Financial MarketsC H A P T E R

11 SAVING AND INVESTINGSECTION 1

Investment promotes economic growth.Investment is the act of redirectingresources from being used today so thatthey can create future benefits. The

financial system makesinvestment possible by allowingthe transfer of money betweensavers and borrowers. Savers arehouseholds and businesses thatlend out their savings.Borrowers are governments andbusinesses who use the moneythey borrow to build roads, fac-tories, and homes. Borrowers

may also use these funds to develop newproducts or provide new services.

Financial intermediaries are insti-tutions which help channel funds fromsavers to borrowers. Examples includebanks and mutual funds, funds whichpool savings from many people and

invest this money in different ways.Financial intermediaries provide threemajor advantages to investors. Theyreduce risk by helping people invest in avariety of opportunities. The idea ofspreading out investments to reduce riskis called diversification. Financialintermediaries also provide informationand liquidity to investors.

Saving and investing involves trade-offs. For example, savings accounts havevery low risk, and are liquid, but they alsohave a low return. Return is the money,such as interest, an investor receives aboveand beyond the sum of money initiallyinvested. An investment with higher riskor less liquidity usually offers a higherpotential return. Investors will be moretempted to take on more risk, or to give upliquidity, if they have a chance of earningmore money on their investment.

TEXT SUMMARY

46 CHAPTER 11 Guide to the Essentials © Prentice-Hall, Inc.

1. How does a financial system makeinvestment possible?

2. Diagram Skills What are threeexamples of financial intermedi-aries?

REVIEW QUESTIONS

GRAPHIC SUMMARY: Market Supply Curve

The financial system

makes possible the trans-

fer of money between

savers and borrowers.

SAVERSHouseholdsBusinesses

FINANCIAL INTERMEDIARIES

BanksFinance companies

Mutual funds BORROWERSGovernments

Businesses

INVEST IN INVEST IN

Investment, the keyto economic growth,is made possible by afinancial system ofsavers, borrowers,and intermediaries.

T H E BIG I D E A

Bonds are loans that the government ora corporation must repay to an investor.Bonds usually pay a fixed amount ofinterest at regular intervals for a setamount of time. At maturity, the endof that period, the issuer repays the parvalue, or the original amount of invest-ment, to the bondholder.

Investors like bonds because they aregood investments and usually have lowrisk. However, because bonds are low-riskinvestments, their returns are often lessthan those of other investments. Issuerslike bonds because once the bond is soldinterest rates on that bond will not go upor down. However issuers must makefixed interest payments and repay theprincipal when due—even in bad years.

There are several types of bonds.Savings bonds are issued by the United

States government. The United StatesTreasury Department issues treasurybonds, and state and local governmentsand municipalities issue municipalbonds. Interest on government-issuedbonds is exempt from certain taxes.Corporations sell corporate bonds toraise money to expand their businesses.

Other types of financialassets include certificates ofdeposit (CDs) and mutualfunds. Markets for financialassets are often classifiedaccording to the length oftime for which funds arelent. Capital markets aremarkets in which money islent for longer than a year. Money mar-kets are markets in which money is lentfor less than a year.

BONDS AND OTHER

FINANCIAL ASSETS

SECTION 2

TEXT SUMMARY

© Prentice-Hall, Inc. Guide to the Essentials CHAPTER 11 47

1. How is interest on bonds usuallypaid?

2. Chart Skills What is one purposeof junk bonds?

REVIEW QUESTIONS

GRAPHIC SUMMARY: Types of Bonds

Bonds help businesses expand and governments build public works. There are different kinds of bonds to

serve different needs and different kinds of investors.

Corporations and governments borrowmoney by selling bondsand other financialassets.

