Financial MarketsChapter 12

Savings. . .and saving? Saving is the absence of spending Savings

Dollars that become available when people abstain from consumption

This is where banks get their capital

The financial system A network of savers, investors, and financial

institutions that work together to transfer savings

Assets Things with worth Certificate of Deposit

Receipt showing that an investor has made an interest-bearing loan to a bank or a government or a corporate bond Economists call these receipts financial assets

because they are worth something (i.e. they have value)

Financial intermediaries Lend funds to borrowers

Insurance funds, pension funds There is a circular flow of funds that

exists to keep the money cycle going

Nonbank Financial Institutions Finance company

Firm that specializes in making loans directly to consumers J.G. Wentworth Loan consolidation places

Life insurance Involves premiums

Price paid to keep a policy Mutual fund

Company that sells stock in itself to individual investors, and then invests the money it receives in stocks and bonds issued by other corporations Receive a dividend earned from the mutual fund’s investments

A dividend is a check given to stockholders representing a portion of profits

Net Asset Value (NAV) Value of the mutual fund divided by the

number of shares issued by the mutual fund

Pension fund Collection of funds to pay out as income

to retired or disabled individuals

Investing

Strategies Risk versus reward

Directly proportional to profit Higher risk = higher profit usually Optimum investment is usually in the middle

Toleration of scenario is key It’s all about your psyche

Safest are US Treasury investments Riskiest are junk bonds

High-yield bonds with a great chance of defaulting

Retirement Retirement accounts are about generating

appreciating value rather than generating income

401(k) Special retirement fund

Tax deferred investment plan that acts as a personal pension fund for employees You don’t pay taxes on money given to a 401(k)

80% of employers match contributions You can roll-over a 401(k) from different jobs

Bonds . . .Barry Bonds (oops) Bonds

Long term obligations that pay a stated rate of interest for a specified number of years

Bonds have three components A Coupon

Interest on the debt Maturity

Life of the bond Par value

Principal or total amount initially borrowed that must be repaid to the lender at maturity

Current yield of the bond Annual interest divided by the purchase price Financial health or credit worthiness is the key

This means that not all bonds are the same

Bond ratings Two companies control bond ratings

Standard and Poor’s Moody’s

Many factors determine bond ratings Health of company Stability Profitability Trends in market

Financial assets and their characteristics

Certificate of Deposit (CD) Long term investment

There is a penalty for early withdrawal Tailor a withdrawal date

College tuition savings is an example Corporate bonds

Larger investment Higher risk at times (equals higher profit) Usually have a B rating

Municipal bonds State and local governments Finance public works Schools

More assets Savings bonds

Issued through the government Slow rate of return on investment

Maturity is usually about 18 years Virtually no risk of default

Treasury items Notes have 2-10 year maturity Bonds have 10-30 year maturity

Safest investment Bill (T-Bill)

Short-term investment Auctioned off at a discounted rate

Individual Retirement Accounts Long-term tax-sheltered time deposits

that an employee can setup as a part of a retirement plan Taxed when you withdraw money

Roth IRA Taxed initially, so money withdrawn is all

after taxes

Markets for Financial Assets Capital market

Money loaned for over a year Long-term CDs and Corporate or Government

Bonds Money market

Money is loaned for less than a year Primary markets

Market where only the original issuer can repurchase or redeem financial assets Government savings bonds and IRAs

Secondary markets Market in which existing financial assets can

be sold to new investors

Investing in Equities, Futures and Options

Equities Stocks that represent ownership shares in a

company Market efficiency

There is a theory that exists that suggests that efficient markets work themselves out

Efficient Market Hypothesis Argument that stocks are always priced about right and

that bargains are hard to find because they are followed so closely by investors

Portfolio diversification Practice of holding a large number of different

stocks so that increases in some can offset decreases in others

Organized Stock Exchanges New York Stock Exchange (NYSE)

Wall Street NYSE has 1400 seats or memberships Yield is the dividend divided by closing price Price to earning ratio or PE ratio is the

stock’s price divided by annual earnings of each share of common stock outstanding

American Stock Exchange Smaller than NYSE

Over-the-Counter Drugs I mean Markets Over-the-counter markets

Securities that are not traded on an organized exchange

National Association of Security Dealers Automated Quotation (NASDAQ)

4,000 companies are traded More than AMEX and NYSE combined

How are we doing? Dow-Jones Industrial Average

Average of thirty active stocks that are the most widely held for the day

Standard and Poor’s 500 Overall market performance

Bull markets are strong Bear markets are mean (bad)

Back to the Future Spot markets

Market in which transactions are made immediately at the prevailing price On-the-spot

Futures contract An agreement to buy or sell at a

predetermined price These are bought at a futures market

What are my options? Options are contracts that provide the right to

purchase or sell commodities or financial assets at some point in the future at a price agreed upon today Call options allow you the ability to buy a share of a

stock at a specified price in the future EX: If I have the right to buy a stock at $70.00

and it goes down $30.00, I can tear up the call option and purchase the stock for $30.00. If the reverse happens, I don’t have to pay more than what the call option notes.

Put options allow you the right to sell a stock at a specified price in the future If I have the right to sell a stock at $50.00 and it

goes down $40.00, I can force the buyer to pay the original $50.00. If the reverse happens, I would tear up the option and sell it at the higher price