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Chapter 11: Financial Markets
Section 1
Key Terms
• investment: the act of redirecting
resources from being consumed today so
that they may create benefits in the future
• financial system: the network of
structures and mechanisms that allows the
transfer of money between savers and
borrowers
• financial asset: a claim on the property or
income of a borrower
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Key Terms, cont.
• financial intermediary: an institution that
helps channel funds from savers to
borrowers
• mutual fund: an organization that pools
the savings of many individuals and
invests this money in a variety of stocks,
bonds, and other financial assets
• hedge fund: a private investment
organization that employs risky strategies
to try to make huge profits for investors
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Key Terms, cont.
• diversification: the strategy of spreading
out investments to reduce risk
• portfolio: a collection of financial assets
• prospectus: an investment report that
provides information to potential investors
• return: the money an investor receives
above and beyond the sum of money
initially invested
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Introduction
• What are the benefits and risks of saving
and investing?
– Savings you deposit in a bank will grow with
hardly any risk at all.
– Investing, while more risky, may yield a larger
return for your initial investment. It may also
prove to be financially devastating if it is illtimed or mismanaged.
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Investing and Free Enterprise
• Investing is essential to the free enterprise
system.
– It promotes economic growth and contributes
to a nation’s wealth.
– People deposit money into a savings account
and the bank lends this money to businesses.
– Businesses can then increase production,
which leads to expansion and growth.
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The Financial System
• Financial systems are established in an
economy so investments can take place.
• When people save money they are really
loaning it to other people.
– Savers receive a document, such as a
passbook or a bond certificate, that confirms
their purchase or deposit.
– These documents represent the claims, or
financial assets, of the borrower.
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Savers and Investors
• Financial systems bring together savers
and investors, or borrowers, which fuels
investment and economic growth.
– Savers include:
• Households
• Individuals
• Businesses
– Investors include:
• Businesses
• Government
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Financial Intermediaries
• Financial intermediaries, including banks and
other financial institutions, accept funds from
savers to make loans to investors.
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Sharing Risk
• Dealing with financial intermediaries offers three
advantages:
– Sharing risk
– Providing information
– Providing liquidity
• Sharing risk
– Diversification allows you to spread out your
investments so that you don’t put all of your money
into one single investment.
– Sharing risk helps ward against losing everything on a
bad investment.
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Types of Risk
• Investors must weigh the risks of investment
against the potential rate of return on their
investment.
– How does diversification lesson the risks described in
the chart?
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Providing Information and Liquidity
• By providing vital data, either in a portfolio or a
prospectus, financial intermediaries reduce the
costs in time and money that lenders and
borrowers would pay if they had to get the
information on their own.
• Financial intermediaries also help people get
access to their money when they need it,
depending on how liquid the investment is.
– Checkpoint: Why do savers and investors generally
work through financial intermediaries?
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Return and Risk
• Some investments, like CDs, are very safe
because they are insured by the government.
• Investing in a new business is far more riskier, but
if the business is
a success, the
return could be
very big.
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Return and Risk, cont.
• In general, the higher the potential return,
the riskier the investment.
• Whenever people evaluate their potential
investments, they must balance the risks
involved with the rewards they expect
to gain.
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Chapter 11: Financial Markets
Section 2
Key Terms
• coupon rate: the interest rate that a bond
issuer will pay to the bondholder
• maturity: the time at which payment to a
bondholder is due
• par value: a bond’s stated value, to be
paid to the bondholder at maturity
• yield: the annual rate of return on a bond
if the bond is held to maturity
• savings bond: a low-denomination bond
issued by the United States government
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Key Terms, cont.
• inflation-indexed bond: a bond that protects
the investor against inflation by its linkage to an
index of inflation
• municipal bond: a bond issued by a state or
local government or a municipality to finance a
public project
• corporate bond: a bond issued by a corporation
to help raise money for an expansion
• junk bond: a bond with high risk and potentially
high yield
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Key Terms, cont.
• capital market: a market in which money
is lent for periods longer than a year
• money market: a market in which money
is lent for periods of one year or less
• primary market: a market for selling
financial assets that can be redeemed only
by the original holder
• secondary market: a market for reselling
financial assets
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Introduction
• Why are bonds bought and sold?
