Financial Markets Chapter 12

Chapter Essential Questions 12.1: What do the components of a financial system work together to accomplish? 12.2 What are the 4 markets for financial assets? 12.3 What do equities represent?

12.1 Savings and the Financial System

I. Saving and Capital Formation A. For economies to be effective, people must be willing to save. i. Saving: absence of spending ii. Savings: dollars that become available when people abstain from consumption. B. There is really only two things you can do with your income: Spend it or Save it.

C. When people save, they make funds available. i. Businesses can borrow savings to produce new goods and services. ii. Example: Jim wants to open a business. He needs to take out a loan from the bank with a high interest rate. Where does the bank get the money? Borrow from the savers and pay them a lower interest rate.

Saving is the absence of spending? 30 10 True False

II. Financial Assets and the Financial System A. People can save in a number of ways: i. Certificate of deposit: receipt showing that an investor has made an interest-bearing loan to a bank or government bond. ii. Financial Assets: claims on the property and the income of the borrower. iii. Summary: 1) Saver transfers funds to the borrower 2) Financial assets or receipts that certify the loans were made.

B. Circular flow of Funds Turn to page 315. Figure 12.1 i. Everybody can participate and benefits from the financial system. ii. Savers will have an outlet to save and borrowers will have a source of financial capital.

III. Financial Intermediaries YAHH!! A. Many surplus funds are placed in financial intermediaries. i. Financial institution that lend the funds that savers provide to borrowers. a. Ex: Pension funds, life insurance, depository institutions.

IV. Non Bank Financial Intermediaries A. Finance Companies i. Firm that specializes in making loans directly to consumers and in buying installment contracts from merchants who sell goods on credit. B. Life Insurance Companies i. The head of a family, for example, purchases a life insurance policy to leave money for family in case of death. ii. Must pay a premium which is price paid for policy monthly, quarterly, or annually.

…continued C. Mutual Funds D. Pension Funds i. Company that sells stock in itself rather to individual investors and then invests the money it receives in stocks and bonds issued by other corporations. ii. Mutual funds are less risky because it is not all in one corporation. D. Pension Funds i. Regular payment intended to provide income security to someone who has worked a certain number of years, certain age, or suffered a certain injury. End 12.1

12.1 EQ Q: What do the components of a financial system work together to accomplish? A: They work together to transfer savings to investors.

12.2 Investment Strategies and Financial Assets

I. Basic Investment Considerations A. The United States offers different types of investments. B. There are several factors when you invest in financial assets: 1) The relationship between risks and returns. 2) The investor’s personal investment goals. 3) Avoiding some types of investments. 4) The consistency of investing.

Risk, Return, & Goals C. Risk: situation in which the outcome is not certain. i. Financial assets are risky and investors must realize what they are getting into. D. Investment Objectives i. An investor must decide what to save for. a. Ex: Retirement, car, college, etc. ii. If an investment seems too complicated, then ignore it. Do not fall for gimmicks. iii. Invest consistently over a long period of time. a. Turn to page 320. Figure 12.3.

What is a 10% annual interest rate accumulated over 25 years What is a 10% annual interest rate accumulated over 25 years? (Given the book information on $10 monthly deposits) $22,605 $13,268 $ 7,594 $ 14,904 10

E. 401K Plans i. A tax deferred investment and savings plan that acts as a personal pension fund for employees. a. Fund deducted from pay check, which are than invested in mutual funds. b. More than 80% of employers match the employer’s contribution by 25%-100%. c. The 401k provides a simple, consistent, and relatively safe way for employees to save.

II. Bonds as Financial Assets A. When the government needs to borrow funds for long-periods, they often issue bonds. Long term obligations that pay a stated rate of interest for a specified number of years. B. A bond has 3 main components: 1) Coupon: stated interest on the bond. 2) Maturity: life of the bond. 3) Per Value: Principal or total amount that must be repaid to the lender.

III. Financial Assets and their characteristics A. Certificates of deposit i. One of the most common forms of investments. ii. Loans that investors make to financial institutions. a. Financial institution sets a term and limit on the CD. Ex: 8 months @ 4.25% 12 months @ 4.75% 60 months @ 5.05 % b. The bank then loans out the money at a higher interest rate.

