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Financial Markets
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Chapter 11: Financial Markets
KEY CONCEPT• The financial system consists of institutions, such as banks,
insurance markets, bond markets, and stock markets, that help transfer funds between savers and investors.
WHY THE CONCEPT MATTERS• When you open a savings account, you play an important role in our
economy. Your savings will be borrowed and invested by businesses and the government. The new products created by these investments help to fuel the nation’s economy.
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The Financial SystemKEY CONCEPTS
• Savings—income not used for consumption• Investment—use of income now in a way that provides a future
benefit– economic investment: money lent to businesses– personal investment: individuals putting savings into financial
assets• Financial system—transfers funds between savers and investors
Savings and Investment
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The Financial System
Bringing Savings and Investment Together • People, businesses save funds; receiver issues written confirmation
– confirmation called financial asset, or claim on borrower’s property • Financial market—where buyers and sellers exchange assets
directly • Financial intermediary—collects funds from savers, invests in
financial assets
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Financial Intermediaries
KEY CONCEPTS• Includes banks, S&Ls, credit unions
– also finance companies, pension funds, life insurance companies• Mutual fund—pools individuals’ money to buy range of financial
assets – investors own shares of entire fund
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Financial Intermediaries
Example: Banking Financial Intermediaries• Provide checking, savings, money market deposit accounts, CDs
– depositors earn interest– federal government insures deposits up to $100,000
• Make loans; to make profit charge higher interest than pay depositors• Offer uninsured money market mutual funds, stocks, bonds,
insurance
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Financial Intermediaries
Example: Nonbank Financial Intermediaries• Finance companies make small loans to households, small
businesses• Mutual funds let individuals own many assets; managers make
decisions• Pension funds invest employees’ money, so will have more at
retirement• Life insurance companies invest income in financial assets
– let people save by building cash values, protect them against loss
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Financial Asset Markets
KEY CONCEPTS• Financial markets categorized according to time, resalability• Capital market—for buying and selling long-term financial assets • Money market—for buying and selling short-term financial assets • Primary market—for financial assets that original buyer must redeem • Secondary market—where financial assets are resold
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Financial Asset Markets
Factor 1: Time• Capital markets—assets held for over a year
– include stocks, bonds, mortgages, long-term CDs• Money markets—loans made for less than a year
– include short-term CDs, Treasury bills
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Financial Asset Markets
Factor 2: Resalability• Primary markets—financial assets can be redeemed only by original
buyer– include savings bonds, small denomination CDs– also market where first issue of stock sold through investment
bankers• Secondary markets—resale markets; offer liquidity to investors
– include stocks, bonds
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Reviewing Key Concepts
Explain the differences between the terms in each of these pairs:
• savings and investment• capital market and money market• primary market and secondary market
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Why Are You Investing?KEY CONCEPTS
• Personal investing is saving• Individual must first determine own investment objective: • financial goal investor uses to decide if an investment is appropriate
Investing in a Market Economy
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Why Are You Investing?
Investment Objectives • Main considerations: when money will be needed, available income• Other issues: need to pay off debts, tax concerns• Savings for emergencies should be liquid• Long-term investments good for retirement and college• Can choose CDs to coincide with timing of savings goals
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Mellody Hobson: Investing in the Future
Creating Educated Investors • President of Ariel Capital Management, mutual fund company• Teaches children, ordinary adults about investing; uses celebrities • Developed study on African-American investing; works to promote it• Believes more people should participate in stock market
– as financial contributor on ABC, reaches millions with information
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Risk and Return
KEY CONCEPTS• Risk—possibility for loss on an investment• Return—profit or loss on an investment
– refers to interest paid on savings or increase in value of stock• Diversification—investing in different financial assets
– purpose: maximize returns, minimize risk
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Risk and Return
What Kind of Risk Are You Willing to Take?• Risk usually means loss of part of initial investment, or principal
– no-risk investments: insured savings and CDs, U.S. government bonds
• Safe investments risk interest rate may not keep up with inflation• Return on riskier investments depends on how profitable company is
– bonds less risky than stocks; bondholders paid off first
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Risk and Return
What Kind of Return Do You Want?• Safe investments have lowest return through fixed interest rates• Stocks, bonds—no guaranteed rates; stocks—higher return over time• If investing over long period, can risk losses in stock some years
– if less time and money, may want safer investment• Diversification gives better chance of offsetting a loss with a gain
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Reviewing Key Concepts
Use each of the three terms below in a sentence that illustrates the meaning of the term:
• investment objective• Return• diversification
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The Stock MarketKEY CONCEPTS
• Companies issue stock, sell to investment bankers in primary market– initial public offering (IPO) is sale that raises money for corporation
• Stock exchange—secondary market where securities resold and bought– buyers expect stock price to rise, so they can resell for a profit
• Capital gains—profit made from sale of stock
Buying and Selling Stocks
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The Stock Market
Why Buy Stock?• Buy to earn dividends, share of company profits
– investors who want income, want dividends• Buy to earn capital gains through resale of stock
– investors who want growth look for potential for capital gains
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The Stock Market