– Bonds are sold by governments and or
corporations to finance projects.
– Bonds offer a higher return than savings
accounts, although they are generally riskier
than savings accounts.
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Bonds as Financial Assets
• Bonds are loans that represent debt that the
seller must repay to the investor.
• Bonds have three basic components:
– Coupon rate - the
interest rate that a
bond issuer
will pay to a bondholder
– Maturity - the time at
which payment to a
bondholder is due
– Par value - the amount
to be paid to the
bondholder at maturity
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Discounts From Par
• Investors can not only
earn money from the
interest on their
bonds but they can
also earn money by
buying bonds at a
discount, called a
discount from par.
– According to the chart,
how do interest rates
affect bond prices?
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Bond Ratings
• In order to decide which bonds to buy,
investors can check bond quality through
independent firms, such as Standard &
Poor’s and Moody’s, which publish bond
issuers’ credit ratings.
– These firms rate bonds on the issuer’s
financial strength, its ability to make future
interest payments, and its ability to repay the
principal when the bond matures.
– A high grade, such as AAA, means that the
bond is safe to invest in.
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Advantages and Disadvantages
• Advantages
– Once a bond is sold, the coupon rate remains
the same.
– The company does not have to share profits with
bondholders if it is doing well.
• Disadvantages
– The company must make fixed interest payments and
cannot change its interest payments.
– A firm’s bonds may be given a low bond rating and be
harder to sell when the firm is not doing well.
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Types of Bonds
• Savings Bonds
– Low-denomination
bonds issued by the
U.S. government, who
pays interest on the
bonds.
• Treasury Bonds, Bills,
and Notes
– The U.S. Treasury
Department issue
Treasury bonds, bills,
and notes, which are
among the safest
investments in terms of
default risk.
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Which of these three types of
government securities is the most
liquid?
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Municipal Bonds
• State and local
governments issue
municipal bonds to
finance such projects as
highways, libraries, parks,
and schools.
• These are attractive to
long-term investments
and are relatively safe.
– Checkpoint: What type
of bond might have been
used to fund the
construction of your
school?
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Corporate and Junk Bonds
• Corporate bonds are issued by corporation to help raise
money to expand business.
– These bonds have a
moderate risk level
because investors
must depend on the
corporation’s success.
• Junk bonds are bonds
with a high risk and a
potentially high return.
– Investors in junk bonds
face a strong possibility
that some of the issuing
firms will default on their
debt.
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Other Types of Financial Assets
• Certificates of Deposit
– CDs are available through banks, which lend
out funds deposited in CDs for a fixed amount
of time.
• Money Market Mutual Funds
– Investors receive higher interest on a money
market mutual fund than they would on a
savings account. These funds, however, are
not covered by FDIC insurance.
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Financial Asset Markets
• Bonds, CDs, and money market mutual funds
are traded on financial asset markets.
• One way to classify financial asset markets is
according to the length of time for which the
funds are lent.
– Capital Markets
• In these markets, money is lent for periods longer than
a year, like in a CD.
– Money Markets
• In these markets, money is lent for periods of a year or
less and include Treasury bills and money market
mutual funds.
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Financial Asset Market, cont.
• Markets may also be classified according to
whether or not assets can be resold to other
buyers.
– Primary Markets
• In a primary market, financial assets can be redeemed
only by the original holder. Examples include savings
bonds and small CDs.
– Secondary Markets
• In a secondary market, financial assets can be resold,
which provides liquidity to investors.
– Checkpoint: What are two ways of classifying
financial asset markets?
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Chapter 11: Financial Markets
Section 3
Key Terms
• share: a portion of stock
• capital gain: the difference between the selling
price and purchase price that results in a
financial gain for the seller
• capital loss: the difference between the selling
price and purchase price that results in a
financial loss for the seller
• stock split: the division of each single share of
a company’s stock into more than one share
• stockbroker: a person who links buyers and
sellers of stock
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Key Terms, cont.
