – demand for stock ↑ & price ↑ as price rises – few companies sell directly to an investor
Stockbroker – also called brokers generally work for brokerage
firms interact with customers in person, phone or
online job – buy & sell on a variety of stock exchanges
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Organized Stock Exchanges
New York Stock Exchange (NYSE) – located on Wall Street in NY City – about 1.5 billion shares of 2,800 of largest
companies in US traded each day brokerage firms pay for privilege of being one
of 1,336 members of exchange Smaller American Stock Exchange (AMEX)
located in NYC trading structure similar to NYSE –
2006 – introduced practice to combine floor & electronic trading
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Organized Stock Exchanges Traditionally trading organized in auction format
each stock had specific location of trading post on the floor Specialist representing that stock ran the auction to
match buyers & sellers though open bidding to determine the price of shares prices vary from minute to minute as auction continues
through the day since 1996 – floor trades use hand held computers to
execute trades more than half of order to buy & sell are done electronically
2006 – NYSE merged with Archipelago Exchange(electronic trading company) – to speed up transactions & trade stocks in electronic markets
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Electronic Markets
Over-the-counter (OTC) – 1970 – National Association of Securities Dealers
(NASD) introduce centralized computer system that allows OTC traders around the country to make trades at best prices possible automated quote system called NASDAQ
2005 – companies covers many sectors – but most are
technology NASD also regulates OTC Bulletin Board as an
electronic market for trading shares in companies too small to be traded on NASDAQ
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Futures and Options Markets
Complicated and high risk investments that involve trying to predict the future
Future – investor who wants to buy in futures wants to
lock in a low price investor who wants to sell in futures wants to
lock in a high price Option –
the investor pays a small fraction of a stock’s current price for the option to buy or sell the stock at a better price in the future
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Recent Developments
Late 1990s – stocks listed on any exchange available to any
trading firm growth of electronic communication networks (ECN)
increased electronic stock trading trading now takes place 24 hrs a day – not just when
the exchanges are open many investors have internet access and are more
knowledgeable about trading▪ huge growth in online brokerages▪ investors can trade at any time and pay lower commissions▪ combines rapid trades and best possible prices
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Measuring How Stocks Perform
About half of all US households now own stock
Stock index – an instrument used to measure and report change in prices of a set of stocks
Measure the performance – of many individual stocks & the stock market as a whole
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Stock Indexes - each index measures the performance of a different group of stocks
PROVIDE A SNAPSHOT OF HOW THE STOCK MARKET IS PERFORMING The Dow –
Standard & Poor’s 500 –
The NASDAQ Composite
GLOBAL STOCK INDEXES – Hang Seng Index –
Hong Kong
The DAX –
Nikkei 225 – Japan
TSE 300 –
FTSE 100 – Britain
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THE DOW JONES COMPANY
Publisher of Wall Street Journal – 1st published the DJIA in 1896 only had 12 companies and
reflected agriculture & mining Since 1928 – the Dow has
included 30 companies – General Electric is only 1 of original companies left
US economy has changed from agriculture to industry to service – companies in the index change to reflect the most successful companies in most important sectors called blue chip stocks
THE DJIA IS A PRICE INDEX Measures changes in the
prices at which stocks are traded original DJIA was the actual
average of the prices of the 12 stocks
Now – the average is weighted so the higher priced stocks have more influence on the average the # quoted is not a price
– but an average measured in points not dollars
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Tracking the Dow
Changes in the Dow reflect trends in stock market prices
Bull market – Bear market –
track the market to determine if market is trending toward bull or bear
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THE 1ST DJIA MEASURE WAS 40.94 In 1972 it reached 1,000
for the 1st time In May 1999 – it topped
11,000 for the 1st time – topped out at 11,722.98 on Jan 14, 2000 – ended longest bull market in history during the 1990s – market
climbed from 2,800 to its peak most bull markets last 2 or 3
years
WELL KNOWN BEAR MARKET FOLLOWED THE STOCK MARKET CRASH OF 1929
During the 20s – the Dow rose from 60 to 381.17 in month after Oct 29,
1929 – dropped to a low of just under 199
next closing price of 400 was Dec. 29, 1954
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Sec. 4: Bonds and Other Financial Instruments
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Why Buy Bonds?
Bond – govt. can also issue bonds
Par value – the amount that the bond issuer promises to pay the buyer at maturity
Maturity – Coupon rate – is the interest rate a
bondholder receives every year until a bond matures
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2 reasons to invest in bonds – 1. 2.
Most people buy bonds for the interest bonds considered less risky b/c holders
are paid before stockholder
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Yield – important to determine this when deciding
whether to buy or sell▪ if sold at par value – ▪ if sold for less than par value – yield higher than
coupon rate▪ if demand strong & price is higher than par value –
Generally – why? – more uncertainty and risk involved
with repayment dates that are farther in the future
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Type of Bonds
Many different kinds of bonds like stocks – higher the risk – classified by who issues the bonds
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US Govt. issues securities called
Treasury bonds, notes or bills
money borrowed through this helps keep the govt. running
.
risk of international bonds depends on financial strength of that particular govt.
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Treasury bonds –
Treasury bills –
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State and local govt. issue
municipal bondsfinance govt. projects – construction of roads,
bridges, schools…
interest earned on many municipal bonds not subject
to federal income tax
why? – state & local govt. collect taxes so will be able to pay interest and repay the buyer upon maturity
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Companies finance
expansion by issuing
corporate bondspay higher
coupon rate than govt.
bonds b/c risk is higher
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Junk bond – is considered high risk but has the
potential for high yield
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Buying Bonds
Need to determine reason for buying to know which type to purchase
Most investors want the guaranteed interest income yield most important to these investors coupon rate and price relative to par value
will determine yield if want to sell bonds before maturity –
study bond market to see if can sell for profit
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Buying Bonds
Market interest rate are important to bond investors inverse relationship between price of
existing bonds & interest rates▪ if interest rates ↑, ▪ if interest rates ↓,
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Buying Bonds
Main risk faced by bond purchaser is the issuer will default level of risk is directly tied to the
financial strength of the bond issuer When govt. or corp. want to issue
bonds – investor than have standard to judge the
risk of the bonds
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Buying Bonds
Systems of bond ratings: 1. Standard & Poor’s 2. Moody’s▪ use a system of letters to designate relative
credit risk of bonds See figure 11.11
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Other Financial Instruments
Other options –
Both have very low risk & provide income in the form of interest
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Certificates of Deposit
Form of time deposit offered primarily by banks, S & Ls and credit unions have a maturity date - issuer pays either a fixed or variable interest
during period CD is held usually interest is reinvested in CD so investor
gets compound interest CD with longer maturity date get higher
interest rates▪ ex – 6 month CD – 3.4%▪ ex – 5 year CD – 4.4%
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Federal govt. insures funds deposited in CDs at most banks & credit unions up to $100,000 per depositor in any given institution main risk – might face interest rate risk it rates rise
and funds are locked for a length of time at a lower rate
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Money Market Mutual Funds
Money market involves financial assets with maturities of 1 yr or less mutual funds allow investors to buy
shares that represent an investment in all the financial assets held by the fund
money market mutual funds (MMMF) – ▪ ex –
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Money Market Mutual Funds
Give investors a higher yield than banks saving accounts – but similar level of liquidity can redeem shares by check, phone or electronic
transfer to a separate checking account federal govt. does not insure MMMFs – funds are
tightly regulated▪ considered quite safe with regard to loss of principal
Less interest rate risk than with CDs b/c money is not committed for a specific length of time yield varies based on the yield of the assets in the
fund