D. Government Savings Bonds B. Corporate Bonds i. Bonds issued by corporations. C. Municipal Bonds i. Bonds issued by state and local government. ii. Municipal bonds are tax-exempt a. The federal government does not tax the interest paid to investors. D. Government Savings Bonds i. Low denomination, nontransferable bonds issued by the United States government.

E. Individual Retirement Accounts i. IRA’s are long term, tax-sheltered time deposits that an employee can set up as part of a retirement plan. ii. Roth IRA IRA who contributions are made after taxes so that no taxes are taken out at maturity.

IV. Markets for Financial Assets A. Capital Markets i. A market where money is loaned for more than one year long. ii. Ex: IRA’s, CD’s, mutual funds. B. Money Markets i. Market where money is loaned for periods of less than one year. ii. Ex: CD’s, Mutual Funds Note: If a person invests in a CD over one year than they are involved in a capital market. If a person invests in a CD less than one year than they are involved in a money market.

C. Primary Markets D. Secondary Markets i. Market where only the original issuer can repurchase or redeem a financial asset. ii. Ex: CD’s, Government Bonds a. Investors tend to cash in short term CD’s and Government Bonds early when cash is needed. D. Secondary Markets i. Market in which existing financial assets can be resold to new owners. ii. Ex: Take over a CD, Bond, etc. End 12.2

12.2 EQ Q: What are the 4 markets for financial assets? A: Capital, Money, Primary and Secondary

12.3 Investing in Equities, Futures and Options

I. Investing A. Equities: B. Market Efficiency i. Stocks that represent ownership shares in corporations. B. Market Efficiency i. Efficient Market Hypothesis (EMH) a. Argument that stocks are always priced about right and that bargains are hard to find because they are followed closely by so many investors. Ex: There are an estimated 100,000 full time, highly trained, professional analysts in the market. 3,000 major stocks in the stock market. Equals about 30 analysts per stock. They relay new information, stock updates, etc.

….continued C. Portfolio Diversification Stock Broker i. Practice of holding a large number of different stocks so that increases in some can offset unexpected decline in others. ii. Highly recommended. Stock Broker i. Person who buys and sells equities for its clients. ii. The broker arranges to have the stocks purchased at a stock exchange.

II. Organized Stock Exchanges A. A number of securities exchanges exist. i. Places where buyers and sellers meet to trade securities.

B. The New York Stock Exchange (NYSE) i. Oldest, largest, most prestigious stock exchange in the United States. ii. NYSE located on Wall Street in NYC. iii. NYSE had 1,400 seats (memberships) on trading floor. a. Brokerage companies such as Merrill Lynch are on floor. b. NYSE lists about 2,800 companies.

C. American Stock Exchange (AMEX) Located in NYC listing about 750 companies.

D. Regional Stock Exchanges i. Chicago, Pacific, Philadelphia, Boston, and Memphis. ii. Regional Stock Exchanges meet the needs of the smaller and middle-sized corporations in their regions.

E. Global Stock Exchanges i. Stock Exchanges through the world such as Sydney, Tokyo, Hong Kong, Singapore, Frankfurt. ii. Developments in computer and internet technology has made it easier for people to trade stocks around the clock.

Discussion Question Q: What happens on the floors of the stock exchange? A: Shares are bought and sold

III. Over the Counter Markets A. The majority of stocks are trades through an over the counter marker (OTC) i. Electronic marketplace for securities that are not traded on an organized exchange. B. Most important OTC exchange is the National Association of Securities Dealers Automated Quotation (NASDAQ) i. 4,000 small and large companies listed.

IV. Stock Performance A. Dow-Jones Industrial Average Most popular and widely publicized measure of stock market performance on the NYSE. i. The average closing price of 30 major stocks. ii. Complicated mathematical equation. iii. Focus on the change in percentage. B. Standard & Poor's 500 i. S&P 500 uses the price changes of 500 representative stocks as an indicator of overall market performance.

V. Bull vs. Bear Markets A. Bull Market B. Bear Market Strong market with the prices moving up for several months or years in a row. B. Bear Market A mean market with the prices declining sharply for several months or years in a row.

12.3 EQ Q: What do equities (aka stocks) represent? A: Ownership of a corporation