• brokerage firm: a business that specializes in
trading stocks
• stock exchange: a market for buying and
selling stock
• futures: contracts to buy or sell commodities at
a particular date in the future at a price specified
today
• options: contracts that give investors the right to
buy or sell stock and other financial assets at a
particular price until a specified future date
• call option: a contract for buying stock at a
particular price until a specified future date
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Key Terms, cont.
• put option: a contract for selling stock at a
particular price until a specified future date
• bull market: a steady rise in the stock
market over a period of time
• bear market: a steady drop or stagnation
in the stock market over a period of time
• speculation: the practice of making highrisk investments with borrowed money in
hopes of getting a big return
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Introduction
• How does the stock market work?
– Stock, or shares in a company, are bought
and sold on the stock market.
– Stock brokers help individuals and businesses
invest their money in the stock market.
– Investors can keep track of the stock market
by checking their local paper. When the
market is doing well, people see a large return
on the initial investment. When it is not doing
well, people may lose a great deal of money.
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Benefits of Buying Stock
• Checkpoint: What are two ways that an investor
can make a profit from buying stocks?
• In addition to selling bonds, corporations can
raise money by selling stock
shares in that corporation.
• The benefits of buying
stock include:
– Dividends—part of the
firm’s profits
– Capital gains—selling
the stock for more than
you paid for it
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Types of Stock
• Stock may be classified by whether or not it pays
dividends.
– Income stock—provides investors with income by
paying dividends
– Growth stock—pays few or no dividends and earnings
are reinvested in the company
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Types of Stock, cont.
• Stock is also classified by whether or not
the holder has a voice in the company:
– Common stock: These holders are voting
members of the company.
– Preferred stock: These holders are nonvoting
members of the company.
• Common stock owners may initiate a stock
split when the price of a stock becomes to
high.
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Risks of Buying Stock
• Buying stock is risky
because the dividends
are determined by how
well a company is doing.
• Because of the laws
governing bankruptcy,
stocks are riskier than
bonds since bondholders
are paid before
stockholders when a
company goes bankrupt.
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How Stocks are Traded
• If you want to buy stock, you would first contact
a stockbroker to advise you on which stocks
to buy.
• You buy stocks on a secondary market known
as a stock exchange.
– The New York Stock Exchange is the country’s
largest and most powerful exchange, handling stock
and bond transactions for the top companies in the
United States and the world.
– The Nasdaq is the second largest securities market
and the largest electronic market.
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Futures and Options
• Futures are contracts to buy or sell
commodities at a particular date in the
future at a specified price today.
• Similarly, options are contracts that give
investors the choice to buy or sell stock
and other financial assets.
• Most people who buy stock hold their
investment for a significant period of time.
– Day traders, on the other hand, trade stocks
daily, which is very risky.
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Measuring Stock Performance
• When the stock market rises steadily over
a period of time it is known as a bull
market.
• When the stock market falls or stagnates
for a significant period it is a bear market.
• The Dow Jones Industrial Average
measures stock performance. It
represents the average value of a
particular set of stocks, and it is reported
as a certain number of points.
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The Great Crash
• Checkpoint: What was the Great Crash of 1929?
• In the 1920s, the stock market was soaring.
– Speculation and buying on margin, however, led to a crash
in the market that crippled
the U.S. economy.
• The Dow began steadily
dropping in September, 1929.
People began to sell their
shares and companies
couldn’t keep up with it. On
October 29, 1929, a record
16.4 million shares were
sold and the market crashed.
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The Aftermath
• The Crash led to the Great Depression.
– Many people lost everything—their homes, their jobs,
and their farms.
• After the Depression, many people saw stocks
as risky investments and avoided them.
• By the 1980s, with the development of mutual
funds, Americans became more comfortable
with stock ownership once again.
– The stock market crashed again in 1987 but was able
to recover much faster than in did in 1929.
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Scandals & the Stock Market Today
• By the 1990s, when people began once again to
buy more stock, investors started to worry that
many companies could not make enough money
to justify their high stock prices.
• The Enron scandal and others caused many
investors to question how much they knew about
the companies they invested in.
• In 2008, the stock market began falling, causing
a major economic crisis in the United States
once again.
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