1. Financial Markets

2. 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.

3. Savings and Investment
Section-1
Savings and Investment
The Financial System
KEY 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. Investing in a Market Economy
Section-2
Investing in a Market Economy
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

13. 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

14. 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

15. 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

16. 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

17. 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

18. Reviewing Key Concepts
Use each of the three terms below in a sentence that illustrates the meaning of the term:
investment objective
Return
diversification

19. Buying and Selling Stocks
Section-3
Buying and Selling Stocks
The Stock Market
KEY 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. Bonds and Other Financial Instruments
Section-4
Bonds and Other Financial Instruments
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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. Reviewing Key Concepts
Use each of the terms below in a sentence that illustrates the meaning of the term:
coupon rate
Maturity
yield

39. 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?

40. The Rise and Fall of Dot-Coms {continued}
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?

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