T H E BIG I D E A

TYPE ISSUER RISK TAX EXEMPTION USED FOR

Savings and U.S. Government Very low Exempt from Federal government Treasury Bonds state and local taxes activities

Municipal State and Low Exempt from income bonds local governments taxes at federal level

and in issuing state

Corporate Corporations Moderate Not tax exempt Expansion of businessesbonds

Junk bonds Corporations High Not tax exempt Finance corporate takeovers

State and local govern-ment activities

THE STOCK MARKETSECTION 3

By selling stock, corporations raise themoney that is necessary to start their busi-nesses and keep them growing. Investors instocks may make a profit in two ways: byreceiving dividends, a payment made by

corporations to stockholders;and by selling the stock for morethan they paid for it. The differ-ence is called a capital gain.However, purchasing stock isrisky. The stock price maydecrease. Investors who sell theirstock for less than they paid for itexperience a capital loss.

Stock is bought and sold inmarkets called stock exchanges. Whenpeople talk about "the stock market" they

usually mean the New York StockExchange (NYSE), the largest in the coun-try. The performance of the NYSE is oftenmeasured by the performance of the fewstocks included in the Dow JonesIndustrial Average, or "The Dow." Whenthe stock market rises steadily over a peri-od of time, a bull market exists. Whenit falls for a period of time, people call it abear market. During the bull market ofthe 1920’s, there was a great amount ofspeculation, high-risk investment withborrowed money in hope of big returns.This period ended in the stock market col-lapse called the "Great Crash" of October1929. Another great bull market occurredin the 1990s.

TEXT SUMMARY

48 CHAPTER 11 Guide to the Essentials © Prentice-Hall, Inc.

1. What is the difference between acapital gain and a capital loss?

2. Graph Skills When did the DowJones Industrial Average reach itslowest point after the Great Crash?

REVIEW QUESTIONS

GRAPHIC SUMMARY: Milestones in the Dow Jones Industrial Average, 1929–1999

The Dow Jones Industrial

Average climbed steadily

since the Great Depression

of the 1930s before rising

sharply in the bull market

of the 1990’s.

Corporations sellstock to investors inorder to raise money.Stocks are traded inmarkets called stockexchanges.

T H E BIG I D E A

11,000

10,000

9,000

8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,000

1930 1940 1950 1960 1970 1980 1990 2000

381Sept. 1929

peak before Great Crash

41June 1932low after

Great Crash

500March 1956

1,000Nov. 1972

2,000Jan. 1987

3,000April 1991

4,000Feb. 1995

6,000Oct. 1996

10,000March 1999

5,000Nov. 1995

8,000July 1997

7,000Feb. 1997

9,000April 1998

11,000July 1999

Do

w J

ones

Ind

ust

rial

Ave

rag

e

YEAR

IDENTIFYING MAIN IDEAS

Write the letter of the correct answer in the blank provided. (10 points each)

____ 1. Investment is the act of

A. depositing money in a savings account.B. redirecting resources from being used

today so they can create future benefits.C. using resources for current needs.D. developing new products.

____ 2. A financial system brings together

A. savers and borrowers.B. savers and consumers.C. banks and mutual funds.D. governments and businesses.

____ 3. The purpose of a financial intermediaryis to help channel funds

A. from one bank to another.B. from saving bonds to building projects.C. from savers to borrowers.D. from stocks to bonds.

____ 4. Which of the following is a reason for diversification?

A. to get the highest possible returnB. to get the most dividendsC. to eliminate riskD. to reduce risk

____ 5. Bonds are

A. loans.B. dividends.C. stocks.D. certificates of deposit.

____ 6. A bond’s par value is generally repaid

A. after 30 years.B. when the lender demands it.C. at maturity.D. when interest rates change.

____ 7. Which of these bonds are issued by the United States government?

A. corporate bondsB. savings bondsC. junk bondsD. municipal bonds

____ 8. Investors who sell stocks for less than they paid for them experience a

A. capital gain.B. capital loss. C. return on investment.D. negative dividend.

____ 9. When the stock market falls over a period of time, it is known as a

A. bear market.B. bull market.C. crash.D. depression.

____ 10. Speculation is

A. low-risk investment with borrowedmoney in hope of small returns.

B. high-risk investment with borrowedmoney in hope of big returns.

C. investment of large amounts of money in mutual funds.

D. diversifying purchases of stockinto many different kinds of companies.

TestC H A P T E R 1 1

© Prentice-Hall, Inc. Guide to the Essentials CHAPTER 11 49

Name _______________________________________________ Class _________________________ Date ___________