Types of Stock • Common stock—gives shareholders voting rights, share of profits
– one vote per share owned to elect board of directors• Preferred stock—gives shareholders share of profits, no voting rights
– investors get guaranteed dividends, paid off first if company
closed– dividends do not increase if stock increases in value
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Trading Stock
KEY CONCEPTS• Most people buy stock to earn capital gains• Stock prices determined by demand and supply; influencing factors:
– company profits or losses, technological advances, overall economy
• Stockbroker—buys and sells securities for customers, earns commission
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Trading Stock
Organized Stock Exchanges• New York Stock Exchange (NYSE) on Wall Street; oldest, largest in
U.S.– traditionally, each stock auctioned from trading post on exchange
floor– today, hand-held computers used to execute many trades– 2006 merger with Archipelago Exchange allowed electronic trades
• American Stock Exchange (AMEX) companies smaller than on the NYSE
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Trading Stock
Electronic Markets• Over-the-counter (OTC) market for stocks not traded on NYSE or
AMEX• NASDAQ is centralized computer system for OTC trading
– second largest exchange in world in number of companies, shares traded
– companies from many sectors of U.S. economy, most in technology
• OTC Bulletin Board is electronic market for smaller companies
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Trading Stock
Futures and Options Markets• Most investors do not trade futures and options• Future—contract to buy, sell on specific future date at preset price• Option—contract giving right to buy, sell in future at preset price
– investor pays small fraction of stock’s current price for option
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Trading Stock
Recent Developments• 1990s regulations allow any firm to trade stocks in any exchange • Through electronic communications networks (ECNs), 24-hour
trading• Investors access Internet; huge growth in online brokerage
companies– lower commissions than traditional brokers– computer technology matches buyers, sellers automatically; rapid
trades
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Measuring How Stocks Perform
KEY CONCEPTS• About half of U.S. households own stocks• Stock index measures, reports the change in prices of a set of stocks
– measures individual stocks and stock market as a whole
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Measuring How Stocks Perform
Stock Indexes• U.S. indexes: DJIA, Standard & Poor’s 500, NASDAQ Composite
Global indexes: Hang Seng, DAX, Nikkei 225, TSE 300, FTSE 100• Since 1896, Dow Jones Industrial Average changed with U.S.
economy – includes most successful companies in most important economic
sectors– uses points to measure changes in prices at which stocks traded
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Measuring How Stocks Perform
Tracking the Dow• Bull market—prices rise steadily over a relatively long period • Bear market—prices decline steadily over a relatively long period • 1972 to 2000 longest bull market in history; most last two to three
years• Dow affected by previous close, Fed, foreign indexes, trade balance• About 21 stock markets overseas with over 1,000 large companies
each
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Reviewing Key Concepts
Explain the relationship between the terms in each of these pairs:
• stock exchange and stockbroker• future and option• bear market and bull market
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Why Buy Bonds?KEY CONCEPTS
• Bonds issued by companies, governments• Par value—amount issuer must pay buyer at maturity • Maturity—date when bond is due to be repaid • Coupon rate—interest rate bondholder gets every year until maturity
Bonds and Other Financial Instruments
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Why Buy Bonds?
KEY CONCEPTS• Investors buy bonds for interest paid and gains made by selling • Yield—annual rate of return on a bond • If bond sold at par value, yield is same as coupon rate
– if sold for less, yield is higher; if sold for more, yield is lower • Bonds with longer maturity dates have higher yields than with shorter
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Why Buy Bonds?
Types of Bonds • U.S. government issues Treasury bonds, notes, bills; very safe• Safety of foreign government bonds depends on the country• State, local governments issue bonds; no federal income tax• Corporate bonds higher risk than government, pay higher coupon
rate – Junk bonds are high-risk, high-yield corporate bonds
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Why Buy Bonds?
Buying Bonds • Most buyers want guaranteed interest income; yield is most important• Investors who sell before maturity want to make profit
– as market interest rates rise, price of bonds with lower rate falls• Main risk to investor is default
– governments, companies get evaluated by credit-rating companies
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Other Financial Instruments
KEY CONCEPTS• Certificates of deposit (CDs), money market mutual funds (MMMFs):
– are very low risk; provide interest income– not generally sold for profit
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Other Financial Instruments
Certificates of Deposit• CDs offered primarily by banking institutions; have maturity date• Pay fixed or variable interest, reinvested for compound interest
– longer maturity dates pay higher interest rates• Federal government insures funds up to $100,000• Risks: can lose interest, some principal if funds withdrawn early
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Other Financial Instruments
Money Market Mutual Funds• MMMFs’ financial assets have maturities of one year or less • Give higher yield than savings accounts with similar liquidity
– can redeem shares by check, phone, electronic transfer• Funds not insured but tightly regulated, so principal considered safe• Yield varies based on yield of assets in fund
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Reviewing Key Concepts
Use each of the terms below in a sentence that illustrates the meaning of the term:
• coupon rate• Maturity• yield
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The Rise and Fall of Dot-Coms
Background• The Internet provided a new tool for accessing potential buyers. Many new
companies, known as dot-coms, quickly appeared.• The value of dot-com stock rose quickly as investors were encouraged by the
initial success of dot-coms and low interest rates in the 1990s. In 2000 and 2001, dot-com stocks fell and many companies went out of business.
What’s the Issue• Why did so many dot-com companies fail?
Thinking Economically• During the dot-com bubble, do you think it was relatively easy or difficult for
Internet start-up companies to raise capital? Why?• Why do you think so many dot-coms failed? Explain with evidence.• What lessons might investors learn from the information presented in
documents A and C?
